**UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549**

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**FORM 10-KSB**
| **x**      | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d)  OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|------------|------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                     |
| ** ** | **For the fiscal year ended December 31, 2006**                                                |
| ** ** | ** **                                                                                     |
| **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 Issuer in Its Charter)

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

 

**1601 Cloverfield Boulevard, Suite 400 South, Santa Monica,California 90404-4082**(Address of Principal Executive Offices, including Zip Code)

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

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Securities registered pursuant to Section 12(b) ofthe Act:  **None**

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

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

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

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

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

State issuer’srevenues for its most recent fiscal year. $24,062,000.

As of April 13,2007, the aggregate market value of the voting common stock held bynon-affiliates of the registrant was approximately $14,023,054, based on theclosing price per share of $2.10 for the registrant’s common stock as reportedon the Over-the-Counter Bulletin Board on such date.

As of April 11,2007, there were 10,217,291 shares of the registrant’s common stock, par value$0.01 per share, issued and outstanding.

Transitional SmallBusiness Disclosure Format. Yes oNo x

Documentsincorporated by reference:  None.

 

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

**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 AND CORPORATE GOVERNANCE;  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 TRANSACTIONS, AND DIRECTOR INDEPENDENCE                                                                      |   |   |
|              |   |                                                                                                                                            |   |   |
| ITEM  13.         |   | EXHIBITS                                                                                                                                        |   |   |
|              |   |                                                                                                                                            |   |   |
| ITEM 14.          |   | PRINCIPAL  ACCOUNTANT FEES AND SERVICES                                                                                                         |   |   |
|              |   |                                                                                                                                            |   |   |
| SIGNATURES        |   |                                                                                                                                            |
|              |   |                                                                                                                                            |   |   |
| POWER OF ATTORNEY |   |                                                                                                                                            |

 

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**NOTE CONCERNING FORWARD-LOOKING STATEMENTS**

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

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

**PART I**

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

**General**

Incorporated underthe laws of the****State of Delawarein July 1999, we were exclusively 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 also became aprovider of anti-piracy solutions in the Internet piracy protection industryand in the second quarter of 2006, became a provider of Internet-basedmarketing services. Our MediaDefender subsidiary was responsible forapproximately 65% of our total revenues in 2006 which was the first full fiscalyear that MediaDefender operated as our subsidiary. Below is an overview of ourthree business segments:

·                  *Internet Piracy Prevention.*Our Internetpiracy prevention (“IPP”) segment is currently operated by MediaDefender, as awholly-owned subsidiary of ARTISTdirect. MediaDefender’s proprietary suite ofIPP solutions offers significant levels of protection on major peer-to-peer (“P2P”)file-sharing networks. MediaDefender’s uber-level solutions are capable ofproviding up to 95% effectiveness in preventing unauthorized downloads ofcustomer-specified content. Although MediaDefender was acquired by us in thethird quarter of fiscal 2005, our IPP segment accounted for 43% of our revenueduring the fiscal year ended December 31, 2005. Our IPP segment accounted for approximately 65%  of our revenue during the fiscal year endedDecember 31, 2006 which was the first full fiscal year that MediaDefenderoperated as our subsidiary.  In 2006MediaDefender launched its new file sharing network marketing service.  This service leverages MediaDefender’sability to capture search requests for entertainment content made by P2P usersand respond with high quality legitimate content.  This content can range from branded contentto advertisements to free promotional material. MediaDefender charges customers per file it distributes to the massiveP2P audience.  Refer to “MediaDefenderOverview-Internet Anti-Piracy Segment” and “Media Defender Acquisition” belowfor additional information.

·                  *Media.*Our media operations include ourcontent-oriented web-sites, a network of third party music sites and ourentertainment marketing initiatives. Revenue from media operations is generatedfrom the sale of online advertising and integrated marketing solutions. Wemarket and sell advertising on a cost-per-impression basis to advertisingagencies and directly to various companies as part of their marketing programs.Customers may purchase advertising space for the entire ARTISTdirect network,or they may tailor advertising based on music genre (e.g., jazz, country orrock music) or based on functionality (e.g., directing advertising to customersusing music download features or broadband-only features of the ARTISTdirectnetwork). Since we are increasingly aware of web-sites outside the ARTISTdirectnetwork that are frequently visited by artists and music fans, we have alsooffered our customers advertising space on behalf of third party music-relatedweb-sites. Our media segment accounted for approximately 24% and approximately38% of our revenue during the fiscal years ended December 31, 2006 and2005, respectively. Refer to “ARTISTdirect Overview-Media and E-CommerceSegments” below for additional information.

·                  *E-Commerce.*E-commerce operations consistof the sale of recorded music and artist-related merchandise on our web-sites.Most of our sales come from our ARTISTdirect shopping area, which offers acomprehensive selection of music CDs and broad range of artist and lifestylemerchandise. Our e-commerce segment accounted for approximately 11% andapproximately 19% of our revenue during the fiscal years endedDecember 31, 2006 and 2005, respectively. 

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

At December 31,2006, we employed 74 full-time employees and five consultants, none of whom arecovered by a collective bargaining agreement. We believe that our relationshipwith our employees and consultants is good.

**MediaDefenderAcquisition**

We consummated theacquisition of MediaDefender in July 2005. The aggregate consideration for theacquisition was $42.5 million in cash, subject to a holdback of $4.25 millionwhich was placed into an escrow account to cover certain indemnification claimsfor a limited period of time.  The entireholdback has been released in accordance with the terms of the mergeragreement. Concurrent with the consummation of the acquisition, we completed a$15.0 million senior secured debt transaction and a $30 million convertiblesubordinated debt transaction. Refer to “Item 6. Management’s Discussion andAnalysis or Plan of Operation – Acquisition of MediaDefender and RelatedTransactions” for additional information related to the financing transactions.

**RecentDevelopments**

*FinancialRestatements*

On December 20,2006, the Audit Committee of our Board of Directors (the “Audit Committee”)determined that we will need to restate the financial statements contained inour Annual Report of Form 10-KSB/A for the fiscal year ended December 31, 2005and Quarterly Reports on Form 10-QSB or Form 10-QSB/A for the quarterly periodsended September 30, 2005, March 31, 2006, June 30, 2006 and September 30, 2006.  The determination was made by the AuditCommittee following our receipt of comments from the staff (the “Staff”) of theSecurities and Exchange Commission (the “SEC”), and following consultation withour senior management, financial advisors and our independent registered publicaccounting firm.  The Staff advised us toconsider Emerging Issues Task Force 00-19, “Accounting for Derivative FinancialInstruments Indexed to, and Potentially Settled in, a Company’s Own Stock” (“EITF00-19”) and, in light of the guidance set forth in EITF 00-19, to furtherevaluate the accounting treatment of certain embedded features contained in ourfinancing documents entered into in connection with the acquisition ofMediaDefender.  We filed the restatedfinancial statements on April 19, 2007. However, the Staff has not yet indicated whether they may have furthercomments.  The adjustments to theFinancial Statements with respect to the restatements were non-cash in natureand were not caused by or related to any changes in the underlying performanceof the Company’s business, including revenues, operating costs and expenses,operating income or loss, operating cash flows or adjusted EBITDA. However, such restatements had a material negative impact on the Company’spreviously reported results of operations and earnings per share, currentliabilities, net working capital and shareholders’ equity (deficiency).

As of a result ofthe restatement and the impact of the change in our accounting treatment due toEITF 00-19, various events of default have been triggered under the senior debtand subordinated debt financing documents entered into in connection with theacquisition of MediaDefender described above. In addition, the Company breached its covenant to maintain an effectiveregistration statement covering the resale of shares of common stock underlyingthe various securities issued to the holders of our senior notes andsubordinated notes, in accordance with the registration rights agreementsentered into with such holders.  On April17, 2007, the Company entered into a Forebearance and Consent Agreement withthe holders of our senior notes wherein the holders agreed to forebear fromexercising their rights and remedies through May 31, 2007 in exchange for apayment by the Company of $250,000, in the aggregate, to the holders (pleasesee below).  The Company may extend theforbearance period through June 30, 2007 by paying the holders an additional$125,000 in the aggregate.  Thesepayments will be credited against amounts due the holders of the senior notes.Please see “Item 6. Management’s Discussion and Analysis or Plan of Operation –Acquisition of MediaDefender and Related Transactions – Impact of Restatement”for a further discussion of the impact on this restatement and theforebearance.

*Forbearance and Consent Agreement*

On April 17, 2007, the Company entered into a Forbearance andConsent Agreement (the “Agreement”) with the lenders (“Senior Lenders”) in the$15 million (approximately $13,307,000 of which is currently outstanding)senior financing (“Senior Financing”) completed by the Registrant effectiveJuly 28, 2005 in conjunction with the acquisition ofMediaDefender, Inc., whereby the Senior Lenders agreed to forbear fromexercising any of their rights and remedies under the Senior Financingtransaction documents (“Senior Documents”) through May 31, 2007 inexchange for a payment by the Registrant of $250,000, in the aggregate, to theSenior Lenders, and upon the other terms and conditions in the Agreement.  The Senior Lenders rights and remedies weretriggered by the various defaults by the Company of the Senior Documents.  The Company may extend the forbearance periodthrough June 30, 2007 by notifying the Senior Lenders of its intention toextend the Agreement prior to May 31, 2007 and paying an additional$125,000, in the aggregate, to the Senior Lenders on or before May 31,2007.  The terms of the Senior Financing,the Company’s acquisition of MediaDefender, Inc. and related transactionswere previously disclosed by the Company in a Current Report on Form 8-K (“Form 8-K”)filed with the SEC on August 3, 2005 and as subsequently amended.

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In addition, the Company previously disclosed in aForm 8-K filed with the SEC on January 24, 2007, that it hadtriggered an event of default under the Senior Documents thereby allowing theSenior Lenders to declare the outstanding principal amount and accrued interestdue under the Senior Financing immediately due and payable.

**MediaDefenderOverview- Internet Anti-Piracy Segment**

MediaDefender wasincorporated under the laws of the State of Delaware in July 2000 as a providerof anti-piracy solutions in the high-growth IPP industry. We completed theacquisition of MediaDefender in the third quarter of fiscal 2005. MediaDefender’ssolutions have been adopted by major entertainment companies as a practicalmeans to thwart Internet piracy and drive consumers to pay for digitizedcontent distributed through authorized Internet sites.  In 2006 MediaDefender launched its new filesharing network marketing service.  Thisservice leverages MediaDefender’s ability to capture search requests forentertainment content made by P2P users and respond with high qualitylegitimate content.  This content canrange from branded content to advertisements to free promotional material.  MediaDefender charges customers per file itdistributes to the massive P2P audience. MediaDefender sales represented approximately 65% of the Company’s totalrevenues in 2006.

*Internet-BasedPiracy.*Piracy has long been and continues to be a problemfor the global content industries. The International Intellectual PropertyAlliance (“IIPA”) estimates that commercial piracy alone costs the U.S. contentindustries approximately $20 billion to $22 billion in lost sales each year.Historically, most consumer participation in piracy required a transaction witha third-party vendor. The advance of new technologies has served to makeanonymous the illegal distribution and consumption of content. This has beenfollowed by a fundamental shift in consumer behavior; piracy in the Internetage is now viewed as an acceptable activity that millions of people around theworld no longer consider illegal or immoral. In the past five years,Internet-based P2P file-sharing networks have emerged as the greatest threat tothe future of content companies.

Due to therelatively small size of MP3 files, music was the first industry to be impactedby Internet piracy. From 1999 to 2003, total music sales in the U.S. declinedby approximately 25%, or $3.7 billion. The 2.3% increase in 2004 album salesmay be partially attributed to the increased use of anti-piracy solutions bymusic companies.  Based on data compiledby The Recording Industry Association of America, or RIAA, the number of CDsshipped from record companies to retail distribution channels fellapproximately 13% in 2006, as compared to the previous year. U.S. music salesdeclined 6.2% in 2006 as higher digital revenue failed to counter illegalcopying and a drop in purchases of CDs. Retail music sales decreased to $11.5 billion in 2006 from $12.3 billionin 2005. This decline represents the greatest drop since 2002, when shippedunits and dollar value fell by 8.9% and 6.7%, respectively.  According to the RIAA, the decline, in saleshad been due in part, to widespread copying and illegal Internet downloading ofmusic.  The growth of broadband Internetaccess is now making larger-sized files, such as movies, software and videogames, similarly vulnerable to Internet-based piracy. Already, the majority ofmotion pictures are available in some form on the Internet before theatricalrelease.

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

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

MediaDefender’ssuite of IPP solutions currently covers the major P2P file-sharing networksthat constitute over 95% of all P2P file-sharing activity and consists of  spoofing, decoying, interdiction,counterposting and queuing. MediaDefender’s IPP solutions are typicallydeployed together, in degrees that vary according to customer preference.

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

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The primary means bywhich MediaDefender’s solutions hinder illegal Internet file-sharing anddownloading include:

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

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

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

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

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

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

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

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

·                  The piracyproblem’s size and nature for each individual release;

·                  When particularcopyrighted materials should be protected;

·                  The IP addressesof individuals who are downloading copyrighted content;

·                  How often aspecific title is requested;

·                  How often atitle is illegally shared; and

·                  Demographics ofillegal sharers.

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

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

*PatentPending Technology.*MediaDefender’s IPP solutions utilizeproprietary software and a robust, scalable IT platform of approximately 1,852servers and 6.0 gigabytes of bandwidth capacity. This patent-pendingcombination of software and IT was created over time and based upon 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 redundantsystems, combined with constant monitoring, allows MediaDefender to providecontinuous coverage and rapidly address potential technical problems.

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*IntellectualProperty.*In December 2002, MediaDefender filed an umbrellapatent application that covers a variety of its concept and back-endtechnologies, which is still pending. Due to the evolving nature of P2P networks,these technologies are not based on any one service, but rather have thefluidity to be transferred to any P2P network. The claims in the patent filingare predominantly methods for managing a large array of computers for thepurpose of preventing piracy on P2P networks.

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

*Customersand Target Markets.*MediaDefender’s current customers includefour major record labels and six major movie studios.  Approximately 73% of MediaDefender’sconsolidated revenues were from four customers. Of those four customers, two customers accounted for 27.0% and 25.0%,respectfully, of MediaDefender’s revenues during the year ended December 31,2006.

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

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

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

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

*Technology*.Our infrastructure is designed to be integrated, scalable, reliable and secure.The software that we use supports the acquisition, management and publicationof content on our web-sites. During fiscal 2006, the management of ourweb-sites and servers for content, applications, database and electroniccommerce was handled internally. Our servers are maintained at IX2 Networks,LLC, a co-location facility in Los Angeles, California. Our operations dependon our and IX2’s ability to protect our systems against fire, power loss,telecommunications failure, break-ins and other events. All web-sites, servers,and systems are monitored and periodic backups are stored at our data center.

Our currente-commerce system is based on systems, applications and products (“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.

*OrderProcessing and Fulfillment.*Our web-sites include an orderingsystem that is designed to facilitate convenient online purchasing ofpre-recorded music and merchandise. Customers can add items to their “shoppingcart” while surfing our web-sites. At any time they can securely “checkout,” atwhich time they need to register (if they are new customers), or enter theirregistered username and password to retrieve previously saved billing, shippingand credit card information. We verify orders submitted for credit card paymentfor fraud detection and sufficient funds before we release the order forfulfillment. We also accept alternative modes of payment, such as checks andmoney orders. Credit card numbers are encrypted, and all customer, commerce andtransactional data are stored in secure databases protected by firewalls. Thetransmission of information over the Internet uses Secure Socket Layer securitytechnology verified by VeriSign, an industry leader in online security.

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

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

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

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

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

We use a number ofmethods to create awareness of the ARTISTdirect network designed to drivetraffic to our web-sites. We have focused much of our marketing activity one-mail direct marketing to communicate with registered users about specificartists and the ARTISTdirect network. Campaigns have included directnotification of special merchandise offers, contests, promotions and available musicdownloads. To the extent our registered users in the future opt out of e-mailsor use technology to block marketing e-mails, our operating results could beadversely affected. Ad-blocking technologies may be used to limit theeffectiveness of web advertising.

*Customers.*During the year ended December 31, 2006,  one customer accounted for $730,000 or 13% oftotal media revenue.  During the yearended December 31, 2005, one customer accounted for $1.79 million, or 34.0% oftotal media revenue. No other customer accounted for more than 10.0% of ourmedia or e-commerce revenue during 2005.

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

·                  for musicconsumers and advertisers with providers of music information, community andcontent such as MTV, America Online, MSN, Yahoo!, Listen.com, myspace.com,mp3.com, billboard.com and various other companies;

·                  with majoronline music retailers such as Amazon.com and iTunes Music Store in sellingmusic and merchandise;

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

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

·                  with traditionalretailers targeting music consumers, including Tower Records and VirginMegastore and their Internet affiliates, in selling music and merchandise.

Our competitorshave worked together to offer music over the Internet, and we may faceincreased competitive pressures as a result. For instance, RealNetworks, TimeWarner, Bertelsmann AG and EMI Group formed MusicNet, a digital musicsubscription platform featuring on-demand downloads and streaming. In addition,YouTube, which is owned by Google, Inc., has enabled the widespread sharing ofmusic videos by its users on its website. Various retailers such as BestBuy have cooperated to distribute musicthrough the iTunes platform. We believe that we are able to compete effectivelyon the basis of:

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

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

·                  the ease of useand consumer acceptance of the ARTISTdirect network.

7

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

·                  longer operatinghistories;

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

·                  greater brandname recognition;

·                  larger existingcustomer bases; and

·                  more popular contentor artists.

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

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

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

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

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

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

Because we haveposted a privacy policy pertaining to all users and visitors to our web-site,we are subject the jurisdiction of the FTC. We may also be subject to the laws and regulations of other states, forexample we are aware that California passed the California Online PrivacyProtection Act, which took effect July 1, 2004 and mandates content and postingrequirements for web-sites privacy policies of web-sites that collect personalinformation from California residents. While we are attempting to be fullycompliant with the FTC and California requirements, our efforts may not be entirelysuccessful. In addition, at times we rely upon outside vendors to maintaindata-collection software, and there can be no assurance that they will at alltimes comply with our instructions to comply with COPPA, our Privacy Policy andFTC and California or other state requirements. If our methods of complyingwith these requirements are inadequate, we may face litigation with the FTC,California governmental authorities or individuals, which would adverselyaffect our business. Should any of our business practices be found to differfrom our privacy policy, we could be subject to sanctions and penalties fromthe FTC or injunctions and penalties from California governmental authorities.It is also possible that users or visitors could try to recover damages in acivil action as well. Attorney Generals in various States also have in the pastsought to enforce posted privacy policies and may continue to do so in thefuture.

8

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

*Conformanceto E-Commerce Statutory Requirements for Formation of Contracts.*Weconduct e-commerce on our web-sites, and through affiliated web-sites. Theapplicable law on online formation of contracts is evolving. On June 30,2000, the federal government enacted the Electronic Signatures in Global andNational Commerce Act (“E-SIGN”), which provides that certain electronicsignatures and electronic contracts with consumers, of the type that we enterinto, are not unenforceable solely because they are electronic.  E-SIGN also specifies requirements forelectronic record retention.  OnJanuary 1, 2000, California adopted a version of the Uniform ElectronicTransactions Act (“UETA”), which also permits electronic signatures andrecord-keeping for certain types of contracts. Forty-six states have adopted a version of UETA.  Because all state-UETA laws are not identical,and the state-UETA laws are not all identical, there are potentiallyconflicting requirements applicable to electronic signatures and electroniccontracts.  We attempt to comply withthese laws, but there is no guarantee that we will be successful.   Judicial interpretation or issuance ofgovernmental regulations interpreting E-SIGN and potentially conflicting State UETA laws with regard to contracts ofthe type entered into by our customers through out web-sites and affiliatedweb-sites could result in customer contracts being set aside or modified. Inthat case, our e-commerce revenue could be materially adversely affected.

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

*OnlineContests and Sweepstakes.*We conduct online promotional contestsand sweepstakes. No purchase is necessary to participate. Our official rules,with material terms and conditions, eligibility restrictions, dates ofparticipation, methods of entry, prize descriptions and restrictions, and oddsof winning, are posted on our web-sites. To avoid having to register and bondour online promotions in the states of New York and Florida, the approximateretail value of the prizes we offer is generally less than $5,000 for a singlepromotion.****Although we structureour promotions in a way that attempts to comply with applicable statutes as webelieve they are currently interpreted and enforced in all fifty states, manyof those statutes were drafted long before the advent of promotions over theInternet, and different states have interpreted substantially similar statutesdifferently. Thus, our ability to conduct online promotions is subject to thebroad discretionary enforcement powers vested in various authorities. Further,our ability 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 to liabilityor lose an effective tool for increasing traffic to and keeping visitors at ourweb-sites, and our business could be adversely affected.

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

We seek to protectmany of our innovations as trade secrets and principally rely upon trade secretand contract law in the Unites States to protect our proprietary rights. Wegenerally enter into confidentiality agreements, “work-made-for-hire” contractsand intellectual property licenses with our employees, consultants andcorporate partners, respectively, as part of our efforts to control access toand distribution of our technologies, content and other 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.

9

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The following sets fortha schedule of our active trademarks:

Federal Trademark Filings
| **MARK**                | ** ** | **APPL. NO.** | ** ** | **REG. NO.** | ** ** | **REG. DATE**  | ** ** |
|-------------------------|------------|--------------------|------------|-------------------|------------|---------------------|------------|
|                    |       |               |       |              |       |                |       |
| ARTISTDIRECT            |       | 75927362           |       | 2742630           |       | July  29, 2003      |       |
| CORPORATE LOGO          |       | 76072567           |       | 2764726           |       | September  16, 2003 |       |
| CORPORATE LOGO          |       | 76072566           |       | 2457335           |       | June  5, 2001       |       |
| CORPORATE LOGO          |       | 76072563           |       | 2469613           |       | July  17, 2001      |       |
| CORPORATE LOGO          |       | 76072562           |       | 243501            |       | July  31, 2001      |       |
| CORPORATE LOGO          |       | 76072561           |       | 2473500           |       | July  31, 2001      |       |
| CORPORATE LOGO          |       | 76072560           |       | 2524524           |       | January  1, 2002    |       |
| THE ULTIMATE  BAND LIST |       | 75306059           |       | 2407553           |       | November  28, 2000  |       |
| ARTISTDIRECT            |       | 75418187           |       | 2355839           |       | June  6, 2000       |       |
| ARTISTDIRECT            |       | 75061781           |       | 2288100           |       | October 19, 1999    |       |

 

State Trademark Filings
| **MARK**                | ** ** | **STATE**    | ** ** | **REG. NO.** | ** ** | **REG. DATE**  | ** ** |
|-------------------------|------------|--------------|------------|-------------------|------------|---------------------|------------|
|                    |       |         |       |              |       |                |       |
| THE ULTIMATE  BAND LIST |       | Puerto  Rico |       | 50161             |       | 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          |       | 1988933           |       |               |       |
| 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          |       |

 

10

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| ARTISTDIRECT            |   | Argentina       |   | 2,264,378     |   | 1886206  |   | 9/20/2002  |   |
|-------------------------|--------|-----------------|--------|---------------|--------|----------|--------|------------|--------|
| ARTISTDIRECT            |   | Argentina       |   | 2,264,379     |   | 1886207  |   | 9/20/2002  |   |
| ARTISTDIRECT            |   | Argentina       |   | 2,264,380     |   | 1886208  |   | 9/20/2002  |   |
| ARTISTDIRECT            |   | Argentina       |   | 2,264,381     |   | 1886209  |   | 9/20/2002  |   |
| ARTISTDIRECT            |   | Argentina       |   | 2,374,721     |   | 1920978  |   | 4/3/2003   |   |
| ARTISTDIRECT            |   | Australia       |   | 818867        |   | 818867   |   | 12/30/1999 |   |
| ARTISTDIRECT            |   | Australia       |   | 908101        |   | 908101   |   | 3/28/2002  |   |
| ARTISTDIRECT            |   | Canada          |   | 864116        |   | 512153   |   | 5/25/1999  |   |
| ARTISTDIRECT            |   | Chile           |   | 471162        |   | 574481   |   | 8/18/2000  |   |
| ARTISTDIRECT            |   | Chile           |   | 471163        |   | 574480   |   | 8/18/2000  |   |
| ARTISTDIRECT            |   | Chile           |   | 471161        |   | 574482   |   | 8/18/2000  |   |
| ARTISTDIRECT            |   | Chile           |   | 471160        |   | 574469   |   | 8/18/2000  |   |
| ARTISTDIRECT            |   | Costa  Rica     |   | 1999-0010547  |   | 121896   |   | 8/24/2000  |   |
| ARTISTDIRECT            |   | Costa  Rica     |   | 1999-0010548  |   | 121134   |   | 7/27/2000  |   |
| ARTISTDIRECT            |   | Costa  Rica     |   | 1999-0010549  |   | 121133   |   | 7/27/2000  |   |
| ARTISTDIRECT            |   | Costa  Rica     |   | 1999-0010550  |   | 121132   |   | 7/27/2000  |   |
| ARTISTDIRECT            |   | Costa  Rica     |   | 2002-0003185  |   | 136854   |   | 1/21/2003  |   |
| ARTISTDIRECT            |   | European  Union |   | 699538        |   | 699538   |   | 6/5/2000   |   |
| ARTISTDIRECT            |   | France          |   | 23158011      |   | 23158011 |   | 4/8/2002   |   |
| ARTISTDIRECT            |   | Germany         |   | 30217395.1/09 |   | 30217395 |   | 4/5/2002   |   |
| ARTISTDIRECT            |   | Japan           |   | 183723/1997   |   | 4359836  |   | 2/10/2000  |   |
| ARTISTDIRECT            |   | Japan           |   | 2002-24588    |   | 4648626  |   | 2/28/2003  |   |
| ARTISTDIRECT            |   | Mexico          |   | 409261        |   | 645860   |   | 3/22/2000  |   |
| ARTISTDIRECT            |   | Mexico          |   | 409262        |   | 645861   |   | 3/22/2000  |   |
| ARTISTDIRECT            |   | Mexico          |   | 409263        |   | 649514   |   | 3/31/2000  |   |
| ARTISTDIRECT            |   | Mexico          |   | 409264        |   | 645862   |   | 3/22/2000  |   |
| ARTISTDIRECT            |   | Mexico          |   | 541632        |   | 743912   |   | 4/29/2002  |   |
| ARTISTDIRECT            |   | Panama          |   | 105638        |   | 105638   |   | 2/15/2001  |   |
| ARTISTDIRECT            |   | Panama          |   | 105641        |   | 105641   |   | 2/15/2001  |   |
| ARTISTDIRECT            |   | Panama          |   | 105640        |   | 105640   |   | 2/15/2001  |   |
| ARTISTDIRECT            |   | Panama          |   | 105642        |   | 105642   |   | 2/15/2001  |   |
| ARTISTDIRECT            |   | Peru            |   | 99622         |   | 22837    |   | 9/12/2000  |   |
| ARTISTDIRECT            |   | Peru            |   | 99623         |   | 22761    |   | 9/8/2000   |   |
| ARTISTDIRECT            |   | Peru            |   | 99624         |   | 22762    |   | 9/8/2000   |   |
| ARTISTDIRECT            |   | Peru            |   | 099625-2000   |   | 25765    |   | 5/24/2001  |   |
| ARTISTDIRECT            |   | Peru            |   | 151884-2002   |   | 82854    |   | 9/4/2002   |   |
| ARTISTDIRECT            |   | United  Kingdom |   | 2296996       |   | 2296996  |   | 10/4/2002  |   |
| ARTISTDIRECT            |   | Venezuela       |   | 2000-003045   |   | S-015483 |   | 11/22/2000 |   |
| ARTISTDIRECT            |   | Venezuela       |   | 2000-003043   |   | S-015481 |   | 11/22/2000 |   |
| ARTISTDIRECT            |   | Venezuela       |   | 2000-003044   |   | S-015482 |   | 11/22/2000 |   |
| ARTISTDIRECT            |   | Venezuela       |   | 2000-003042   |   | S-015480 |   | 11/22/2000 |   |
| ARTISTDIRECT  DIGITAL   |   | Japan           |   | 2002-095128   |   | 4688729  |   | 7/4/2003   |   |
| THE ULTIMATE  BAND LIST |   | Argentina       |   | 2.119.984     |   | 1720730  |   | 2/10/1999  |   |
| THE ULTIMATE BAND  LIST |   | Argentina       |   | 2.119.985     |   | 1720731  |   | 2/10/1999  |   |
| THE ULTIMATE  BAND LIST |   | Australia       |   | 750646        |   | 750646   |   | 12/9/1997  |   |
| THE ULTIMATE  BAND LIST |   | Brazil          |   | 820399086     |   | *        |   |       |   |
| THE ULTIMATE  BAND LIST |   | Canada          |   | 863917        |   | 511964   |   | 5/18/1999  |   |
| THE ULTIMATE  BAND LIST |   | Chile           |   | 471173        |   | 574472   |   | 8/18/2000  |   |
| THE ULTIMATE  BAND LIST |   | Chile           |   | 471172        |   | 574473   |   | 8/18/2000  |   |
| THE ULTIMATE  BAND LIST |   | Chile           |   | 471171        |   | 574474   |   | 8/18/2000  |   |
| THE ULTIMATE  BAND LIST |   | Chile           |   | 471170        |   | 574475   |   | 8/18/2000  |   |
| THE ULTIMATE  BAND LIST |   | Costa  Rica     |   | 1999-0010555  |   | 121887   |   | 8/24/2000  |   |
| THE ULTIMATE  BAND LIST |   | Costa  Rica     |   | 1999-0010556  |   | 121894   |   | 8/24/2000  |   |
| THE ULTIMATE  BAND LIST |   | Costa  Rica     |   | 1999-0010557  |   | 121130   |   | 7/27/2000  |   |
| THE ULTIMATE  BAND LIST |   | Costa  Rica     |   | 1999-0010558  |   | 121895   |   | 8/24/2000  |   |
| THE ULTIMATE  BAND LIST |   | European  Union |   | 699355        |   | 699355   |   | 2/25/2000  |   |
| THE ULTIMATE  BAND LIST |   | Japan           |   | 183722/1997   |   | 4359835  |   | 2/10/2000  |   |
| THE ULTIMATE  BAND LIST |   | Mexico          |   | 409269        |   | 647112   |   | 3/27/2000  |   |
| THE ULTIMATE  BAND LIST |   | Mexico          |   | 409270        |   | 647113   |   | 3/27/2000  |   |
| THE ULTIMATE  BAND LIST |   | Mexico          |   | 409271        |   | 645866   |   | 3/22/2000  |   |
| THE ULTIMATE  BAND LIST |   | Mexico          |   | 409272        |   | 645867   |   | 3/22/2000  |   |

 

11

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| THE ULTIMATE  BAND LIST |   | Panama          |   | 105628       |   | 105628   |   | 2/15/2001  |   |
|-------------------------|--------|-----------------|--------|--------------|--------|----------|--------|------------|--------|
| THE ULTIMATE  BAND LIST |   | Panama          |   | 105627       |   | 105627   |   | 4/6/2001   |   |
| THE ULTIMATE  BAND LIST |   | Panama          |   | 105626       |   | 105626   |   | 2/13/2001  |   |
| THE ULTIMATE  BAND LIST |   | Panama          |   | 105629       |   | 105629   |   | 2/13/2001  |   |
| THE ULTIMATE  BAND LIST |   | Peru            |   | 99630        |   | 23005    |   | 9/28/2000  |   |
| THE ULTIMATE  BAND LIST |   | Peru            |   | 99631        |   | 22959    |   | 9/20/2000  |   |
| THE ULTIMATE  BAND LIST |   | Peru            |   | 99632        |   | 26107    |   | 6/18/2001  |   |
| THE ULTIMATE  BAND LIST |   | Peru            |   | 99633        |   | 23034    |   | 9/29/2000  |   |
| UBL                     |   | Argentina       |   | 2,119,987    |   | 1846303  |   | 10/2/2001  |   |
| UBL                     |   | Argentina       |   | 2,119,986    |   | 1870610  |   | 5/10/2002  |   |
| UBL                     |   | Australia       |   | 750647       |   | 750647   |   | 12/9/1997  |   |
| UBL                     |   | Brazil          |   | 820399060    |   | *        |   |       |   |
| UBL                     |   | Brazil          |   | 820399051    |   | *        |   |       |   |
| UBL                     |   | Canada          |   | 863917       |   | 503204   |   | 10/28/1998 |   |
| UBL                     |   | Chile           |   | 471167       |   | 574476   |   | 8/18/2000  |   |
| UBL                     |   | Chile           |   | 471166       |   | 574477   |   | 8/18/2000  |   |
| UBL                     |   | Chile           |   | 471165       |   | 574478   |   | 8/18/2000  |   |
| UBL                     |   | Chile           |   | 471164       |   | 574479   |   | 8/18/2000  |   |
| UBL                     |   | Costa  Rica     |   | 1999-0010551 |   | 121890   |   | 8/24/2000  |   |
| UBL                     |   | Costa  Rica     |   | 1999-0010552 |   | 121888   |   | 8/24/2000  |   |
| UBL                     |   | Costa  Rica     |   | 1999-0010553 |   | 121131   |   | 7/27/2000  |   |
| UBL                     |   | Costa  Rica     |   | 1999-0010554 |   | 121889   |   | 8/24/2000  |   |
| UBL                     |   | European  Union |   | 698951       |   | 698951   |   | 3/3/2000   |   |
| UBL                     |   | Japan           |   | 183721/1997  |   | 4359834  |   | 2/10/2000  |   |
| UBL                     |   | Mexico          |   | 409265       |   | 645863   |   | 3/22/2000  |   |
| UBL                     |   | Mexico          |   | 409266       |   | 645864   |   | 3/22/2000  |   |
| UBL                     |   | Mexico          |   | 409267       |   | 684935   |   | 1/31/2001  |   |
| UBL                     |   | Mexico          |   | 409268       |   | 645865   |   | 3/22/2000  |   |
| UBL                     |   | Panama          |   | 105636       |   | 105636   |   | 2/15/2001  |   |
| UBL                     |   | Panama          |   | 105635       |   | *        |   |       |   |
| UBL                     |   | Panama          |   | 105634       |   | 105634   |   | 2/13/2001  |   |
| UBL                     |   | Panama          |   | 105637       |   | 105637   |   | 2/13/2001  |   |
| UBL                     |   | Peru            |   | 99626        |   | 23004    |   | 9/28/2000  |   |
| UBL                     |   | Peru            |   | 99627        |   | 22958    |   | 9/20/2000  |   |
| UBL                     |   | Peru            |   | 99628        |   | 25918    |   | 5/31/2001  |   |
| UBL                     |   | Peru            |   | 99629        |   | 23033    |   | 9/29/2000  |   |
| UBL                     |   | Venezuela       |   | 2000-003035  |   | S-015477 |   | 11/22/2000 |   |
| UBL                     |   | Venezuela       |   | 2000-003036  |   | S-015478 |   | 11/22/2000 |   |
| UBL                     |   | Venezuela       |   | 2000-003034  |   | S-015476 |   | 11/22/2000 |   |
| UBL                     |   | Venezuela       |   | 2000-003037  |   | S-015479 |   | 11/22/2000 |   |

 

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* Indicates thatapplication is pending and not yet registered.

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

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

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Our web-sites,depending upon the specific musical work, may offer audio streaming of part orall of an entire song or “Web casting,” or the downloading of an entire song inMP3 or other compressed audio formats. Full-length streaming only occurs inspecial instances after obtaining a license from the record label or bandmanager for the “sound recording.” In that case, an ASCAP or BMI blanket musiclicense is also obtained by us or by our artists for rights to perform theassociated underlying “musical composition.” Where we offer full-lengthdownloads of songs in MP3 or other compressed audio formats, we seek to obtainthe rights to transmit, reproduce and perform the “sound recording” in writingfrom the person or entity owning or controlling copyrights in such “soundrecording.” With respect to rights in the “musical compositions” embodied insuch “sound recordings” offered for download, we seek to clear rights inmusical composition in one or more of the following three ways:

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

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

·                  a representationand warranty from the owner of the copyrights in the “sound recording” that nomechanical royalties are owed to any third parties.

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

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

For example, theCopyright Office has opined that additional royalties, besides those collectedfor musical compositions by ASCAP or BMI, are due for webcasted music that isselected by or on behalf of the recipient pursuant to 17 U.S.C. Section114(j)(7). If upheld, that ruling would prevent us from expanding our serviceto permit users to play a requested song via our web-site without payingadditional royalties.

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

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

*Seasonality.*The seasonality of our e-commerce segment affects ourrevenue. Our CDs and other online goods are most often purchased during thewinter holiday season and also during the summer months, traditionally whenartists go on concert tour.

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

The followingtable provides a schedule of corporate offices and facilities leased by us:
| **Location**                                     | ** ** | **Primary Function**                                    | ** ** | **Square Footage** | ** ** | **Lease Term**                      | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------------------|------------|-------------------------|------------|------------------------------------------|------------|
| ** **                                       | ** ** | ** **                                                   | ** ** | ** **              | ** ** | ** **                               | ** ** |
| Santa Monica,  California                        |       | Corporate  headquarters for ARTISTdirect and   MediaDefender |       | 14,817                  |       | 6  years, ending   November 30, 2011     |       |
|                                             |       |                                                         |       |                    |       |                                     |       |
| Co-Location Room   Los Angeles, California       |       | 70  Servers and 2X100 Mbps   Bandwidth                       |       | 300                     |       | monthly                                  |       |
|                                             |       |                                                         |       |                    |       |                                     |       |
| Co-Location Facility 1   Los Angeles, California |       | 920  Servers and 4X1000 Mbps  Bandwidth                      |       | NA                      |       | Lease  ends   February 2010              |       |
|                                             |       |                                                         |       |                    |       |                                     |       |
| Co-Location Facility 2   Los Angeles, California |       | 920  Servers and 4X1000 Mbps   Bandwidth                     |       | NA                      |       | Lease  ends   February 2010              |       |
|                                             |       |                                                         |       |                    |       |                                     |       |
| Co-Location Facility 3   Los Angeles, California |       | 92 Servers  and 1X1000 Mbps  Bandwidth                       |       | NA                      |       | Lease  is   being terminated   June 2007 |       |

 

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

**ITEM3.****                             LEGALPROCEEDINGS**

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

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

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

There were nomatters submitted to a vote of our stockholders during the fourth quarter ofthe fiscal year ended December 31, 2006.

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**PART II**

**ITEM 5.****                          MARKETFOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS ISSUERSPURCHASES OF EQUITY SECURITIES**

*MarketInformation*

Our common stockhas been listed for quotation on the Over-the-Counter Bulletin Board under thesymbol “ARTD.OB” since May 9, 2003. Prior to that, our common stock was listedon The Nasdaq National Market. The following table sets forth the high and lowsales prices for our common stock, as reported by the Over-the-Counter BulletinBoard for fiscal 2005 and 2006, respectively:
|                | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **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 |   |
|           |       |     |       |    |       |
| **2006**       |       |     |       |    |       |
| First Quarter  |       | $        | 4.53       |    | $          | 2.50 |   |
| Second Quarter |       | $        | 4.65       |    | $          | 2.75 |   |
| Third Quarter  |       | $        | 3.55       |    | $          | 2.90 |   |
| Fourth Quarter |       | $        | 3.55       |    | $          | 2.25 |   |

 

The closing priceof our common stock on April 12, 2007 was $2.10 per share, as reported on theOver-The-Counter Bulletin Board.  TheOver-the-Counter quotations reflect inter-dealer prices, without retailmark-up, mark-down or commission, and may not represent actual transactions.

*Holdersof Record*

As of April 11,2007, we had 232 holders of record of our common stock, excluding shares heldin “street name” by brokerage firms and other nominees who hold shares formultiple investors.

*Dividends*

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

*EquityCompensation Plan Information*

Refer toItem 11 “Security Ownership of Certain Beneficial Owners and Managementand Related Stockholder Matters” below for information with respect to ourequity compensation plans.

*AdditionalInformation*

Copies of ourprior 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.

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

Overview:

The Company conducts itsmedia and e-commerce business operations through an online music networkappealing to music fans, artists and marketing partners.  The ARTISTdirect Network(www.artistdirect.com) is a network of web-sites offering multi-media content,music news and information, communities organized around shared musicinterests, music-related specialty commerce and digital music services.

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On July 28, 2005, theCompany consummated the acquisition of MediaDefender in accordance with theterms set forth in an agreement and plan of merger entered into by and amongARTISTdirect, ARTISTdirect Merger Sub, Inc., a Delaware corporation and theCompany’s wholly-owned subsidiary (“Merger Sub”), and MediaDefender (the “MergerAgreement”).  Under the terms of theMerger Agreement, Merger Sub merged with and into MediaDefender, the separatecorporate existence of Merger Sub ceased and MediaDefender survived as theCompany’s wholly-owned subsidiary.  Thestockholders of MediaDefender received aggregate consideration of $42,500,000in cash, subject to certain holdbacks and adjustments described in the MergerAgreement.

MediaDefender is aleading provider of anti-piracy solutions in the Internet-piracy-protection (“IPP”)industry.  During the year ended December31, 2006, MediaDefender also began to offer file-sharing marketing services,wherein MediaDefender redirects, for a fee, specific peer-to-peer traffic onthe Internet to designated client destinations.

In order to fund theacquisition of MediaDefender, the Company completed a $15,000,000 seniorsecured debt transaction and a $30,000,000 convertible subordinated debttransaction, as described below at “Financing Transactions with Respect toMediaDefender, Inc. Acquisition”.

The two founders ofMediaDefender, Randy Saaf, who serves as the Chief Executive Officer ofMediaDefender, and OctavioHerrera, who serves as the President ofMediaDefender, each invested $2,250,000 in the convertible subordinated debttransaction entered into to fund the acquisition of MediaDefender on the sameterms and conditions as the other investors in such financing, as describedbelow at “Financing Transactions with Respect to MediaDefender, Inc.Acquisition”.

In accordance with theMerger Agreement, the Company acknowledged the terms of Employment Agreementsentered into on July 28, 2005 by MediaDefender with each of Randy Saaf andOctavio Herrera, confirming the terms of their employment.  Mr. Saaf and Mr. Herrera each earna base salary of no less than $350,000 per annum during the initial term of theagreements, which continue until December 31, 2008, and are also entitledto receive performance bonuses of up to $350,000 if MediaDefender achievesdefined operating earnings before interest, taxes, depreciation andamortization (calculated using the same accounting methods and policies asMediaDefender has historically used) (“MediaDefender EBITDA”) exceeding$7,000,000 and $7,500,000 in fiscal 2007 and fiscal 2008, respectively.  Mr. Saaf and Mr. Herrera are eachentitled to receive twelve months of severance pay at the rate of 100% of theirmonthly salary and the pro rata portion of the performance bonus referencedabove if they are terminated “without cause”. In addition, the Company granted stock options to purchase 200,000shares of common stock to each of Mr. Saaf and Mr. Herrera,exercisable at $3.00 per share for a period of five years and vesting quarterlyover a period of three and one-half years.

Upon the closing of the transaction, the Companyissued 1,109,032 shares of common stock and a seven-year warrant to purchase114,985 shares of common stock with an exercise price of $1.55 per share toWNT07 Holdings, LLC (“WNT07”).  Themanagers of WNT07 are Eric Pulier and Teymour Boutros-Ghali, both of whom wereat the time of issuance of the consideration and currently are members of theCompany’s Board of Directors.  The sharesand warrants were issued as consideration for services provided byMr. Pulier and Mr. Boutros-Ghali as consultants to the Company inconnection with the acquisition of MediaDefender.  The consideration issued to WNT07 wasapproved by the disinterested members of the Company’s Board of Directors.  The shares and warrants were issued inreliance upon exemptions from registration pursuant toSection 4(2) under the Securities Act and Rule 506 promulgatedthereunder.  The shares of common stockwere valued at $1,585,916 ($1.43 per share) and the warrants were valued at$83,939, based on a valuation report prepared by an independent valuationfirm.  The aggregate value of $1,669,855was allocated $333,971 (20%) to a covenant not to compete (as described below)and $1,335,884 (80%) to the costs that the Company incurred to acquire MediaDefender,based on management’s estimate of the relative values, as confirmed by theindependent valuation firm.  The amountallocated to the covenant not to compete is being amortized throughApril 1, 2007.

Theacquisition of MediaDefender 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.  The fair value of the intangible assetsacquired and their respective amortization periods were determined by an independentvaluation firm.  The following tablesummarizes the assets acquired and liabilities assumed of MediaDefender atJuly 28, 2005.

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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     |   |

 

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

Pro Forma Information:

The following pro formaoperating data presents the results of operations for the year endedDecember 31, 2005, as if the Company had acquired MediaDefender effectiveJanuary 1, 2005.  Discontinued operationsfor the year ended December 31, 2005 are not included.  The pro forma results are not necessarilyindicative of the financial results that might have occurred had theacquisition actually taken place on January 1, 2005, or of future results ofoperations.
| ** **                                          | ** ** | **(in thousands) ** | ** ** |
|-----------------------------------------------------|------------|-------------------------------|------------|
| ** **                                          | ** ** | **(Restated)**                | ** ** |
| ** **                                          | ** ** | ** **                    | ** ** |
| Net revenue                                         |       | $                             | 20,637     |   |
|                                                |       |                          |       |
| Net loss                                            |       | $                             | (35,222    | ) |
|                                                |       |                          |       |
| Adjusted EBITDA                                     |       | $                             | 7,095      |   |
|                                                |       |                          |       |
| Net loss per  common share – basic and diluted |       | $                             | (7.64      | ) |
|                                                |       |                          |       |
| Weighted average common  shares outstanding         |       | 4,611,149                     |       |

 

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The Company’s presentation of financial results includes “AdjustedEBITDA” as a financial measure, which is not a measure of performancecalculated in accordance with accounting principles generally accepted in theUnited States (“GAAP”). Adjusted EBITDA is a non-GAAP financial measure thatrepresents income or loss from continuing operations before net interestexpense, provision for income taxes, depreciation and amortization, as well ascertain other items, including stock-based compensation, impairment losses, andnon-recurring gains.  Management excludesthese items in assessing financial performance, primarily due to theirnon-operational nature or because they are outside of the Company’s normaloperations. The Company has provided this information because managementbelieves that it is useful to investors in understanding the Company’sfinancial condition and results of operations.

 

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

 

Restatement of FinancialStatements:

OnDecember 20, 2006, the Company determined that it was necessary to restate thefinancial statements contained in its previously-filed Annual Report on Form10-KSB/A for the fiscal year ended December 31, 2005 and Quarterly Reports onForm 10-QSB or Form 10-QSB/A for the quarterly periods ended September 30,2005, March 31, 2006, June 30, 2006 and September 30, 2006 (collectively, the “FinancialStatements”).  The determination was made by the Company’s Audit Committeefollowing receipt by the Company of comments from the staff (the “Staff”) ofthe Securities and Exchange Commission (the “SEC”), and following consultationwith the Company’s senior management, financial advisors and independentregistered public accounting firm.  The Staff advised the Company toconsider EITF 00-19, “Accounting for Derivative Financial Instruments Indexedto, and Potentially Settled in, a Company’s Own Stock” (“EITF 00-19”), and, inlight of the guidance set forth in EITF 00-19, to further evaluate theaccounting treatment of certain embedded derivatives contained in theoutstanding Sub-Debt Notes issued by the Company in July 2005, as well as theaccounting treatment of certain warrants issued to the Company’s lenders inJuly 2005, in conjunction with the acquisition of MediaDefender.  TheCompany filed the restated Financial Statements on April 19, 2007. However, the Staff has not indicated whether they may have further comments.  The adjustments to the Financial Statementswith respect to the restatements were non-cash in nature and were not caused byor related to any changes in the underlying operating performance of theCompany’s business, including revenues, operating costs and expenses, operatingincome or loss, operating cash flows or adjusted EBITDA.  However, suchrestatements had a material negative impact on the Company’s previouslyreported results of operations and earnings per share, current liabilities, networking capital and shareholders’ equity (deficiency).

TheSub-Debt Notes contain reset, anti-dilution and change-in-control provisionsthat the Company has determined caused such debt instruments to be classifiedas “non-conventional” debt.  Uponevaluation of such debt instruments under Statement of Financial AccountingStandards No. 133, “Accounting for Derivative Instruments and HedgingActivities” (“SFAS No. 133”) and EITF 00-19, it was determined that the Companywas required to bifurcate and value certain rights embedded in the Sub-DebtNotes on the date of issuance (including, specifically, the initial $1.55 pershare fixed conversion feature, which was in excess of the $1.43 per share fairmarket value of the Company’s common stock on the date of issuance) and toclassify such rights as either assets or liabilities.  The fair value of these bifurcatedderivatives, as determined by an independent valuation firm as of July 28,2005, was calculated using a lattice (binomial) valuation model, and utilizedhighly subjective and theoretical assumptions that can materially affect fairvalues from period to period.  

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Inaddition, the recognition of these derivative amounts did not have any impacton revenues, operating expenses, income taxes or cash flows.  The Company recorded an initial embeddedderivative liability of $10,534,000, which was recorded as a discount to the$30,000,000 of convertible subordinated notes, and is being amortized over theterm of the debt.  The carrying value ofthe embedded derivative liability is being adjusted to reflect any materialchanges in such liability from the date of issuance to the end of eachreporting period, with any such changes included in the statement ofoperations.  The Company has accountedfor registration rights penalties in accordance with Statement of FinancialAccounting Standards No. 5, “Accounting for Contingencies”, and EITF 00-19-2, “Accountingfor Registration Payment Arrangements”, which the Company adopted as ofDecember 31, 2006.

In addition to theadjustment for the embedded derivatives associated with the Sub-Debt Notes, theCompany revised the initial valuation and subsequent changes to fair value ofthe warrants issued in conjunction with the Senior Financing and the Sub-DebtFinancing.

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

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

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

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

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

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

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

 

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The following tablepresents the impact of the restatement on the statements of operations for theyear ended December 31, 2005 (amounts in thousands): 

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

 

Going Concern:

Asdescribed above, as a result of communications with the Staff of the SEC in2006, in particular regarding the application of accounting rules andinterpretations related to embedded derivatives associated with the Company’s subordinatedconvertible notes payable issued in July 2005, the Company determined torestate previously issued financial statements. As a result, in December 2006, the Company was required to suspend theuse of its then effective registration statement for the holders of its seniorand subordinated indebtedness and thus triggered an event of default withrespect to its registration rights agreements with the holders of suchindebtedness.  Accordingly, beginningJanuary 18, 2007, the Company began to incur estimated liquidated damages underits registration rights agreements aggregating approximately $540,000 per month(seven months of which, equivalent to $3,777,000, had been accrued as a currentliability at December 31, 2006), and the interest rate on its subordinatedconvertible notes payable increased from 4% per annum to 12% per annum, anincrease of approximately $183,000 per month.

Theadjustments to the financial statements with respect to the restatements werenon-cash in nature and were not caused by or related to any changes in theunderlying operating performance of the Company’s business, including revenues,operating costs and expenses, operating income or loss, income taxes, operatingcash flows or adjusted EBITDA.  The fair value of these bifurcatedderivatives of $10,534,000, as determined by an independent valuation firm, wascalculated using a binomial lattice option-pricing model utilizing highlysubjective and theoretical assumptions that can materially affect fair valuesfrom period to period.  The recognitionof these derivative amounts, initially recorded as a reduction to the relateddebt and being amortized to interest expense through the life of the debt, withthe resulting changes in fair value of the liability being included in otherincome (expense) in the statement of operations each reporting period, did nothave any impact on revenues, operating expenses, income taxes or cashflows.  However, such restatements had amaterial negative impact on the Company’s previously reported results ofoperations and earnings per share, current liabilities, net working capital andshareholders’ equity (deficiency).

During2005 and 2006, the Company’s consolidated operations generated sufficient cashflows from operations to enable the Company to fund its operating requirementsand to fund its non-event of default scheduled debt service obligations to boththe senior and subordinated debt holders, and management currently anticipatesthat cash flows from operations will be adequate to fund operating and debtservice requirements (based on the original terms as contemplated in the seniorand subordinated loan agreements) in 2007 and generate operating cash flows inexcess of these amounts for at least the next twelve months.

Asdescribed above, as a result of the requirement to restate previously issuedfinancial statements, which resulted in the recording of the embeddedderivative liability, the reclassification of the senior and subordinatedindebtedness to current liabilities, and the recording of estimated liquidateddamages payable under registration rights agreements of $3,777,000, the Companywas not in compliance with certain of its financial covenants under both theSenior Financing and the Sub-Debt Financing at December 31, 2006.

As ofDecember 31, 2006, approximately $13,307,000 was outstanding with respect tothe Senior Financing, and approximately $27,658,000 was outstanding withrespect to the Sub-Debt Financing.  Upon the occurrence of an event ofdefault, holders of at least 25% of the outstanding senior indebtedness maydeclare the outstanding principal and accrued interest on all senior notesimmediately due and payable upon written notice to the Company, and each holderof outstanding subordinated indebtedness may demand redemption of all or anyportion of their respective notes as described in the subordinated financingdocuments.  

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TheCompany has not received a request to accelerate or redeem any portion of theoutstanding indebtedness from any senior or subordinated holder.  TheCompany does not have the capital resources necessary to repay any acceleratedindebtedness or redemption.

Theaccompanying consolidated financial statements have been prepared in conformitywith accounting principles generally accepted in the United States of America,which contemplate continuation of the Company as a going concern.  As a result of the foregoing, the Company’sindependent registered public accounting firm, in its report on the Company’s2006 consolidated financial statements, expressed substantial doubt about theCompany’s ability to continue as a going concern.  The consolidated financial statements do notinclude any adjustments relating to the recoverability and classification ofrecorded asset amounts or the amounts and classification of liabilities thatcould result from the outcome of this uncertainty.

Pursuantto a Forbearance and Consent Agreement dated as of April 17, 2007, theinvestors in the Senior Financing agreed to forbear from the exercise of theirrights and remedies under the Senior Financing documents as a result of theevents of default with respect to the unavailability of the Company’sregistration statement, as well as certain other events of default thatcurrently exist or may come into existence during the forbearance period,through May 31, 2007, in exchange for a cash payment of $250,000.  Any payments made by the Company under theForbearance and Consent Agreement will `be credited against accruedregistration delay cash penalties or any other amounts that are or may becomedue and payable.  The Company has theright to extend the Forbearance and Consent Agreement through June 30, 2007 byan additional cash payment of $125,000 on or before May 31, 2007.

TheCompany has entered into an exclusive agreement with a financial advisor to assistin negotiations with the holders of its senior and subordinated debtobligations to obtain a waiver of and amendment to certain of the financingdocuments with respect to the events of default, the impact of therestatements, the payment of cash penalties, and various related matters.  The Company is unable to predict the outcomeof such negotiations.  The Company isexploring various alternatives to resolve the defaults under its senior and subordinateddebt obligations.  To the extent that theCompany is unable to restructure its senior and subordinated debt obligationsin a satisfactory manner, the ongoing penalties and default interest will havea significant and material negative impact on the Company’s cash flows andearnings, such that the Company may not have sufficient cash resources tomaintain operations in the future.  Insuch event, the Company may be required to consider a formal or informalrestructuring or reorganization.

Financing Transactionswith Respect to MediaDefender, Inc. Acquisition:

In conjunction with theacquisition of MediaDefender (see “Overview” above), the Company completed a$15,000,000 senior secured debt transaction (the “Senior Financing”) and a$30,000,000 convertible subordinated debt transaction (the “Sub-Debt Financing”).

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

Inaddition, not later than ninety days after the close of each fiscal year, theCompany is obligated to apply 60% of its excess cash flow, as defined in theNote Purchase Agreement (the “Annual Cash Sweep”), to prepay the principalamount of the Senior Notes.  At December31, 2005, the 2005 Annual Cash Sweep was $390,000, which was shown as a currentliability at December 31, 2005, and which was paid in April 2006.  At December 31, 2006, there was no amountpayable for the 2006 Annual Cash Sweep.

TheSenior Financing investors also received five-year warrants to purchase anaggregate of 3,250,000 shares of the Company’s common stock at an exerciseprice of $2.00 per share (collectively, the “Senior Warrants”).  The Senior Warrants were valued at $1,982,500based on a valuation report prepared by an independent valuation firm utilizingthe Black-Scholes option-pricing model, and were recorded as a discount to the$15,000,000 of senior secured debt, and are being amortized to interest expenseover the term of the debt.

TheSenior Warrants were subject to certain anti-dilution and price resetprovisions, as well certain registration rights obligations requiring the Companyto file and maintain effective a registration statement with the SEC coveringthe shares of common stock underlying such warrants, which, if not compliedwith, subjects the Company to a cash penalty of 1.5% of the Senior Financingper thirty day period.  Accordingly, inaccordance with EITF No. 00-19, the fair value of the Senior Warrants wasrecorded as warrant liability in the Company’s balance sheet at July 28, 2005,and is being adjusted to reflect any material changes in such liability fromthe date of issuance to the end of each reporting period, with any such changesincluded in other income (expense) in the statement of operations.

TheSub-Debt Financing was completed in accordance with the terms set forth in theSecurities Purchase Agreement entered into on July 28, 2005 by the Companyand each of the investors indicated on the schedule of buyers attachedthereto (the “Securities Purchase Agreement”). 

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Pursuantto the terms 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.  The interest rate increases to 12.00% perannum during any period in which the Company is in default of its obligationsunder the Sub-Debt Note.  CommencingSeptember 30, 2006, interest is payable quarterly in cash or shares of commonstock, at the option of the Company. Each Sub-Debt Note had an initial conversion price of $1.55 per share,and was subject to certain anti-dilution, reset and change-of-controlprovisions.  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, two times within any twelve-monthperiod, the Company has the right to require the holder of each Sub-Debt Noteto convert all or a portion equal to not less than 25% of the note conversionamount (limited to 50% of the note conversion amount if pursuant to clause (a)below) into shares of the Company’s common stock in the event that (a) theclosing sale price of the Company’s common stock equals or exceeds $2.32 pershare for each of any fifteen consecutive trading days, with a minimum tradingvolume of 200,000 shares of common stock on each such trading day, (b) theclosing sale price of the Company’s common stock equals or exceeds $3.10 pershare on each trading day during the fifteen consecutive trading day period,with a minimum trading volume of 200,000 shares of common stock on each suchtrading day, subject in both cases to appropriate adjustments for stock splits,stock dividends, stock combinations and other similar transactions after theissuance date, or (c) completion of an equity financing (including the issuanceof securities convertible into equity securities, or long-term debt securitiesissued as a unit with equity securities, of the Company) at a price per shareof not less than $2.50 generating aggregate gross proceeds of at least$20,000,000 from outside third party investors.

Theholders of the Sub-Debt Notes are entitled to receive any dividends paid ordistributions made to the holders of common stock to the same extent as if suchholders had converted their Sub-Debt Notes into common stock (without regard toany limitations on conversion) and had held such shares of common stock on therecord date for such dividend or distribution, with such payment to be made concurrentlywith the payment of the dividend or distribution to the holders of commonstock.

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

Inconjunction with the aforementioned financing transactions, a SubordinationAgreement dated July 28, 2005 was entered into between the Company, the SeniorFinancing investors, and the Sub-Debt Financing investors pursuant to which theSub-Debt Financing investors agreed to subordinate their rights to theinvestors in the Senior Financing on certain terms and conditions describedtherein.

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.

Pursuant to the terms ofthe Note Purchase Agreement and the Securities Purchase Agreement, the Companywas required to amend its Certificate of Incorporation to increase the numberof authorized shares of common stock from 15,000,000 shares to 60,000,000shares.  The Company obtained therequisite approvals of the Board of Directors and stockholders and filed a Certificateof Amendment to the Certificate of Incorporation with the Delaware Secretary ofState on November 7, 2005 to effect the increase in the authorized shares ofcommon stock.

If allof the securities issued in the Senior Financing and the Sub-Debt Financing areconverted or exercised into shares of the Company’s common stock in accordancewith their respective terms, it will result in significant dilution to theCompany’s existing stockholders and a possible change in control of theCompany.  If all of the Company’soutstanding equity-based instruments are converted or exercised into shares ofthe Company’s common stock in accordance with their respective terms, includingthose issued in conjunction with the acquisition of MediaDefender, there wouldbe a total of approximately 38,000,000 shares of the Company’s common stockissued and outstanding.

Thesecurities issued by the Company in the Senior Financing and the Sub-DebtFinancing were offered and sold in reliance upon exemptions from registrationpursuant to Section 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.

TheSub-Debt Notes and the Sub-Debt Warrants were subject to certain registrationrights obligations requiring the Company to file and maintain effective aregistration statement with the SEC covering the shares of common stockunderlying such warrants, which, if not complied with, subjects the Company toa cash penalty of 1.0% of the Sub-Debt Financing per thirty day period.  Accordingly, in accordance with EITFNo. 00-19, the fair value of the Sub-Debt Warrants was recorded as warrantliability in the Company’s balance sheet at July 28, 2005, and is being adjustedto reflect any material changes in such liability from the date of issuance tothe end of each reporting period, with any such changes included in otherincome (expense) in the statement of operations.

TheSub-Debt Notes contain reset, anti-dilution and change-in-control provisionsthat the Company has determined causes such debt instruments to be classifiedas “non-conventional” debt.  Uponevaluation of such debt instruments under SFAS No. 133, “Accounting forDerivative Instruments and Hedging Activities” (“SFAS No. 133”) and EITF 00-19,“Accounting for Derivative Financial Instruments Indexed to, and PotentiallySettled in, a Company’s Own Stock” (“EITF 00-19”), it was determined that theCompany was required to bifurcate and value certain rights embedded in theSub-Debt Notes on the date of issuance (including, specifically, the initial$1.55 per share fixed conversion feature, which was in excess of the $1.43 pershare fair market value of the Company’s common stock on the date of issuance)and to classify such rights as either assets or liabilities.  

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Thefair value of these bifurcated derivatives as of July 28, 2005, as determinedby an independent valuation firm, was calculated using a lattice (binomial)valuation model utilizing highly subjective and theoretical assumptions thatcan materially affect fair values from period to period.  The recognition of these derivative amountsdid not have any impact on revenues, operating expenses or cash flows.  The Company recorded an initial embeddedderivative liability of $10,534,000, which was recorded as a discount to the$30,000,000 of convertible subordinated notes, and is being amortized over theterm of the debt.  The carrying value ofthe embedded derivative liability is being adjusted to reflect any materialchanges in such liability from the date of issuance to the end of eachreporting period, with any such changes included in other income (expense) inthe statement of operations.  The Companyhas accounted for registration rights penalties in accordance with SFAS No. 5, “Accountingfor Contingencies”, and EITF 00-19-2, “Accounting for Registration PaymentArrangements”, which the Company adopted as of December 31, 2006.

The Sub-Debt Notes contain several embedded derivative features (bothassets and liabilities) that have been accounted for at fair value.  The various embedded derivative features ofthe Sub-Debt Notes have been valued at the date of inception of the Sub-DebtFinancing and at the end of each reporting period thereafter.  The material derivative featuresinclude:  (1) the standard conversionfeature of the debentures, (2) a limitation on the conversion by the holder,and (3) the Company’s right to force conversion.  An independent valuation firm valued theembedded derivative features and determined that, except for the above-notedfeatures, the remaining derivate attributes (both assets and liabilities) wereimmaterial, both individually and in the aggregate, and effectively offset eachother.  The value of the embeddedderivatives were bifurcated from the Sub-Debt Notes and recorded as derivativeliability, with the initial amount recorded as discount on the related Sub-DebtNotes.  This discount is being amortizedto interest expense over the life of the Sub-Debt Notes.

The Company determined that the warrants issued in conjunction with theSenior Financing and the Sub-Debt Financing created derivative liabilities inaccordance with EITF 00-19 because share settlement of these financialinstruments was not within the control of the Company, since the Company couldnot conclude that it had sufficient authorized but unissued common sharesavailable to satisfy its potential share obligations under the warrantagreements.  The Company reached thisconclusion because:   (1) the Company hasan obligation to file a registration statement with the SEC to register thecommon stock underlying the warrants, and to have such registration statementdeclared effective, and to maintain effective such registration statement, orto pay penalties in the form of liquidated damages for each thirty-day period thatsuch registration statement is not effective, (2) the warrants containeddilution protection features, with no limit or cap on the number of shares thatcould be issued by the Company pursuant to such provisions, and (3) thewarrants contained certain price reset features.  Because the warrants contain certainanti-dilution and price reset provisions, as well as have registration rights,the fair value of the warrants was accounted for as a derivative and presentedas warrant liability.

Pursuantto the terms of a letter agreement, dated July 15, 2005, by and betweenthe Company and Broadband Capital Management LLC (“Broadband”), effective July28, 2005, the Company issued to Broadband a Sub-Debt Note in the amount of$1,460,500 (in addition to the $30,000,000 referred to above) and five-yearwarrants to purchase 1,516,935 shares of common 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 securities were issued as partialconsideration for Broadband’s services as the Company’s placement agent in theSub-Debt Financing and the Senior Financing. The securities were issued in reliance upon exemptions from registrationpursuant to Section 4(2) under the Securities Act and Rule 506promulgated thereunder.  The Broadbandwarrants were valued at $1,077,024 based on a valuation report prepared by anindependent valuation firm utilizing the Black-Scholes option-pricingmodel.  The aggregate value of theSub-Debt Note, the warrants and additional cash payments to Broadbandaggregating $299,500 were charged to deferred financing costs and are beingamortized to other expense over the term of the debt.  The securities issued to Broadband wereaccounted for in a manner consistent with the accounting for the Sub-Debt Notesand Sub-Debt Warrants as described above.

Pursuantto the terms of a letter agreement, dated June 21, 2005, by and betweenthe Company and Libra FE, LP (“Libra”), effective July 28, 2005, the Companyissued to Libra a seven-year warrant to purchase 237,500 shares of its commonstock with an exercise price of $2.00 per share upon the closing of the SeniorFinancing (the “Libra Warrant”).  TheWarrant was issued as partial consideration for Libra’s services as the Company’splacement agent in the Senior Financing described above.  The Company entered into a RegistrationRights Agreement with Libra on July 28, 2005 (the “Libra RegistrationRights Agreement”), pursuant to which the Company will include the sharesunderlying the Libra Warrant in the registration statement covering thesecurities issued in the Senior Financing and the Sub-Debt Financing describedabove.  The Libra Warrant was issued inreliance upon exemptions from registration pursuant toSection 4(2) under the Securities Act and Rule 506 promulgatedthereunder.  The Libra Warrant was valuedat $175,750 based on a valuation report prepared by an independent valuationfirm utilizing the Black-Scholes option-pricing model.  The aggregate value of the warrants andadditional payments to Libra of $450,997 were charged to deferred financingcosts and are being amortized to other expense over the term of the debt.

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TheLibra Warrant was 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, which if not complied withcould subject the Company to a cash penalty of $5,000 per thirty dayperiod.  In accordance with EITF No. 00-19, the fair value of thewarrants was recorded as warrant liability at July 28, 2005, and was beingadjusted to reflect any material changes in such liability from the date of issuanceto the end of each reporting period, with any such changes included in otherincome (expense) in the statement of operations as other income (expense).  Effective April 19, 2006, the Libra Warrantwas exercised on a cashless basis at $2.00 per share, resulting in the issuanceof 123,864 shares of common stock.

At thedate of exercise of any of the Senior Warrants, the Sub-Debt Warrants or theLibra Warrant, or the conversion of Sub-Debt Notes into common stock, the prorata fair value of the related warrant liability and/or embedded derivativeliability is transferred to additional paid-in capital.

Pursuantto the Senior Financing and Sub-Debt Financing documents, the Company isrequired to comply on a quarterly basis with certain financial covenants,including minimum working capital, maximum capital expenditures, minimumleverage ratio, minimum EBITDA and minimum fixed charge coverage ratio.  These financial covenants are identical inthe Senior Financing and the Sub-Debt Financing documents.

Due tothe accounting classification of the warrants issued in conjunction with theSenior Financing and the Sub-Debt Financing as a current liability inaccordance with SFAS No. 133 and EITF 00-19, the Company was not in compliancewith certain of these financial covenants at December 31, 2005.

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

EffectiveApril 27, 2006, certain of the investors in the Senior Financing exercisedtheir warrants to purchase 2,816,667 shares of common stock at $1.85 per share,resulting in the issuance of 2,816,667 shares of common stock in exchange forcash proceeds of $5,212,000, of which $1,303,000 was used to reduce therespective principal balances on the Senior Notes payable held by suchexercising investors.

OnNovember 7, 2006, the Company entered into a waiver (the “Sub-Debt Waiver”)with the holders of the Sub-Debt Notes.  A provision of the Sub-Debt Notescontains a negative covenant pertaining to the Company’s Consolidated FixedCharge Coverage Ratio (as such term is defined in the Sub-Debt Notes), which isto be calculated on a quarterly basis (the “Fixed Charge Covenant”).  TheFixed Charge Covenant did not contemplate that the first cash payment ofaccrued interest was not due and payable to the holders of the Sub-Debt Notesuntil September 30, 2006 (the “First Interest Payment”), an approximatefourteen-month period from the original issuance date of the Sub-DebtNotes.  As a result of the Company timely making the First InterestPayment, the Company was forced to breach the Fixed Charge Covenant.  Theholders of the Sub-Debt Notes agreed to waive this event of default under theSub-Debt Notes that may have been triggered due to a breach of the Fixed ChargeCovenant resulting from the First Interest Payment.

OnNovember 7, 2006, the Company also entered into a waiver (the “Senior Waiver”)with the purchasers of the Senior Notes originally issued by the Company. The Note Purchase Agreement contains the same Fixed Charge Covenant that iscontained in the Sub-Debt Notes (the “Senior Fixed Charge Covenant”).  Asa result of the Company timely making the First Interest Payment, the Companywas forced to breach the Senior Fixed Charge Covenant.  The holders of theSenior Notes agreed to waive the event of default under the Note PurchaseAgreement that may have been triggered due to a breach of the Senior FixedCharge Covenant resulting from the First Interest Payment.

Thefinancing documents governing the terms and conditions of the senior andsubordinated indebtedness require the Company to maintain an effectiveregistration statement covering the resale of shares of common stock underlyingthe various securities issued by the Company to each holder.  A resaleregistration statement on Form SB-2, as amended (Reg. No. 333-129626), wasdeclared effective by the SEC on December 9, 2005.  The Companysubsequently filed Post-Effective Amendment No. 1 to the registration statementon Form SB-2 (Reg. No. 333-129626), which was declared effective by the SEC onMay 1, 2006.  

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As aresult of the determination to restate previously issued financial statements(see “Restatement of Financial Statements” above), the Form SB-2 has not beenavailable for use by the holders since December 21, 2006.

The financingdocuments specify that an event of default of the senior and subordinatedindebtedness is triggered if a resale registration statement is unavailable foruse by the holders for a period of more than ten consecutive trading days afterthe expiration of an allowable ten day grace period.  The Company invokedits use of the ten-day allowable grace period on December 21, 2006, whichexpired on December 31, 2006.  As of January 18, 2007, the Form SB-2remained unavailable for use by the holders, and it will continue to beunavailable for use until the Company prepares and files a post-effectiveamendment to the Form SB-2 with restated financial statements and otherrequired financial statements, as appropriate, which is then declared effectiveby the SEC.  Accordingly, an event of default of the senior andsubordinated indebtedness has been triggered by the unavailability of the FormSB-2 to the holders.  The financingdocuments provide that while the Form SB-2 remains unavailable for use, holdersof senior indebtedness are entitled to a cash penalty equal to 1.5% of theoriginal Senior Financing, on a pro rata basis, and the holders of subordinatedindebtedness are entitled to a cash penalty equal to 1.0% of the originalSub-Debt Financing, on a pro rata basis.  These cash penalties are due andpayable by the Company at the end of each thirty-day period while the Form SB-2remains unavailable.  The first cash penalty payment was due on January30, 2007.  The Company has not made anycash penalty payments to the holders of the Senior Financing or the Sub-DebtFinancing.

TheCompany delivered notice to holders of its outstanding senior and subordinatedindebtedness that, as of January 18, 2007, an event of default had beentriggered under their respective senior and subordinated financingdocuments.  As of December 31, 2006, approximately $13,307,000 wasoutstanding with respect to the Senior Financing, and approximately $27,658,000was outstanding with respect to the Sub-Debt Financing.  Upon theoccurrence of an event of default, holders of at least 25% of the outstandingsenior indebtedness may declare the outstanding principal and accrued intereston all senior notes immediately due and payable upon written notice to theCompany, and each holder of outstanding subordinated indebtedness may demandredemption of all or any portion of their respective notes as described in thesubordinated financing documents.  The Company has not received a requestto accelerate or redeem any portion of the outstanding indebtedness from anysenior or subordinated holder.  The Company does not have the capitalresources necessary to repay any accelerated indebtedness or redemption. All quarterly interest payments due on the outstanding senior and subordinatedindebtedness were timely paid by the Company through December 2006.  In addition, the quarterly interest paymentdue on the outstanding senior indebtedness in March 2007 was timely paid.  Pursuant to the terms of the SubordinationAgreement, interest on the outstanding subordinated convertible notes payablecannot be paid as a result of the existence of the events of default describedherein.

Pursuantto a Forbearance and Consent Agreement dated as of April 17, 2007, theinvestors in the Senior Financing agreed to forbear from the exercise of theirrights and remedies under the Senior Financing documents as a result of theevents of default with respect to the unavailability of the Company’sregistration statement, as well as certain other events of default thatcurrently exist or may come into existence during the forbearance period,through May 31, 2007, in exchange for a cash payment of $250,000.  Any payments made by the Company under theForbearance and Consent Agreement will be credited against accrued registrationdelay cash penalties or any other amounts that are or may become due andpayable.  The Company has the right toextend the Forbearance and Consent Agreement through June 30, 2007 by anadditional cash payment of $125,000 on or before May 31, 2007.

TheForbearance and Consent Agreement did not impact the investors in the Sub-DebtFinancing.  As the SubordinationAgreement (as described above) limits the rights of the investors in theSub-Debt Financing, the Company has not paid any interest or penalties to the investorsin the Sub-Debt Financing in 2007.  TheCompany has not entered into any agreements with the investors in the Sub-DebtFinancing.

Aspreviously discussed, at December 31, 2006, the registration statement coveringthe resale of shares of common stock underlying the various securities issuedby the Company to each holder of the senior and subordinated indebtedness wasnot effective.  Management currentlyestimates that a registration statement covering such shares of common stockcould be declared effective no earlier than August 2007.  Accordingly, in accordance with SFAS No. 5, “Accountingfor Contingencies”, and EITF 00-19-2, which the Company adopted as of December31, 2006, the Company has accrued seven months liquidated damages under theregistration rights agreements aggregating approximately $3,777,000 as a chargeto operations and a current liability at December 31, 2006.  Since the registration rights component ofthe derivative liabilities was not material through September 30, 2006, there wasno cumulative-effect adjustment recorded as a result of the transition ruleswith respect to the adoption of EITF-00-19-2 at December 31, 2006.  The Company will continue to review thestatus of the registration statement and adjust the accrued liquidated damagesunder the registration rights agreements at each quarter end as appropriate.

Asdescribed above, as a result of the requirement to restate previously issuedfinancial statements, which resulted in the recording of the embeddedderivative liability, the reclassification of the senior and subordinatedindebtedness to current liabilities, and the recording of estimated liquidateddamages payable under registration rights agreements of $3,777,000, the Companywas not in compliance with certain of its financial covenants under both theSenior Financing and the Sub-Debt Financing at December 31, 2006.

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The Company hasentered into an exclusive agreement with a financial advisor to assist in negotiationswith the holders of its senior and subordinated debt obligations to obtain awaiver of and amendment to certain of the financing documents with respect to theevents of default, the impact of the restatements, the payment of cashpenalties, and various related matters. The Company is unable to predict the outcome of such negotiations.  The Company is exploring various alternativesto resolve the defaults under its senior and subordinated debtobligations.  To the extent that theCompany is unable to restructure its senior and subordinated debt obligationsin a satisfactory manner, the ongoing penalties and default interest will havea significant and material negative impact on the Company’s cash flows andearnings, such that the Company may not have sufficient cash resources tomaintain operations in the future.  Insuch event, the Company may be required to consider a formal or informalrestructuring or reorganization.

Critical AccountingPolicies:

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

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

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

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

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

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

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

Stock-Based Compensation.  Priorto January 1, 2006, the Company accounted for stock-based employee compensationin accordance with the provisions of Accounting Principles Board (“APB”)Opinion No. 25 and FASB Interpretation No. 44 (“FIN 44”), “Accountingfor Certain Transactions Involving Stock Compensation”, and complied with thedisclosure requirements of SFAS No. 123, “Accounting for Stock-BasedCompensation”.  Under APB No. 25,compensation expense was recorded based on the difference, if any, between thefair value of the Company’s stock and the exercise price on the measurementdate.  

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The Company accounted for stock issued to non-employees in accordancewith SFAS No. 123, which required entities to recognize as expense overthe service period the fair value of all stock-based awards on the date ofgrant, and EITF 96-18, “Accounting for Equity Investments That Are Issued toOther Than Employees for Acquiring, or in Conjunction with Selling, Goods orServices”, and EITF 00-18, “Accounting Recognition for Certain Transactionsinvolving Equity Instruments Granted to Other Than Employees”, which addressedthe measurement date and recognition approach for stock-basedtransactions.  The Company recognizedcompensation expense related to variable awards in accordance with FASBInterpretation No. 28, “Accounting for Stock Appreciation Rights and OtherVariable Stock Option or Award Plans” (“FIN 28”).  For fixed awards, the Company recognizedexpense over the vesting period or the period of service.

In December 2004, the FASB issued SFAS No. 123 (revised2004), “Share- Based Payment” (“SFAS No. 123R”), a revision to SFASNo. 123, “Accounting for Stock-Based Compensation”.  SFAS No. 123R superceded AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued to Employees”,and amended SFAS No. 95, “Statement of Cash Flows”.  SFAS No. 123R requires that the Companymeasure the cost of employee services received in exchange for equity awardsbased on the grant date fair value of the awards, with the related costrecognized as compensation expense over the vesting period of the awards.  The Company adopted SFAS No. 123Reffective January 1, 2006, and is using the modified prospective method,in which compensation cost is recognized beginning with the effective date (a)based on the requirements of SFAS No. 123R for all share-based payments grantedafter the effective date and (b) based on the requirements of SFAS No. 123R forall awards granted to employees prior to the effective date of SFAS No. 123Rthat remain unvested on the effective date.

Goodwill, IntangibleAssets 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.

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

The Company evaluates therecoverability of goodwill by estimating the future discounted cash flows ofthe businesses to which the goodwill relates. The Company uses a rate corresponding to its cost of capital, riskadjusted where appropriate, in determining discounted cash flows.  Estimated cash flows are determined bydisaggregating the business segments to a reporting level for which meaningfulidentifiable cash flows can be determined. When estimated future discounted cash flows are less than the carryingvalue of the net assets (tangible and identifiable intangibles) and relatedgoodwill, the Company will perform an impairment test to measure the amountof 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.  Indetermining the estimated future cash flows, the Company considers current andprojected future levels of income based on management’s plans for thatbusiness, as well as business trends, prospects and market and economicconditions.

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

Derivative Instruments. Statement of Financial Accounting Standards No. 133, “Accounting forDerivative Instruments and Hedging Activities” (“SFAS No. 133”), requires allderivatives to be recorded on the balance sheet at fair value.  The calculation of the fair value ofderivatives utilizes highly subjective and theoretical assumptions that canmaterially affect fair values from period to period.  The recognition of these derivative amountsdoes not have any impact on cash flows.

EITF 00-19, “Accounting for Derivative Financial Instruments Indexedto, and Potentially Settled in, a Company’s Own Stock (“EITF 00-19”), requiresfreestanding contracts that are settled in a company’s own stock, includingcommon stock warrants, to be designated as an equity instrument, an asset or aliability.  Under the provisions of EITF00-19, a contract designated as an asset or a liability must be carried at fairvalue on a company’s balance sheet, with any changes in fair value recorded ina company’s results of operations.

TheCompany has accounted for registration rights penalties in accordance withStatement of Financial Accounting Standards No. 5, “Accounting forContingencies”, and EITF 00-19-2, “Accounting for Registration PaymentArrangements”, which the Company adopted as of December 31, 2006.  Since the registration rights component ofthe derivative liabilities was not material through September 30, 2006, therewas no cumulative-effect adjustment recorded as a result of the transitionrules with respect to the adoption of EITF-00-19-2 at December 31, 2006.

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The Company accounts for derivatives, including the embeddedderivatives associated with the Sub-Debt Notes and the warrants issued in conjunctionwith the Senior Financing and the Sub-Debt Financing, at fair value, adjustedat the end of each reporting period to reflect any material changes, with anysuch changes included in other income (expense) in the statement of operations.

At thedate of exercise of any of the warrants, or the conversion of Sub-Debt Notesinto common stock, the pro rata fair value of the related warrant liabilityand/or embedded derivative liability is transferred to additional paid-incapital.

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

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

Recent AccountingPronouncements:

In February 2007, theFASB issued Statement of Financial Accounting Standards No. 159, “The FairValue Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”),which provides companies with an option to report selected financial assets andliabilities at fair value.  SFAS No. 159’s objective is to reduce bothcomplexity in accounting for financial instruments and the volatility inearnings caused by measuring related assets and liabilities differently.  Generally accepted accounting principles haverequired different measurement attributes for different assets and liabilitiesthat can create artificial volatility in earnings.  SFAS No. 159 helps to mitigate this type ofaccounting-induced volatility by enabling companies to report related assetsand liabilities at fair value, which would likely reduce the need for companiesto comply with detailed rules for hedge accounting.  SFAS No. 159 also establishes presentationand disclosure requirements designed to facilitate comparisons betweencompanies that choose different measurement attributes for similar types ofassets and liabilities.  SFAS No. 159requires companies to provide additional information that will help investorsand other users of financial statements to more easily understand the effect ofthe company’s choice to use fair value on its earnings.  SFAS No. 159 also requires companies todisplay the fair value of those assets and liabilities for which the companyhas chosen to use fair value on the face of the balance sheet.  SFAS No.159 does not eliminate disclosure requirements included in other accountingstandards, including requirements for disclosures about fair value measurementsincluded in SFAS No. 157 and SFAS No. 107. SFAS No. 159 is effective as of the beginning of a company’s firstfiscal year beginning after November 15, 2007.  Early adoption ispermitted as of the beginning of the previous fiscal year provided that thecompany makes that choice in the first 120 days of that fiscal year and alsoelects to apply the provisions of SFAS No. 157. The Company is currently assessing the potential effect of SFAS No. 159on its financial statements.

In December 2006,the FASB issued FSP EITF 00-19-2, “**Accounting for Registration Payment Arrangements (“EITF00-19-2”), which** addresses an issuer’s accounting forregistration payment arrangements.  EITF00-19-2 specifies that the contingent obligation to make future payments orotherwise transfer consideration under a registration payment arrangement,whether issued as a separate agreement or included as a provision of afinancial instrument or other agreement, should be separately recognized andmeasured in accordance with FASB No. 5, “**Accounting for Contingencies”**.  The guidance in EITF 00-19-2 amends FASB No.133, “**Accounting forDerivative Instruments and Hedging Activities” and FASB No. 150, “Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity”, and**FASB Interpretation No. 45, “**Guarantor’s Accountingand Disclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others”, to** include scope exceptions forregistration payment arrangements.  EITF00-19-2 further clarifies that a financial instrument subject to a registrationpayment arrangement should be accounted for in accordance with other applicablegenerally accepted accounting principles without regard to the contingentobligation to transfer consideration pursuant to the registration paymentarrangement.  EITF 00-19-2 is effectiveimmediately for registration payment arrangements and the financial instrumentssubject to those arrangements that are entered into or modified subsequent tothe date of issuance of EITF 00-19-2. For registration payment arrangements and financial instruments subjectto those arrangements that were entered into prior to the issuance of EITF00-19-2, EITF 00-19-2 is effective for financial statements issued for fiscalyears beginning after December 15, 2006, and interim periods within thosefiscal years. Early adoption of EITF 00-19-2 for interim or annual periods forwhich financial statements or interim reports have not been issued ispermitted.  The Company has chosen toearly adopt EITF 00-19-2 effective December 31, 2006, the effect of which isdiscussed at “Financing Transactions With Respect to MediaDefender, Inc.Acquisition” above.

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In September 2006, theFASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”), whichprovides enhanced guidance for using fair value to measure assets andliabilities.  SFAS No. 157 provides acommon definition of fair value and establishes a framework to make themeasurement of fair value in generally accepted accounting principles moreconsistent and comparable.  SFAS No. 157also requires expanded disclosures to provide information about the extent towhich fair value is used to measure assets and liabilities, the methods andassumptions used to measure fair value, and the effect of fair value measureson earnings.  SFAS No. 157 is effectivefor financial statements issued in fiscal years beginning after November 15,2007 and to interim periods within those fiscal years.  The Company is currently assessing thepotential effect of SFAS No. 157 on its financial statements.

In September 2006, theSEC issued SAB No. 108, “Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in Current Year Financial Statements” (“SAB No.108”).  SAB No. 108 was issued in orderto eliminate the diversity in practice surrounding how public companiesquantify financial statement misstatements. SAB No. 108 requires that registrants quantify errors using both abalance sheet (iron curtain) approach and an income statement (rollover)approach and then evaluate whether either approach results in a misstatedamount that, when all relevant quantitative and qualitative factors areconsidered, is material. SAB No. 108 is effective for fiscal years ending afterNovember 15, 2006.  The Company adoptedSAB No. 108 during 2006.  The adoption ofSAB No. 108 did not have a material effect on the Company’s financialstatements.

In June 2006, the FASB issuedFIN 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASBStatement No. 109” (“FIN 48”), which seeks to reduce the diversity in practiceassociated with the accounting and reporting for uncertainty in income taxpositions.  FIN 48 prescribes acomprehensive model for the financial statement recognition, measurement,presentation and disclosure of uncertain tax positions taken or expected to betaken in an income tax return. FIN 48 presents a two-step process forevaluating a tax position.  The firststep is to determine whether it is more-likely-than-not that a tax positionwill be sustained upon examination, based on the technical merits of theposition.  The second step is to measurethe benefit to be recorded from tax positions that meet themore-likely-than-not recognition threshold, by determining the largest amountof tax benefit that is greater than 50 percent likely of being realized uponultimate settlement, and recognizing that amount in the financial statements.  FIN 48 is effective for fiscal yearsbeginning after December 15, 2006.  TheCompany does not believe that the adoption of FIN 48 will have a materialeffect on its financial statements.

Management does notbelieve that any other recently issued, but not yet effective, accountingstandards, if currently adopted, would have a material effect on the Company’sfinancial statements.

Results of Operations -Years Ended December 31, 2006 and 2005:

The following tablepresents information with respect to the Company’s consolidated statements ofoperations, excluding income (loss) from discontinued operations, as to actualamounts and as a percentage of total net revenue, for the years ended December31, 2006 and 2005.  As a result of theacquisition of MediaDefender effective July 28, 2005, the operations ofMediaDefender have been consolidated for the five months ended December 31,2005, as compared to the twelve months ended December 31, 2006.  Accordingly, the Company’s results ofoperations for the year ended December 31, 2005 are not directly comparable toits results of operations for the year ended December 31, 2006.

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Consolidated Statementsof Operations ($000):
| ** **                                                                                                                                                                                  | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                                                                  | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| ** **                                                                                                                                                                                  | ** ** | **$**                                       | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** |
| **:**                                                                                                                                                                                       | ** ** | ** **                                  | ** ** | ** ** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| Net revenue                                                                                                                                                                                 |       |                                        |       |   |   |   |   |   |   |
| E-commerce                                                                                                                                                                                  |       | $                                           | 2,649      |   | 11.0 | % | $ | 2,665 |   | 19.1 | % |
| Media                                                                                                                                                                                       |       | 5,670                                       |       | 23.6 | % | 5,297 |   | 37.9 | % |
| Anti-piracy and file-sharing marketing services                                                                                                                                             |       | 15,743                                      |       | 65.4 | % | 6,009 |   | 43.0 | % |
| Total net revenue                                                                                                                                                                           |       | 24,062                                      |       | 100.0 | % | 13,971 |   | 100.0 | % |
| Cost of revenue:                                                                                                                                                                            |       |                                        |       |   |   |   |   |   |   |
| E-commerce                                                                                                                                                                                  |       | 2,495                                       |       | 10.4 | % | 2,400 |   | 17.2 | % |
| Media                                                                                                                                                                                       |       | 3,088                                       |       | 12.8 | % | 2,745 |   | 19.7 | % |
| Anti-piracy and file-sharing marketing services                                                                                                                                             |       | 7,797                                       |       | 32.4 | % | 2,659 |   | 19.0 | % |
| Total cost of revenue                                                                                                                                                                       |       | 13,380                                      |       | 55.6 | % | 7,804 |   | 55.9 | % |
| Gross profit                                                                                                                                                                                |       | 10,682                                      |       | 44.4 | % | 6,167 |   | 44.1 | % |
| Operating  expenses:                                                                                                                                                                        |       |                                        |       |   |   |   |   |   |   |
| Sales and marketing                                                                                                                                                                         |       | 1,163                                       |       | 4.9 | % | 527 |   | 3.8 | % |
| General and administrative (including stock-based  compensation)                                                                                                                            |       | 9,213                                       |       | 38.3 | % | 4,138 |   | 29.6 | % |
| Provision for doubtful accounts                                                                                                                                                             |       | 705                                         |       | 2.9 | % | 105 |   | 0.7 | % |
| Total operating costs                                                                                                                                                                       |       | 11,081                                      |       | 46.1 | % | 4,770 |   | 34.1 | % |
| Income (loss) from operations                                                                                                                                                               |       | (399                                        | )          | (1.7 | )% | 1,397 |   | 10.0 | % |
| Interest income                                                                                                                                                                             |       | 126                                         |       | 0.5 | % | 29 |   | 0.2 | % |
| Interest expense                                                                                                                                                                            |       | (5,852                                      | )          | (24.3 | )% | (2,873 | ) | (20.6 | )% |
| Estimated liquidated damages under registration  rights agreements                                                                                                                          |       | (3,777                                      | )          | (15.7 | )% | — |   | — |   |
| Other income, net                                                                                                                                                                           |       | 57                                          |       | 0.2 | % | — |   | — |   |
| Change in fair value of warrant liability                                                                                                                                                   |       | 1,124                                       |       | 4.7 | % | (10,735 | ) | (76.8 | )% |
| Change in fair value of embedded liability                                                                                                                                                  |       | 7,792                                       |       | 32.4 | % | (20,043 | ) | (143.5 | )% |
| Reduction in exercise price of warrants                                                                                                                                                     |       | (641                                        | )          | (2.6 | )% | — |   | — |   |
| Write-off of unamortized discount on debt and  deferred financing costs due to conversion of subordinated convertible notes  payable and principal payments on senior secured notes payable |       | (1,624                                      | )          | (6.7 | )% | (45 | ) | (0.3 | )% |
| Amortization of deferred financing costs                                                                                                                                                    |       | (858                                        | )          | (3.6 | )% | (402 | ) | (2.9 | )% |
| Loss from continuing operations before income taxes                                                                                                                                         |       | (4,052                                      | )          | (16.8 | )% | (32,672 | ) | (233.9 | )% |
| Provision for income taxes                                                                                                                                                                  |       | 838                                         |       | 3.5 | % | 241 |   | 1.7 | % |
| Loss from  continuing operations                                                                                                                                                            |       | (4,890                                      | )          | (20.3 | )% | $ | (32,913 | ) | (235.6 | )% |
|                                                                                                                                                                                             |            |                                             |            |  |  |  |  |  |  |  |  |

 

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

Included in AdjustedEBITDA are direct operating expenses for each segment.  The following table summarizes net revenueand Adjusted EBITDA by operating segment for the years ended December 31, 2006and 2005, respectively.  Corporateexpenses consist of general operating expenses that are not directly related tothe operations of the segments.  Areconciliation of Net Loss to Adjusted EBITDA is also provided.

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| ** **                                                         | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                         | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| ** **                                                         | ** ** | ** **                                  | ** ** | **(Restated)** | ** ** |
| ** **                                                         | ** ** | **(in thousands)**                     | ** ** |
|                                                               |       |                                        |       |   |   |
| Net Revenue:                                                       |       |                                        |       |   |   |
| E-commerce                                                         |       | $                                           | 2,649      |   | $ | 2,665 |   |
| Media                                                              |       | 5,670                                       |       | 5,297 |   |
| Anti-piracy and file-sharing marketing services                    |       | 15,743                                      |       | 6,009 |   |
|                                                               |       | $                                           | 24,062     |   | $ | 13,971 |   |
|                                                               |       |                                        |       |   |   |
| Adjusted EBITDA:                                                   |       |                                        |       |   |   |
| E-commerce                                                         |       | $                                           | 6          |   | $ | 157 |   |
| Media                                                              |       | 1,919                                       |       | 2,198 |   |
| Anti-piracy and file-sharing marketing services                    |       | 8,935                                       |       | 3,851 |   |
|                                                               |       | 10,860                                      |       | 6,206 |   |
| Corporate:                                                         |       |                                        |       |   |   |
| General and administrative expenses                                |       | (4,672                                      | )          | (2,969 | ) |
| Estimated liquidated damages under registration  rights agreements |       | (3,777                                      | )          | — |   |
|                                                               |       | $                                           | 2,411      |   | $ | 3,237 |   |

 
| ** **                                                                                                                                                                                  | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                                                                  | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| ** **                                                                                                                                                                                  | ** ** | ** **                                  | ** ** | **(Restated)** | ** ** |
| ** **                                                                                                                                                                                  | ** ** | **(in thousands)**                     | ** ** |
|                                                                                                                                                                                        |       |                                        |       |   |   |
| Reconciliation  of Adjusted EBITDA to Net Loss:                                                                                                                                             |       |                                        |       |   |   |
| Adjusted EBITDA per segments                                                                                                                                                                |       | $                                           | 2,411      |   | $ | 3,237 |   |
| Stock-based compensation                                                                                                                                                                    |       | (2,281                                      | )          | (73 | ) |
| Depreciation and amortization                                                                                                                                                               |       | (554                                        | )          | (205 | ) |
| Amortization of intangible assets                                                                                                                                                           |       | (3,752                                      | )          | (1,562 | ) |
| Amortization of deferred financing costs                                                                                                                                                    |       | (858                                        | )          | (402 | ) |
| Reduction in exercise price of warrants                                                                                                                                                     |       | (641                                        | )          | — |   |
| Write-off of unamortized discount on debt and  deferred financing costs due to conversion of subordinated convertible notes  payable and principal payments on senior secured notes payable |       | (1,624                                      | )          | (45 | ) |
| Interest income                                                                                                                                                                             |       | 126                                         |       | 29 |   |
| Other income,  net                                                                                                                                                                          |       | 57                                          |       | — |   |
| Interest  expense, including amortization of discount on debt of $3,142 and $1,486 in  2006 and 2005, respectively                                                                          |       | (5,852                                      | )          | (2,873 | ) |
| Change in fair  value of warrant liability                                                                                                                                                  |       | 1,124                                       |       | (10,735 | ) |
| Change in fair  value of derivative liability                                                                                                                                               |       | 7,792                                       |       | (20,043 | ) |
| Provision for  income taxes                                                                                                                                                                 |       | (838                                        | )          | (241 | ) |
| Loss from  discontinued operations of ARTISTdirect Records, LLC                                                                                                                             |       | —                                      |       | (271 | ) |
| Gain from sale  of ARTISTdirect Records, LLC (substantially all non-cash)                                                                                                                   |       | —                                      |       | 21,079 |   |
| Net loss                                                                                                                                                                                    |       | $                                           | (4,890     | ) | $ | (12,105 | ) |

 

Management believes thatAdjusted EBITDA enhances an overall understanding of the Company’s financialperformance by investors because it is frequently used by securities analystsand other interested parties in evaluating companies in its industrysegment.  In addition, managementbelieves that Adjusted EBITDA is useful in evaluating the Company’s operatingperformance compared to that of other companies in its industry segment becausethe calculation of Adjusted EBITDA eliminates the accounting effects offinancing costs, income taxes and capital spending, which items may vary for differentcompanies for reasons unrelated to overall operating performance.

However, Adjusted EBITDAis not a recognized measurement under GAAP, and when analyzing the Company’soperating performance, investors should use Adjusted EBITDA in addition to, andnot as an alternative for, income (loss) from operations, income (loss) beforeincome taxes, and net income (loss), or any other measure utilized indetermining the Company’s operating performance that is calculated inaccordance with GAAP.  Because AdjustedEBITDA is not calculated in accordance with GAAP, it may not be comparable tosimilarly-titled measures utilized by other companies.  Furthermore, Adjusted EBITDA is not intendedto be a measure of the Company’s free cash flow, as it does not consider certainongoing cash requirements, such as a required debt service payments and incometaxes.

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Net Revenue.  The Company’s net revenue increased by$10,091,000 or 72.2%, to $24,062,000 for the year ended December 31, 2006, ascompared to $13,971,000 for the year ended December 31, 2005, primarily as aresult of the acquisition of MediaDefender on July 28, 2005.  Accordingly, MediaDefender’s revenues wereconsolidated for twelve months in 2006, as compared to five months in 2005.

MediaDefender providedrevenue of $15,743,000 for the year ended December 31, 2006, as compared torevenue of $6,009,000 for the year ended December 31, 2005.  Included in MediaDefender’s 2006 revenues was$580,000 from file-sharing marketing services which MediaDefender introduced in2006, including $500,000 from a short-term program with a new entertainmentservices customer during the three months ended June 30, 2006.  MediaDefender’s revenue accounted for 65.4%of the Company’s total net revenue for the year ended December 31, 2006, ascompared to 43.0% of the Company’s total net revenue for the year endedDecember 31, 2005.  The Company expectsthat revenues from MediaDefender will represent a significant proportion of itstotal revenues in the foreseeable future.

Duringthe year ended December 31, 2006, approximately 73% of MediaDefender’sconsolidated revenues were from four customers, with one customer accountingfor 27%, another customer accounting for 25%, a third customer accounting for11%, and a fourth customer accounting for 10%. During the year ended December 31, 2005, approximately 64% ofMediaDefender’s consolidated revenues were from two customers, with onecustomer accounting for 35% and the other customer accounting for 29%.

At September 30, 2006,MediaDefender was owed $580,000 by a major music industry customer foranti-piracy services rendered from February through September 2006.  At September 30, 2006, this customer hadasserted certain offsets against MediaDefender’s invoices.  In December2006, in consultation with legal counsel, the Company resolved this matter, asa result of which the Company reserved $280,000 at December 31, 2006 andcollected $300,000 in January 2007.

Media revenue increasedby $373,000, or 7.0%, to $5,670,000 for the year ended December 31, 2006, ascompared to $5,297,000 for the year ended December 31, 2005.  A short-term program with a majoradvertiser/sponsor during the three months ended June 30, 2005 contributedapproximately $1,786,000 or 34% of media revenue for the year ended December31, 2005.  The program ended June 30,2005 and, as designed, did not continue. The Company was able to replace this single revenue source with multiplerevenue sources in 2006.

The increase in mediarevenues in 2006 as compared to 2005 was primarily the result of an increase inthe number of online advertisers, an increase in the cost per thousand (“CPM”)amounts earned from the sales of impression and non-impression basedadvertising, and the expansion of the Company’s affiliations with otherweb-sites for which the Company both markets advertising and participates inadvertising revenues, as well as ancillary traffic associated with theacquisition of MediaDefender.  The Company markets and sells advertisingon a CPM basis to advertising agencies and directly to various companiesseeking to reach one or more of the distinct demographic audiences viewingcontent in the ARTISTdirect Network.  TheCompany also markets and sells sponsorships for various portions of theARTISTdirect Network.  Customers maypurchase advertising space on the entire ARTISTdirect Network, or they maytailor advertising to specific areas or sections of the Company’sweb-sites.  During the years ended December 31, 2006 and 2005, the Company’smedia revenues were generated primarily by a single outside sales organizationthat represented the Company with respect to advertising and sponsorship saleson the Company’s web-site and through affiliated web-sites.  The Companyintends to continue to focus on increasing revenue from its media operationsbusiness segment in 2007.

E-commerce revenuedecreased by $16,000, or 0.6%, to $2,649,000 for the year ended December 31,2006, as compared to $2,665,000 for the year ended December 31, 2005.  During the years ended December 31, 2006and 2005, approximately 67% of e-commerce revenues were generated from theproducts related to a single music merchandising entity.

Cost of Revenue.  The Company’s total cost of revenue increasedby $5,576,000 or 71.5%, to $13,380,000 for the year ended December 31, 2006, ascompared to $7,804,000 for the year ended December 31, 2005, primarily asa result of the acquisition of MediaDefender on July 28, 2005.  Depreciation of property and equipment isincluded in cost of revenue for all business segments.

MediaDefender’s cost ofrevenue was $7,797,000 or 49.5% of its net revenue in 2006, as compared to$2,659,000 or 44.3% of its net revenue in 2005. The increase in MediaDefender’s cost of revenues in 2006 as compared to2005 reflects the impact of increasing bandwidth, personnel and occupancy costsincurred during 2006, which costs are expected to have a continuing negativeimpact on cost of revenue in 2007, but which are expected to provide increasedrevenue in the long-term.  The Company expectsto recover some of these incremental costs as its contracts are renegotiated in2007, and is also implementing new strategies to increase revenues and improvemargins in the short-term from both existing and new business initiatives.  However, management does not expect that itsnew business initiatives will contribute significantly to revenue and grossmargin until the third quarter of 2007, at the earliest.  Included in MediaDefender’s 2006 cost ofrevenue are third-party development costs and payroll and related expenses forin-house development costs incurred in the design and production ofMediaDefender’s services of approximately $120,000, which efforts are expectedto continue in 2007.  Also included inMediaDefender’s cost of revenue for the years ended December 31, 2006 and 2005was the amortization of proprietary technology acquired in the MediaDefendertransaction of $2,534,000 and $1,056,000, respectively.

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Media cost of revenueincreased by $343,000 or 12.5% to $3,088,000 for the year ended December 31,2006, as compared to $2,745,000 for the year ended December 31, 2005, primarilyas a result of an increase in impressions being delivered by affiliateweb-sites with which the Company has revenue-sharing arrangements andadvertising serving costs.  The Companyis in the process of implementing various business initiatives to improveoperating results throughout the network.

E-commerce cost ofrevenue increased by $95,000, or 4.0%, to $2,495,000 for the year endedDecember 31, 2006, as compared to $2,400,000 for the year endedDecember 31, 2005.

As a result of theforegoing, gross profit was $10,682,000 for the year ended December 31, 2006,as compared to $6,167,000 for the year ended December 31, 2005, reflectinggross margins of 44.4% and 44.1%, respectively. A summary of gross profit and gross margin by segment is as follows($000):
|                                                 | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| **Segment:**                                    | ** ** | **Gross  Profit**                           | ** ** | **Gross  Margin** | ** ** | **Gross  Profit** | ** ** | **Gross  Margin** | ** ** |
| E-commerce                                      |       | $                                           | 154        |   | 5.8 | % | $ | 265 |   | 9.9 | % |
| Media                                           |       | 2,582                                       |       | 45.5 | % | 2,552 |   | 48.2 | % |
| Anti-piracy and file-sharing marketing services |       | 7,946                                       |       | 50.5 | % | 3,350 |   | 55.7 | % |
| Totals                                          |       | $                                           | 10,682     |   | 44.4 | % | $ | 6,167 |   | 44.1 | % |

 

Sales and Marketing.  The Company’s sales and marketing expenseincreased by $636,000, or 120.7%, to $1,163,000 for the year ended December 31,2006, as compared to $527,000 for the year ended December 31, 2005, primarilyas a result of the amortization of customer relationships acquired in theMediaDefender transaction of $755,000 and $314,000 in 2006 and 2005,respectively.

General andAdministrative.  The Company’s generaland administrative expense increased by $5,075,000, or 122.6%, to $9,213,000for the year ended December 31, 2006, as compared to $4,138,000 for the yearended December 31, 2005, in part as a result of the acquisition of MediaDefender.

For the year endedDecember 31, 2006, general and administrative expenses included stock-basedcompensation costs of $2,281,000, as compared to $73,000 for the year endedDecember 31, 2005, primarily as a result of the adoption of SFAS No. 123Reffective January 1, 2006, and the amortization of non-competition agreementsin 2006 and 2005 of $463,000 and $193,000, respectively, resulting from theMediaDefender transaction.

During the year endedDecember 31, 2006, the Company incurred legal, accounting, consulting andprinting fees and costs of approximately $750,000 relating to the preparationand filing of various documents with the SEC, amendments to its financingagreements, the annual stockholders meeting, and other ordinary course legal andaccounting matters.  As a result of thenecessity to restate the Company’s previously-issued financial statements(which were filed with the SEC on April 19, 2007) and the resultant default onthe Company’s senior and subordinated debt agreements in January 2007 (see “GoingConcern” above), the Company expects to incur significant continuing costs inthis regard in 2007.  General andadministrative expenses also increased in 2006 as compared to 2005 as a resultof increased management and board compensation, consulting fees, rent andoccupancy costs, insurance expense and Delaware franchise taxes.

Significant components ofgeneral and administrative expenses consist of management compensation (andbonuses, when applicable), personnel and personnel-related costs, insurance,legal and accounting fees, board compensation, consulting fees and occupancycosts.

The Company currentlyestimates that MediaDefender’s senior management will earn performance bonusespursuant to their respective employment agreements aggregating $700,000 during2007 based on achieving the requisite MediaDefender EBITDA threshold in 2007 of$7,000,000.

Provision for DoubtfulAccounts.  The Company’s provision fordoubtful accounts increased to $705,000 for the year ended December 31, 2006,as compared to $105,000 for the year ended December 31, 2005.  

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The provision fordoubtful accounts for the years ended December 31, 2006 and 2005 by segment wasas follows:
|                                                  | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | **(in thousands)**                     | ** ** |
| ** **                                       | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| E-commerce                                       |       | $                                           | 34         |   | $ | 21 |   |
| Media                                            |       | 317                                         |       | 83 |   |
| Anti-piracy and  file-sharing marketing services |       | 354                                         |       | 1 |   |
| Total                                            |       | $                                           | 705        |   | $ | 105 |   |

 

The increase in theprovision for doubtful accounts with respect to the media segment in 2006related to network advertising services rendered prior to July 2006, thecollection of which was uncertain at December 31, 2006.  The increase in the provision for doubtfulaccounts with respect to anti-piracy and file-sharing marketing services in2006 relates primarily to the $280,000 adjustment related to amounts due from amajor music industry customer for anti-piracy services rendered in 2006 (asdescribed above).  The Company hasreallocated resources in its accounting department and enhanced its financialcontrols and procedures to manage accounts receivable more effectively andattempt to limit future charges for bad debt write-offs.

Income (Loss) fromOperations.  For the year ended December31, 2006, loss from operations was $(399,000), as compared to income fromoperations of $1,397,000 for the year ended December 31, 2005.

Interest Income.  Interest income was $126,000 and $29,000 forthe years ended December 31, 2006 and 2005, respectively.

Interest Expense.  Interest expense of $5,852,000 and $2,873,000relates to the $15,000,000 of secured notes payable issued in the SeniorFinancing, which bear interest at 11.25% per annum, and the $30,000,000 ofsubordinated convertible notes payable issued in the Sub-Debt Financing, whichbear interest at 4.0% per annum, both of which were issued to finance theacquisition of MediaDefender in July 2005.

Additional considerationin the form of warrants issued to the lenders was accounted for at fair valueand recorded as a reduction to the carrying amount of the debt, and is being amortizedto interest expense over the term of the debt. Accordingly, the amortization of this discount on debt included ininterest expense for the years ended December 31, 2006 and 2005 was $730,000and $337,000, respectively.

The Sub-Debt Notescontain several embedded derivative features that have been accounted for atfair value.  The various embeddedderivative features of the Sub-Debt Notes have been valued at the date ofinception of the Sub-Debt Financing and at the end of each reporting period thereafter.  The value of the embedded derivatives werebifurcated from the Sub-Debt Notes and recorded as derivative liability, withthe initial amount recorded as discount on the related Sub-Debt Notes.  This discount is being amortized to interestexpense over the life of the Sub-Debt Notes. Accordingly, the amortization of this discount on debt included ininterest expense for the years ended December 31, 2006 and 2005 was $2,142,000and $1,266,000, respectively.

EstimatedLiquidated Damages Under Registration Rights Agreements.  As discussed above at “Going Concern”, atDecember 31, 2006, the registration statement covering the resale of shares ofcommon stock underlying the various securities issued by the Company to eachholder of the senior and subordinated indebtedness was not effective.  Management currently estimates that aregistration statement covering such shares of common stock could be declaredeffective no earlier than August 2007. Accordingly, in accordance with SFAS No. 5, “Accounting for Contingencies”,and EITF 00-19-2, which the Company adopted as of December 31, 2006, theCompany has accrued seven months liquidated damages under the registrationrights agreements aggregating approximately $3,777,000 as a charge tooperations and a current liability at December 31, 2006.  Since the registration rights component ofthe derivative liabilities was not material through September 30, 2006, therewas no cumulative-effect adjustment recorded as a result of the transitionrules with respect to the adoption of EITF-00-19-2 at December 31, 2006.  The Company will continue to review thestatus of the registration statement and adjust the accrued liquidated damagesunder the registration rights agreements at each quarter end as appropriate.

Other Income, Net.  Other income, net, was $57,000 for the yearended December 31, 2006.  The Company didnot have any other income, net, for the year ended December 31, 2005.

Change in Fair Value ofWarrant Liability.  In accordance withEITF 00-19, the fair value of the warrants issued in connection with thefinancing of the MediaDefender acquisition in July 2005 was recorded as warrantliability.  The carrying value of thewarrants is adjusted quarterly to reflect any changes in the fair value suchliability and is included in the statement of operations as other income(expense).  For the years ended December31, 2006 and 2005, the Company recorded income (expense) of $1,124,000 and($10,735,000), respectively, to reflect the change in warrant liability duringsuch periods.

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Change in Fair Value ofDerivative Liability.  In accordance withEITF 00-19, the fair value of the embedded derivatives was bifurcated from thesubordinated convertible notes payable issued in connection with the financingof the MediaDefender acquisition in July 2005 and recorded as a derivativeliability.  The carrying value of thederivative liability is adjusted quarterly to reflect any changes in the fairvalue of such liability and is included in the statement of operations as otherincome (expense).  For the years endedDecember 31, 2006 and 2005, the Company recorded income (expense) of $7,792,000and ($20,043,000), respectively, to reflect the change in derivative liabilityduring such periods.

Reduction in ExercisePrice of Warrants.  EffectiveApril 7, 2006, the Company entered into various agreements with theinvestors in its Senior Financing and Sub-Debt Financing to amend theirrespective registration rights agreements and to amend and waive certainfinancial covenants.  In consideration thereof, the Company offered totemporarily reduce the exercise price of the 3,250,000 warrants held by theinvestors in the Senior Financing from $2.00 to $1.85 per share through April30, 2006, and agreed to permanently reduce the exercise price of the 1,596,744warrants held by the investors in the Sub-Debt Financing from $1.55 to $1.43per share on certain terms and conditions.  Any exercise of theaforementioned warrants at the reduced exercise price was required to be forcash only.  The conversion price of the Sub-Debt Notes of $1.55 per sharewas not affected.  The Company also entered into similar agreements, asapplicable, and provided identical temporary and permanent reductions towarrant exercise prices, with Broadband Capital Management LLC (1,516,935warrants originally exercisable at $1.55 per share) and Libra FE, LP (237,500warrants originally exercisable at $2.00 per share).  As a result of theaforementioned warrant exercise price reductions, during the year endedDecember 31, 2006, the Company recorded a charge to operations for theaggregate fair value of such exercise price reductions of $641,000, consistingof $218,000 relating to the warrants held by the investors in the Sub-DebtFinancing and $423,000 relating to the warrants held and exercised by theinvestors in the Senior Financing.

Amortization of DeferredFinancing Costs.  Amortization ofdeferred financing costs was $858,000 and $402,000 for the years ended December31, 2006 and 2005, respectively.  Deferredfinancing costs consist of consideration paid to third parties with respect tothe acquisition and financing of the MediaDefender transaction, including cashpayments, subordinated convertible notes payable and the fair value of warrantsissued for placement agent fees, which were deferred and are being amortizedover the term of the related debt.

Write-Off of UnamortizedDiscount on Debt and Deferred Financing Costs Due to Conversion of SubordinatedConvertible Notes Payable and Principal Payments on Senior Secured Notes Payable.  Deferred financing costs and debt discountcosts aggregating $1,624,000 and $45,000 were charged to operations as a resultof the conversion of subordinated convertible notes payable and the principalpayments on senior secured notes payable during the years ended December 31,2006 and 2005, respectively.

Loss from ContinuingOperations Before Income Taxes.  As aresult of the aforementioned factors, the loss from continuing operationsbefore income taxes was $(4,052,000) for the year ended December 31, 2006, ascompared to a loss from continuing operations before income taxes of$(32,672,000) for the year ended December 31, 2005.

Provision for IncomeTaxes.  As a result of the profitableoperations of MediaDefender, the non-deductibility of certain non-cash chargesfor tax reporting purposes, and permanent limitations on the Company’s abilityto utilize its net operating loss carry-forwards, the Company recorded aprovision for income taxes of $838,000 for the year ended December 31, 2006, ascompared to a provision for income taxes of $241,000 for the year endedDecember 31, 2005.

DiscontinuedOperations.  On February 28, 2005,ADI completed the sale of 100% of the common stock of ARTISTdirect Recordings,Inc., a Delaware corporation and wholly-owned subsidiary, to Radar RecordsHoldings, LLC (“Radar Records”), an entity owned by Frederick W. (Ted) Field,the Company’s Chairman, pursuant to a Transfer Agreement, for a cash payment of$115,000.  ADI and Radar Records hadpreviously entered into an agreement to form a co-venture to develop a newrecord label, ARTISTdirect Records, LLC (“ARTISTdirect Records”), effectiveJune 29, 2001.  As a result of thecompletion of this transaction on February 28, 2005, ADI no longer had anyequity or other economic interest in ARTISTdirect Records.

For the year endedDecember 31, 2005, the Company recognized a loss from discontinued operationsof $271,000, reflecting ADI’s interest in ARTISTdirect Records for the twomonths ended February 28, 2005.

As a result of thedisposition of ADI’s interest in ARTISTdirect Records effective February 28,2005, the Company recognized a gain (primarily non-cash) of $21,079,000 in itsconsolidated statement of operations for the year ended December 31, 2005,primarily as a result of the elimination of the liabilities of ARTISTdirectRecords.

Net Loss.  As a result of the foregoing factors, netloss was $(4,890,000) for the year ended December 31, 2006, as compared to anet loss of $(12,105,000) for the year ended December 31, 2005.

Liquidity and CapitalResources:

Going Concern:

As morefully described above at “Going Concern”, as a result of communications withthe Staff of the SEC in 2006, in particular regarding the application ofaccounting rules and interpretations related to embedded derivatives associatedwith the Company’s subordinated convertible notes payable issued in July 2005,the Company determined that it was necessary to restate previously issuedfinancial statements.  

35

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As aresult, in December 2006, the Company was required to suspend the use of itsthen effective registration statement for the holders of its senior andsubordinated indebtedness and thus incurred an event of default with respect toit registration rights agreements with the holders of such indebtedness.  Accordingly, beginning January 18, 2007, theCompany began to incur estimated liquidated damages under its registrationrights agreements aggregating approximately $540,000 per month (seven months ofwhich, equivalent to $3,777,000, had been accrued as a current liability atDecember 31, 2006), and the interest rate on its subordinated convertible notespayable increased from 4% per annum to 12% per annum, an increase ofapproximately $183,000 per month.

Asdescribed above, as a result of the requirement to restate previously issuedfinancial statements, which resulted in the recording of the embeddedderivative liability, the reclassification of the senior and subordinatedindebtedness to current liabilities, and the recording of estimated liquidateddamages payable under registration rights agreements of $3,777,000, the Companywas not in compliance with certain of its financial covenants under both theSenior Financing and the Sub-Debt Financing at December 31, 2006.

Theaccompanying consolidated financial statements have been prepared in conformitywith accounting principles generally accepted in the United States of America,which contemplate continuation of the Company as a going concern.  As a result of the foregoing, the Company’sindependent registered public accounting firm, in its report on the Company’s2006 consolidated financial statements, expressed substantial doubt about theCompany’s ability to continue as a going concern.  The consolidated financial statements do notinclude any adjustments relating to the recoverability and classification ofrecorded asset amounts or the amounts and classification of liabilities thatcould result from the outcome of this uncertainty.

TheCompany has entered into an exclusive agreement with a financial advisor to assistin negotiations with the holders of its senior and subordinated debtobligations to obtain a waiver of and amendment to certain of the financingdocuments with respect to the events of default, the impact of therestatements, the payment of cash penalties, and various related matters.  The Company is unable to predict the outcomeof such negotiations.  The Company isexploring various alternatives to resolve the defaults under its senior and subordinateddebt obligations.  To the extent that theCompany is unable to restructure its senior and subordinated debt obligationsin a satisfactory manner, the ongoing penalties and default interest will havea significant and material negative impact on the Company’s cash flows andearnings, such that the Company may not have sufficient cash resources tomaintain operations in the future.  Insuch event, the Company may be required to consider a formal or informalrestructuring or reorganization.

Overview.

Until the acquisition ofMediaDefender effective July 28, 2005, the Company financed its continuingoperations primarily from the sale of its equity securities.  Concurrent with the acquisition ofMediaDefender in July 2005, the Company completed a $15,000,000 SeniorFinancing and a $30,000,000 Sub-Debt Financing, which generated approximately$1,000,000 for general working capital purposes.  In addition, MediaDefender had workingcapital of $2,745,000 at the acquisition date. The Company anticipates that this business will continue to generateprofitable results of operations and cash flows.

As of December 31, 2006and 2005, the Company had $5,602,000 and $3,102,000 of unrestricted cash andcash equivalents, respectively.  AtDecember 31, 2006, the Company had a working capital deficiency of $50,816,000,primarily because of the reclassification of senior secured notes payable andsubordinated convertible notes payable from long-term liabilities to currentliabilities, the accrual of estimated liquidated damages payable underregistration rights agreements of $3,777,000, and warrant liability of$4,715,000 and derivative liability of $18,356,000 at such date.  At December 31, 2005, the Company had aworking capital deficiency of $41,986,000, primarily because of warrantliability of $15,104,000 and derivative liability of $30,202,000 at such date.

During December 2006, theCompany made the required $1,050,000 cash payment to the founders ofMediaDefender, and paid accrued interest to its lenders aggregating $657,000.

Duringthe year ended December 31, 2006, the Company issued 2,203,870 shares of commonstock upon the conversion of $3,416,000 of subordinated convertible notespayable.  During the year ended December 31, 2005, the Company issued250,000 shares of common stock upon the conversion of $386,221 of subordinatedconvertible notes payable, including 825 shares as payment for accrued interestrelated to the principal converted.

During2005 and 2006, the Company’s consolidated operations generated sufficient cashflows from operations to enable the Company to fund its operating requirementsand to fund its non-event of default scheduled debt service obligations to boththe senior and subordinated debt holders, and management currently anticipatesthat cash flows from operations will be adequate to fund operating and debtservice requirements (based on the original terms as contemplated in the seniorand subordinated loan agreements) in 2007 and generate operating cash flows inexcess of these amounts for at least the next twelve months.

Operating.  Net cash provided by operating activities forthe year ended December 31, 2006 was $900,000, as compared to net cash providedby operating activities for the year ended December 31, 2005 of$1,486,000.  

36

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Net cash provided bycontinuing operations for the year ended December 31, 2006 was $988,000, ascompared to net cash provided by continuing operations for the year endedDecember 31, 2005 of $1,524,000.

Operating cash flow fromcontinuing operations decreased in 2006 as compared to 2005 primarily as aresult of a substantial increase in various general and administrative expensesin 2006, including SEC reporting, registration and compliance costs (includingcosts related to the restatement), board fees, corporate governance costs,management compensation and consulting costs, occupancy costs, insurance costsand Delaware franchise taxes.  The impacton operating cash flow from continuing operations in 2006 from the increase inaccounts receivable was substantially offset by the accrual for estimatedliquidated damages payable under registration rights agreements at December 31,2006.

Investing.  Net cash used in investing activities for theyear ended December 31, 2006 was $2,127,000, which consisted of guaranteedpayments to MediaDefender management of $1,050,000 and additions to propertyand equipment of $1,077,000.  Additionsto property and equipment in 2006 included leasehold improvements related tothe Company’s new Santa Monica office facility of $261,000 and purchases ofproperty and equipment of $816,000, primarily by MediaDefender.  Net cash used in investing activities for theyear ended December 31, 2005 was $43,368,000, which consisted of $42,500,000paid to acquire MediaDefender, costs incurred with respect to the MediaDefenderacquisition of $1,115,000, and purchases of property and equipment of $303,000,reduced by cash acquired in the MediaDefender transaction of $435,000 and theproceeds from the sale of ARTISTdirect Records of $115,000.

Financing.  Net cash provided by financing activities forthe year ended December 31, 2006 was $3,727,000, which consisted of $5,326,000from the exercise of warrants and $99,000 from the exercise of stock options,offset by principal payments on senior secured notes payable of $1,693,000 andan increase of $5,000 in restricted cash that secures certain letters ofcredit.  Net cash provided by financingactivities for the year ended December 31, 2005 was $43,828,000, whichconsisted of the proceeds from the $15,000,000 Senior Financing and the$30,000,000 Sub-Debt Financing, and the issuance of bridge notes byARTISTdirect Records of $37,000 during the two months ended February 28, 2005,reduced by payments for deferred financing costs of $1,025,000 and an increasein restricted cash of $184,000.

Contractual Obligations:

As of December 31,2006, the Company’s principal commitments for the next five fiscal yearsconsisted of contractual commitments as summarized below.  The summary shown below assumes that thesenior secured notes payable and the subordinated convertible notes payable areoutstanding for their full terms (based on the original terms as contemplatedin the senior and subordinated loan agreements), without any early reduction ofthe principal balances based on cash flows.
| ** **                                                             | ** ** | ** ** | ** ** | **Payments Due by Year (in thousands)** | ** ** |
|------------------------------------------------------------------------|------------|------------|------------|------------------------------------------------------------------|------------|
| **Contractual cash obligations**                             | ** ** | **Total**  | ** ** | **2007**                                                         | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** |
|                                                                   |       |       |       |                                                             |       |   |   |   |   |   |   |   |   |
| Employment  contracts (1)                                              |       | $          | 3,291      |                                                             | $          | 1,743 |   | $ | 1,515 |   | $ | 33 |   | $ | — |   | $ | — |   |
| Lease  obligations                                                     |       | 6,311      |       | 2,168                                                            |       | 1,618 |   | 1,442 |   | 613 |   | 470 |   |
| Estimated  liquidated damages under registration rights agreements (2) |       | 3,777      |       | 3,777                                                            |       | — |   | — |   | — |   | — |   |
| Senior secured  notes payable                                          |       | 13,307     |       | —                                                           |       | — |   | 13,307 |   | — |   | — |   |
| Interest on  senior secured notes payable                              |       | 3,847      |       | 1,518                                                            |       | 1,518 |   | 811 |   | — |   | — |   |
| Subordinated  convertible notes payable                                |       | 27,658     |       | —                                                           |       | — |   | 27,658 |   | — |   | — |   |
| Interest on  subordinated convertible notes payable (3)                |       | 4,130      |       | 2,391                                                            |       | 1,106 |   | 633 |   | — |   | — |   |
| Total  contractual cash obligations                                    |       | $          | 62,321     |                                                             | $          | 11,597 |   | $ | 5,757 |   | $ | 43,884 |   | $ | 613 |   | $ | 470 |   |

 

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(1)  Base compensation only; does not include anyperformance bonuses.

(2)  Based on management’s estimate of sevenmonths liquidated damages under the registration rights agreements.

(3)  Assumes interest at 12% default rate duringperiod in 2007 in which a resale registration statement is estimated to not beeffective.

Capital Expenditures.  The Company estimates that it will havecapital expenditures aggregating approximately $700,000 for the year endingDecember 31, 2007, primarily related to the planned expansion of MediaDefender’soperations.

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Off-Balance SheetArrangements.  At December 31, 2006,the Company did not have any transactions, obligations or relationships thatcould be considered off-balance sheet arrangements.

**RISKFACTORS**

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

**RISKS RELATED TO OUR BUSINESS**

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

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

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

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

***We have substantial debt obligations, which is materiallyand adversely affecting our business.***

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

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

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

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***Our relationships with entertainment industry participantsare particularly important to our newly-acquired Internet piracy preventionsegment, and if we fail to maintain such relationships fostered byMediaDefender our business prospects could be materially harmed.***

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

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

Based on datacompiled by The Recording Industry Association of America, or RIAA, the numberof CDs shipped from record companies to retail distribution channels fellapproximately 13% in 2006, as compared to the previous year. U.S. music salesdeclined 6.2% in 2006 as higher digital revenue failed to counter illegalcopying and a drop in purchases of CDs. Retail music sales decreased to $11.5 billion in 2006 from $12.3 billionin 2005. This decline represents the greatest drop since 2002, when shippedunits and dollar value fell by 8.9% and 6.7%, respectively.  According to the RIAA, the decline, in saleshad been due in part, to widespread copying and illegal Internet downloading ofmusic.  If the overall trend continues,it may affect our e-commerce business and have a material affect on ourrevenues.

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

If we do notincrease advertising revenue in our media and e-commerce segments, our businesswill be adversely affected. Increasing our advertising revenue depends uponmany factors, including our ability to:

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

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

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

·                  successfullydevelop, sell and execute entertainment marketing solutions;

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

·                  accuratelymeasure the size and demographic characteristics of our audience;

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

·                  increase theamount of revenue per advertisement.

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

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

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

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

·                  diminishedtechnical expertise and creativity of our production staff; and

·                  inability toanticipate and capitalize on trends in music.

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***We depend on a limited number of customers and if we were tolose these customers, our business could be adversely affected.***

During the yearended December 31, 2006,  no customeraccounted for more than 10.0% of our media or e-commerce revenue.  However, during the year ended December 31,2005, one customer accounted for $1.79 million, or 33.0% of total media revenue.MediaDefender’s current customers include four major record labels and sixmajor movie studios.  Approximately 73%of MediaDefender’s consolidated revenues were from four customers.  Of those four customers, two customersaccounted for 27.0% and 25.0%, respectfully, of MediaDefender’s revenues duringthe year ended December 31, 2006.  If wewere to lose any of these customers, our business and results of operationscould be adversely affected.

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

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

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

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

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

·                  longer operatinghistories;

·                  significantlygreater financial, technical and marketing resources;

·                  greater brandname recognition;

·                  larger existingcustomer bases; and

·                  more popularcontent or artists.

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

***We depend on a limited number of suppliers for musicmerchandise, fulfillment and distribution and if we cannot secure alternatesuppliers, our business may be harmed.***

We rely to a largeextent on timely distribution by third parties. During 2006, we relied on twovendors, Alliance Entertainment, and Benn Co. to fulfill and distribute ourorders for music and related merchandise. During the year endedDecember 31, 2006, approximately 94% and 6%, respectively, of our totalcustomer orders were fulfilled by Alliance and Benn Co., respectively. Wepurchase a significant portion of our artist-licensed merchandise from Benn Co.and most all of our compact discs from Alliance. Our contracts with Allianceand Benn Co. are both on a month-to-month basis. Our business could besignificantly disrupted if Alliance or Benn Co. were to terminate or breach theiragreements or suffer adverse developments that affect their ability to supplyproducts to us. If, for any reason, Alliance, Benn Co. or other vendors areunable or unwilling to supply products to us in sufficient quantities and in atimely manner, we may not be able to secure alternative suppliers, onacceptable terms, in a timely manner or at all.

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

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

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

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

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

Our ability toattract and retain artists, users, advertisers and merchants for our onlinenetwork depends on the performance, reliability and availability of ourweb-sites and network infrastructure. Our own staff performs the maintenanceand operation of substantially all of our Internet communications hardware andservers. We have periodic maintenance windows, and we experience outages fromtime to time caused by temporary problems in our own systems or software. Whilewe have implemented procedures designed to improve the reliability of oursystems, these interruptions may continue to occur from time to time. Our usersalso depend on third party Internet service providers and web-site operatorsfor access to our web-sites. These entities have experienced significantoutages in the past, and could experience outages, delays and otherdifficulties due to system failures in the future which are unrelated to oursystems, but which could nonetheless adversely affect our business.

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

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

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

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

The music contentavailable on the ARTISTdirect network is typically comprised of copyrightedworks owned or controlled by multiple third parties. Most of the content on ourartist-specific web-sites is either owned or licensed by the artist. On otherparts of the ARTISTdirect network, depending on the nature of the content andhow we use the music content, we typically license such rights from publishers,record labels, performing rights societies or artists. 

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We frequently either donot have written contracts or have short-term contracts with copyright owners,and, accordingly, our access to copyrighted content depends upon thewillingness of such parties to continue to make their content available. If thefees for music content increase substantially or if significant music contentbecomes unavailable, our ability to offer music content could be materiallylimited. We have not obtained a license for some of the content offered on theARTISTdirect network, including links to other music-related sites andthirty-second streamed song samples, because we believe that a license is notrequired under existing law. However, this area of law remains uncertain andmay not be resolved for a number of years. When this area of law is resolved,we may be required to obtain licenses for such content, alter or remove thecontent from our web-sites and be forced to pay potentially significantfinancial damages for past conduct.

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

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

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

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

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

Our privacy policydiscloses how we use individually identifiable information that we collect.This policy is displayed and accessible throughout the ARTISTdirect network.Despite this policy, however, if third persons were able to penetrate ournetwork security or otherwise misappropriate our users’ personal information orcredit card information, we could be subject to liability. We could also besubject to liability for claims for unauthorized purchases with credit cardinformation, impersonation or other similar fraud claims, or other misuses ofpersonal information, such as for unauthorized marketing purposes. These claimscould result in costly and time-consuming litigation.

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

***We may be sued for content available or posted on ourweb-sites or products through our web-sites or for linking and framing ofthird-party web-sites.***

We may be liableto third parties for content published on our web-sites and other web-siteswhere our syndicated content appears if the music, artwork, text or othercontent available violates their copyright, trademark or other intellectualproperty rights or if the available content is defamatory, obscene orpornographic. Similar claims have been brought, sometimes successfully, againstweb-site operators in the past. We also may be liable for content uploaded orposted by our users on our web-sites, such as digitally distributed musicfiles, postings on our message boards, chat room discussions and copyrightableworks. In addition, we could have liability to some of our content licensors forclaims made against them for content available on our web-sites. 

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We also could be exposedto these types of claims for content that may be accessed from our web-sites orvia links to other web-sites or for products sold through our web-site. Whilewe have resolved all of these types of claims made against us in the past, wemay not be able to do so in the future. We intend to implement measures toreduce exposure to these types of claims, but such measures may not besuccessful and may require us to expend significant resources. Any litigationas a result of defending these types of claims could result in substantialcosts and damages. Our insurance may not adequately protect us against thesetypes of claims or the costs of their defense or payment of damages. We link toand “frame” third-party web-sites of our artists without express writtenpermission to do so. In addition, in the past we have provided a search featureto allow users to find music residing elsewhere on the Internet. Thosepractices are controversial, and have, in instances not involving us, resultedin litigation. Various claims, including trademark and copyright infringement,unfair competition, and commercial misappropriation, as well as infringement ofthe right of publicity may be asserted against us as a result. The lawregarding linking and framing remains unsettled; it is uncertain as to howexisting laws, especially trademark and copyright law, will be applied by thejudiciary to the Internet. Also, Congress is increasingly active in passing newlaws related to the Internet, and there is uncertainty as to the impact offuture potential laws, especially those involving domain names, databases andprivacy.

**RISKS RELATED TO OUR CAPITALSTRUCTURE**

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

The price of ourcommon stock may fluctuate in the future. The stock market, in general, and 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 the technology and relatedindustries have experienced dramatic volatility in the market prices of theircommon stock.  We believe that a numberof factors, both within and outside of our control, could cause the price ofour common stock to fluctuate, perhaps substantially.  Factors such as the following could have asignificant adverse impact on the market price of our common stock:

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

·                  U.S. and foreigngovernmental actions;

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

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

·                  our financialposition and results of operations;

·                  period-to-periodfluctuations in our operating results;

·                  changes inestimates of our performance by any securities analysts;

·                  marketconditions for technology stocks in general; and

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

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

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

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

·                  marketvisibility for our common stock may be limited; and

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

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

Our common stockis considered to be a “penny stock” since it meets one or more of thedefinitions in Rule 3a51-1 under the Securities Exchange Act of 1934, asamended (the “Exchange Act”).  Theseinclude but are not limited to the following: (i) the stock trades at aprice less than $5.00 per share; (ii) it is NOT traded on a “recognized”national exchange; (iii) it is NOT quoted on the NASDAQ Stock Market, oreven if so, has a price less than $5.00 per share; or (iv) is issued by acompany with net tangible assets less than $2.0 million, if in businessmore than a continuous three years, or with average revenues of less than$6.0 million for the past three years. The principal result or effect of being designated a “penny stock” isthat securities broker-dealers cannot recommend the stock but must trade in iton an unsolicited basis. Section 15(g) of the Exchange Act and Rule 15g-2 promulgatedthereunder by the SEC require broker-dealers dealing in penny stocks to providepotential investors with a document disclosing the risks of penny stocks and toobtain a manually signed and dated written receipt of the document beforeeffecting any transaction in a penny stock for the investor’s account.

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

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

Rules adopted bythe SEC pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 requireannual assessment of our internal control over financial reporting, andattestation of the assessment by our independent registered public accountants.  This requirement for management’s assessmentof our internal control over financial reporting will first apply to our annualreport for fiscal 2007 and the requirement for our auditor’s attestation willfirst apply to our annual report for fiscal 2008.  The standards that must be met for managementto assess the internal control over financial reporting as effective are newand complex, and require significant documentation, testing and possibleremediation to meet the detailed standards. We may encounter problems or delays in completing activities necessaryto make an assessment of our internal control over financial reporting.  We have previously disclosed in our periodicfilings with the SEC the determination of our principal executive officer andprincipal financial officer that we presently have material weakness in ourinternal controls.  We are currentlyattempting to address these issues by reviewing and revising our internalaccounting policies and procedures.  Inaddition, the attestation process by our independent registered publicaccountants is new and we may encounter problems or delays in completing theimplementation of any requested improvements and receiving an attestation ofthe assessment by our independent registered public accountants.  If we cannot assess our internal control overfinancial reporting as effective, or our independent registered publicaccountants are unable to provide an unqualified attestation report on suchassessment, investor confidence and share value may be negatively impacted.  We expect to incur additional accountingrelated expenses associated with compliance with Section 404.

***If all of the equity-based securities issued by us tofinance the acquisition of  MediaDefenderare converted or exercised in accordance with their respective terms,significant dilution to our existing stockholders will result.***

There arecurrently 10,217,291 shares of our common stock issued and outstanding.  Assuming the conversion or exercise of allequity-based securities issued in connection with the financing transactionscompleted to finance the acquisition of MediaDefender, there will be approximately37,340,969 shares of our common stock issued and outstanding (which alsoassumes exercise of all our currently outstanding options and warrants).  Any sales in the public market of the commonstock issuable upon the conversion or exercise of all equity-based securitiesissued in connection with such financing transactions could adversely affectprevailing market prices of our common stock.

**RISKS RELATED TO THERESTATEMENT**

***The restatement of our financial statements has created astrain on our internal resources, distracted management and increased our costsand may have an impact on our common stock price.***

In connection withour receipt of comments from the Staff of the SEC, we have restated thefinancial statements contained in our Annual Report on Form 10-KSB/A for thefiscal year ended December 31, 2005 and Quarterly Reports on Form 10-QSB orForm 10-QSB/A for the quarterly periods ended September 30, 2005, March 31,2006, June 30, 2006 and September 30, 2006. Execution of these restatements has created a significant strain on ourinternal resources, distracted management and increased our costs.  These restatements may cause investors tolose confidence in the accuracy and completeness of our financial reports, andthis may have an adverse effect on our common stock price.

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***Due to the restatement of our financial statements, we havefailed to maintain an effective registration statement for the resale of theshares of our holders of notes and warrants issued in connection with theacquisition of MediaDefender, which has resulted in cash penalties and whichcould have a material negative impact on our liquidity and cash flow.***

Pursuant toregistration rights granted to the holders of our notes and warrants issued inconnection with the acquisition of MediaDefender, we were to maintain aneffective registration statement covering the resale of shares of common stockunderlying these notes and warrants.  Wefiled the Form SB-2 which was declared effective by the SEC on December 9,2005, and a Post-Effective Amendment No. 1 to the Form SB-2 which was declaredeffective by the SEC on December 27, 2006. As a result of the restatements, the Form SB-2 has not been available tothe holders of our notes and warrants described above, since December 21,2006.  The financing documents providethat while the Form SB-2 remains unavailable for use, (i) holders of the SeniorNotes are entitled to a cash penalty, each 30 day period, of $225,000, equal to1.5% of the original aggregate amount of Senior Notes of $15,000,000; and (ii)holders of the Sub-Debt Notes are entitled to a cash penalty, each 30 dayperiod, of $314,605, equal to 1.0% of the original aggregate amount of Sub-DebtNotes of $31,460,500.  These cashpenalties are due and payable by us at the end of each 30-day period.  The first cash penalty payment was due onJanuary 30, 2007, however the we have not made any payments. As of December 31,2006,  we have accrued $3,777,000 in cashpenalties.  These payments may have amaterial negative impact on our liquidity and cash flow.

On April 17, 2007,the Company entered into a Forebearance and Consent Agreement with the holdersof our senior notes wherein the holders agreed to forebear from exercisingtheir rights and remedies through May 31, 2007 in exchange for a payment by theCompany of $250,000, in the aggregate, to the holders.  The Company may extend the forbearance periodthrough June 30, 2007 by paying the holders an additional $125,000 in theaggregate.  These payments will becredited against amounts due the holders of the senior notes.

***As a result of the restatement, we have triggered an eventof default under the terms of the Senior Notes and Sub-Debt Notes, and upon anevent of default, the outstanding notes may become due and payable, and we maynot have the ability to meet this obligation.***

As a result of therestatement discussed above, on January 18, 2007, we delivered notice to theholders of the Senior Notes and Sub-Debt Notes, that an event of default hadbeen triggered under the Senior Note and Sub-Debt Note financing documents.  At January 18, 2007, approximately$13,307,000 of the Senior Notes, and approximately $27,658,000 of the Sub-DebtNotes remain outstanding.  Upon theoccurrence of an event of default, holders of at least 25% of the outstandingSenior Notes may declare the outstanding principal and accrued interest on allSenior Notes immediately due and payable, and each holder of the outstandingSub-Debt Notes may demand redemption of all or any portion of their respectivenotes.  We have not received a request toaccelerate or redeem any portion of the outstanding indebtedness from anyholder of the Senior Notes or Sub-Debt Notes. We cannot assure you that we will not receive such a request, and if wedo, we may not have the ability to meet this obligation and this could have amaterial negative impact on our liquidity and cash flow.

***As a result of triggering an event of default under theterms of the Senior Notes and Sub-Debt Notes, referred to above, we haveinitiated discussions to request a waiver from certain parties, pertaining tothe default, and we are unable to predict the outcome of such discussions.***

We have initiated discussions with the Senior Lenders and theSubordinated Investors to request a waiver of and amendment to certain of theirrespective financing documents to address the events of default, the impact ofthe restatements, the payment of cash penalties, and various other relatedmatters.  However, we are unable topredict the outcome of such discussions.

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

Generally accepted accounting principles andaccompanying accounting pronouncements, implementation guidelines, andinterpretations for many aspects of our business are highly complex and involvesubjective judgments.  Changes in theseaccounting standards, new accounting pronouncements and interpretations, by usor by our regulatory agencies, may occur that could adversely affect theCompany’s reported financial position, results of operations and/or cash flows.

**SPECIAL NOTE REGARDINGFORWARD-LOOKING STATEMENTS**

In addition tohistorical information, this Annual Report contains statements relating to ourfuture business and/or results, including, without limitation, the statementsunder the captions “Risk Factors,” “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” and “Description of Business.”  These statements include certain projectionsand business trends that are “forward-looking” within the meaning of the UnitedStates Private Securities Litigation Reform Act of 1995.  You can identify these statements by the useof words like “may,” “will,” “could,” “should,” “project,” “believe,” “anticipate,”“expect,” “plan,” “estimate,” “forecast,” “potential,” “intend,” “continue” andvariations of these words or comparable words. 

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

·                  Our limitedoperating history;

·                  Our ability toprotect our intellectual property rights;

·                  Our ability tosuccessfully develop and commercialize our proposed products;

·                  The degree andnature of our competition;

·                  Our ability toemploy and retain qualified employees;

·                  The limitedtrading market for our common stock; and

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

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

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

Our consolidatedfinancial statements appear in a separate section of this Annual Report, see “Indexto Consolidated Financial Statements.” Such information is incorporated herein by reference.

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

Not Applicable.

**ITEM 8A.****                CONTROLS AND PROCEDURES**

***Evaluation of Disclosure Controls and Procedures***

As required byRule 13a-15(e) under the Exchange Act, as of December 31, 2006, theend of the period to which this annual report relates, we have carried out anevaluation of the effectiveness of the Company’s disclosure controls andprocedures. This evaluation was carried out under the supervision and with theparticipation of our management, including our Chief Executive Officer and ourChief Financial Officer.

Disclosurecontrols and procedures are controls and other procedures that are designed toensure that information required to be disclosed in our reports filed orsubmitted under the Exchange Act is recorded, processed, summarized andreported, within the time periods specified in the Securities and ExchangeCommission’s rules and forms. Disclosure controls and procedures include,without limitation, controls and procedures designed to ensure that informationrequired to be disclosed in our reports filed under the Exchange Act isaccumulated and communicated to management, including the Chief ExecutiveOfficer and Chief Financial Officer as appropriate, to allow timely decisionsregarding required disclosure. Management recognizes that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving their objectives, and management necessarilyapplies its judgment in evaluating the cost-benefit relationship of possiblecontrols and procedures.  

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Based on the evaluationof our disclosure controls and procedures as of December 31, 2006, ourChief Executive Officer and Chief Financial Officer concluded that, as of suchdate, our disclosure controls and procedures were not effective due to thematerial weakness discussed below.  Amaterial weakness is a control deficiency, or combination of controldeficiencies, that results in more than a remote likelihood that a materialmisstatement of the annual or interim financial statements will not beprevented or detected.

As disclosed inItem 8B herein, the Audit Committee of our Board of Directors authorized us toamend and restate the financial statements contained in the previously-filedAnnual Report on Form 10-KSB/A for the fiscal year ended December 31, 2005 andQuarterly Reports on Form 10-QSB or Form 10-QSB/A for the quarterly periodsended September 30, 2005, March 31, 2006, June 30, 2006 and September 30, 2006(collectively, the “Financial Statements”). See Notes 1 and 2 to the 2006 consolidated financial statements includedherein for more information.  Inconnection with the restatement, our Chief Executive Officer and our ChiefFinancial Officer considered the effect of the errors on the adequacy of ourdisclosure controls and procedures as of the end of the period covered by thisAnnual Report on Form 10-KSB for the year ended December 31, 2006. Due tothe restatement, the certifying officers determined that a material weaknesshad occurred in relation to our reporting at September 30, 2005 throughSeptember 30, 2006 and that the disclosure controls and procedures relating tothis subject matter were therefore not effective.  The staff of the SEC advised the Company toconsider EITF 00-19 and, in light of the guidance set forth in EITF 00-19, tofurther evaluate the accounting treatment of certain embedded derivativescontained in the outstanding Sub-Debt Notes issued by the Company in July 2005,as well as the accounting treatment of certain warrants issued to the Company’slenders in July 2005, in conjunction with the acquisition ofMediaDefender.  The Company furtherevaluated its previous conclusions in relation to these transactions throughthe use of a specialist and determined that restatement was necessary. Therestated financial statements were filed with the SEC on April 19, 2007.

***Changes in Internal Control Over Financial Reporting***

There were nochanges to our internal control over financial reporting (as defined in Rules13a-15(f) and 15d-15(f) under the Exchange Act) during our mostrecently completed fiscal quarter that materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

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

**Non-Relianceon Previously Issued Financial Statements or a Related Audit Report or CompletedInterim Review**.

On December 20, 2006, the Company determined that itwas necessary to restate the financial statements contained in itspreviously-filed Annual Report on Form 10-KSB/A for the fiscal year endedDecember 31, 2005 and Quarterly Reports on Form 10-QSB or Form 10-QSB/A for thequarterly periods ended September 30, 2005, March 31, 2006, June 30, 2006 andSeptember 30, 2006 (collectively, the “Financial Statements”).  Thedetermination was made by the Company’s Audit Committee following receipt bythe Company of comments from the staff (the “Staff”) of the SEC, and followingconsultation with the Company’s senior management, financial advisors andindependent registered public accounting firm.  The Staff advised theCompany to consider EITF 00-19 and, in light of the guidance set forth in EITF00-19, to further evaluate the accounting treatment of certain embeddedderivatives contained in the outstanding Sub-Debt Notes issued by the Companyin July 2005, as well as the accounting treatment of certain warrants issued tothe Company’s lenders in July 2005, in conjunction with the acquisition ofMediaDefender.  The Company filed the restated Financial Statements onApril 19, 2007. However, the Staff has not indicated whether they may havefurther comments.  The adjustments to theFinancial Statements with respect to the restatements were non-cash in natureand were not caused by or related to any changes in the underlying operatingperformance of the Company’s business, including revenues, operating costs andexpenses, operating income or loss, operating cash flows or adjustedEBITDA.  However, such restatements had a material negative impact on theCompany’s previously reported results of operations and earnings per share,current liabilities, net working capital and shareholders’ equity (deficiency).

The Sub-Debt Notes contain reset, anti-dilution andchange-in-control provisions that the Company has determined causes such debtinstruments to be classified as “non-conventional” debt.  Upon evaluation of such debt instrumentsunder Statement of Financial Accounting Standards No. 133, “Accounting forDerivative Instruments and Hedging Activities” (“SFAS No. 133”) and EITF 00-19,it was determined that the Company was required to bifurcate and value certainrights embedded in the Sub-Debt Notes on the date of issuance (including,specifically, the initial $1.55 per share fixed conversion feature, which wasin excess of the $1.43 per share fair market value of the Company’s commonstock on the date of issuance) and to classify such rights as either assets orliabilities.  The fair value of thesebifurcated derivatives, as determined by an independent valuation firm as ofJuly 28, 2005, was calculated using a lattice (binomial) valuation model, andutilized highly subjective and theoretical assumptions that can materiallyaffect fair values from period to period. In addition, the recognition of these derivative amounts did not haveany impact on revenues, operating expenses, income taxes or cash flows.  The Company recorded an initial embeddedderivative liability of $10,534,000, which was recorded as a discount to the$30,000,000 of convertible subordinated notes, and is being amortized over theterm of the debt.  

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Thecarrying value of the embedded derivative liability is being adjusted toreflect any material changes in such liability from the date of issuance to theend of each reporting period, with any such changes included in the statementof operations.  The Company has accountedfor registration rights penalties in accordance with Statement of FinancialAccounting Standards No. 5, “Accounting for Contingencies” and EITF 00-19-2, “Accountingfor Registration Payment Arrangements”, which the Company adopted as ofDecember 31, 2006.

In addition to theadjustment for the embedded derivatives associated with the Sub-Debt Notes, theCompany revised the initial valuation and subsequent changes to fair value ofthe warrants issued in conjunction with the Senior Financing and the Sub-DebtFinancing.

A summary of the significantadjustments recorded to restate the financial statements as of and for the yearended December 31, 2005 is presented below. The restatement did not have an impact on the Company’s cash flows forthe year ended December 31, 2005.

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

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

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

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

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

**PART III**

**ITEM 9.****                         DIRECTORS, EXECUTIVE OFFICERS,PROMOTERS AND CONTROL PERSONS AND CORPORATE GOVERNANCE; COMPLIANCE WITHSECTION 16(A) OF THE EXCHANGE ACT**

**Directors**

The followingtable sets forth, as of April 1, 2007, the names of, and certaininformation concerning, our directors:
| Name                  | ** ** | **Age** | ** ** | **Position**                                       | ** ** | **Director Since** | ** ** | **End of Term** |
|-----------------------|------------|---------|------------|----------------------------------------------------|------------|-------------------------|------------|---------------------------|
| Frederick W. Field    |       | 54      |       | Chairman of the Board of Directors                 |       | 2001                    |       | 2007                      |
| Fred Davis            |       | 47      |       | Director                                           |       | 2005                    |       | 2007                      |
| Teymour Boutros-Ghali |       | 51      |       | Director                                           |       | 2005                    |       | 2007                      |
| Eric Pulier           |       | 40      |       | Director                                           |       | 2004                    |       | 2008                      |
| Dimitri Villard       |       | 63      |       | Director                                           |       | 2005                    |       | 2008                      |
| Jonathan V. Diamond   |       | 48      |       | President, Chief  Executive Officer   and Director |       | 2003                    |       | 2009                      |
| James N. Lane         |       | 55      |       | Director                                           |       | 2005                    |       | 2009                      |

 

*Frederick W. Field.*  Mr. Field has served as our Chairman of the Board since June 2001 andserved as our Chief Executive Officer from June 2001 untilSeptember 2003. Mr. Field also currently serves as Chief ExecutiveOfficer of ARTISTdirect Records, LLC and as Chairman of the Board and ChiefExecutive Officer of Radar Pictures, Inc., a film production company. From1990 to 2001, Mr. Field served as Co-Chairman of Interscope Records, amusic production company. From 1979 to 1997, Mr. Field served as Chairmanof the Board and Chief Executive Officer of Interscope Communications, Inc.

*Fred Davis.  * Mr. Davis has served as adirector since November 2005. Mr. Davis currently serves as a SeniorPartner at the Law Firm of Davis, Shapiro, Lewit,  & Hayes which heco-founded in 1997. Prior to 1997, Mr. Davis served as an Executive Vice Presidentat EMI Records. Mr. Davis received a bachelors degree from TuftsUniversity and a J.D. degree from Fordham School of Law.

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*Teymour Boutros-Ghali.*  Mr. Boutros-Ghali has served as director since January 2005. FromJanuary 2002 to the present, Mr. Boutros-Ghali has served as ManagingPartner of Monitor Ventures, an early-stage venture capital firm. FromJanuary 2000 to January 2002, he served as an angel investor and amember of the Board Directors of several media and technology companies, includingDigital Evolution, AllBusiness, Switchouse and IGR. Mr. Boutros-Ghali receivedhis SM and PhD from the Massachusetts Institute of Technology and his BA fromCambridge University.

*Eric Pulier.*  Mr. Pulier has served as a director since November 2004. Currently,Mr. Pulier serves as the Founder and Executive Chairman of SOASoftware, Inc., a position which he has held since 2001. Mr. Pulieralso served as a Director and/or founder of multiple technology companies inthe United States, including US Interactive, Inc., Gluecode, Inc.,Media Platform On-Demand, Santa Monica Media Corporation, a publicly-tradedcompany, and the Center for Telecommunications Management. Mr. Pulier hasbeen a pioneer in the software and digital interactive industries for over15 years. He has been instrumental in establishing ground-breakingcompanies in several sectors including corporate communications, professionalservices, security and enterprise software. Mr. Pulier is a Magna CumLaude graduate of Harvard University.

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

*Jonathan V. Diamond.*  Mr. Diamond has served as our Chief Executive Officer and director sinceSeptember 2003. From January 2003 to August 2006, he served as theChairman, Chief Executive Officer and currently serves as a director of ALJRegional Holdings, Inc., formerly YouthStream Media Networks, Inc., apublicly-traded company (ALJJ. PK).  Hewas the co-founder of N2K, Inc. and served as its Vice Chairman and ChiefExecutive Officer through its 1999 merger with CDnow, Inc., an e-commercecompany. He continued to serve as Chairman of the combined company until itssale to Bertelsmann Music Group in August 2000. Mr. Diamond was aco-founder of GRP Records, an independent music label acquired by MCA in 1990.Mr. Diamond received a M.B.A. from the Columbia University Graduate Schoolof Business and a B.A. in Economics and Music from the University of MichiganHonors College.

*James N. Lane.*  Mr. Lane has served as a director since May 2005. Mr. Lane hasalso served as Chairman and Chief Executive Officer of Devonwood CapitalPartners since 2002.  From 1997-2002, Mr. Lane was Chairman and ChiefExecutive Officer of SG Capital Partners, a private equity firm affiliated withSociete General and SG Cowen Securities.  Prior to establishing SG CapitalPartners, Mr. Lane’s career spanned approximately 20 years at GoldmanSachs, & Co. He was a former General Partner and founding member andCo-Head of Goldman Sachs’ Principal Investment Area. Until August 31, 2006, Mr.Lane served as a director of ALJ Regional Holdings, Inc., formerly YouthStream MediaNetworks, Inc., a publicly-traded company (ALJJ. PK).  Mr. Lane received a B.A. degree fromWheaton College and a M.B.A. from Columbia University.

**Executive Officers**

The following table sets forth, as of April 1,2007, the names of, and certain information concerning, our executive officersthat do not also serve as a director:
| Name                  | ** ** | **Age** | ** ** | **Position**                                           |
|-----------------------|------------|---------|------------|--------------------------------------------------------|
| Robert N.  Weingarten |       | 54      |       | Chief Financial Officer and Secretary of  ARTISTdirect |
| Rene Rousselet        |       | 51      |       | Corporate Controller of ARTISTdirect(1)                |
| Randy Saaf            |       | 30      |       | Chief Executive Officer of MediaDefender, Inc.    |
| Octavio Herrera       |       | 30      |       | President of MediaDefender, Inc.                  |

 

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(1)            Hiredas our Principal Accounting Officer on February 2, 2007 (please see our CurrentReport on Form 8-K filed on February 6, 2007 for moreinformation).

*Robert N. Weingarten.*  Mr. Weingarten has served as our Chief Financial Officer and Secretarysince January 2004. From July 1992 to present, Mr. Weingartenhas been the sole shareholder of Resource One Group, Inc., a financialconsulting and advisory company.  From February 2003 to August 2006,he served as the Chief Financial Officer of ALJ Regional Holdings, Inc.,formerly YouthStream Media Networks, Inc., a publicly-traded company(ALJJ. PK). Since 1979, Mr. Weingarten has served as a consultant andadvisor to numerous public companies in various stages of development,operation or reorganization.  Mr. Weingarten received an M.B.A.Degree in Finance from the University of Southern California in 1975 and a B.A.Degree in Accounting from the University of Washington in 1974. Mr. Weingarten currently serves as a director of New Dawn Mining Corp.,which is a non-trading public company located in Canada.

*René Rousselet*. Mr. Rousselet hasserved as our Corporate Controller since September 2006 and as our PrincipalAccounting Officer since February 2, 2007. From May 2006 to September 2006, Mr.Rousselet worked as a consultant for Tag-It Pacific, Inc. (TAG), apublicly-traded apparel company. From November 2004 to May 2006, he served asthe Chief Financial Officer of Asbestos Control Testing, Inc., a privately heldinterior demolition company, and from 1999 to 2004 he was the President andChief Financial Officer of a privately held professional employmentorganization called ProService Inc. Prior to 1999, Mr. Rousselet served aseither the Chief Financial Officer or Corporate Controller for a variety ofentertainment companies in Los Angeles including two public companies calledHemdale Communications Inc. (no longer in existence) and The Kushner-LockeCompany (KLOC.PK), a television programming company. Mr. Rousselet received aDegree in Accounting from California State University Northridge in 1977 andbecame a Certified Public Accountant in 1979 while working as a Senior Auditorat Arthur Andersen & Co.

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*Randy Saaf.*  Mr. Saaf currently serves as Chief Executive Officer of our wholly-ownedsubsidiary MediaDefender, Inc., which was acquired on July 28, 2005.Mr. Saaf previously served as both President and Chief Executive Officerof MediaDefender, Inc. since he co-founded the company in July 2000.Mr. Saaf received his Bachelor of Science degree in Engineering fromHarvey Mudd College in 1998.

*Octavio Herrera.*  Mr. Herrera currently serves as President of our wholly-owned subsidiaryMediaDefender, Inc., which was acquired on July 28, 2005.Mr. Herrera previously served as VP, Business Development and ChiefFinancial Officer of MediaDefender, Inc. since he co-founded the companyin July 2000. Mr. Herrera received a Bachelor degree in Physics fromOccidental College in 1998.

**Family Relationships**

There are no family relationships among the directorsand executive officers.

**Term of Office**

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

**Changes to the Procedure forConsideration of Director-Nominees**

*Stockholder Nominees.*

The Nominating Committee, instead of the Board, willnow consider nominees to the Board proposed by stockholders.  The Nominating Committee was established toensure that the Company is able to attract and retain qualified individuals toserve on the Board of Directors and to establish a fair process for thehandling of stockholder nominations to the Board of Directors.  The other proocedures currently in place bywhich security holders may recommend nominees to the Company remains unchanged.

**Changes to the terms served by BoardMembers**

On April 17, 2006, the Board approved and adopted anamendment and restatement of the Registrant’s Bylaws (the “*Amendment*”). The purpose of the Amendment,in part, was to re-classify the Board into three classes with terms expiring in2007, 2008 and 2009, respectively, and for successive three year termsthereafter.  At the Company’s Annual Meetingof Stockholders in June 2006, the Stockholders approved the Amendment and thedirectors were elected into the various classes.

**Section 16(a) BeneficialOwnership Compliance**

Section 16(a) of the Securities Exchange Actof 1934 requires our directors and certain executive officers and persons whoown more than ten percent of a registered class of ARTISTdirect’s equitysecurities (collectively, the “*ReportingPersons*”), to file reports of ownership and changes in ownershipwith the Securities and Exchange Commission. The Reporting Persons are requiredby Securities and Exchange Commission regulation to furnish our with copies ofall Section 16(a) forms they file.

To our knowledge, based solely on our review of thecopies of such forms received by us, or written representations from theReporting Persons, all Section 16(a) forms were timely filed duringfiscal 2006.

**Code of Ethics**

We have adopted a Code of Ethics that is applicable toour directors and our employees, including our principal executive officer,principal financial officer, principal accounting officer, controller, orpersons performing similar functions. The Code of Ethics was included as anexhibit to our Form 10-K filed with the Securities and Exchange Commissionon May 17, 2004. A copy is available free of charge on the Securities andExchange Commission’s website located on the Internet at *www.sec.gov*. Amendments to and waiversfrom the Code of Ethics will also be disclosed in future filings with theSecurities and Exchange Commission.

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**The Board of Directors and Committees**

The Board is responsible for the supervision of theoverall affairs of the Company. The Board met five times during the fiscal yearended December 31, 2006. During fiscal 2006, each director attended,either in-person or by telephone, at least 75 percent of all Board meetings andmeetings of any committee on which he served, with the exception of Mr. Pulierwho attended 60 percent of the Board meetings.

***Audit Committee***

The Board re-established an Audit Committee in November 2005.The Audit Committee’s responsibilities include, but are not limited to:

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

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

·       discussingour systems of internal control over financial reporting, and

·       meetingindependently with the independent registered public accounting firm andmanagement.

The Audit Committee currently consists of James N.Lane and Dimitri Villard, both of whom are “independent” under the listingstandards of the American Stock Exchange. Even though the Company’s stock istraded on the OTC Bulletin Board, the Company has chosen to use the morestringent definition of “independent” under the listing standards of theAmerican Stock Exchange. Mr. Lane qualifies as a “financial expert” underItem 401 of Regulation S-B of the Securities and Exchange Act of 1934, asamended. The Audit Committee operates under a written Audit Committee Charterthat was previously approved by the Board. A copy of the Audit Committee Charter was filed as an exhibit to theCompany’s Proxy Statement filed on May 8, 2006 with the SEC. The AuditCommittee met 6 times during the fiscal year ended December 31, 2006.

***CompensationCommittee***

The Board established a Compensation Committee inNovember 2005. The Compensation Committee administers the Company’scompensation and benefit plans, in particular, the incentive compensation andequity-based plans, and approves salaries, bonuses, and other compensationarrangements and policies for the Company’s officers, including the ChiefExecutive Officer. The Board has adopted a written charter for the CompensationCommittee, a copy of which was filed as an exhibit to the Company’s ProxyStatement filed on May 8, 2006 with the Securities and Exchange Commission. TheCompensation Committee currently consists of Fred Davis and Dimitri Villard,both of whom are “independent” under the listing standards of the AmericanStock Exchange. The Compensation Committee met five times and took one actionvia unamimous written consent during the fiscal year ended December 31,2006.

***CompensationCommittee Interlocks***

There were no compensation committee interlocks duringfiscal 2006.

***NominatingCommittee***

The Board established a Nominating Committee in June2006.  The Nominating Committee currentlyconsists of James N. Lane and Fred Davis, both of whom are “independent” underthe listing standards of the American Stock Exchange. The Nominating Committeewas established to ensure that the Company is able to attract and retainqualified individuals to serve on the Board of Directors and to establish afair process for the handling of stockholder nominations to the Board ofDirectors. 

*Set forth below is the report of ourAudit Committee. The information contained in this report shall not be deemedto be “soliciting material” or to be “filed” with the Securities and ExchangeCommission, nor shall such information be incorporated by reference into anyfuture filing under the Securities Act of 1933, as amended, or the SecuritiesExchange Act of 1934, as amended, except to the extent that we specificallyincorporate such information by reference in such filing.*

**REPORT OF THE AUDIT COMMITTEE**

The Audit Committee of the Board of Directors isresponsible for providing independent, objective oversight of the Company’saccounting functions and internal controls and to assist the Board infulfilling its responsibility to oversee management’s financial reportingprocess.  In this regard, the AuditCommittee monitors (i) the integrity of the Company’s financial statements anddisclosures, including oversight of the accounting and financial reportingprocess and the audits of the financial statements of the Company, (ii) theCompany’s compliance with its general legal, ethical and regulatoryrequirements and (iii) the independence and performance of the Company’sindependent registered public accounting firm. The Audit Committee is currently comprised of two directors, JamesN. Lane and Dimitri Villard, each of whom is considered “independent”, asdefined by the American Stock Exchange listing standards.  The Audit Committee operates under a writtenAudit Committee Charter that was previously approved by the Board.  

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A copyof the Audit Committee Charter was filed as an exhibit to the Company’s ProxyStatement filed on May 8, 2006 with the Securities and Exchange Commission.

Management is responsible for the Company’s financialstatements, internal controls and financial reporting process.  The independent registered public accountingfirm is responsible for performing an audit of the Company’s consolidatedfinancial statements in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), in conformity with accountingprinciples generally accepted in the United States of America, and to issue itsreport thereon.  The independentregistered public accounting firm also performs limited reviews of the Company’sunaudited interim financial statements included in its quarterly filings withthe Securities and Exchange Commission. The independent registered public accounting firm also assists the AuditCommittee in fulfilling its responsibilities with respect to the review of theCompany’s financial statements and the adequacy and effectiveness of itsinternal controls.  The Audit Committeeexpects the independent registered public accounting firm to call to itsattention any accounting, auditing, internal accounting control, regulatory orother related matters that such firm believes warrant consideration or actionby the Audit Committee.  The AuditCommittee’s responsibility is to monitor and oversee these processes.

In connection with these responsibilities, the AuditCommittee met several times during 2006 with management and/or the independentregistered public accounting firm with respect to various matters.  The Audit Committee has met with managementand the independent registered public accounting firm to review and discuss theDecember 31, 2006 financial statements. The Audit Committee met privately with the independent registered publicaccounting firm and discussed any issues deemed significant by the accountingfirm.  The Audit Committee also discussedwith the independent registered public accounting firm the matters required byStatement on Auditing Standards (“SAS”) No. 61 (Communication with AuditCommittees), as may be modified or supplemented.  The Audit Committee also received writtendisclosures and the letter from the independent registered public accountingfirm required by Independence Standards Board Standard No. 1 (IndependenceDiscussions with Audit Committees), which requires the written disclosure ofall relationships between the Company and the independent registered publicaccounting firm that, in the professional judgment of the independentregistered public accounting firm, may reasonably be thought to bear on suchfirm’s independence, and confirmation that, in such firm’s professionaljudgment, it is independent of the company that it is auditing.

Based on the Audit Committee’s discussions withmanagement, review of the independent registered public accounting firm’sletter and discussions with the independent registered public accounting firm,the Audit Committee has recommended that the Board include the auditedfinancial statements in the Company’s Annual Report on Form 10-KSB for theyear ended December 31, 2006 in its filing with the Securities andExchange Commission.

The Audit Committee has reviewed the non-audit feesincurred by the Company in 2006, which consist of professional servicesrendered with respect to the Company’s various filings with the Securities andExchange Commission, including work done relating to the restatement of various2005 and 2006 financial statements, and related matters, and the preparation ofcorporate income tax returns, and has concluded that the amount and nature ofthose fees is compatible with maintaining the independent registered publicaccounting firm’s independence.
|            | Respectfully Submitted,     |
|------------|-----------------------------|
|       |                        |
| ** ** | **Audit Committee Members** |
|       | Dimitri Villard, Chairman   |
|       | James N. Lane               |

 

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

**Executive Compensation**

The following table sets forth information concerningthe compensation earned by our Chief Executive Officer, our two other mosthighly compensated executive officers (who served during fiscal years endedDecember 31, 2006 and 2005, and whose total compensation during fiscal yearsended December 31, 2006 and 2005 exceeded $100,000) (collectively, the “*Named Executive Officers*”).  We have also included two additionalindividuals who serve as executive officers of MediaDefender, our wholly-ownedsubsidiary.

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**Summary Compensation Table**

** **
| Name and   Principal Position | ** ** | **Year** | ** ** | **Salary ($)** | ** ** | **Bonus ($)** | ** ** | **Stock   Awards  ($)** | ** ** | **Option   Awards  ($)** | ** ** | **Non-Equity   Incentive Plan   Compensation  ($)** | ** ** | **Nonqualified   Deferred   Compensation  ($)** | ** ** | **All  Other  Compensation  ($)** | ** ** | **Total  ($)** | ** ** |
|----------------------------------------------|------------|----------|------------|---------------------|------------|--------------------|------------|------------------------------|------------|-------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------|------------|----------------|------------|
| Jonathan V. Diamond                          |       | 2006     |       | 350,000             |       |               |       |                         |       |                          |       |                                                               |       |                                                      |       |                              |       | 350,000        |       |
| Chief Executive Officer                      |       | 2005     |       | 267,250             |       | 75,000             | (1)        |                         |       |                          |       |                                                               |       |                                                      |       |                              |       | 342,250        |       |
| Robert N. Weingarten                         |       | 2006     |       | 195,000             |       |               |       |                         |       |                          |       |                                                               |       |                                                      |       |                              |       | 195,000        |       |
| Chief Financial Officer                      |       | 2005     |       | 147,250             |       | 50,000             | (1)        |                         |       |                          |       |                                                               |       |                                                      |       |                              |       | 197,250        |       |
| Nicholas Turner                              |       | 2006     |       | 150,000             | (4)        |               |       |                         |       |                          |       |                                                               |       |                                                      |       | 31,000                            | (5)        | 181,000        |       |
| VP, Business Development                     |       | 2005     |       | 137,500             |       | 40,000             | (1)        |                         |       |                          |       |                                                               |       |                                                      |       |                              |       | 177,500        |       |
| Randy Saaf  Chief Executive Officer,    |       | 2006     |       | 350,000             |       |               |       |                         |       |                          |       |                                                               |       |                                                      |       | 534,600                           | (3)        | 884,600        |       |
| MediaDefender                                |       | 2005     |       | 147,880             | (2)        |               |       |                         |       |                          |       |                                                               |       |                                                      |       |                              |       | 147,880        |       |
| Octavio Herrera                              |       | 2006     |       | 350,000             |       |               |       |                         |       |                          |       |                                                               |       |                                                      |       | 534,600                           | (3)        | 884,600        |       |
| President, MediaDefender                     |       | 2005     |       | 147,880             | (2)        |               |       |                         |       |                          |       |                                                               |       |                                                      |       |                              |       | 147,880        |       |

 

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(1)                 Represents discretionary cash bonusesawarded to our Chief Executive Officer and Chief Financial Officer. We awardedsuch bonuses as consideration for management successfully completing ourcorporate restructuring during the three months ended March 31, 2005. Suchbonuses were paid in fiscal 2005. We also awarded a discretionary cashbonus to our VP, Business Development of $40,000, which was reviewed and approvedby the Compensation Committee of our Board of Directors, and was accrued atDecember 31, 2005. This bonus was paid in 2006.

(2)                 Joined the Company effective July 28,2005.

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

(4)                 Includes $62,500 for regular salary and anadditional $87,500 for consulting fees. Mr. Turner’s relationship with the Company terminated on December 31,2006.

(5)                 Includes $30,000 as a termination paymentfor the consulting agreement and $1,000 for a settlement to release allpotential claims against the company as part of the termination of a consultingagreement.

**OUTSTANDING EQUITY AWARDS AT FISCALYEAR-END**

The following table sets forth certain informationrelating to unexercised and outstanding options for each named executiveofficer as of December 31, 2006. No other equity awards otherwisereportable in this table have been granted to any of our named executiveofficers.

 
|                                                  | ** ** | **Option Awards**                                                                 | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|
| **Name**                                         | ** ** | **Number of  Securities  Underlying  Unexercised  Options (#)  Exercisable** | ** ** | **Number of  Securities  Underlying  Unexercised  Options  (#)  Unexercisable** | ** ** | **Option  Exercise  Price  ($)** | ** ** | **Option  Expiration  Date** | ** ** |
| Jonathan V. Diamond                              |       | 869,242                                                                                |       | 2,143,515 |   | $ | 1.55 |   | 08/05/10 |   |
| Chief Executive Officer                          |       |                                                                                   |       |   |   |   |   |   |   |
|                                             |       |                                                                                   |       |   |   |   |   |   |   |
| Robert N. Weingarten                             |       | 280,411                                                                                |       | 389,583 |   | 1.55 |   | 08/05/10 |   |
| Chief Financial Officer                          |       |                                                                                   |       |   |   |   |   |   |   |
|                                             |       |                                                                                   |       |   |   |   |   |   |   |
| Nicholas Turner                                  |       | 92,000                                                                                 |       | — |   | .79 |   | 01/01/12 |   |
| Former VP, Business Development                  |       |                                                                                   |       |   |   |   |   |   |   |
|                                             |       |                                                                                   |       |   |   |   |   |   |   |
| Randy Saaf                                       |       | 23,810                                                                                 |       | 176,190 |   | 3.00 |   | 07/28/12 |   |
| Chief Executive  Officer,  MediaDefender(1) |       |                                                                                   |       |   |   |   |   |   |   |
|                                             |       |                                                                                   |       |   |   |   |   |   |   |
| Octavio Herrera                                  |       | 23,810                                                                                 |       | 176,190 |   | 3.00 |   | 07/28/12 |   |
| President, MediaDefender(1)                      |       |                                                                                   |       |   |   |   |   |   |   |
|                                                  |            |                                                                                        |            |  |  |  |  |  |  |  |

 

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

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**DIRECTOR COMPENSATION**

**DirectorCompensation**

*Bonuses to Officers and Directors:*

At December 31, 2005, the Company accrued$100,000 with respect to board fees to two independent directors and $40,000with respect to a discretionary bonus to its former Vice President, BusinessDevelopment, which were paid in 2006. During the year ended December 31, 2005, the Company accrued andpaid bonuses of $75,000 and $50,000, respectively, to its Chief ExecutiveOfficer and Chief Financial Officer, respectively.

*Board of Directors Compensation:*

For the year ended December 31, 2006, eachnon-employee member of the Company’s Board of Directors received a cashretainer of $15,000, and a grant of stock options having a value (based uponthe appropriate Black-Scholes option valuation methodology) equal to$35,000.  The strike price for the options was set on the date of grantand the options vested entirely on December 31, 2006.  In addition,each director that serves on a Committee of the Board of Directors received,for each committee served, an additional cash retainer of $10,000, and a grantof stock options having a value equal to $15,000, having the same terms andconditions as options granted to all non-employee members of the Board ofDirectors generally.  The stock optiongrants were made on July 7, 2006 under the 2006 Equity Plan.

Fred Davis, who joined the Company’s Board ofDirectors in November 2005, and who did not receive any board compensation in2005, was considered a new director in 2006, and received a one-time grant ofstock options having a value equal to $25,000, a three-year vesting term andotherwise having the same terms and conditions as options granted to allnon-employee members of the Board of Directors generally.

Upon therecommendation of the Compensation Committee, the full board of directorsapproved an annual compensation arrangement for our independent directors forfiscal 2007 in March 2007 which is similar to the compensation paid in 2006.Such arrangement consists of the following:

***Fiscal 2007***

Directors who are not our employees will receive thefollowing compensation in fiscal 2007:

·       *Cash:* a cash retainer of $15,000, payablein equal installments of $7,500 in the third and fourth quarter of fiscal 2007;and

·       *Equity*: a grant of 10,000 stock options.The strike price for the options will be set on the date of grant and theoption will vest entirely on December 31, 2007.

In addition, each director that serves on a Committeeof the Board will receive the following compensation in fiscal 2007:

·       *Cash:* for each committee served, anadditional cash retainer of $10,000, payable in equal installments of $5,000 inthe third and fourth quarter of fiscal 2007; and

·       *Equity:* a grant of 5,000 stock options andhaving the same terms and conditions as options granted to all non-employeeBoard members generally.

All directors are reimbursed for reasonableout-of-pocket expenses incurred in attending meetings of the Board or anycommittee of the Board.

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***Fiscal 2006***

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

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

·       *Equity*: a grant of stock options having avalue (based upon appropriate Black-Scholes option valuation methodology) equalto $35,000. The strike price for the options will be set on the date of grantand the option will vest entirely on December 31, 2006.

In addition, each director that serves on a Committeeof the Board will receive the following compensation in fiscal 2006:

·       *Cash:* for each committee served, anadditional cash retainer of $10,000, payable in equal installments of $5,000 inthe third and fourth quarter of fiscal 2006; and

·       *Equity:* grant of stock options having avalue equal to $15,000, and having the same terms and conditions as optionsgranted to all non-employee Board members generally.

Mr. Davis received a one-time grant of stockoptions (please see above for more information).

All directors are reimbursed for reasonableout-of-pocket expenses incurred in attending meetings of the Board or anycommittee of the Board.

**Tabular Format**

The following table sets forth the compensation paidto all persons who served as members of our board of directors (other than ournamed executive officers) during the 2006 fiscal year. No director who is alsoa named executive officer received any compensation for services as a directorin 2006.

We reimburse each of our non-employee directors fortheir reasonable expenses incurred in connection with attending meetings of theboard of directors and related committees. 
| **Name**               | ** ** | **Fees Earned or   Paid in Cash   ($)** | ** ** | **Stock  Awards ($)** | ** ** | **Option Awards   ($)** | ** ** | **Non-Equity   Incentive Plan   Compensation ($)** | ** ** | **Nonqualified   Deferred   Compensation ($)** | ** ** | **All Other   Compensation ($)** | ** ** | **Total ($)** | ** ** |
|------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------|------------|-----------------------------------|------------|------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|-------------------------------------------------|------------|--------------------|------------|
|                   |       |                                                                  |       |                       |       |                              |       |                                                                   |       |                                                          |       |                                            |       |               |       |
| Frederick W.  Field    |       | 15,000                                                                |       | -0-                        |       | 35,000                            | (1)        | -0-                                                                    |       | -0-                                                           |       | -0-                                             |       | 50,000             |       |
| Fred Davis             |       | 35,000                                                                |       | -0-                        |       | 65,000                            | (1)        | -0-                                                                    |       | -0-                                                           |       | -0-                                             |       | 100,000            |       |
| Teymour  Boutros-Ghali |       | 15,000                                                                |       | -0-                        |       | 35,000                            | (1)        | -0-                                                                    |       | -0-                                                           |       | -0-                                             |       | 50,000             |       |
| Eric Pulier            |       | 15,000                                                                |       | -0-                        |       | -0-                               |       | -0-                                                                    |       | -0-                                                           |       | -0-                                             |       | 15,000             |       |
| Dimitri Villard        |       | 35,000                                                                |       | -0-                        |       | 65,000                            | (1)        | -0-                                                                    |       | -0-                                                           |       | -0-                                             |       | 100,000            |       |
| James N. Lane          |       | 35,000                                                                |       | -0-                        |       | 65,000                            | (1)        | -0-                                                                    |       | -0-                                                           |       | -0-                                             |       | 100,000            |       |

 

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(1)                This amount represents the fair marketvalue calculated in accordance with the Black-Scholes method of certain issuancesof stock options (at the time of issuance) to this director in payment of feesearned in connection with his services as a member of the Board of Directors.

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

The following table sets forth, as of April 1, 2007,the number and percentage of shares of Common Stock beneficially owned,directly or indirectly, by each of our directors, director-nominees, the NamedExecutive Officers (as defined below), beneficial owners known by the Companyof more than five percent of the outstanding shares of our Common Stock and byour directors and executive officers as a group. Beneficial ownership isdetermined in accordance with the Rule 13d-3(a) of the SecuritiesExchange Act of 1934, as amended, and do not necessarily indicate ownership forany other purpose, and generally includes voting or investment power withrespect to the shares and shares which such person has the right to acquirewithin 60 days of April 1, 2007.

55

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|                                                                                                                                      | ** ** | ** **                   | ** ** | **Amount and Nature** | ** ** | ** **          | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|---------------------|------------|
| ** **                                                                                                                           | ** ** | **Title of Class** | ** ** | **of Beneficial**          | ** ** | **Percent**         | ** ** |
| **Beneficial Owner(1)**                                                                                                         | ** ** | **of Stock**            | ** ** | **Ownership(2)**                | ** ** | **of Class**** | ** ** |
| *5% Stockholders:*                                                                                                                   |       |                         |       |                            |       |                |       |
|                                                                                                                                 |       |                         |       |                            |       |                |       |
| JMB Capital Partners,  L.P.  1999 Avenue of the Stars, Suite 2040  Los Angeles, California 90067                                |       | Common                       |       | 1,916,667                       | (3)        | 18.8                |       |
| WNTO7 Holdings, LLC  c/o Wayne, Gaynor, Umanoff & Pollack, LLP  6100 Center Drive, Suite 950  Los Angeles, California 90045 |       | Common                       |       | 1,224,017                       | (4)        | 12.0                |       |
| CCM Master Qualified  Fund, Ltd.  One North Wacker Drive, Suite 4725  Chicago, Illinois 60606                                   |       | Common                       |       | 2,245,936                       | (5)        | 22.0                | (6)        |
| Act II Master Fund,  Ltd.  444 Madison Avenue  New York, New York 10022                                                         |       | Common                       |       | 595,050                         | (7)        | 5.8                 |       |
| Jonathan M. Glaser  11601 Wilshire Boulevard, Suite 2180  Los Angeles, California 90025                                         |       | Common                       |       | 621,400                         | (13)       | 6.1                 |       |
| *Current Executive Officers and  Directors:*                                                                                         |       |                         |       |                            |       |                |       |
|                                                                                                                                 |       |                         |       |                            |       |                |       |
| Frederick W. Field                                                                                                                   |       | Common                       |       | 314,694                         | (8)        | 3.1                 |       |
| Jonathan V. Diamond                                                                                                                  |       | Common                       |       | 927,298                         | (8)        | 9.1                 |       |
| Robert N. Weingarten                                                                                                                 |       | Common                       |       | 295,694                         | (8)        | 2.9                 |       |
| Teymour Boutros-Ghali                                                                                                                |       | Common                       |       | 183,603                         | (9)        | 1.8                 |       |
| Eric Pulier                                                                                                                          |       | Common                       |       | 1,040,414                       | (10)       | 10.2                |       |
| Dimitri Villard                                                                                                                      |       | Common                       |       | 107,888                         | (8)        | 1.1                 |       |
| James N. Lane                                                                                                                        |       | Common                       |       | 102,606                         | (8)        | 1.0                 |       |
| Fred Davis                                                                                                                           |       | Common                       |       | 26,409                          | (14)       | *                   |       |
| Randy Saaf                                                                                                                           |       | Common                       |       | 224,520                         | (11)       | 2.2                 |       |
| Octavio Herrera                                                                                                                      |       | Common                       |       | 224,520                         | (11)       | 2.2                 |       |
| Nicholas Turner                                                                                                                      |       | Common                       |       | 92,000                          | (9)        | *                   |       |
| Rene Rousselet                                                                                                                       |       | Common                       |       | 50,000                          | (8)        | *                   |       |
| All current directors  and executive officers as a group (12 Persons)                                                           |       | Common                       |       | 3,589,646                       | (12)       | 35.1                |       |

 

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*                    Indicatesless than 1.0%

**             Basedon 10,217,291 shares of Common Stock outstanding as of April 11, 2007.

(1)             Unlessotherwise indicated, the address for each of the individuals listed in thetable is c/o ARTISTdirect, Inc., 1601 Cloverfield Boulevard, Suite 400 South,Santa Monica, California, 90404-4082.

(2)             Unlessotherwise indicated by footnote, the persons named in the table have solevoting and sole investment power with respect to all shares of common stockshown as beneficially owned by them, subject to applicable community propertylaws.

(3)             Basedon Schedule 13G filed on December 21, 2006.

(4)             Includes114,985 shares of Common Stock that may be exercised within 60 days ofApril 1, 2007 pursuant to a warrant. Members of WNT07 Holdings, LLC include Teymour Boutros-Ghali and FDTTrust-2005. Teymour Boutros-Ghali and Eric Pulier, both members of our Boardare the managing members and have voting power with respect to the shares.

(5)             Basedon Schedule 13G filed on February 14, 2007.

(6)             CCMMaster Qualified Fund, Ltd. was also issued a $13,000,000 principal amountconvertible subordinated note and a warrant to purchase 691,935 shares ofcommon stock in the subordinated debt financing completed by us in July 2005.Both contain a limitation on exercise provision that prevents CCM MasterQualified Fund, Ltd. from holding more than 9.99% of our outstanding CommonStock.

(7)             Basedon Schedule 13G filed on February 13, 2007.

(8)             Consistssolely of stock options to purchase shares of Common Stock that are exercisablewithin 60 days of April 1, 2007, except for the shares held by ReneRousselet who holds 12,500 options exercisable within 60 days of April 1, 2007.

(9)             Referto footnote (4) above. Mr. Boutros-Ghali holds a 15% economicinterest in WNT07 Holdings, LLC.  Inaddition, this number consists of 12,324 options owned personally by Mr.Boutros-Ghali that can be exercised within 60 days of April 1, 2007.

56

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(10)       Referto footnote (4) above. FDT Trust-2005 holds a 85% economic interest inWNT07 Holdings, LLC. The trustee of FDT Trust-2005 is Greg Pulier, the brotherof Eric Pulier. The beneficiaries of the trust consist of the livingdescendants of Myron Pulier, the father of Eric Pulier, as determined by GregPulier.

(11)       Consistsof a warrant to purchase 119,758 shares of Common Stock and options to purchase104,762 shares of Common Stock that are exercisable within 60 days ofApril 1, 2007. Messrs. Saaf and Herrera each elected to invest $2.25 million inour subordinated financing completed by us in July 2005.

(12)       Referto footnotes (4) and (8)-(11) above.

(13)       Basedon Schedule 13G filed on December 31, 2006.

(14)       Consistsof 26,409 options that have fully vested as of December 31, 2006.

**Employment Agreements**

On July 28, 2005, the Company entered into anEmployment Agreement with Jonathan Diamond, the Company’s Chief ExecutiveOfficer. During the term of the Employment Agreement, which shall continuethrough December 31, 2008, Mr. Diamond will earn a base salary of noless than $350,000 per annum, plus certain specified perquisites that include amonthly car allowance. Mr. Diamond is also eligible to receive an annualdiscretionary bonus of up to 100% of base salary, as determined by theCompensation Committee of the Board of Directors or, if none, the Board ofDirectors, and an annual performance bonus of up to 100% of base salary if theCompany achieves specified earnings targets in fiscal 2007 and 2008.Mr. Diamond shall also be entitled to receive stock options at thediscretion of the Company’s Board of Directors. In the event Mr. Diamondis 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.   On June 19, 2006 and July 31, 2006, theCompany entered into agreements with Mr. Diamond to incorporate non-materialmodifications into the Employment Agreement.

On July 28, 2005, the Company entered into anEmployment Agreement with Robert Weingarten, the Company’s Chief FinancialOfficer. During the term of the Employment Agreement, which shall continuethrough December 31, 2008, Mr. Weingarten will earn a base salary ofno less than $195,000 per annum, plus certain specified perquisites thatinclude a monthly car allowance. Mr. Weingarten is also eligible 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 eventMr. Weingarten is terminated “without cause,” he shall be entitled toreceive 12 months of severance pay at the rate of 100% of his monthlysalary, any performance bonus due for the year in which termination occurs andall stock options subject to time vesting shall be deemed fully vested andexercisable.  On June 19, 2006 and July31, 2006, the Company entered into agreements with Mr. Weingarten toincorporate non-material modifications into the Employment Agreement.

In accordance with the MediaDefender transaction, theCompany acknowledged the terms of Employment Agreements entered into onJuly 28, 2005 by MediaDefender with each of Randy Saaf, who serves asChief Executive Officer of MediaDefender, and Octavio Herrera, who serves asPresident of MediaDefender. Mr. Saaf and Mr. Herrera will each earn a base salary of noless than $350,000 per annum during the initial term of the agreements, whichshall continue until December 31, 2008. Mr. Saaf and Mr. Herrera are each entitled to receive twelvemonths of severance pay at the rate of 100% of their monthly salary and thepro-rata portion of the performance bonus referenced below if they areterminated “without cause.”  In addition,the Company granted stock options to purchase 200,000 shares of common stock toeach of Mr. Saaf and Mr. Herrera, exercisable for a period of fiveyears at $3.00 per share.  On July 28,2006, the Company entered into agreements with Mr. Saaf and Mr. Herrera toincorporate non-material modifications into the Employment Agreements.

Future paymentsunder employment agreements are as follows:
| Years Ending December 31, | ** ** | **(in thousands)** | ** ** |
|------------------------------------------|------------|-------------------------|------------|
|                                     |       |                    |       |
| 2007                                     |       | $                       | 1,743      |   |
| 2008                                     |       | 1,515                   |       |
| 2009                                     |       | 33                      |       |
|                                     |       | $                       | 3,291      |   |

 

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*ConsultingAgreements*

On October 9, 2006, the Company entered into aneighteen-month non-exclusive consulting agreement with Wood River Ventures, LLCand Jonathan Dolgen for consulting and advisory services with respect to thebusiness and operations of the Company.  The consulting agreement providesfor an aggregate cash fee of $187,500, payable quarterly in six installments of$31,250, and a stock award valued at $112,500, consisting of 34,615 shares ofcommon stock based on the Company’s closing stock price on October 10, 2006 of$3.25 per share to be issued under the Company’s 2006 Equity IncentivePlan.  The shares vest pro rata over the eighteen-month period of theconsulting agreement, beginning on October 10, 2006 and thereafter monthly onthe first day of each month of the term of the consulting agreement throughMarch 2008.  Accordingly, during the yearended December 31, 2006, the Company issued 5,769 shares of common stock underthis consulting agreement.

On October 1,2006, the Company entered into a one-year non-exclusive consulting agreementwith an individual for business development consulting services.  The consulting agreement provides for anaggregate cash fee of $108,000, consisting of an initial payment of $18,000 anda base fee payable monthly in twelve installments of $7,500, and stock options,consisting of an initial award of options to acquire 25,000 shares of commonstock, and subsequent awards of options to acquire 5,000 shares of common stockon the last day of each month of the term of the consulting agreement through September30, 2007.  The stock options are fullyvested when issued.  Accordingly, duringthe year ended December 31, 2006, the Company issued options to acquire 35,000shares of common stock under this consulting agreement.

**Option Plans**

We currently maintain our 2006 Equity Incentive Plan,our 1999 Employee Stock Option Plan, our 1999 Artist Plan, our 1999 Artist andArtist Advisor Plan and our 2004 Consultant Plan (collectively, the “*Current**OptionPlans*”). At April 1, 2007, an aggregate of 1,354,344 stockoptions were outstanding under the Current Option Plans. The are an additional 4,087,127stock options outstanding at April 1, 2007 that were issued by us outside ofthe Current Option Plans.

**EQUITY COMPENSATION PLAN INFORMATION**

The following table provides information as of April1, 2007 regarding compensation plans (including individual compensationarrangements) under which our securities are authorized for issuance.Information is included for both equity compensation plans approved by ourstockholders and equity compensation plans not approved by our stockholders.
| Plan Category                                      | ** ** | **Number of Securities to be  Issued Upon Exercise of  Outstanding Options,  Warrants and Rights  (a)** | ** ** | **Weighted-average Exercise  Price of Outstanding  Options, Warrants and  Rights  (b)** | ** ** | **Number of Securities  Remaining Available  for Future Issuance  Under Equity  Compensation Plans  (excluding securities  reflected in column (a))  (c)** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by stockholders     |       | 302,370                                                                                                                                                   |       | $                                                                                                                | 7.50       |                                                                                                                                                                                                              | 142,110    |   |
| Equity  compensation plans not approved by stockholders |       | 4,765,379                                                                                                                                                 |       | $                                                                                                                | 3.22       |                                                                                                                                                                                                              | 1,942,731  |   |
| Total                                                   |       | 5,067,749                                                                                                                                                 |       | $                                                                                                                | 3.46       |                                                                                                                                                                                                              | 2,084,841  |   |

 

*1999 Employee Stock Option Plan*

The 1999 Employee Stock Option Plan became effectiveon October 6, 1999 in connection with our conversion from ARTISTdirect, LLCinto ARTISTdirect, Inc. All options to purchase membership units in the limitedliability company which were outstanding at the time of such conversion wereassumed by the corporation and converted into options for shares of our CommonStock. The number of shares subject to each assumed and converted option wasequal to the number of membership units in the limited liability company whichwere subject to that option immediately prior to the conversion, and theexercise price per share remained the same as the per unit exercise price ineffect under the option at the time of conversion.

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

The 1999 Employee Stock Option Plan is anon-stockholder approved plan under which options may be granted to employees,non-employee members of our Board, and consultants and other independentadvisors in our employ or service. The number of shares of Common Stockissuable over the term of the 1999 Employee Stock Option Plan was initially650,000 shares and automatically increases each year by two percent of thetotal number of shares of our Common Stock outstanding on the last trading dayin December in the immediately preceding calendar year, provided that no annualincrease shall exceed 87,500.

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

*1999 Artist Plan*

The 1999 Artist Plan became effective on October 6,1999 in connection with our conversion from ARTISTdirect, LLC intoARTISTdirect, Inc. All options to purchase membership units in the limitedliability company which were outstanding at the time of such conversion wereassumed by the corporation and converted into options for shares of our CommonStock. The number of shares subject to each assumed and converted option wasequal to the number of membership units in the limited liability company whichwere subject to that option immediately prior to the conversion, and theexercise price per share remained the same as the per unit exercise price ineffect under the option at the time of conversion. Except for the conversion ofthe securities subject to the option into shares of our Common Stock, eachoption will continue to be governed by the terms of the agreement evidencingthat option at the time of our conversion into a corporation.

The 1999 Artist Plan is a non-stockholder approvedplan under which options were granted to performing artists who providedproducts and services through the ARTISTchannel Web sites we operate andmaintain for them pursuant to ARTISTchannel agreements. The number of shares ofCommon Stock issuable over the term of the 1999 Artist Plan was initially400,000 shares and automatically increases each year by two percent of thetotal number of shares of our Common Stock outstanding on the last trading dayin December in the immediately preceding calendar year, provided that no annualincrease shall exceed 87,500.

All option grants under the 1999 Artist Plan have anexercise price per share equal to the fair market value per share of our CommonStock on the grant date. Each option vests in installments over the period theoptionee’s ARTISTchannel agreement remains in effect. The options will vest onan accelerated basis in the event ARTISTdirect is acquired and those optionsare not assumed or replaced by the acquiring entity. Each option has a maximumterm (not to exceed ten years) set by the plan administrator (our CompensationCommittee) at the time of grant, subject to earlier termination following thetermination of the optionee’s ARTISTchannel agreement. All options are non-statutoryoptions under the Federal tax law.

*1999 Artist and Artist Advisor Plan*

The 1999 Artist and Artist Advisor Plan becameeffective on October 6, 1999 in connection with our conversion fromARTISTdirect, LLC into ARTISTdirect, Inc. All options to purchase membershipunits in the limited liability company which were outstanding at the time ofsuch conversion were assumed by the corporation and converted into options forshares of our Common Stock. The number of shares subject to each assumed and convertedoption was equal to the number of membership units in the limited liabilitycompany which were subject to that option immediately prior to the conversion,and the exercise price per share remained the same as the per unit exerciseprice in effect under the option at the time of conversion. Except for theconversion of the securities subject to the option into shares of our CommonStock, each option will continue to be governed by the terms of the agreementevidencing that option at the time of our conversion into a corporation.

The 1999 Artist and Artist Advisor Plan is anon-stockholder approved plan under which options were granted to performingartists and their attorneys, business managers, agents and other advisors whoprovided services to us. The number of shares of Common Stock issuable over theterm of the 1999 Artist and Artist Advisor Stock Option Plan was initially185,000 shares and increased by 37,500 shares on January 1, 2001 and2002, respectively to a total of 260,000 as of December 31, 2002 (subject toadjustment for certain changes in our capital structure). The share reservewill automatically increase on the first trading day in January each calendaryear by an amount equal to one percent of the total number of shares of ourCommon Stock outstanding on the last trading day in December in the immediatelypreceding calendar year, but in no event will any such annual increase exceed37,500 shares.

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All option grants under the 1999 Artist and ArtistAdvisor Stock Option Plan have an exercise price per share equal to the fairmarket value per share of our Common Stock on the grant date. Each option vestsin installments over the optionee’s period of service with us. The options willvest on an accelerated basis in the event we are acquired and those options arenot assumed or replaced by the acquiring entity. Each option has a maximum term(not to exceed ten years) set by the plan administrator at the time of grant,subject to earlier termination following the termination of the optionee’s servicefor cause. All options are non-statutory options under the Federal tax law.

Share issuances under the 1999 Employee Stock OptionPlan, the 1999 Artist Plan and the 1999 Artist and Artist Advisor Plan will notreduce or otherwise affect the number of shares of Common Stock available forissuance under the 1999 Employee Stock Purchase Plan, and share issuances under1999 Employee Stock Purchase Plan will not reduce or otherwise affect thenumber of shares of Common Stock available for issuance under the 1999 EmployeeStock Option Plan, the 1999 Artist Plan and the 1999 Artist and Artist AdvisorPlan.

*2004 Consultant Stock Plan*

Effective September 29, 2004, the Board adopted the2004 Consultant Stock Plan in order for us to be able to compensate consultants,at our option, who provide bona fide services to us not in connection withcapital raising or promotion of our securities. The 2004 Consultant Stock Planwill expire on September 29, 2014, and provides for the issuance of up to500,000 shares of Common Stock to consultants at fair market value. The 2004Consultant Stock Plan is a non-stockholder approved plan.

*2006 Equity Incentive Plan*

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

A total of1,500,000 new shares of the Registrant’s common stock have initially beenreserved for issuance under the 2006 Equity Plan.

Awards under the2006 Equity Plan may be granted to any of the Registrant’s employees,directors, officers, consultants or those of the Registrant’s affiliates.Awards may consist of stock options (both incentive stock options andnon-statutory stock options), stock awards, stock appreciation rights and cashawards. An incentive stock option may be granted under the 2006 Equity Planonly to a person who, at the time of the grant, is an employee of theRegistrant or a parent or subsidiary of the Registrant.

The 2006 EquityPlan will be administered by the Registrant’s Compensation Committee, which theBoard of Directors appointed to be the “Administrator” of the plan, with fullpower to authorize the issuance of shares of the Registrant’s common stock andto grant options or rights to purchase shares of the Registrant’s common stock.The Administrator has the power to determine the terms of the awards, includingthe exercise price, the number of shares subject to each award, theexercisability of the awards and the form of consideration payable uponexercise. The Compensation Committee may delegate the day-to-day administrationof the 2006 Equity Plan to one or more individuals.

The 2006 EquityPlan provides that in the event of a merger of the Registrant with or intoanother corporation or of a “change in control” of the Registrant, includingthe sale of all or substantially all of the Registrant’s assets, and certainother events, the Board of Directors or the Compensation Committee may, in itsdiscretion, provide for the assumption or substitution of, or adjustment to,each outstanding award, accelerate the vesting of options and stockappreciation rights, and terminate any restrictions on stock awards or cashawards or provide for the cancellation of awards in exchange for a cash paymentto the participant.

The 2006 EquityPlan will terminate on June 19, 2016, unless terminated earlier by theBoard of Directors or the Compensation Committee. No awards may be made afterthe termination date; however, unless otherwise expressly provided in an applicableaward agreement, any award granted under the plan prior to the expiration mayextend beyond the end of such period through the award’s normal expirationdate.

The Board ofDirectors or the Compensation Committee may generally amend or terminate the2006 Equity Plan as determined to be advisable. The Internal Revenue Code orthe rules of the Securities and Exchange Commission may also require theRegistrant’s stockholders to approve certain amendments. The Board of Directorsor the Compensation Committee may amend the 2006 Equity Plan withoutstockholder approval to comply with legal, regulatory and listing requirementsand to avoid unanticipated consequences determined to be inconsistent with thepurpose of the plan or any award agreement.

A complete copy ofthe 2006 Equity Plan can be found in the Registrant’s definitive proxystatement on Schedule 14A filed with the Securities and Exchange Commission onMay 8, 2006.

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*Non-Plan; Non-Stockholder ApprovedStock Option Grants*

Effective May 31,2001, we issued to Frederick W. (Ted) Field, our Chairman and former ChiefExecutive Officer, a non-qualified stock option to purchase 302,370 shares ofcommon stock exercisable at $7.50 per share through May 30, 2008.  The option vested over a period of five yearsfrom June 29, 2001, and was fully vested in 2006.  The fair value of the stock option,determined pursuant to the Black-Scholes option-pricing model, was $2,006,000,of which $201,000 was charged to operations in 2006.

Effective September 29, 2003, we issued toJonathan V. Diamond, our Chief Executive Officer, a non-plan, non-qualifiedstock option to purchase 259,659 shares of common stock exercisable throughAugust 15, 2010 at $0.85 per share, which was the approximate fair marketvalue of the common stock on the date of grant. The option vested over a period of three years from the date of grant,and was fully vested in 2006.  The fairvalue of the stock option, determined pursuant to the Black-Scholesoption-pricing model, was $221,000, of which $36,000 was charged to operationsin 2006.

Effective March 29, 2004, we issued to Robert N.Weingarten, our Chief Financial Officer, a non-plan, non-qualified stock optionto purchase 120,000 shares at $0.50 per share, which was not less than the fairmarket value on the date of grant, exercisable through March 29,2011.  The option vests and becomesexercisable in a series of thirty-six successive equal monthlyinstallments from March 29, 2004 through March 29, 2007.  The fair value of the stock option, determinedpursuant to the Black-Scholes option-pricing model, was $42,000, of which$14,000 was charged to operations in 2006.

On July 28, 2005, we issued Jonathan Diamond ,our President and Chief Executive Officer, a non-plan, non-qualified stockoption to purchase 2,753,098 shares of Common Stock exercisable at$1.55 per share, which was the approximate fair market value of the CommonStock on the date of grant, through August 25, 2010. Approximately 38percent of such stock options vests at the rate of 1/3rd per year over athree-year period and the remaining approximately 62 percent vests upon theachievement of certain financial milestones by ARTISTdirect.

On July 28, 2005, we issued Robert Weingarten,our Chief Financial Officer, a non-plan, non-qualified stock option to purchase550,000 shares of Common Stock exercisable at $1.55 per share, which was notless than the fair market value on the date of grant, through August 25, 2010.One half of such stock option vests at the rate of 1/3 per year over a threeyear period and one half will vest upon the achievement of certain financialmilestones by ARTISTdirect.

The above-referenced stock option grants were issuedwithout registration in reliance upon the exemption afforded by Section 4(2) ofthe Securities Act of 1933, as amended, based on certain representations madeto us by the recipients.

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

**Certain Relationships and Related Transactions**

*OfficeSub-Lease*

From the thirdquarter of 2003 through March 2006, the Company’s administrative offices werelocated in an office leased by Radar Pictures, Inc., a company owned byTed Field, the Chairman of the Board of Directors of the Company, pursuant to amonth-to-month arrangement.  For the yearended December 31, 2005, the Company accrued $90,000 to RadarPictures, Inc. as rent and facilities usage expense.  On February 28, 2005, the Company paidRadar Pictures, Inc. accrued rent through December 31, 2004.Commencing January 1, 2005, the Company began paying rent at a rate of $7,500per month for these facilities.  TheCompany relocated to new office facilities in March 2006.

*Transactions Related toMediaDefender Acquisition*

In conjunction with the acquisition of MediaDefender,the Company issued 1,109,032 shares of common stock and a seven-year warrant topurchase 114,985 shares of common stock with an exercise price of $1.55 pershare to WNT07 Holdings, LLC.  Themanagers of WNT07 Holdings, LLC are Eric Pulier and Teymour Boutros-Ghali, bothof whom are members of the Company’s Board of Directors.  The shares and warrants were issued asconsideration for services provided by Mr. Pulier andMr. Boutros-Ghali as consultants to the Company in connection with theacquisition of MediaDefender.

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 Agreement prohibits any of the Advisors(i) from engaging in certain competitive business activities and(ii) from soliciting existing employees of the Company or itssubsidiaries.  The covenants not tocomplete or solicit expire on the earlier of April 1, 2007 or the date oftermination of Advisor’s services with the Company.

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The Company also acknowledged the terms ofNon-Competition Agreements entered into on July 28, 2005 by MediaDefenderand Mr. Saaf and Mr. Herrera. The Non-Competition Agreements prohibit Mr. Saaf andMr. Herrera from (i) engaging in certain competitive businessactivities, (ii) soliciting customers of MediaDefender or the Company,(iii) soliciting existing employees of MediaDefender or the Company and(iv) disclosing any confidential information regarding MediaDefender orthe Company.  Each agreement has a termof four years and shall continue to remain in force and effect in theevent the above-referenced Employment Agreements are terminated prior to theend of the four-year term of the Non-Competition Agreements.  In consideration, Mr. Saaf andMr. Herrera were each entitled to a cash payment of $525,000 fromMediaDefender on December 31, 2006, which payments were timely made.

Randy Saaf and Octavio Herrera, formerly principalsand stockholders of MediaDefender and currently both executive officers of theCompany’s wholly-owned subsidiary, MediaDefender, each invested $2,250,000 inthe Sub-Debt Financing on the same terms and conditions as the other Sub-DebtFinancing investors.

*Eric Pulier*

Effective as of January 1, 2006, the Companyentered into a one-year consulting agreement with Eric Pulier, a director ofthe Company, through WNT Consulting Group, a California limited liabilitycompany wholly-owned by Mr. Pulier (“WNT”). The consulting agreement was approved by the disinterested members ofthe Company’s Board of Directors. Effective January 12, 2007, the parties mutually agreed to terminatethis consulting agreement, which had automatically renewed for a secondone-year term through December 31, 2007.  Under the terms of the originalconsulting agreement, Mr. Pulier received a base fee of $10,000 per month,certain other mandatory payments, and was also eligible to receive cash bonuseson the achievement of certain specified milestones.  The terminationagreement provided for a one-time cash payment to Mr. Pulier (through WNT) inthe amount of $100,000 (which was paid in January 2007), in consideration forthe termination of the consulting agreement and an acknowledgement and completerelease of any and all claims related to unpaid compensation, bonus amounts orother out-of-pocket expenses (in cash or otherwise) that may have been owed bythe Company as of January 12, 2007.  Mr. Pulier will continue to serve asa member of the Company’s Board of Directors.  The termination agreementwas approved by the Compensation Committee of the Company’s Board of Directors.

On January 12, 2007, the Company entered into a newconsulting agreement with Mr. Pulier (through WNT).  During the term ofthe new consulting agreement, which commenced January 12, 2007 and continues ineffect until any party provides ten days prior written notice to the otherparties of its intention to terminate, Mr. Pulier will provide non-exclusiveconsulting and advisory services to the Company outside of the ordinary courseof his services as a member of the Board of Directors.  In consideration,Mr. Pulier (through WNT) is entitled to receive hourly compensation at the rateof $500 per hour.  Any consulting request made by the Company must beapproved in advance by all parties prior to commencement of services.  Thenew consulting agreement was approved by the Compensation Committee of theCompany’s Board of Directors.

*Nicholas Turner*

On November 28, 2006, the Company acknowledged theterms of a release of claims (the “Release”) entered into by Nicholas Turner,the Company’s former Vice President, Business Development.  Pursuant tothe terms of the Release, Mr. Turner has agreed to fully waive any and allclaims that he may have against the Company, including any such claims relatedto the terms of his employment or otherwise, if any, that may have arisen priorto the execution date of the Release.  The Company further acknowledgedthat the effective date of Mr. Turner’s resignation as the Company’s VicePresident, Business Development was August 31, 2006.

The Company and Mr. Turner also entered into anindependent contractor agreement dated November 28, 2006 (the “ContractorAgreement”), in order to provide for Mr. Turner’s temporary continued serviceswith the Company.  The Contractor Agreement was scheduled to remain ineffect for a period of eight months, commencing as of September 1, 2006 (the “Term”);provided, that, the Contractor Agreement could be terminated prior to the endof the Term by Mr. Turner for any reason or by the Company (i) for “cause,”(ii) the death or disability of Mr. Turner or (iii) for any reason at itsoption effective as of December 31, 2006 by making a one-time cash payment toMr. Turner of $30,000 in the aggregate (the “Early Termination Option”). The Contractor Agreement prohibited Mr. Turner from engaging in certaincompetitive business activities and from soliciting existing employees,customers, clients or vendors of the Company or its subsidiaries.  The covenants not to compete or solicitexpire on the later of April 30, 2007 and the date of termination of Mr. Turner’sconsulting services with the Company.  Inconsideration, Mr. Turner was entitled to receive from the Company a base feeof $12,500 for the first four-month period (comprised of $5,000 in cash and$7,500 in the form of a short-term loan, which would be forgiven on April 30,2007 if Mr. Turner has complied with the provisions of the covenants not tocompete or solicit) and $7,500 per month during the second four-month period (includinga recoupable advance), as well as certain commission and bonus amounts,assuming achievement of specified milestones. The Contractor Agreement was approved by the Compensation Committee ofthe Company’s Board of Directors.

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

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*Fred Davis*

During the year ended December 31, 2006, the Companyincurred legal fees of approximately $45,000 to Davis Shapiro Lewit &Hayes, LLP, a law firm in which Fred Davis, a director of the Company, is apartner.

**DirectorIndependence**

Our board ofdirectors is comprised of a majority of independent directors.

*IndependentDirectors*. The current independent directors of the Board areas follows:  Frederick W. Field (Chairman), Fred Davis (member ofCompensation and Nominating Committees), James Lane (member of Audit andNominating Committees) Teymour Boutros-Ghali and Dimitri Villard (member ofAudit Committee and Compensation Committee).****Eachof these directors qualifies as an independent director in accordance with thepublished listing requirements of the American Stock Exchange. In addition, ourboard of directors has made a subjective determination as to each independentdirector that no relationships exist which, in the opinion of our board ofdirectors, would interfere with the exercise of independent judgment incarrying out the responsibilities of a director. In making thesedeterminations, our directors reviewed and discussed information provided bythe directors and us with regard to each director’s business and personalactivities as they may relate to us and our management.

*BoardStructure and Committees*. Our board of directors hasestablished an audit committee, nominating committee and a compensationcommittee. Our board of directors and its committees set schedules to meetthroughout the year and also can hold special meetings and act by writtenconsent from time to time as appropriate. Our board of directors has delegatedvarious responsibilities and authority to its committees as generally describedabove (see “The Board of Directors and Committees”). The committees willregularly report on their activities and actions to the full board ofdirectors. Each member of each committee of our board of directors qualifies asan independent director.

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

The informationrequired by this Item is set forth in the section of this Annual Report onForm 10-KSB entitled “EXHIBIT INDEX” and is incorporated herein byreference.

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

Aggregate fees billed by our current independent registeredpublic accounting firm, and where indicated, by our predecessor independentregistered public accounting firm, for the years ended December 31, 2006and 2005, respectfully, are as follows:
|                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|
| Audit Fees                              |       | $        | 213,970    |     | $          | 149,585 |   |
| Audit-Related  Fees                     |       | $        | 137,890    |     | $          | 85,250 | (1) |
| Tax Fees                                |       | $        | 40,490     |     | $          | 48,930 |   |
| All Other Fees                          |       | $        | —     |     | $          | 172,350 |   |
| Audit Fees Relating to  the Restatement |       | $        | 30,030     |     | $          | — |   |

 

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(1)             $25,050billed by KPMG.

**Audit Fees; Audit-Related Fees**

Audit and audit-related fees consist of fees for theaudit of our financial statements, the review of our interim financialstatements and other audit services, including the review of and, asapplicable, consent to documents filed by us with the Securities and ExchangeCommission.

**Tax Fees**

Tax fees consist of fees for tax compliance, includingthe preparation of tax returns, tax advice, and tax planning services. Taxadvice and tax planning services relate to advice regarding mergers andacquisitions and assistance with tax audits and appeals.

**All Other Fees**

All other fees consist of fees for audit-related feesand the audit of financial statements for MediaDefender, Inc.

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**Policy on Accounting Matters; Pre-Approval of Audit andNon-Audit Services of Independent Registered Public Accounting Firm**

The primary purpose of the Audit Committee is toassist the Board in monitoring (i) the integrity of our financialstatements and disclosures, including oversight of the accounting and financialreporting processes and the audits of our financial statements (ii) thecompliance by us with our legal, ethical and regulatory requirements and(iii) the independence and performance of our independent registeredpublic accounting firm.

The Audit Committee’s policy is to pre-approve all auditand non-audit services, other than *deminimis* non-audit services, provided by the independent registeredpublic accounting firm. These services may include, among others, auditservices, audit-related services, tax services and other services. Pre-approvalis generally provided for up to one year and any pre-approval is detailed as toparticular service or category of services and is generally subject to aspecific budget. The independent registered public accounting firm andmanagement are required to periodically report to the full Board regarding theextent of services provided by the independent registered public accountingfirm in accordance with this pre-approval, and the fees for the servicesperformed to date.

The Audit Committee has considered the provision ofnon-audit services provided by our independent registered public accountingfirm to be compatible with maintaining their independence. The Audit Committeewill continue to approve all audit and permissible non-audit services providedby our independent registered public accounting firm. These services mayinclude audit services and related services, tax services, and other services.

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.
|        | ** **     | **ARTISTdirect, Inc.** |
|--------|----------------|------------------------|
|   | ** **     | ** **             |
| Date:  | April 30, 2007 | By:                    | /s/ Jonathan V. Diamond |
|   |           |                   | Jonathan V. Diamond |
|   |           |                   | Chief Executive Officer (Principal Executive  Officer) |
|   |           |                   |   |
| Date:  | April 30, 2007 | By:                    | /s/ Robert N.  Weingarten |
|   |           |                   | Robert N. Weingarten |
|   |           |                   | Chief Financial Officer (Principal Financial  Officer) |

 

**POWER OF ATTORNEY**

KNOW ALL PERSONSBY THESE PRESENTS, that each of the persons whose signature appears belowhereby constitutes and appoints Jonathan V. Diamond and Robert N.Weingarten, each of them acting individually, as his attorney-in-fact, eachwith the full power of substitution, for him in any and all capacities, to signany and all amendments to this Annual Report on Form 10-KSB, and to filethe same, with all exhibits thereto and other documents in connectiontherewith, with the Securities and Exchange Commission, granting unto saidattorneys-in-fact, and each of them, full power and authority to do and performeach and every act and thing requisite and necessary to be done in and aboutthe premises as fully to all intents and purposes as he might or could do inperson, hereby ratifying and confirming our signatures as they may be signed byour said attorney-in-fact and any and all amendments to this Annual Report onForm 10-KSB.

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the Registrant and in thecapacities and on the dates indicated.
| Signature                  | ** ** | **Title**                                                            | ** ** | **Date**            |
|----------------------------|------------|----------------------------------------------------------------------|------------|---------------------|
|                       |       |                                                                 |       |                |
| /s/ Frederick W.  Field    |       | Chairman of the Board of Directors                                   |       | April 30, 2007 |
| Frederick W.  Field        |       |                                                                 |       |                |
|                       |       |                                                                 |       |                |
|                       |       |                                                                 |       |                |
|                       |       | President, Chief Executive Officer and Director                      |       |                |
| /s/ Jonathan V.  Diamond   |       | (Principal Executive Officer)                                        |       | April 30, 2007 |
| Jonathan V.  Diamond       |       |                                                                 |       |                |
|                       |       |                                                                 |       |                |
|                       |       |                                                                 |       |                |
| /s/ Robert N.  Weingarten  |       | Chief Financial Officer and Secretary (Principal Financial  Officer) |       | April 30, 2007 |
| Robert N.  Weingarten      |       |                                                                 |       |                |
|                       |       |                                                                 |       |                |
| /s/ Rene  Rousselet        |       | Corporate Controller (Principal Accounting Officer)                  |       | April 30, 2007 |
| Rene Rousselet             |       |                                                                 |       |                |
|                       |       |                                                                 |       |                |
| /s/ Teymour  Boutros-Ghali |       | Director                                                             |       | April 30, 2007 |
| Teymour  Boutros-Ghali     |       |                                                                 |       |                |
|                       |       |                                                                 |       |                |
|                       |       |                                                                 |       |                |
| /s/ Fred Davis             |       | Director                                                             |       | April 30, 2007 |
| Fred Davis                 |       |                                                                 |       |                |
|                       |       |                                                                 |       |                |
|                       |       |                                                                 |       |                |
| /s/ James Lane             |       | Director                                                             |       | April 30, 2007 |
| James Lane                 |       |                                                                 |       |                |
|                       |       |                                                                 |       |                |
|                       |       |                                                                 |       |                |
| /s/ Eric Pulier            |       | Director                                                             |       | April 30, 2007 |
| Eric Pulier                |       |                                                                 |       |                |
|                       |       |                                                                 |       |                |
|                       |       |                                                                 |       |                |
| /s/ Dimitri  Villard       |       | Director                                                             |       | April 30, 2007 |
| Dimitri Villard            |       |                                                                 |       |                |

 

65

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ARTISTDIRECT,INC. AND SUBSIDIARIES

INDEXTO CONSOLIDATED FINANCIAL STATEMENTS

YEARSENDED DECEMBER 31, 2006 AND 2005

**Table ofContents**
| Report of Independent Registered  Public Accounting Firm:                                              |   |   |   |
|--------------------------------------------------------------------------------------------------------|--------|--------|--------|
| Gumbiner Savett Inc.                                                                                   |   |   |   |
|                                                                                                   |   |   |   |
| Consolidated Financial Statements:                                                                     |   |   |   |
| Balance Sheets — December 31, 2006 and  2005                                                      |   |   |   |
| Statements of Operations —  Years Ended December 31, 2006 and 2005                                |   |   |   |
| Statements  of Changes in Stockholders’ Deficiency — Years Ended December 31, 2006 and  2005 |   |   |   |
| Statements  of Cash Flows — Years Ended December 31, 2006 and 2005                                |   |   |   |
| Notes to  Consolidated Financial Statements — Years Ended December 31, 2006 and 2005              |   |   |   |

 

66

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM

To the Board of Directors and Stockholders

ARTISTdirect, Inc.

We have audited theaccompanying consolidated balance sheets of ARTISTdirect, Inc. and subsidiaries(the “Company”) as of December 31, 2006 and 2005, and the related consolidatedstatements of operations, stockholders’ deficiency and cash flows for each ofthe years then ended.  These financialstatements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these consolidated financial statements based on our audits.

We conducted our auditsin accordance with standards of the Public Company Accounting****Oversight Board (United States).  Those standards require that we plan andperform the audits to obtain reasonable assurance about whether theconsolidated financial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the consolidated financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made by management,as well as evaluating the overall consolidated financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the consolidated financial position of ARTISTdirect, Inc. andsubsidiaries as of December 31, 2006 and 2005, and the consolidated results oftheir operations and their cash flows for the years then ended in conformitywith accounting principles generally accepted in the United States of America.

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

The accompanying consolidatedfinancial statements have been prepared assuming that the Company will continueas a going concern.  As more fullydescribed in Note 1, the Company is in default under its senior and subordinateddebt agreements.  This could cause arequest for accelerated payment or redemption of the debt.  The Company does not have the capitalresources necessary to repay accelerated indebtedness or redemption of thedebt.  These conditions raise substantialdoubt regarding the Company’s ability to continue as a going concern.  The financial statements do not include anyadjustments that might result from the outcome of this uncertainty.

/s/ Gumbiner Savett Inc.

GUMBINER SAVETT INC.

April 27, 2007

Santa Monica, California

67

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ARTISTdirect, Inc. and Subsidiaries

Consolidated BalanceSheets

(amounts in thousands,except for share data)
| ** **                                                                                                                 | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                 | ** ** | **2006**              | ** ** | **2005** | ** ** |
| ** **                                                                                                                 | ** ** | ** **            | ** ** | **(Restated)** | ** ** |
|                                                                                                                       |       |                  |       |   |   |
| Assets                                                                                                                     |       |                  |       |   |   |
| Current assets:                                                                                                            |       |                  |       |   |   |
| Cash and cash  equivalents                                                                                                 |       | $                     | 5,602      |   | $ | 3,102 |   |
| Restricted cash                                                                                                            |       | 364                   |       | 359 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $421 and $177 at  December 31, 2006 and 2005, respectively |       | 6,928                 |       | 3,667 |   |
| Income taxes  refundable                                                                                                   |       | —                |       | 1,211 |   |
| Finished goods  inventory                                                                                                  |       | 281                   |       | 303 |   |
| Prepaid expenses  and other current assets                                                                                 |       | 204                   |       | 85 |   |
| Total current  assets                                                                                                      |       | 13,379                |       | 8,727 |   |
|                                                                                                                       |       |                  |       |   |   |
| Property and equipment                                                                                                     |       | 4,197                 |       | 3,120 |   |
| Less accumulated  depreciation and amortization                                                                            |       | (1,729                | )          | (1,175 | ) |
| Property and  equipment, net                                                                                               |       | 2,468                 |       | 1,945 |   |
|                                                                                                                       |       |                  |       |   |   |
| Other assets:                                                                                                              |       |                  |       |   |   |
| Intangible  assets:                                                                                                        |       |                  |       |   |   |
| Customer  relationships, net                                                                                               |       | 1,195                 |       | 1,950 |   |
| Proprietary  technology, net                                                                                               |       | 4,012                 |       | 6,546 |   |
| Non-competition  agreements, net                                                                                           |       | 728                   |       | 1,191 |   |
| Goodwill                                                                                                                   |       | 31,085                |       | 31,085 |   |
| Total intangible  assets, net                                                                                              |       | 37,020                |       | 40,772 |   |
| Deferred financing  costs, net                                                                                             |       | 2,084                 |       | 3,300 |   |
| Deposits                                                                                                                   |       | 21                    |       | 25 |   |
| Total other  assets                                                                                                        |       | 39,125                |       | 44,097 |   |
|                                                                                                                       |       | $                     | 54,972     |   | $ | 54,769 |   |

 

(continued)

68

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ARTISTdirect, Inc. and Subsidiaries

Consolidated BalanceSheets (continued)

(amounts in thousands,except for share data)

 
| ** **                                                                                                         | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                         | ** ** | **2006**              | ** ** | **2005** | ** ** |
| ** **                                                                                                         | ** ** | ** **            | ** ** | **(Restated)** | ** ** |
| ** **                                                                                                         | ** ** | ** **            | ** ** | ** ** | ** ** |
| Liabilities and  Stockholders’ Deficiency                                                                     |       |                  |       |   |   |
| Current liabilities:                                                                                               |       |                  |       |   |   |
| Accounts payable                                                                                                   |       | $                     | 1,832      |   | $ | 911 |   |
| Accrued expenses                                                                                                   |       | 1,575                 |       | 2,072 |   |
| Accrued interest  payable                                                                                          |       | 67                    |       | 607 |   |
| Deferred revenue                                                                                                   |       | 39                    |       | 377 |   |
| Income taxes  payable                                                                                              |       | 495                   |       | — |   |
| Estimated  liquidated damages payable under registration rights agreements                                         |       | 3,777                 |       | — |   |
| Warrant  liability                                                                                                 |       | 4,715                 |       | 15,104 |   |
| Derivative  liability                                                                                              |       | 18,356                |       | 30,202 |   |
| Senior secured  notes payable, net of discount of $1,110 at December 31, 2006 (in default)                         |       | 12,197                |       | 390 |   |
| Subordinated  convertible notes payable, net of discount of $6,516 at December 31, 2006 (in  default)              |       | 21,142                |       | — |   |
| Guaranteed  payments to MediaDefender management                                                                   |       | —                |       | 1,050 |   |
| Total current  liabilities                                                                                         |       | 64,195                |       | 50,713 |   |
|                                                                                                               |       |                  |       |   |   |
| Long-term liabilities:                                                                                             |       |                  |       |   |   |
| Senior secured  notes payable, net of discount of $1,766 at December 31, 2005, less current  portion               |       | —                |       | 12,844 |   |
| Subordinated  convertible notes payable, net of discount of $10,268 at December 31, 2005                           |       | —                |       | 20,806 |   |
| Deferred rent                                                                                                      |       | 199                   |       | — |   |
| Deferred income  taxes payable                                                                                     |       | 264                   |       | 264 |   |
| Total long-term  liabilities                                                                                       |       | 463                   |       | 33,914 |   |
|                                                                                                               |       |                  |       |   |   |
| Commitments and  contingencies                                                                                     |       |                  |       |   |   |
|                                                                                                               |       |                  |       |   |   |
| Stockholders’  deficiency:                                                                                    |       |                  |       |   |   |
| Common stock,  $0.01 par value -                                                                                   |       |                  |       |   |   |
| Authorized –  60,000,000 shares                                                                               |       |                  |       |   |   |
| Issued and  outstanding – 10,188,445 shares and 4,861,149 shares at December 31, 2006 and  2005, respectively |       | 102                   |       | 49 |   |
| Additional  paid-in-capital                                                                                        |       | 233,197               |       | 208,207 |   |
| Deferred  compensation                                                                                             |       | —                |       | (19 | ) |
| Accumulated  deficit                                                                                               |       | (242,985              | )          | (238,095 | ) |
| Total  stockholders’ deficiency                                                                               |       | (9,686                | )          | (29,858 | ) |
|                                                                                                               |       | $                     | 54,972     |   | $ | 54,769 |   |

 

See accompanying notes toconsolidated financial statements.

69

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ARTISTdirect, Inc.and Subsidiaries

ConsolidatedStatements of Operations

(amountsin thousands, except for share data)
| ** **                                                                                                                                                                                   | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                                                                   | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| ** **                                                                                                                                                                                   | ** ** | ** **                                  | ** ** | **(Restated)** | ** ** |
| Net revenue:                                                                                                                                                                                 |       |                                        |       |   |   |
| E-commerce                                                                                                                                                                                   |       | $                                           | 2,649      |   | $ | 2,665 |   |
| Media                                                                                                                                                                                        |       | 5,670                                       |       | 5,297 |   |
| Anti-piracy and  file-sharing marketing services                                                                                                                                             |       | 15,743                                      |       | 6,009 |   |
| Total net  revenue                                                                                                                                                                           |       | 24,062                                      |       | 13,971 |   |
|                                                                                                                                                                                         |       |                                        |       |   |   |
| Cost of revenue:                                                                                                                                                                             |       |                                        |       |   |   |
| E-commerce                                                                                                                                                                                   |       | 2,495                                       |       | 2,400 |   |
| Media                                                                                                                                                                                        |       | 3,088                                       |       | 2,745 |   |
| Anti-piracy and  file-sharing marketing services                                                                                                                                             |       | 7,797                                       |       | 2,659 |   |
| Total cost of  revenue                                                                                                                                                                       |       | 13,380                                      |       | 7,804 |   |
| Gross profit                                                                                                                                                                                 |       | 10,682                                      |       | 6,167 |   |
|                                                                                                                                                                                         |       |                                        |       |   |   |
| Operating expenses:                                                                                                                                                                          |       |                                        |       |   |   |
| Sales and  marketing                                                                                                                                                                         |       | 1,163                                       |       | 527 |   |
| General and  administrative, including stock-based compensation costs of $2,281 and $73 in  2006 and 2005, respectively                                                                      |       | 9,213                                       |       | 4,138 |   |
| Provision for  doubtful accounts                                                                                                                                                             |       | 705                                         |       | 105 |   |
| Total operating  costs                                                                                                                                                                       |       | 11,081                                      |       | 4,770 |   |
| Income (loss)  from operations                                                                                                                                                               |       | (399                                        | )          | 1,397 |   |
|                                                                                                                                                                                         |       |                                        |       |   |   |
| Other income (expense):                                                                                                                                                                      |       |                                        |       |   |   |
| Interest income                                                                                                                                                                              |       | 126                                         |       | 29 |   |
| Interest expense                                                                                                                                                                             |       | (5,852                                      | )          | (2,873 | ) |
| Estimated  liquidated damages under registration rights agreements                                                                                                                           |       | (3,777                                      | )          | — |   |
| Other income,  net                                                                                                                                                                           |       | 57                                          |       | — |   |
| Change in fair  value of warrant liability                                                                                                                                                   |       | 1,124                                       |       | (10,735 | ) |
| Change in fair  value of derivative liability                                                                                                                                                |       | 7,792                                       |       | (20,043 | ) |
| Reduction in  exercise price of warrants                                                                                                                                                     |       | (641                                        | )          | — |   |
| Amortization of  deferred financing costs                                                                                                                                                    |       | (858                                        | )          | (402 | ) |
| Write-off of  unamortized discount on debt and deferred financing costs due to conversion  of subordinated convertible notes payable and principal payments on senior  secured notes payable |       | (1,624                                      | )          | (45 | ) |
| Loss from  continuing operations before income taxes                                                                                                                                         |       | (4,052                                      | )          | (32,672 | ) |
| Provision for  income taxes                                                                                                                                                                  |       | 838                                         |       | 241 |   |
| Loss from  continuing operations                                                                                                                                                             |       | (4,890                                      | )          | (32,913 | ) |
| Income (loss)  from discontinued operations:                                                                                                                                                 |       |                                        |       |   |   |
| Loss from  operations of ARTISTdirect Records, LLC                                                                                                                                           |       | —                                      |       | (271 | ) |
| Gain from sale  of interest in ARTISTdirect Records, LLC (substantially all non-cash)                                                                                                        |       | —                                      |       | 21,079 |   |
| Income from  discontinued operations                                                                                                                                                         |       | —                                      |       | 20,808 |   |
| Net loss                                                                                                                                                                                     |       | $                                           | (4,890     | ) | $ | (12,105 | ) |
|                                                                                                                                                                                         |       |                                        |       |   |   |
| Loss per common share –  basic and diluted:                                                                                                                                             |       |                                        |       |   |   |
| From continuing  operations                                                                                                                                                                  |       | $                                           | (0.56      | ) | $ | (8.29 | ) |
| From  discontinued operations                                                                                                                                                                |       | —                                      |       | 5.24 |   |
| Net loss                                                                                                                                                                                     |       | $                                           | (0.56      | ) | $ | (3.05 | ) |
|                                                                                                                                                                                         |       |                                        |       |   |   |
| Weighted average common  shares outstanding:                                                                                                                                                 |       |                                        |       |   |   |
| Basic and Diluted                                                                                                                                                                            |       | 8,764,038                                   |       | 3,969,145 |   |

 

See accompanyingnotes to consolidated financial statements.

70

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ARTISTdirect, Inc. and Subsidiaries

Consolidated Statement ofStockholders’ Deficiency (2005 Restated)

(amounts inthousands, except for share data)
| ** **                                                                                                                           | ** ** | **Common Stock** | ** ** | **Treasury** | ** ** | **Additional  Paid-In** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------|------------|-------------------------|------------|
| ** **                                                                                                                           | ** ** | **Shares**            | ** ** | **Amount**   | ** ** | **Stock**               | ** ** | **Capital** | ** ** |
| Balance at January 1,  2005                                                                                                          |       | 3,502,117             |       | $            | 38         |                    | $          | (3,442 | ) | $ | 209,135 |   |
| Fair value of  stock options granted for consulting services                                                                         |       | —                |       | —       |       | —                  |       | 92 |   |
| Common stock  issued upon conversion of subordinated convertible notes payable                                                       |       | 250,000               |       | 3            |       | —                  |       | 385 |   |
| Derivative  liability transferred to additional paid-in capital as a result of conversion  of subordinated convertible notes payable |       | —                |       | —       |       | —                  |       | 375 |   |
| Warrants issued  to consultants as consulting fee in conjunction with MediaDefender  acquisition                                     |       | —                |       | —       |       | —                  |       | 84 |   |
| Common stock  issued to consultants as consulting fee in conjunction with MediaDefender  acquisition                                 |       | 1,109,032             |       | 11           |       | —                  |       | 1,575 |   |
| Cancellation of  outstanding shares of treasury stock                                                                                |       | —                |       | (3           | )          | 3,442                   |       | (3,439 | ) |
| Amortization of  deferred compensation                                                                                               |       | —                |       | —       |       | —                  |       | — |   |
| Net loss                                                                                                                             |       | —                |       | —       |       | —                  |       | — |   |
| Balance at December 31,  2005                                                                                                   |       | 4,861,149             |       | 49           |       | —                  |       | 208,207 |   |
| Fair value of  stock options granted for consulting services                                                                         |       | —                |       | —       |       | —                  |       | 35 |   |
| Fair value of  stock options                                                                                                         |       | —                |       | —       |       | —                  |       | 2,208 |   |
| Common stock  issued for consulting services                                                                                         |       | 5,769                 |       | —       |       | —                  |       | 19 |   |
| Common stock  issued upon exercise of stock options                                                                                  |       | 97,287                |       | 1            |       | —                  |       | 79 |   |
| Common stock  issued upon exercise of warrants                                                                                       |       | 3,020,370             |       | 30           |       | —                  |       | 5, 296 |   |
| Common stock  issued upon conversion of subordinated convertible notes payable                                                       |       | 2,203,870             |       | 22           |       | —                  |       | 3,394 |   |
| Warrant  liability transferred to additional paid-in capital as a result of exercise  of warrants                                    |       | —                |       | —       |       | —                  |       | 9,483 |   |
| Derivative  liability transferred to additional paid-in capital as a result of conversion  of subordinated convertible notes payable |       | —                |       | —       |       | —                  |       | 4,053 |   |
| Reduction in  exercise price of warrants exercised by holders of senior secured notes  payable                                       |       | —                |       | —       |       | —                  |       | 423 |   |
| Amortization of  deferred compensation                                                                                               |       | —                |       | —       |       | —                  |       | — |   |
| Net loss                                                                                                                             |       | —                |       | —       |       | —                  |       | — |   |
| Balance at December 31, 2006                                                                                                         |       | 10,188,445            |       | $            | 102        |                    | $          | — |   | $ | 233,197 |   |

 

(continued)

71

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ARTISTdirect, Inc. and Subsidiaries

Consolidated Statement ofStockholders’ Deficiency (2005 Restated) (continued)

(amounts inthousands, except for share data)

 

 
| ** **                                                                                                                           | ** ** | **Deferred  Compensation** | ** ** | **Accumulated  Deficit** | ** ** | **Total  Stockholders’  Deficiency** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|--------------------------|------------|-------------------------------------------|------------|
| Balance at  January 1, 2005                                                                                                          |       | $                          | —     |                     | $          | (225,990                                  | )          | $ | (20,259 | ) |
| Fair value of stock options granted for consulting  services                                                                         |       | (92                        | )          | —                   |       | —                                    |       |
| Common stock issued upon conversion of subordinated  convertible notes payable                                                       |       | —                     |       | —                   |       | 388                                       |       |
| Derivative liability transferred to additional  paid-in capital as a result of conversion of subordinated convertible notes  payable |       | —                     |       | —                   |       | 375                                       |       |
| Warrants issued to consultants as consulting fee in  conjunction with MediaDefender acquisition                                      |       | —                     |       | —                   |       | 84                                        |       |
| Common stock issued to consultants as consulting fee  in conjunction with MediaDefender acquisition                                  |       | —                     |       | —                   |       | 1,586                                     |       |
| Cancellation of outstanding shares of treasury stock                                                                                 |       | —                     |       | —                   |       | —                                    |       |
| Amortization of deferred compensation                                                                                                |       | 73                         |       | —                   |       | 73                                        |       |
| Net loss                                                                                                                             |       | —                     |       | (12,105                  | )          | (12,105                                   | )          |
| Balance at  December 31, 2005                                                                                                   |       | (19                        | )          | (238,095                 | )          | (29,858                                   | )          |
| Fair value of stock options granted for consulting  services                                                                         |       | —                     |       | —                   |       | 35                                        |       |
| Fair value of stock options                                                                                                          |       | —                     |       | —                   |       | 2,208                                     |       |
| Common stock issued for consulting services                                                                                          |       | —                     |       | —                   |       | 19                                        |       |
| Common stock issued upon exercise of stock options                                                                                   |       | —                     |       | —                   |       | 80                                        |       |
| Common stock issued upon exercise of warrants                                                                                        |       | —                     |       | —                   |       | 5,326                                     |       |
| Common stock issued upon conversion of subordinated  convertible notes payable                                                       |       | —                     |       | —                   |       | 3,416                                     |       |
| Warrant liability transferred to additional paid-in  capital as a result of exercise of warrants                                     |       | —                     |       | —                   |       | 9,483                                     |       |
| Derivative liability transferred to additional  paid-in capital as a result of conversion of subordinated convertible notes  payable |       | —                     |       | —                   |       | 4,053                                     |       |
| Reduction in exercise price of warrants exercised by  holders of senior secured notes payable                                        |       | —                     |       | —                   |       | 423                                       |       |
| Amortization of deferred compensation                                                                                                |       | 19                         |       | —                   |       | 19                                        |       |
| Net loss                                                                                                                             |       | —                     |       | (4,890                   | )          | (4,890                                    | )          |
| Balance at December 31,  2006                                                                                                        |       | $                          | —     |                     | $          | (242,985                                  | )          | $ | (9,686 | ) |

 

See accompanyingnotes to consolidated financial statements.

72

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ARTISTdirect, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(amounts in thousands)
| ** **                                                                                                         | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                         | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| ** **                                                                                                         | ** ** | ** **                                  | ** ** | **(Restated)** | ** ** |
| Cash flows from  operating activities:                                                                             |       |                                        |       |   |   |
| Net loss                                                                                                           |       | $                                           | (4,890     | ) | $ | (12,105 | ) |
| Income from discontinued operations                                                                                |       | —                                      |       | (20,808 | ) |
| Loss from continuing operations                                                                                    |       | (4,890                                      | )          | (32,913 | ) |
| Adjustments to reconcile loss from continuing  operations to net cash provided by continuing operating activities: |       |                                        |       |   |   |
| Depreciation and amortization                                                                                      |       | 9,911                                       |       | 3,570 |   |
| Provision for doubtful accounts                                                                                    |       | 705                                         |       | 105 |   |
| Stock-based compensation                                                                                           |       | 2,281                                       |       | 73 |   |
| Deferred income taxes                                                                                              |       | —                                      |       | 42 |   |
| Change in fair value of warrant liability                                                                          |       | (1,124                                      | )          | 10,735 |   |
| Change in fair value of derivative liability                                                                       |       | (7,792                                      | )          | 20,043 |   |
| Reduction in exercise price of warrants                                                                            |       | 641                                         |       | — |   |
| Sub-total                                                                                                          |       | (268                                        | )          | 1,655 |   |
| Changes in operating assets and liabilities, net of  effect from acquisition of MediaDefender:                     |       |                                        |       |   |   |
| (Increase) decrease in -                                                                                           |       |                                        |       |   |   |
| Accounts receivable                                                                                                |       | (3,966                                      | )          | (510 | ) |
| Finished goods inventory                                                                                           |       | 22                                          |       | (165 | ) |
| Prepaid expenses and other current assets                                                                          |       | (119                                        | )          | 64 |   |
| Income taxes refundable                                                                                            |       | 1,211                                       |       | (1,211 | ) |
| Other assets                                                                                                       |       | 4                                           |       | (1 | ) |
| Increase (decrease) in -                                                                                           |       |                                        |       |   |   |
| Accounts payable                                                                                                   |       | 921                                         |       | 333 |   |
| Accrued expenses                                                                                                   |       | (410                                        | )          | 432 |   |
| Accrued interest payable                                                                                           |       | (540                                        | )          | 607 |   |
| Deferred revenue                                                                                                   |       | (338                                        | )          | 320 |   |
| Deferred rent                                                                                                      |       | 199                                         |       | — |   |
| Income taxes payable                                                                                               |       | 495                                         |       | — |   |
| Estimated liquidated damages payable under  registration rights agreements                                         |       | 3,777                                       |       | — |   |
| Net cash provided by continuing operations                                                                         |       | 988                                         |       | 1,524 |   |
| Net cash used in discontinued operations                                                                           |       | (88                                         | )          | (38 | ) |
| Net cash provided by operating activities                                                                          |       | 900                                         |       | 1,486 |   |
|                                                                                                               |       |                                        |       |   |   |
| Cash flows from  investing activities:                                                                             |       |                                        |       |   |   |
| Additions to property and equipment                                                                                |       | (1,077                                      | )          | (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 |   |
| Guaranteed payments to MediaDefender management                                                                    |       | (1,050                                      | )          | — |   |
| Net cash used in investing activities                                                                              |       | (2,127                                      | )          | (43,368 | ) |
|                                                                                                               |       |                                        |       |   |   |
| Cash flows from  financing activities:                                                                             |       |                                        |       |   |   |
| Proceeds from senior and subordinated debt  financings                                                             |       | —                                      |       | 45,000 |   |
| Payments for deferred financing costs                                                                              |       | —                                      |       | (1,025 | ) |
| Proceeds from exercise of stock options                                                                            |       | 99                                          |       | — |   |
| Proceeds from exercise of warrants                                                                                 |       | 5,326                                       |       | — |   |
| Principal payments on senior secured notes payable                                                                 |       | (1,693                                      | )          | — |   |
| Decrease in restricted cash                                                                                        |       | (5                                          | )          | (184 | ) |
| Net cash provided by discontinued operations –                                                                |       |                                        |       |   |   |
| Proceeds from issuance of bridge notes by  ARTISTdirect Records, LLC                                               |       | —                                      |       | 37 |   |
| Net cash provided by financing activities                                                                          |       | 3,727                                       |       | 43,828 |   |
|                                                                                                               |       |                                        |       |   |   |
| Cash and cash  equivalents:                                                                                        |       |                                        |       |   |   |
| Net increase                                                                                                       |       | 2,500                                       |       | 1,946 |   |
| Balance at beginning of year                                                                                       |       | 3,102                                       |       | 1,156 |   |
| Balance at end  of year                                                                                            |       | $                                           | 5,602      |   | $ | 3,102 |   |

 

(continued)

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ARTISTdirect, Inc. and Subsidiaries

Consolidated Statements of Cash Flows (continued)

(amounts in thousands)

 
| ** **                                                                                                                           | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| ** **                                                                                                                           | ** ** | ** **                                  | ** ** | **(Restated)** | ** ** |
| Supplemental  disclosure of cash flow information:                                                                                   |       |                                        |       |   |   |
| Cash paid for -                                                                                                                      |       |                                        |       |   |   |
| Interest                                                                                                                             |       | $                                           | 3,243      |   | $ | 657 |   |
| Income taxes                                                                                                                         |       | $                                           | —     |   | $ | 1,637 |   |
|                                                                                                                                 |       |                                        |       |   |   |
| Non-cash  investing and financing activities:                                                                                        |       |                                        |       |   |   |
| Warrant liability transferred to additional paid-in  capital as a result of exercise of warrants                                     |       | $                                           | 9,483      |   | $ | — |   |
| Derivative liability transferred to additional  paid-in capital as a result of conversion of subordinated convertible notes  payable |       | $                                           | 4,053      |   | $ | 375 |   |
| Common stock issued upon conversion of subordinated  convertible notes payable                                                       |       | $                                           | 3,416      |   | $ | 388 |   |
| Issuance of subordinated convertible note payable to  placement agent                                                                |       | $                                           | —     |   | $ | 1,460 |   |
| Issuance of warrants to holders of senior secured  notes payable                                                                     |       | $                                           | —     |   | $ | 1,983 |   |
| Issuance of warrants to holders of subordinated  convertible notes payable                                                           |       | $                                           | —     |   | $ | 1,134 |   |
| Recognition of embedded derivatives bifurcated from  subordinated convertible notes payable                                          |       | $                                           | —     |   | $ | 10,534 |   |
| Issuance of common stock to directors as consulting  fee in conjunction with MediaDefender acquisition                               |       | $                                           | —     |   | $ | 1,586 |   |
| Issuance of warrants to directors as consulting fee  in conjunction with MediaDefender acquisition                                   |       | $                                           | —     |   | $ | 84 |   |
| Issuance of warrants to placement agent with respect  to senior secured notes payable                                                |       | $                                           | —     |   | $ | 176 |   |
| Issuance of warrants to placement agent with respect  to senior secured notes payable and subordinated convertible notes payable     |       | $                                           | —     |   | $ | 1,077 |   |
| Guaranteed payments to MediaDefender management  accounted for as non-competition 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 accompanyingnotes to consolidated financial statements.

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ARTISTDIRECT, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

YEARS ENDED DECEMBER 31, 2006 AND 2005 (2005 restated)

1.  BASIS OF PRESENTATION

ORGANIZATION AND BUSINESSACTIVITIES

ARTISTdirect, Inc.,a Delaware corporation (“ADI”), was formed on October 6, 1999 upon itsmerger with ARTISTdirect, LLC. ARTISTdirect, LLC was organized as a California limited liabilitycompany and commenced operations on August 8, 1996.  The Company is headquartered in Santa Monica,California.  Unless the context indicatesotherwise, ADI and its subsidiaries are referred to herein as the “Company”.

On July 28,2005, the Company completed the acquisition of MediaDefender, Inc., aprivately-held Delaware corporation (“MediaDefender”) (see Note 4).  MediaDefender was founded inJuly 2000.  This transaction wasaccounted for as a purchase in accordance with SFAS No. 141, “BusinessCombinations”, and the operations of the two companies have been consolidatedcommencing August 1, 2005. MediaDefender is a leading provider of anti-piracy solutions in theInternet-piracy-protection (“IPP”) industry. During the year ended December 31, 2006, MediaDefender also began tooffer file-sharing marketing services, wherein MediaDefender redirects, for afee, specific peer-to-peer traffic on the Internet to designated clientdestinations.

The Company is adigital media entertainment company that is home to an online music networkand, through its MediaDefender subsidiary, is a leading provider of anti-piracysolutions in the IPP industry.  TheARTISTdirect Network (www.artistdirect.com) is a network of web-sites appealingto music fans, artists and marketing partners that offers multi-media content,music news and information, communities organized around shared musicinterests, music-related specialty commerce and digital music services.

PRINCIPLES OFCONSOLIDATION

The accompanyingfinancial statements include the consolidated accounts of ADI and itssubsidiaries in which it has controlling financial interests.  All intercompany accounts and transactionshave been eliminated for all periods presented.

GAIN ON SALE OF INTERESTIN SUBSIDIARY

OnFebruary 28, 2005, ADI completed the sale of 100% of the common stock ofARTISTdirect Recordings, Inc., a Delaware corporation and wholly-ownedsubsidiary, to Radar Records Holdings, LLC (“Radar Records”), an entity ownedby Frederick W. (Ted) Field, the Company’s Chairman, pursuant to a TransferAgreement, for a cash payment of $115,000. ADI and Radar Records had previously entered into an agreement to form aco-venture to develop a new record label, ARTISTdirect Records, LLC (“ARTISTdirectRecords”), effective June 29, 2001.  As aresult of the completion of this transaction on February 28, 2005, ADI nolonger had any equity or other economic interest in ARTISTdirect Records, andRadar Records became the owner of a majority of the membership interests inARTISTdirect Records and thus acquired the receivable reflecting the$33,000,000 of loan advances previously provided to ARTISTdirect Records byADI.  In conjunction with thistransaction, at February 28, 2005, ADI wrote-off the intercompany balancedue from ARTISTdirect Records of $80,000, which previously was eliminated inconsolidation.

As a result of theexistence of various conflicts of interest with respect to approval of theTransfer Agreement, full disclosure of these conflicts of interest was made toADI’s Board of Directors and the required approval by the disinterested membersof ADI’s Board of Directors was obtained prior to the closing of thetransaction.

As a result of thesale of all of ADI’s interest in ARTISTdirect Recordings to Radar Recordseffective February 28, 2005, ADI accounted for its interest inARTISTdirect Records as a discontinued operation in 2005 in accordance with SFASNo. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”,and the assets and liabilities of ARTISTdirect Records were classified as “heldfor sale” through February 28, 2005.

For the year endedDecember 31, 2005, the Company recognized a loss from discontinued operationsof $271,000, reflecting ADI’s interest in ARTISTdirect Records for the twomonths ended February 28, 2005.

As a result of thedisposition of ADI’s interest in ARTISTdirect Records effective February 28,2005, the Company recognized a gain (primarily non-cash) of $21,079,000 in itsconsolidated statement of operations for the year ended December 31, 2005,primarily as a result of the elimination of the liabilities of ARTISTdirectRecords.

RESTATEMENT OF FINANCIALSTATEMENTS

On December 20, 2006, the Company determined that itwas necessary to restate the financial statements contained in itspreviously-filed Annual Report on Form 10-KSB/A for the fiscal year endedDecember 31, 2005 and Quarterly Reports on Form 10-QSB or Form 10-QSB/A for thequarterly periods ended September 30, 2005, March 31, 2006, June 30, 2006 andSeptember 30, 2006 (collectively, the “Financial Statements”).  Thedetermination was made by the Company’s Audit Committee following receipt bythe Company of comments from the staff (the “Staff”) of the Securities andExchange Commission (the “SEC”), and following consultation with the Company’ssenior management, financial advisors and independent registered publicaccounting firm.

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TheStaff advised the Company to consider EITF 00-19, “Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock” (“EITF 00-19”), and, in light of the guidance set forth in EITF 00-19,to further evaluate the accounting treatment of certain embedded derivativescontained in the outstanding Sub-Debt Notes (as subsequently defined) issued bythe Company in July 2005, as well as the accounting treatment of certainwarrants issued to the Company’s lenders in July 2005, in conjunction with theacquisition of MediaDefender.  The Company filed the restated FinancialStatements on April 19, 2007.  However, the Staff has not indicatedwhether they may have further comments. The adjustments to the Financial Statements with respect to the restatementswere non-cash in nature and were not caused by or related to any changes in theunderlying operating performance of the Company’s business, including revenues,operating costs and expenses, operating income or loss, operating cash flows oradjusted EBITDA.  However, such restatements had a material negativeimpact on the Company’s previously reported results of operations and earningsper share, current liabilities, net working capital and shareholders’ equity(deficiency).

The Sub-Debt Notes contain reset, anti-dilution andchange-in-control provisions that the Company has determined caused such debtinstruments to be classified as “non-conventional” debt.  Upon evaluation of such debt instrumentsunder Statement of Financial Accounting Standards No. 133, “Accounting forDerivative Instruments and Hedging Activities” (“SFAS No. 133”) and EITF 00-19,it was determined that the Company was required to bifurcate and value certainrights embedded in the Sub-Debt Notes on the date of issuance (including,specifically, the initial $1.55 per share fixed conversion feature, which wasin excess of the $1.43 per share fair market value of the Company’s commonstock on the date of issuance) and to classify such rights as either assets orliabilities.  The fair value of thesebifurcated derivatives, as determined by an independent valuation firm as ofJuly 28, 2005, was calculated using a lattice (binomial) valuation model, andutilized highly subjective and theoretical assumptions that can materiallyaffect fair values from period to period. In addition, the recognition of these derivative amounts did not haveany impact on revenues, operating expenses, income taxes or cash flows.  The Company recorded an initial embeddedderivative liability of $10,534,000, which was recorded as a discount to the$30,000,000 of convertible subordinated notes, and is being amortized over theterm of the debt.  The carrying value ofthe embedded derivative liability is being adjusted to reflect any materialchanges in such liability from the date of issuance to the end of eachreporting period, with any such changes included in other income (expense) inthe statement of operations.  The Companyhas accounted for registration rights penalties in accordance with Statement ofFinancial Accounting Standards No. 5, “Accounting for Contingencies”, and EITF00-19-2, “Accounting for Registration Payment Arrangements”, which the Companyadopted as of December 31, 2006.

In addition to theadjustment for the embedded derivatives associated with the Sub-Debt Notes, theCompany revised the initial valuation and subsequent changes to fair value ofthe warrants issued in conjunction with the Senior Financing and the Sub-DebtFinancing.

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

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

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

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

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

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

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The followingtable presents the impact of the restatement on the effected balance sheetcategories at December 31, 2005 (amounts in thousands):

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

 

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

 

GOING CONCERN

As described above, as a result of communications withthe Staff of the SEC in 2006, in particular regarding the application ofaccounting rules and interpretations related to embedded derivatives associatedwith the Company’s subordinated convertible notes payable issued in July 2005,the Company determined that it was necessary to restate previously issuedfinancial statements.  As a result, inDecember 2006, the Company was required to suspend the use of its theneffective registration statement for the holders of its senior and subordinatedindebtedness and thus triggered an event of default with respect to itsregistration rights agreements with the holders of such indebtedness.  Accordingly, beginning January 18, 2007, theCompany began to incur estimated liquidated damages under its registrationrights agreements aggregating approximately $540,000 per month (seven months ofwhich, equivalent to $3,777,000, had been accrued as a current liability atDecember 31, 2006), and the interest rate on its subordinated convertible notespayable increased from 4% per annum to 12% per annum, an increase ofapproximately $183,000 per month.

The adjustments to the financial statements withrespect to the restatements were non-cash in nature and were not caused by orrelated to any changes in the underlying operating performance of the Company’sbusiness, including revenues, operating costs and expenses, operating income orloss, income taxes, operating cash flows or adjusted EBITDA.  The fairvalue of these bifurcated derivatives of $10,534,000, as determined by anindependent valuation firm, was calculated using a binomial latticeoption-pricing model utilizing highly subjective and theoretical assumptionsthat can materially affect fair values from period to period.  The recognition of these derivative amounts,initially recorded as a reduction to the related debt and being amortized tointerest expense through the life of the debt, with the resulting changes infair value of the liability being included as other income (expense) in thestatement of operations each reporting period, did not have any impact onrevenues, operating expenses, income taxes or cash flows.

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However,such restatements had a material negative impact on the Company’s previouslyreported results of operations and earnings per share, current liabilities, networking capital and shareholders’ equity (deficiency).

During 2005 and 2006, the Company’s consolidatedoperations generated sufficient cash flows from operations to enable theCompany to fund its operating requirements and its non-event of defaultscheduled debt service obligations to both the senior and subordinated debtholders, and management currently anticipates that cash flows from operationswill be adequate to fund operating and debt service requirements (based on theoriginal terms as contemplated in the senior and subordinated loan agreements)in 2007 and generate operating cash flows in excess of these amounts for atleast the next twelve months.

As described above, as a result of the requirement torestate previously issued financial statements, which resulted in the recordingof the embedded derivative liability, the reclassification of the senior andsubordinated indebtedness to current liabilities, and the recording of estimatedliquidated damages payable under registration rights agreements of $3,777,000,the Company was not in compliance with certain of its financial covenants underboth the Senior Financing and the Sub-Debt Financing at December 31, 2006.

As of December 31, 2006, approximately $13,307,000 wasoutstanding with respect to the Senior Financing, and approximately $27,658,000was outstanding with respect to the Sub-Debt Financing.  Upon theoccurrence of an event of default, holders of at least 25% of the outstandingsenior indebtedness may declare the outstanding principal and accrued intereston all senior notes immediately due and payable upon written notice to theCompany, and each holder of outstanding subordinated indebtedness may demandredemption of all or any portion of their respective notes as described in thesubordinated financing documents.  The Company has not received a requestto accelerate or redeem any portion of the outstanding indebtedness from anysenior or subordinated holder.  The Company does not have the capitalresources necessary to repay any accelerated indebtedness or redemption.

Pursuant to a Forbearance and Consent Agreement datedas of April 17, 2007, the investors in the Senior Financing agreed to forbearfrom the exercise of their rights and remedies under the Senior Financingdocuments as a result of the events of default with respect to theunavailability of the Company’s registration statement, as well as certainother events of default that currently exist or may come into existence duringthe forbearance period, through May 31, 2007, in exchange for a cash payment of$250,000.  Any payments made by theCompany under the Forbearance and Consent Agreement will be credited againstaccrued registration delay cash penalties or any other amounts that are or maybecome due and payable.  The Company hasthe right to extend the Forbearance and Consent Agreement through June 30, 2007by an additional cash payment of $125,000 on or before May 31, 2007.

The accompanying consolidated financial statementshave been prepared in conformity with accounting principles generally acceptedin the United States of America, which contemplate continuation of the Companyas a going concern.  As a result of theforegoing, the Company’s independent registered public accounting firm, in itsreport on the Company’s 2006 consolidated financial statements, expressedsubstantial doubt about the Company’s ability to continue as a goingconcern.  The consolidated financialstatements do not include any adjustments relating to the recoverability andclassification of recorded asset amounts or the amounts and classification ofliabilities that could result from the outcome of this uncertainty.

The Company has entered into an exclusive agreementwith a financial advisor to assist in negotiations with the holders of itssenior and subordinated debt obligations to obtain a waiver of and amendment tocertain of the financing documents with respect to the events of default, theimpact of the restatements, the payment of cash penalties, and various relatedmatters.  The Company is unable topredict the outcome of such negotiations. The Company is exploring various alternatives to resolve the defaultsunder its senior and secured debt obligations. To the extent that the Company is unable to restructure its senior andsubordinated debt obligations in a satisfactory manner, the ongoing penaltiesand default interest will have a significant and material negative impact onthe Company’s cash flows and earnings, such that the Company may not havesufficient cash resources to maintain operations in the future.  In such event, the Company may be required toconsider a formal or informal restructuring or reorganization.

2.  SIGNIFICANT ACCOUNTING POLICIES

CASH EQUIVALENTS

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

RESTRICTED CASH

As ofDecember 31, 2006 and 2005, restricted cash consisted of a bankcertificate of deposit with balances of $184,000 and $179,000, respectively,securing a bank letter of credit provided as security for charge-backs to theCompany’s e-commerce credit card processor. In addition, at December 31, 2006 and 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 for $180,000 issued inconjunction with the Company’s new office lease which commenced inFebruary 2006 (see Note 16).  DuringFebruary 2007, the irrevocable bank stand-by letter of credit was reduced to$90,000, and restricted cash was reduced commensurately.

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ACCOUNTS RECEIVABLE

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

PROPERTY AND EQUIPMENT

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

Depreciation iscomputed on the straight-line method based on the estimated useful lives of theassets, which is generally three years for computer equipment and software andseven years for furniture and fixtures. Leasehold improvements are amortized over the remaining life of therelated lease, which has been determined to be shorter than the life of theasset.

GOODWILL, INTANGIBLEASSETS AND LONG-LIVED ASSETS

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

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

The Companyevaluates the recoverability of goodwill by estimating the future discountedcash flows of the businesses to which the goodwill relates.  The Company uses a rate corresponding to itscost of capital, risk adjusted where appropriate, in determining discountedcash flows.  Estimated cash flows aredetermined by disaggregating the business segments to a reporting level forwhich meaningful identifiable cash flows can be determined.  When estimated future discounted cash flowsare less than the carrying value of the net assets (tangible and identifiableintangibles) and related goodwill, the Company will perform an impairmenttest to measure the amount of the impairment loss, if any.  Impairment losses, limited to the carryingvalue of goodwill, represent the excess of the carrying amount of a reportingunit’s goodwill over the implied fair value of that goodwill.  In determining the estimated future cashflows, the Company considers current and projected future levels of incomebased on management’s plans for that business, as well as business trends,prospects and market and economic conditions.

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

There was noimpairment of long-lived assets or goodwill in 2005 or 2006.

DERIVATIVE FINANCIALINSTRUMENTS

Statement of Financial Accounting Standards No. 133, “Accountingfor Derivative Instruments and Hedging Activities” (“SFAS No. 133”), requiresall derivatives to be recorded on the balance sheet at fair value.  The calculation of the fair value ofderivatives utilizes highly subjective and theoretical assumptions that canmaterially affect fair values from period to period.

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The recognition of these derivative amounts does not have any impact oncash flows.

EITF 00-19, “Accounting for Derivative FinancialInstruments Indexed to, and Potentially Settled in, a Company’s Own Stock (“EITF00-19”), requires freestanding contracts that are settled in a company’s ownstock, including common stock warrants, to be designated as an equityinstrument, an asset or a liability. Under the provisions of EITF 00-19, a contract designated as an asset ora liability must be carried at fair value on a company’s balance sheet, withany changes in fair value recorded in a company’s results of operations.

The Company has accounted for registration rightspenalties in accordance with Statement of Financial Accounting Standards No. 5,“Accounting for Contingencies”, and EITF 00-19-2, “Accounting for RegistrationPayment Arrangements”, which the Company adopted as of December 31, 2006.  Since the registration rights component ofthe derivative liabilities was not material through September 30, 2006, therewas no cumulative-effect adjustment recorded as a result of the transitionrules with respect to the adoption of EITF-00-19-2 at December 31, 2006.

The Company accounts for derivatives, including theembedded derivatives associated with the Sub-Debt Notes and the warrants issuedin conjunction with the Senior Financing and the Sub-Debt Financing, at fairvalue, adjusted at the end of each reporting period to reflect any materialchanges, with any such changes included in other income (expense) in thestatement of operations.

At the date of exercise of any of the warrants, or theconversion of Sub-Debt Notes into common stock, the pro rata fair value of therelated warrant liability and/or embedded derivative liability is transferredto additional paid-in capital.

DEFERRED FINANCING COSTS

Deferred financing costs consist of cash and non-cashconsideration paid to third parties with respect to the acquisition and financingof the MediaDefender transaction, including legal fees and placement agentfees.  Such costs are being deferred andamortized over the term of the related debt. Upon the conversion of subordinated convertible notes payable intocommon stock and the partial repayment of the senior secured notes payable, thepro rata portion of any related unamortized deferred financing costs arecharged to operations.

DISCOUNT ON DEBT

Additional consideration in the form of warrants and otherderivative financial instruments issued to lenders was accounted for at fairvalue based on reports prepared by independent valuation firms.  The fair value of warrants and derivativeswas recorded as a reduction to the carrying amount of the related debt, and isbeing amortized to interest expense over the term of such debt, with theinitial offsetting entries recorded as warrant liability and derivativeliability on the balance sheet.  Upon theconversion of subordinated convertible notes payable into common stock, the prorata portion of any related unamortized discount on debt is charged tooperations.

REVENUE RECOGNITION

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

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

The Companyrecords amounts charged to customers for shipping and handling in accordancewith EITF 00-10, “Accounting for Shipping and Handling Fees and Costs” (“EITF 00-10”).  Pursuant to EITF 00-10, the Companyrecords amounts charged to customers for shipping and handling as revenue, andrecords the related costs incurred for shipping and handling to direct cost ofproduct sales in the statement of operations. For the years ended December 31, 2006 and 2005, the Companyrecorded $581,000 and $629,000, respectively, as revenue for shipping andhandling fees charged to customers. For the years ended December 31, 2006and 2005, the Company recorded $374,000 and $361,000, respectively, of shippingand handling costs as direct cost of product sales in the statements ofoperations.

Media revenueconsists primarily of the sale of advertisements and sponsorships undershort-term contracts.  To date, theduration of the Company’s advertising commitments has generally averaged fromone to three months, although certain programs can last up to one year.  The Company’s online obligations typicallyinclude the guarantee of a minimum number of times (“impressions”) that anadvertisement appears in pages viewed by the users of the Company’s onlineproperties.  Online advertising revenueis generally recognized as the impressions are served during the period inwhich the advertisement is displayed, provided that no significant obligationsof the Company remain and collection of the resulting receivable is reasonablyassured.  

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To the extent thatminimum guaranteed page deliveries are not met, recognition of thecorresponding revenue is deferred until the guaranteed impressions aredelivered.

The Companyrecognizes revenue for sponsorship arrangements over the period during whichthe advertising is provided, generally on a straight-line basis.  The Company recognizes revenue for a bannerimpression deliverable as the banner impressions are delivered.  The Company recognizes revenue forweb-page sponsorships on a straight-line basis over the term of thesponsorship.  The Company recognizesrevenue for custom content when the content is provided to the customer.

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

COST OF REVENUE

Cost of productsales consists of amounts payable related to e-commerce sales, which includesthe cost of merchandise sold and royalties, and online commerce transactioncosts, including credit card fees, fulfillment charges and shipping costs.  Distribution expenses consist of variousdistribution costs, including the cost of processing returns and warehousinginventory.

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

Depreciationexpense is included in the related cost of revenue category.

DISCONTINUED OPERATIONS

The Company hasaccounted for its iMusic record label and its interest in ARTISTdirect Records,LLC as discontinued operations for all periods presented in accordance withSFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets” (see Notes 1 and 12).

INVENTORIES

Inventories, netof a provision for obsolescence of $69,000 and $103,000 at December 31, 2006and 2005, respectively, consist of music-related merchandise maintained in thewarehouse of the Company’s distributor. Inventories are stated at the lower of cost or net realizablevalue.  Cost is determined using thefirst-in, first-out method.

INCOME TAXES

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

DEVELOPMENT COSTS

Development costsconsist primarily of third-party development costs and payroll and relatedexpenses for in-house development costs incurred in the design and productionof the Company’s content and services, including revisions to the Company’sweb-site.  These costs are included incost of revenue and are charged to operations as incurred, and totaledapproximately $120,000 during the year ended December 31, 2006.

ADVERTISING COSTS

Advertising costsare included in selling and marketing expense and are charged to operations asincurred, and totaled $104,000 and $22,000 during the years ended December 31,2006 and 2005, respectively.

CONCENTRATION OF RISK

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

Concentrations ofcredit risk with respect to trade receivables generated by the Company’soperations are generally limited.

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However, MediaDefender’scustomers consist primarily of large reputable companies in the music andentertainment industries.

The Companypurchases 58% of its music-related merchandise inventory from onesupplier.  The Company is subject to riskin the event that any of the suppliers is unable to fulfill its orders.  However, there are a number of differentsuppliers who can provide such products to the Company.

During the yearsended December 31, 2006 and 2005, approximately 67% of e-commerce revenueswere generated from the products related to a single music merchandisingentity.

During the yearended December 31, 2006, one customer accounted for $730,000 or 13% oftotal media revenue, of which $335,000 was due from this customer atDecember 31, 2006.  During the yearended December 31, 2005, one major advertiser/sponsor accounted for$1,786,000 or 34% of total media revenue, all of which was paid during 2005.

During the yearended December 31, 2006 and 2005, the Company’s media revenues weregenerated primarily by a single outside sales organization that represented theCompany with respect to advertising and sponsorship sales on the Company’sweb-site and through affiliated web-sites.

During the year ended December 31, 2006,approximately 73% of MediaDefender’s consolidated revenues were from fourcustomers, with one customer accounting for 27%, another customer accountingfor 25%, a third customer accounting for 11%, and a fourth customer accountingfor 10%.  At December 31, 2006, theamounts due from such customers were $854,039, $620,000, $773,333 and $649,549,respectively, which were included in accounts receivable.

During the year ended December 31, 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 such customers were $420,000 and $835,000, respectively,which were included in accounts receivable.

During the year ended December 31, 2006,MediaDefender purchased approximately 67% of its bandwidth from threesuppliers.  At December 31, 2006,there were no amounts payable to such suppliers.  During the year ended December 31, 2005,MediaDefender purchased approximately 87% of its bandwidth from threesuppliers.  At December 31, 2005,amounts payable to one of these suppliers was $22,000.  Although there are other suppliers ofbandwidth, a change in suppliers could cause delays, which could adverselyaffect operations in the short-term.

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

FAIR VALUE OF FINANCIALINSTRUMENTS

The carryingamounts of cash and cash equivalents, accounts receivable, accounts payable andestimated liquidated damages payable under registration rights agreementsapproximate their respective fair values because of the short maturity of theseinstruments.  The carrying amounts ofsenior secured notes payable and subordinated convertible notes payableapproximate their respective fair values because of their current interest ratespayable and other features of such debt in relation to current marketconditions.  The carrying value ofwarrant liability and derivative liability approximate their respective fairvalues since they are adjusted to fair value at each period end.

NET LOSS PER COMMON SHARE

The Companycalculates net loss per share in accordance with Statement of FinancialAccounting Standards No. 128, “Earnings Per Share” (“SFAS No. 128”), and EITF03-6, “Participating Securities and the Two-Class Method under FASB StatementNo. 128”.  EITF 03-6 clarifies the use ofthe “two-class” method of calculating earnings per share as originallyprescribed in SFAS No. 128 and provides guidance on how to determine whether asecurity should be considered a “participating security”.  The Company has determined that itsconvertible subordinated notes payable are a participating security, as eachnote holder is entitled to receive any dividends paid and distributions made tothe common stockholders as if the note had been converted into common stock onthe record date.

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

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The calculation of diluted weighted average common shares outstandingfor the year ended December 31, 2006 and 2005 is based on the average of theclosing price of the Company’s common stock during each respective period.  The calculation of diluted loss per share forthe years ended December 31, 2006 and 2005 excluded the effect from theconversion of subordinated convertible notes payable and the exercise of stockoptions and senior and sub-debt warrants aggregating approximately 25,785,830shares and 25,785,830 shares of common stock, respectively, since their effectwould have been anti-dilutive.

Issued but unvested shares of common stock are excluded from thecalculation of basic earnings per share, but are included in the calculation ofdiluted earnings per share, to the extent that they are not anti-dilutive.

STOCK-BASED COMPENSATION

Prior to January 1, 2006, the Company accounted forstock-based employee compensation in accordance with the provisions ofAccounting Principles Board (“APB”) Opinion No. 25 and FASB InterpretationNo. 44 (“FIN 44”), “Accounting for Certain Transactions Involving StockCompensation”, and complied with the disclosure requirements of SFASNo. 123, “Accounting for Stock-Based Compensation”.  Under APB No. 25, compensation expensewas recorded based on the difference, if any, between the fair value of theCompany’s stock and the exercise price on the measurement date.  The Company accounted for stock issued tonon-employees in accordance with SFAS No. 123, which required entities torecognize as expense over the service period the fair value of all stock-basedawards on the date of grant, and EITF 96-18, “Accounting for Equity InvestmentsThat Are Issued to Other Than Employees for Acquiring, or in Conjunction withSelling, Goods or Services”, and EITF 00-18, “Accounting Recognition forCertain Transactions involving Equity Instruments Granted to Other ThanEmployees”, which addressed the measurement date and recognition approach forstock-based transactions.  The Companyrecognized compensation expense related to variable awards in accordance withFASB Interpretation No. 28, “Accounting for Stock Appreciation Rights andOther Variable Stock Option or Award Plans” (“FIN 28”).  For fixed awards, the Company recognizedexpense over the vesting period or the period of service.

                InDecember 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-BasedPayment” (“SFAS No. 123R”), a revision to SFAS No. 123, “Accountingfor Stock-Based Compensation”.  SFASNo. 123R superceded Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees”, and amended SFAS No. 95, “Statement ofCash Flows”.  SFAS No. 123R requiresthat the Company measure the cost of employee services received in exchange forequity awards based on the grant date fair value of the awards, with therelated cost recognized as compensation expense over the vesting period of theawards.  The Company adoptedSFAS No. 123R effective January 1, 2006, and is using themodified prospective method, in which compensation cost is recognized beginningwith the effective 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.

As required by SFAS No.123, pro forma information regarding net loss per share for the year endedDecember 31, 2005 was determined as if the Company had accounted for itsemployee stock options under the fair value method.  The fair value for these options wasestimated at the date of grant using either the Black-Scholes option-pricingmodel or the report of an independent valuation firm.  The assumptions used in the model and theweighted average fair value of each option granted during the year endedDecember 31, 2005 are as follows:
| Risk-free interest rate                 |   | 5.00 | %      |
|-----------------------------------------|--------|------|--------|
| Volatility                              |   | 170  | %      |
| Dividend yield                          |   | 0    | %      |
| Weighted average  expected life (years) |   | 5    |   |
| Weighted average fair  value of option  |   | $    | 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.  Pro forma information for the year endedDecember 31, 2005 (restated) is as follows (in thousands, except for sharedata):
| Net loss — as reported                                                                                     |   | $      | (12,105 | ) |
|-----------------------------------------------------------------------------------------------------------------|--------|--------|---------|---|
| Less:  Stock-based employee compensation expense determined under fair value methods  not charged to operations |   | (859   | )       |
| Net loss — pro  forma                                                                                      |   | $      | (12,964 | ) |
|                                                                                                            |   |   |    |
| Net loss per  share — basic and diluted:                                                                   |   |   |    |
| As reported                                                                                                     |   | $      | (3.05   | ) |
| Pro forma                                                                                                       |   | $      | (3.27   | ) |

 

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At December 31,2006, the unvested portion of the grant date fair value of awards will becharged to operations over the remaining vesting period of the outstandingoptions and warrants as follows (amounts are in thousands):
| Years Ending December 31, | ** ** | ** ** | ** ** |
|------------------------------------------|------------|------------|------------|
|                                     |       |       |       |
| 2007                                     |       | $          | 1,552      |   |
| 2008                                     |       | 1,033      |       |
| 2009                                     |       | 26         |       |
| Total                                    |       | $          | 2,611      |   |

 

In calculating theBlack-Scholes value of stock options issued, the Company uses the full term ofthe option, an appropriate risk-free interest rate (generally from 4% to 5%),and a 0% dividend yield. The Company calculates expected volatility utilizingan average of closing stock prices for an appropriate calculation period, whichhas generated volatility factors ranging from approximately 100% to 163% during2005 and 2006.

ESTIMATES

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

RECLASSIFICATION

Certain amountshave been reclassified from their presentation in 2005 to conform to the currentyear’s presentation.  Suchreclassifications did not have any effect on income (loss) from operations ornet income (loss).

3.  RECENT ACCOUNTING PRONOUNCEMENTS

In February 2007,the FASB issued Statement of Financial Accounting Standards No. 159, “The FairValue Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”),which provides companies with an option to report selected financial assets andliabilities at fair value.  SFAS No. 159’s objective is to reduce bothcomplexity in accounting for financial instruments and the volatility inearnings caused by measuring related assets and liabilities differently.  Generally accepted accounting principles haverequired different measurement attributes for different assets and liabilitiesthat can create artificial volatility in earnings.  SFAS No. 159 helps to mitigate this type ofaccounting-induced volatility by enabling companies to report related assetsand liabilities at fair value, which would likely reduce the need for companiesto comply with detailed rules for hedge accounting.  SFAS No. 159 also establishes presentationand disclosure requirements designed to facilitate comparisons betweencompanies that choose different measurement attributes for similar types ofassets and liabilities.  SFAS No. 159requires companies to provide additional information that will help investorsand other users of financial statements to more easily understand the effect ofthe company’s choice to use fair value on its earnings.  SFAS No. 159 also requires companies todisplay the fair value of those assets and liabilities for which the companyhas chosen to use fair value on the face of the balance sheet.  SFAS No.159 does not eliminate disclosure requirements included in other accountingstandards, including requirements for disclosures about fair value measurementsincluded in SFAS No. 157 and SFAS No. 107. SFAS No. 159 is effective as of the beginning of a company’s firstfiscal year beginning after November 15, 2007.  Early adoption ispermitted as of the beginning of the previous fiscal year provided that thecompany makes that choice in the first 120 days of that fiscal year and alsoelects to apply the provisions of SFAS No. 157. The Company is currently assessing the potential effect of SFAS No. 159on its financial statements.

InDecember 2006, the FASB issued FSP EITF 00-19-2, “**Accounting for Registration Payment Arrangements (“EITF00-19-2”), which** addresses an issuer’s accounting forregistration payment arrangements.  EITF00-19-2 specifies that the contingent obligation to make future payments orotherwise transfer consideration under a registration payment arrangement,whether issued as a separate agreement or included as a provision of afinancial instrument or other agreement, should be separately recognized andmeasured in accordance with FASB No. 5, “**Accounting for Contingencies”**.  The guidance in EITF 00-19-2 amends FASB No.133, “**Accounting forDerivative Instruments and Hedging Activities” and FASB No. 150, “Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity”, and**FASB Interpretation No. 45, “**Guarantor’s Accountingand Disclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others”, to** include scope exceptions forregistration payment arrangements.  EITF00-19-2 further clarifies that a financial instrument subject to a registrationpayment arrangement should be accounted for in accordance with other applicablegenerally accepted accounting principles without regard to the contingentobligation to transfer consideration pursuant to the registration paymentarrangement.  EITF 00-19-2 is effectiveimmediately for registration payment arrangements and the financial instrumentssubject to those arrangements that are entered into or modified subsequent tothe date of issuance of EITF 00-19-2. For registration payment arrangements and financial instruments subjectto those arrangements that were entered into prior to the issuance of EITF00-19-2, EITF 00-19-2 is effective for financial statements issued for fiscalyears beginning after December 15, 2006, and interim periods within those fiscalyears. Early adoption of EITF 00-19-2 for interim or annual periods for whichfinancial statements or interim reports have not been issued is permitted.  

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The Company has chosen toearly adopt EITF 00-19-2 effective December 31, 2006, the effect of which isdiscussed at Note 5.

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”), whichprovides enhanced guidance for using fair value to measure assets andliabilities.  SFAS No. 157 provides acommon definition of fair value and establishes a framework to make themeasurement of fair value in generally accepted accounting principles moreconsistent and comparable.  SFAS No. 157also requires expanded disclosures to provide information about the extent towhich fair value is used to measure assets and liabilities, the methods andassumptions used to measure fair value, and the effect of fair value measureson earnings.  SFAS No. 157 is effectivefor financial statements issued in fiscal years beginning after November 15,2007 and to interim periods within those fiscal years.  The Company is currently assessing thepotential effect of SFAS No. 157 on its financial statements.

In September 2006,the SEC issued SAB No. 108, “Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in Current Year Financial Statements” (“SAB No.108”).  SAB No. 108 was issued in orderto eliminate the diversity in practice surrounding how public companiesquantify financial statement misstatements. SAB No. 108 requires that registrants quantify errors using both abalance sheet (iron curtain) approach and an income statement (rollover)approach and then evaluate whether either approach results in a misstatedamount that, when all relevant quantitative and qualitative factors areconsidered, is material. SAB No. 108 is effective for fiscal years ending afterNovember 15, 2006.  The Company adoptedSAB No. 108 during 2006.  The adoption ofSAB No. 108 did not have a material effect on the Company’s financial statements.

In June 2006, theFASB issued FIN 48, “Accounting for Uncertainty in Income Taxes—aninterpretation of FASB Statement No. 109” (“FIN 48”), which seeks to reduce thediversity in practice associated with the accounting and reporting foruncertainty in income tax positions.  FIN48 prescribes a comprehensive model for the financial statement recognition,measurement, presentation and disclosure of uncertain tax positions taken orexpected to be taken in an income tax return. FIN 48 presents a two-step processfor evaluating a tax position.  The firststep is to determine whether it is more-likely-than-not that a tax positionwill be sustained upon examination, based on the technical merits of theposition.  The second step is to measurethe benefit to be recorded from tax positions that meet themore-likely-than-not recognition threshold, by determining the largest amountof tax benefit that is greater than 50 percent likely of being realized uponultimate settlement, and recognizing that amount in the financialstatements.  FIN 48 is effective forfiscal years beginning after December 15, 2006. The Company does not believe that the adoption of FIN 48 will have amaterial effect on its financial statements.

Management doesnot believe that any other recently issued, but not yet effective, accountingstandards, if currently adopted, would have a material effect on the Company’sfinancial statements.

4.  ACQUISITION OF MEDIADEFENDER, INC.

On July 28,2005, the Company consummated the acquisition of MediaDefender, Inc., aprivately-held Delaware corporation (“MediaDefender”), pursuant to the terms ofan Agreement and Plan of Merger (the “Merger Agreement”) entered into by andamong the Company, ARTISTdirect Merger Sub, Inc., a Delaware corporationand wholly-owned subsidiary of the Company (“Merger Sub”), andMediaDefender.  Under the terms of theMerger Agreement, Merger Sub merged with and into MediaDefender, the separatecorporate existence of Merger Sub ceased and MediaDefender survived as awholly-owned subsidiary of the Company. The stockholders of MediaDefender received aggregate consideration of$42,500,000 in cash, subject to certain holdbacks and adjustments described inthe Merger Agreement.  The amount ofconsideration paid by the Company upon the closing of the transaction wasdetermined in arm’s-length negotiations 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, and MediaDefender or any of its affiliates,officers or directors, or associates of any such officers or directors.

MediaDefender is aleading provider of anti-piracy solutions in the Internet-piracy-protection (“IPP”)industry.  During the year ended December31, 2006, MediaDefender also began to offer file-sharing marketing services,wherein MediaDefender redirects, for a fee, specific peer-to-peer traffic onthe Internet to designated client destinations.

In order to fundthe acquisition of MediaDefender, the Company completed a $15,000,000 seniorsecured debt transaction and a $30,000,000 convertible subordinated debttransaction, as described at Note 5.

In accordance withthe Merger Agreement, the Company acknowledged the terms of EmploymentAgreements entered into on July 28, 2005 by MediaDefender with each ofRandy Saaf and Octavio Herrera, confirming the terms of their employment.  Mr. Saaf and Mr. Herrera each earna base salary of no less than $350,000 per annum during the initial term of theagreements, which continue until December 31, 2008, and are also entitledto receive performance bonuses of up to $350,000 if MediaDefender achievesoperating earnings before interest, taxes, depreciation and amortization(calculated using the same accounting methods and policies as MediaDefender hashistorically used) exceeding $7,000,000 and $7,500,000 in fiscal 2007 and 2008,respectively.  Mr. Saaf and Mr. Herreraare each entitled to receive twelve months of severance pay at the rate of 100%of their monthly salary and the pro rata portion of the performance bonusreferenced above if they are terminated “without cause”.  In addition, the Company granted stockoptions to purchase 200,000 shares of common stock to each of Mr. Saaf andMr. Herrera, exercisable at $3.00 per share for a period of five years andvesting quarterly over a period of three and one-half years.

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The Company alsoacknowledged the terms of Non-Competition Agreements entered into on July 28,2005 by MediaDefender and 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 term of four yearsand shall continue to remain in force and effect in the event the above-referencedEmployment Agreements are terminated prior to the end of the four-year term ofthe Non-Competition Agreements.  Inconsideration, Mr. Saaf and Mr. Herrera were each entitled to a cashpayment of $525,000 from MediaDefender on December 31, 2006, whichpayments were timely made.

As a result ofthese agreements, effective July 28, 2005, the Company recorded an assetof $1,050,000 for the non-competition agreements and a related liability of$1,050,000 for the guaranteed payments to MediaDefender management.  The $1,050,000 allocated to non-competitionagreements is being amortized over the life of the employment agreements.

Mr. Saaf andMr. Herrera each invested $2,250,000 in the convertible subordinated debttransaction entered into to fund the acquisition of MediaDefender on the sameterms and conditions as the other investors in such financing (see Note 5).

Upon the closing of thetransaction, the Company issued 1,109,032 shares of common stock and aseven-year warrant to purchase 114,985 shares of common stock with an exerciseprice of $1.55 per share to WNT07 Holdings, LLC (“WNT07”).  The managers of WNT07 are Eric Pulier andTeymour Boutros-Ghali, both of whom were at the time of the issuance of theconsideration and currently are members of the Company’s Board ofDirectors.  The shares and warrants wereissued as consideration for services provided by Mr. Pulier andMr. Boutros-Ghali as consultants to the Company in connection with theacquisition of MediaDefender.  Theconsideration issued to WNT07 was approved by the disinterested members of theCompany’s Board of Directors.  The sharesand warrants were issued in reliance upon exemptions from registration pursuantto Section 4(2) under the Securities Act and Rule 506promulgated thereunder.  The shares ofcommon stock were valued at $1,585,916 ($1.43 per share) and the warrants werevalued at $83,939, based on a valuation report prepared by an independentvaluation firm.  The aggregate value of$1,669,855 was allocated $333,971 (20%) to a covenant not to compete (asdescribed below) and $1,335,884 (80%) to the costs that the Company incurred toacquire MediaDefender, based on management’s estimate of the relative values,as confirmed by the independent valuation firm. The amount allocated to the covenant not to compete is being amortizedthrough April 1, 2007.

On July 28, 2005, the Company entered into aNon-Competition Agreement with WNT07, Eric Pulier and Teymour Boutros-Ghali(collectively, the “Advisors”).  TheNon-Competition Agreement prohibits any of the Advisors (i) from engagingin certain competitive business activities and (ii) from solicitingexisting employees of the Company or its subsidiaries.  The covenants not to complete or solicitexpire on the earlier of April 1, 2007 or the date of termination ofAdvisor’s services with the Company.

The acquisition of MediaDefender was accounted for asa purchase in accordance with SFAS No. 141, “Business Combinations”, andthe operations of the two companies have been consolidated commencingAugust 1, 2005.  The fair value ofthe intangible assets acquired and their respective amortization periods weredetermined by an independent valuation firm. The following table summarizes the assets acquired and liabilitiesassumed of MediaDefender at July 28, 2005.

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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     |   |

 

Thefollowing pro forma operating data presents the results of operations for theyear ended December 31, 2005, as if the Company had acquired MediaDefendereffective January 1, 2005.  Discontinuedoperations for the year ended December 31, 2005 are not included.  The pro forma results are not necessarilyindicative of the financial results that might have occurred had theacquisition actually taken place on January 1, 2005, or of future results ofoperations.
|                                                     | ** ** | **(in thousands)** | ** ** |
|-----------------------------------------------------|------------|-------------------------|------------|
| ** **                                          | ** ** | ** **              | ** ** |
| Net revenue                                         |       | $                       | 20,637     |   |
|                                                |       |                    |       |
| Net loss                                            |       | $                       | (35,222    | ) |
|                                                |       |                    |       |
| Net loss per common  share – basic and diluted |       | $                       | (7.64      | ) |
|                                                |       |                    |       |
| Weighted average common shares outstanding          |       | 4,611,149               |       |

 

5.  FINANCING TRANSACTIONS WITH RESPECT TOMEDIADEFENDER, INC. ACQUISITION

In conjunction with theacquisition of MediaDefender (see Note 4), the Company completed a $15,000,000senior secured debt transaction (the “Senior Financing”) and a $30,000,000convertible subordinated debt transaction (the “Sub-Debt Financing”).

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

Inaddition, not later than ninety days after the close of each fiscal year, theCompany is obligated to apply 60% of its excess cash flow, as defined in theNote Purchase Agreement (the “Annual Cash Sweep”), to prepay the principalamount of the Senior Notes.  At December31, 2005, the 2005 Annual Cash Sweep was $390,000, which was shown as a currentliability at December 31, 2005, and which was paid in April 2006.  At December 31, 2006, there was no amountpayable for the 2006 Annual Cash Sweep.

The Senior Financing investors also received five-yearwarrants to purchase an aggregate of 3,250,000 shares of the Company’s commonstock at an exercise price of $2.00 per share (collectively, the “SeniorWarrants”).  The Senior Warrants werevalued at $1,982,500 based on a valuation report prepared by an independentvaluation firm utilizing the Black-Scholes option-pricing model, and wererecorded as a discount to the $15,000,000 of senior secured debt, and are beingamortized to interest expense over the term of the debt.

The Senior Warrants were subject to certainanti-dilution and price reset provisions, as well certain registration rightsobligations requiring the Company to file and maintain effective a registrationstatement with the SEC covering the shares of common stock underlying suchwarrants, which, if not complied with, subjects the Company to a cash penaltyof 1.5% of the Senior Financing per thirty day period.  Accordingly, in accordance with EITFNo. 00-19, the fair value of the Senior Warrants was recorded as warrantliability in the Company’s balance sheet at July 28, 2005, and is beingadjusted to reflect any material changes in such liability from the date ofissuance to the end of each reporting period, with any such changes included inother income (expense) in the statement of operations.

The Sub-DebtFinancing was completed in accordance with the terms set forth in theSecurities Purchase Agreement entered into on July 28, 2005 by the Companyand each of the investors indicated on the schedule of buyers attachedthereto (the “Securities Purchase Agreement”). Pursuant to the terms of the Securities Purchase Agreement, eachinvestor received a convertible subordinated note with a term offour years that bears interest at the rate of 4.00% per annum (each a “Sub-DebtNote”), with any unpaid principal and accrued interest due and payable atmaturity.  The interest rate increases to12.00% per annum during any period in which the Company is in default of itsobligations under the Sub-Debt Note. Commencing September 30, 2006, interest is payable quarterly in cash orshares of common stock, at the option of the Company.  Each Sub-Debt Note had an initial conversionprice of $1.55 per share, and was subject to certain anti-dilution, reset andchange-of-control provisions.  Inaddition, each Sub-Debt Note is subject to mandatory conversion by the Companyin the event certain trading price targets for the Company’s common stock aremet

Following effectiveness of a registration statementfiled by the Company for the securities issued in the Sub-Debt Financing, twotimes within any twelve-month period, the Company has the right to require theholder of each Sub-Debt Note to convert all or a portion equal to not less than25% of the note conversion amount (limited to 50% of the note conversion amountif pursuant to clause (a) below) into shares of the Company’s common stock inthe event that (a) the closing sale price of the Company’s common stock equalsor exceeds $2.32 per share for each of any fifteen consecutive trading days,with a minimum trading volume of 200,000 shares of common stock on each suchtrading day, (b) the closing sale price of the Company’s common stock equals orexceeds $3.10 per share on each trading day during the fifteen consecutivetrading day period, with a minimum trading volume of 200,000 shares of commonstock on each such trading day, subject in both cases to appropriateadjustments for stock splits, stock dividends, stock combinations and othersimilar transactions after the issuance date, or (c) completion of an equityfinancing (including the issuance of securities convertible into equitysecurities, or long-term debt securities issued as a unit with equitysecurities, of the Company) at a price per share of not less than $2.50generating aggregate gross proceeds of at least $20,000,000 from outside thirdparty investors.

Theholders of the Sub-Debt Notes are entitled to receive any dividends paid ordistributions made to the holders of common stock to the same extent as if suchholders had converted their Sub-Debt Notes into common stock (without regard toany limitations on conversion) and had held such shares of common stock on therecord date for such dividend or distribution, with such payment to be made concurrentlywith the payment of the dividend or distribution to the holders of commonstock.

TheSub-Debt Financing investors also received five-year warrants to purchase anaggregate of 1,596,774 shares of common stock at an exercise price of $1.55 pershare, subject to certain anti-dilution and price reset provisions (collectively,the “Sub-Debt Warrants”).  The Sub-DebtWarrants were valued at $1,133,710 based on a valuation report prepared by anindependent valuation firm utilizing the Black-Scholes option-pricing model,and were recorded as a discount to the $30,000,000 of convertible subordinateddebt, and are being amortized to interest expense over the term of the debt.

Inconjunction with the aforementioned financing transactions, a SubordinationAgreement dated July 28, 2005 was entered into between the Company, the SeniorFinancing investors, and the Sub-Debt Financing investors pursuant to which theSub-Debt Financing investors agreed to subordinate their rights to theinvestors in the Senior Financing on certain terms and conditions describedtherein.

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.

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Pursuant to the terms ofthe Note Purchase Agreement and the Securities Purchase Agreement, the Companywas required to amend its Certificate of Incorporation to increase the numberof authorized shares of common stock from 15,000,000 shares to 60,000,000shares.  The Company obtained the requisiteapprovals of the Board of Directors and stockholders and filed a Certificate ofAmendment to the Certificate of Incorporation with the Delaware Secretary ofState on November 7, 2005 to effect the increase in the authorized shares ofcommon stock.

If allof the securities issued in the Senior Financing and the Sub-Debt Financing areconverted or exercised into shares of the Company’s common stock in accordancewith their respective terms, it will result in significant dilution to theCompany’s existing stockholders and a possible change in control of theCompany.  If all of the Company’soutstanding equity-based instruments are converted or exercised into shares ofthe Company’s common stock in accordance with their respective terms, includingthose issued in conjunction with the acquisition of MediaDefender, there wouldbe a total of approximately 38,000,000 shares of the Company’s common stockissued and outstanding.

Thesecurities issued by the Company in the Senior Financing and the Sub-DebtFinancing were offered and sold in reliance upon exemptions from registrationpursuant to Section 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.

The Sub-Debt Notes and the Sub-Debt Warrants weresubject to certain registration rights obligations requiring the Company tofile and maintain effective a registration statement with the SEC covering theshares of common stock underlying such warrants, which, if not complied with,subjects the Company to a cash penalty of 1.0% of the Sub-Debt Financing perthirty day period.  Accordingly, inaccordance with EITF No. 00-19, the fair value of the Sub-Debt Warrantswas recorded as warrant liability in the Company’s balance sheet at July 28,2005, and is being adjusted to reflect any material changes in such liabilityfrom the date of issuance to the end of each reporting period, with any suchchanges included in other income (expense) in the statement of operations.

The Sub-Debt Notes contain reset, anti-dilution andchange-in-control provisions that the Company has determined causes such debtinstruments to be classified as “non-conventional” debt.  Upon evaluation of such debt instrumentsunder SFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities” (“SFAS No. 133”) and EITF 00-19, “Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock” (“EITF 00-19”), it was determined that the Company was required tobifurcate and value certain rights embedded in the Sub-Debt Notes on the dateof issuance (including, specifically, the initial $1.55 per share fixedconversion feature, which was in excess of the $1.43 per share fair marketvalue of the Company’s common stock on the date of issuance) and to classifysuch rights as either assets or liabilities. The fair value of these bifurcated derivatives as of July 28, 2005, asdetermined by an independent valuation firm, was calculated using a lattice(binomial) valuation model utilizing highly subjective and theoreticalassumptions that can materially affect fair values from period to period.  The recognition of these derivative amountsdid not have any impact on revenues, operating expenses or cash flows.  The Company recorded an initial embeddedderivative liability of $10,534,000, which was recorded as a discount to the$30,000,000 of convertible subordinated notes, and is being amortized over theterm of the debt.  The carrying value ofthe embedded derivative liability is being adjusted to reflect any materialchanges in such liability from the date of issuance to the end of eachreporting period, with any such changes included in other income (expense) inthe statement of operations.  The Companyhas accounted for registration rights penalties in accordance with SFAS No. 5, “Accountingfor Contingencies”, and EITF 00-19-2, “Accounting for Registration PaymentArrangements”, which the Company adopted as of December 31, 2006.

The Sub-Debt Notes contain several embedded derivativefeatures (both assets and liabilities) that have been accounted for at fairvalue.  The various embedded derivativefeatures of the Sub-Debt Notes have been valued at the date of inception of theSub-Debt Financing and at the end of each reporting period thereafter.  The material derivative featuresinclude:  (1) the standard conversionfeature of the debentures, (2) a limitation on the conversion by the holder,and (3) the Company’s right to force conversion.  An independent valuation firm valued theembedded derivative features and determined that, except for the above-notedfeatures, the remaining derivate attributes (both assets and liabilities) wereimmaterial, both individually and in the aggregate, and effectively offset eachother.  The value of the embeddedderivatives were bifurcated from the Sub-Debt Notes and recorded as derivativeliability, with the initial amount recorded as discount on the related Sub-DebtNotes.  This discount is being amortizedto interest expense over the life of the Sub-Debt Notes.

The Company determined that the warrants issued inconjunction with the Senior Financing and the Sub-Debt Financing createdderivative liabilities in accordance with EITF 00-19 because share settlementof these financial instruments was not within the control of the Company, sincethe Company could not conclude that it had sufficient authorized but unissuedcommon shares available to satisfy its potential share obligations under thewarrant agreements.  The Company reachedthis conclusion because:  (1) the Companyhas an obligation to file a registration statement with the SEC to register thecommon stock underlying warrants, and to have such registration statementdeclared effective, and to maintain effective such registration statement, orto pay penalties in the form of liquidated damages for each thirty-day periodthat such registration statement is not effective, (2) the warrants containeddilution protection features, with no limit or cap on the number of shares thatcould be issued by the Company pursuant to such provisions, and (3) thewarrants contained certain price reset features.

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Becausethe warrants contain certain anti-dilution and price reset provisions, as wellas have registration rights, the fair value of the warrants was accounted foras a derivative and presented as warrant liability.

The Company, with the assistance of an independentvaluation firm, calculated the fair value of the embedded derivativesassociated with the Sub-Debt Notes utilizing a binomial lattice option-pricingmodel.  The valuation model used thefollowing assumptions for the original valuation and similar assumptions foreach succeeding valuation:

·       Initialfair value of common stock:  $1.43

·  Fair value of common stock at each subsequentreporting period-end:  closing price onlast business day of reporting period

·       Conversionprice:  $1.55

·       Terminaltime period:  subordinated convertiblenotes payable mature on July 2009 (3 years and 11 months)

·       Timestep:  Period between each pricemovement, calculated monthly

·  Expected Return:  4.04% (the risk-free rate was based on thetreasury security rate with the same term as the subordinated convertible notespayable as of the specified valuation date)

·       Initialvolatility factor:  55%

·       Volatility factor at eachsubsequent reporting period-end:  asdetermined by comparison to market peer group

Pursuantto the terms of a letter agreement, dated July 15, 2005, by and betweenthe Company and Broadband Capital Management LLC (“Broadband”), effective July28, 2005, the Company issued to Broadband a Sub-Debt Note in the amount of$1,460,500 (in addition to the $30,000,000 referred to above) and five-yearwarrants to purchase 1,516,935 shares of common 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 securities were issued as partialconsideration for Broadband’s services as the Company’s placement agent in theSub-Debt Financing and the Senior Financing. The securities were issued in reliance upon exemptions from registrationpursuant to Section 4(2) under the Securities Act and Rule 506promulgated thereunder.  The Broadbandwarrants were valued at $1,077,024 based on a valuation report prepared by anindependent valuation firm utilizing the Black-Scholes option-pricing model.  The aggregate value of the Sub-Debt Note, thewarrants and additional cash payments to Broadband aggregating $299,500 werecharged to deferred financing costs and are being amortized to other expenseover the term of the debt.  Thesecurities issued to Broadband were accounted for in a manner consistent withthe accounting for the Sub-Debt Notes and Sub-Debt Warrants as described above.

Pursuantto the terms of a letter agreement, dated June 21, 2005, by and betweenthe Company and Libra FE, LP (“Libra”), effective July 28, 2005, the Companyissued to Libra a seven-year warrant to purchase 237,500 shares of its commonstock with an exercise price of $2.00 per share upon the closing of the SeniorFinancing (the “Libra Warrant”).  TheWarrant was issued as partial consideration for Libra’s services as the Company’splacement agent in the Senior Financing described above.  The Company entered into a RegistrationRights Agreement with Libra on July 28, 2005 (the “Libra RegistrationRights Agreement”), pursuant to which the Company will include the sharesunderlying the Libra Warrant in the registration statement covering thesecurities issued in the Senior Financing and the Sub-Debt Financing describedabove.  The Libra Warrant was issued inreliance upon exemptions from registration pursuant toSection 4(2) under the Securities Act and Rule 506 promulgatedthereunder.  The Libra Warrant was valuedat $175,750 based on a valuation report prepared by an independent valuationfirm utilizing the Black-Scholes option-pricing model.  The aggregate value of the warrants andadditional payments to Libra of $450,997 were charged to deferred financingcosts and are being amortized to other expense over the term of the debt.

The Libra Warrant was 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, which if not complied with could subject the Company to a cashpenalty of $5,000 per thirty day period.  In accordance with EITF No. 00-19,the fair value of the warrants was recorded as warrant liability at July 28,2005, and was being adjusted to reflect any material changes in such liabilityfrom the date of issuance to the end of each reporting period, with any suchchanges included in other income (expense) in the statement of operations asother income (expense).  Effective April19, 2006, the Libra Warrant was exercised on a cashless basis at $2.00 pershare, resulting in the issuance of 123,864 shares of common stock.

The Company calculated the fair value of the warrantsusing the Black Scholes option-pricing model, using the volatility factordetermined by the independent valuation firm. The valuation model used the following assumptions for the originalvaluation and similar assumptions for each succeeding valuation:

·       Initialfair value of common stock:  $1.43

·  Fair value of common stock at each subsequentreporting period-end:  closing price onlast business day of reporting period

·  Exercise price:

Senior warrants:  $2.00 (reducedto $1.85 in April 2006)

Sub-Debt warrants:  $1.55(reduced to $1.43 in April 2006)

Libra warrants:  $2.00

·  Time Period:

Senior warrants:  7 years

Sub-debt warrants:  5 years

Libra warrants:  7 years

·  Expected Return: 4.04% (the risk-free rate wasbased on the treasury security rate with the same term as the warrants as ofthe specified valuation date)

·  Initial volatility factor: 55%

·  Volatility factor at each subsequent reportingperiod-end:  as determined by comparisonto market peer group

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At thedate of exercise of any of the Senior Warrants, the Sub-Debt Warrants or theLibra Warrant, or the conversion of Sub-Debt Notes into common stock, the prorata fair value of the related warrant liability and/or embedded derivativeliability is transferred to additional paid-in capital.

Pursuant to the Senior Financing and Sub-DebtFinancing documents, the Company is required to comply on a quarterly basiswith certain financial covenants, including minimum working capital, maximumcapital expenditures, minimum leverage ratio, minimum EBITDA and minimum fixedcharge coverage ratio.  These financialcovenants are identical in the Senior Financing and the Sub-Debt Financingdocuments.

Due to the accounting classification of the warrantsissued in conjunction with the Senior Financing and the Sub-Debt Financing as acurrent liability in accordance with SFAS No. 133 and EITF 00-19, the Companywas not in compliance with certain of these financial covenants atDecember 31, 2005.

On April 7, 2006, the lenders provided waiverswith respect to such past events of default under the Senior Notes and amendedtheir loan documents such that the warrant liability and any change thereto infuture periods will not affect future covenant and excess cash flowcalculations.  In consideration thereof,the Company offered to temporarily reduce the exercise price of the 3,250,000warrants held by the investors in the Senior Financing from $2.00 to $1.85 pershare through April 30, 2006, and agreed to permanently reduce the exerciseprice of the 1,596,744 warrants held by the investors in the Sub-Debt Financingfrom $1.55 to $1.43 per share on certain terms and conditions.  Anyexercise of the aforementioned warrants at the reduced exercise price wasrequired to be for cash only.  The conversion price of the Sub-Debt Notesof $1.55 per share was not affected.  The Company also entered intosimilar agreements, as applicable, and provided identical temporary andpermanent reductions to warrant exercise prices, with Broadband Capital ManagementLLC (1,516,935 warrants originally exercisable at $1.55 per share) and LibraFE, LP (237,500 warrants originally exercisable at $2.00 per share).  TheCompany also agreed to utilize 25% of the net proceeds from the exercise of thewarrants held by the investors in the Senior Financing to reduce the respectiveprincipal balances on the Senior Notes payable held by such exercisinginvestors, and to pay any related unpaid accrued interest on such principalpayments.  The aforementioned waivers didnot extend to the embedded derivative liabilities associated with the Sub-Debt.

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

On November 7, 2006, the Company entered into a waiver(the “Sub-Debt Waiver”) with the holders of the Sub-Debt Notes.  Aprovision of the Sub-Debt Notes contains a negative covenant pertaining to theCompany’s Consolidated Fixed Charge Coverage Ratio (as such term is defined inthe Sub-Debt Notes), which is to be calculated on a quarterly basis (the “FixedCharge Covenant”).  The Fixed Charge Covenant did not contemplate that thefirst cash payment of accrued interest was not due and payable to the holdersof the Sub-Debt Notes until September 30, 2006 (the “First Interest Payment”),an approximate fourteen-month period from the original issuance date of theSub-Debt Notes.  As a result of the Company timely making the FirstInterest Payment, the Company was forced to breach the Fixed Charge Covenant. The holders of the Sub-Debt Notes agreed to waive this event of default underthe Sub-Debt Notes that may have been triggered due to a breach of the FixedCharge Covenant resulting from the First Interest Payment.

On November 7, 2006, the Company also entered into awaiver (the “Senior Waiver”) with the purchasers of the Senior Notes originallyissued by the Company.  The Note Purchase Agreement contains the sameFixed Charge Covenant that is contained in the Sub-Debt Notes (the “SeniorFixed Charge Covenant”).  As a result of the Company timely making theFirst Interest Payment, the Company was forced to breach the Senior FixedCharge Covenant.  The holders of the Senior Notes agreed to waive theevent of default under the Note Purchase Agreement that may have been triggereddue to a breach of the Senior Fixed Charge Covenant resulting from the FirstInterest Payment.

The financing documents governing the terms andconditions of the senior and subordinated indebtedness require the Company tomaintain an effective registration statement covering the resale of shares ofcommon stock underlying the various securities issued by the Company to eachholder.

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Aresale registration statement on Form SB-2, as amended (Reg. No. 333-129626),was declared effective by the SEC on December 9, 2005.  The Companysubsequently filed Post-Effective Amendment No. 1 to the registration statementon Form SB-2 (Reg. No. 333-129626), which was declared effective by theSEC on May 1, 2006.  As a result of the determination to restatepreviously issued financial statements (see Note 1), the Form SB-2 has not beenavailable for use by the holders since December 21, 2006.

The financing documents specify that an event ofdefault of the senior and subordinated indebtedness is triggered if a resaleregistration statement is unavailable for use by the holders for a period ofmore than ten consecutive trading days after the expiration of an allowable tenday grace period.  The Company invoked its use of the ten-day allowable graceperiod on December 21, 2006, which expired on December 31, 2006.  As ofJanuary 18, 2007, the Form SB-2 remained unavailable for use by the holders,and it will continue to be unavailable for use until the Company prepares andfiles a post-effective amendment to the Form SB-2 with restated financialstatements and other required financial statements, as appropriate, which isthen declared effective by the SEC.  Accordingly, an event of default ofthe senior and subordinated indebtedness has been triggered by theunavailability of the Form SB-2 to the holders. The financing documents provide that while the Form SB-2 remainsunavailable for use, holders of senior indebtedness are entitled to a cashpenalty equal to 1.5% of the original Senior Financing, on a pro rata basis,and the holders of subordinated indebtedness are entitled to a cash penaltyequal to 1.0% of the original Sub-Debt Financing, on a pro rata basis. These cash penalties are due and payable by the Company at the end of eachthirty-day period while the Form SB-2 remains unavailable.  The first cashpenalty payment was due on January 30, 2007. The Company has not made any cash penalty payments to the holders of theSenior Financing or the Sub-Debt Financing.

The Company delivered notice to holders of itsoutstanding senior and subordinated indebtedness that, as of January 18, 2007,an event of default had been triggered under their respective senior andsubordinated financing documents.  As of December 31, 2006, approximately$13,307,000 was outstanding with respect to the Senior Financing, andapproximately $27,658,000 was outstanding with respect to the Sub-DebtFinancing.  Upon the occurrence of an event of default, holders of atleast 25% of the outstanding senior indebtedness may declare the outstandingprincipal and accrued interest on all senior notes immediately due and payableupon written notice to the Company, and each holder of outstanding subordinatedindebtedness may demand redemption of all or any portion of their respectivenotes as described in the subordinated financing documents.  The Companyhas not received a request to accelerate or redeem any portion of theoutstanding indebtedness from any senior or subordinated holder.  TheCompany does not have the capital resources necessary to repay any acceleratedindebtedness or redemption.  All quarterly interest payments due on theoutstanding senior and subordinated indebtedness were timely paid by theCompany through December 2006.  In addition,the quarterly interest payment due on the outstanding senior indebtedness inMarch 2007 was timely paid.  Pursuant tothe terms of the Subordination Agreement, interest on the outstandingsubordinated convertible notes payable cannot be paid as a result of theexistence of the events of default described herein.

Pursuant to a Forbearance and Consent Agreement datedas of April 17, 2007, the investors in the Senior Financing agreed to forbearfrom the exercise of their rights and remedies under the Senior Financingdocuments as a result of the events of default with respect to theunavailability of the Company’s registration statement, as well as certainother events of default that currently exist or may come into existence duringthe forbearance period, through May 31, 2007, in exchange for a cash payment of$250,000.  Any payments made by theCompany under the Forbearance and Consent Agreement will be credited againstaccrued registration delay cash penalties or any other amounts that are or maybecome due and payable.  The Company hasthe right to extend the Forbearance and Consent Agreement through June 30, 2007by an additional cash payment of $125,000 on or before May 31, 2007.

The Forbearance and Consent Agreement did not impactthe investors in the Sub-Debt Financing. As the Subordination Agreement (as described above) limits the rights ofthe investors in the Sub-Debt Financing, the Company has not paid any interestor penalties to the investors in the Sub-Debt Financing in 2007.  The Company has not entered into anyagreements with the investors in the Sub-Debt Financing.

As previously discussed, at December 31, 2006, theregistration statement covering the resale of shares of common stock underlyingthe various securities issued by the Company to each holder of the senior andsubordinated indebtedness was not effective. Management currently estimates that a registration statement coveringsuch shares of common stock could be declared effective no earlier than August2007.  Accordingly, in accordance withSFAS No. 5, “Accounting for Contingencies”, and EITF 00-19-2, which the Companyadopted as of December 31, 2006, the Company has accrued seven monthsliquidated damages under the registration rights agreements aggregatingapproximately $3,777,000 as a charge to operations and a current liability atDecember 31, 2006.  Since theregistration rights component of the derivative liabilities was not materialthrough September 30, 2006, there was no cumulative-effect adjustment recordedas a result of the transition rules with respect to the adoption ofEITF-00-19-2 at December 31, 2006.  TheCompany will continue to review the status of the registration statement andadjust the accrued liquidated damages under the registration rights agreementsat each quarter end as appropriate.

As described above, as a result of the requirement torestate previously issued financial statements, which resulted in the recordingof the embedded derivative liability, the reclassification of the senior andsubordinated indebtedness to current liabilities, and the recording ofestimated liquidated damages payable under registration rights agreements of$3,777,000, the Company was not in compliance with certain of its financialcovenants under both the Senior Financing and the Sub-Debt Financing atDecember 31, 2006.

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The Company has entered into an exclusive agreementwith a financial advisor to assist in negotiations with the holders of itssenior and subordinated debt obligations to obtain a waiver of and amendment tocertain of the financing documents with respect to the events of default, theimpact of the restatements, the payment of cash penalties, and various relatedmatters.  The Company is unable topredict the outcome of such negotiations. The Company is exploring various alternatives to resolve the defaultsunder its senior and subordinated debt obligations.  To the extent that the Company is unable torestructure its senior and subordinated debt obligations in a satisfactorymanner, the ongoing penalties and default interest will have a significant andmaterial negative impact on the Company’s cash flows and earnings, such thatthe Company may not have sufficient cash resources to maintain operations inthe future.  In such event, the Companymay be required to consider a formal or informal restructuring orreorganization.

6.  PROPERTY AND EQUIPMENT

Property and equipmentare recorded at cost and consist of the following:
|                                                 | ** ** | **December 31,**   | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                                      | ** ** | **(in thousands)** | ** ** |
| ** **                                      | ** ** | ** **              | ** ** | ** ** | ** ** |
| Computer  equipment and software                |       | $                       | 3,744      |   | $ | 2,977 |   |
| Furniture and  fixtures                         |       | 192                     |       | 143 |   |
| Leasehold improvements                          |       | 261                     |       | — |   |
|                                            |       | 4,197                   |       | 3,120 |   |
| Less accumulated  depreciation and amortization |       | (1,729                  | )          | (1,175 | ) |
| Property and  equipment, net                    |       | $                       | 2,468      |   | $ | 1,945 |   |

 

Leasehold improvementsrelate to the Company’s new office facilities lease (see Note 16).

7.  GOODWILL AND OTHER INTANGIBLE ASSETS

Components of the Company’s identifiable amortizableintangible assets at December 31, 2006 and 2005, all of which wererecorded in conjunction with the acquisition of MediaDefender in July 2005 (seeNote 4), are as follows:
|                             | ** ** | **Balance at  Beginning of  Year** | ** ** | **Amortization  Expense** | ** ** | **Balance at  End of Year** | ** ** |
|-----------------------------|------------|----------------------------------------------|------------|---------------------------|------------|--------------------------------------------|------------|
| ** **                  | ** ** | **(in thousands)**                      | ** ** |
| ** **                  | ** ** | ** **                                   | ** ** | ** **                | ** ** | ** **                                 | ** ** |
| December 31, 2006           |       |                                         |       |                      |       |                                       |       |
| Customer relationships      |       | $                                            | 1,950      |                      | $          | 755                                        |       | $ | 1,195 |   |
| Proprietary technology      |       | 6,546                                        |       | 2,534                     |       | 4,012                                      |       |
| Non-competition  agreements |       | 1,191                                        |       | 463                       |       | 728                                        |       |
| Total                       |       | $                                            | 9,687      |                      | $          | 3,752                                      |       | $ | 5,935 |   |
|                        |       |                                         |       |                      |       |                                       |       |
| December 31, 2005           |       |                                         |       |                      |       |                                       |       |
| Customer relationships      |       | $                                            | 2,264      |                      | $          | 314                                        |       | $ | 1,950 |   |
| Proprietary technology      |       | 7,602                                        |       | 1,056                     |       | 6,546                                      |       |
| Non-competition  agreements |       | 1,384                                        |       | 193                       |       | 1,191                                      |       |
| Total                       |       | $                                            | 11,250     |                      | $          | 1,563                                      |       | $ | 9,687 |   |

 

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Amortization expense with respect to intangible assetsfor the years ended December 31, 2006 and 2005 was $3,752,000 and$1,563,000, respectively.  Scheduledamortization expense with respect to intangible assets for the next threesucceeding years is as follows (amounts are in thousands):
| Years Ending December 31, | ** ** | ** ** | ** ** |
|------------------------------------------|------------|------------|------------|
| ** **                               | ** ** | ** ** | ** ** |
|                                     |       |       |       |
| 2007                                     |       | $          | 3,601      |   |
| 2008                                     |       | 2,182      |       |
| 2009                                     |       | 152        |       |
| Total                                    |       | $          | 5,935      |   |

 

Goodwill at December 31, 2006 and 2005 was$31,085,000, which was recorded in conjunction with the acquisition ofMediaDefender in July 2005 (see Note 4). In accordance with SFAS No. 142, “Goodwill and Other IntangibleAssets”, an intangible asset that is not subject to amortization such asgoodwill shall be, at a minimum, tested for impairment annually.  The first of the impairment tests consists ofa comparison of the total fair value of each reporting unit and the reportingunit’s net assets on the date of the test. If the fair value is in excess of the net assets, there is no indicationof impairment and no need to perform the second tier impairment test.  The Company performed this test as ofJuly 31, 2006, the one-year anniversary of the acquisition ofMediaDefender, and determined that there was no indication of impairment atthat date, or subsequently through December 31, 2006.

8.    DEFERRED FINANCING COSTS

Components of the Company’s deferred financing costsat December 31, 2006 and 2005 are as follows:
|                                        | ** ** | **Balance at  Beginning of  Year** | ** ** | **Amortization  Expense** | ** ** | **Write-offs  Resulting from  Conversions  and  Repayments  of Debt** | ** ** | **Balance at  End of Year** | ** ** |
|----------------------------------------|------------|----------------------------------------------|------------|---------------------------|------------|---------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                             | ** ** | **(in thousands)**                      | ** ** |
|                                   |       |                                         |       |                      |       |                                                                            |       |                                       |       |
| Year Ended  December 31, 2006          |       |                                         |       |                      |       |                                                                            |       |                                       |       |
| Deferred  financing costs related to:  |       |                                         |       |                      |       |                                                                            |       |                                       |       |
| Subordinated convertible notes payable |       | $                                            | 2,400      |                      | $          | 618                                                                             |       | $                                          | 263        |   | $ | 1,519 |   |
| Senior secured notes payable           |       | 900                                          |       | 240                       |       | 95                                                                              |       | 565                                        |       |
| Total                                  |       | $                                            | 3,300      |                      | $          | 858                                                                             |       | $                                          | 358        |   | $ | 2,084 |   |
|                                   |       |                                         |       |                      |       |                                                                            |       |                                       |       |
| Year Ended  December 31, 2005          |       |                                         |       |                      |       |                                                                            |       |                                       |       |
| Deferred  financing costs related to:  |       |                                         |       |                      |       |                                                                            |       |                                       |       |
| Subordinated convertible notes payable |       | $                                            | 2,722      |                      | $          | 291                                                                             |       | $                                          | 31         |   | $ | 2,400 |   |
| Senior secured notes payable           |       | 1,011                                        |       | 111                       |       | —                                                                          |       | 900                                        |       |
| Total                                  |       | $                                            | 3,733      |                      | $          | 402                                                                             |       | $                                          | 31         |   | $ | 3,300 |   |

 

Amortization expense with respect to deferredfinancing costs for the years ended December 31, 2006 and 2005 was$858,000 and $402,000, respectively. Scheduled amortization expense with respect to deferred financing costsfor the next three succeeding years is as follows (amounts are in thousands):

| Years Ending December 31, | ** ** | ** ** | ** ** |
|------------------------------------------|------------|------------|------------|
| ** **                               | ** ** | ** ** | ** ** |
|                                     |       |       |       |
| 2007                                     |       | $          | 841        |   |
| 2008                                     |       | 841        |       |
| 2009                                     |       | 402        |       |
| Total                                    |       | $          | 2,084      |   |

 

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9.  ALLOWANCE FOR DOUBTFUL ACCOUNTS

A summary of the activitywith respect to the allowance for doubtful accounts is as follows:
|                                  | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------|------------|---------------------------------------------|------------|
| ** **                       | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| ** **                       | ** ** | **(in thousands)**                     | ** ** |
| ** **                       | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Balance,  beginning of year      |       | $                                           | 177        |   | $ | 171 |   |
| Provision for  doubtful accounts |       | 705                                         |       | 105 |   |
| Amounts charged  off             |       | (461                                        | )          | (99 | ) |
| Balance, end of year             |       | $                                           | 421        |   | $ | 177 |   |

 

The provision fordoubtful accounts for the years ended December 31, 2006 and 2005 by segment wasas follows:
|                                                  | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | **(in thousands)**                     | ** ** |
| ** **                                       | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| E-commerce                                       |       | $                                           | 34         |   | $ | 21 |   |
| Media                                            |       | 317                                         |       | 83 |   |
| Anti-piracy and  file-sharing marketing services |       | 354                                         |       | 1 |   |
| Total                                            |       | $                                           | 705        |   | $ | 105 |   |

 

10.  ACCRUED EXPENSES

Accrued expenses arecomprised of the following:
|                                                           | ** ** | **December 31,**   | ** ** |
|-----------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                                                | ** ** | **(in thousands)** | ** ** |
| ** **                                                | ** ** | ** **              | ** ** | ** ** | ** ** |
| Accrued cost of  sales                                    |       | $                       | 169        |   | $ | 265 |   |
| Accrued compensation  and related costs                   |       | 223                     |       | 670 |   |
| Accrued  professional fees                                |       | 448                     |       | 467 |   |
| Accrued business  and property taxes                      |       | 143                     |       | 168 |   |
| Liabilities  related to discontinued operations of iMusic |       | 61                      |       | 149 |   |
| Other accrued  expenses                                   |       | 531                     |       | 353 |   |
| Total accrued  expenses                                   |       | $                       | 1,575      |   | $ | 2,072 |   |

 

11.  INCOME TAXES

Thecomponents of the provision for income taxes are as follows:
|            | ** ** | **Years Ended December 31,** | ** ** |
|------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| ** ** | ** ** | **(in thousands)**                     | ** ** |
| Current:   |       |                                        |       |   |   |
| Federal    |       | $                                           | 660        |   | $ | 158 |   |
| State      |       | 178                                         |       | 40 |   |
|       |       | $                                           | 838        |   | $ | 198 |   |
|       |       |                                        |       |   |   |
| Deferred:  |       |                                        |       |   |   |
| Federal    |       | $                                           | —     |   | $ | 12 |   |
| State      |       | —                                      |       | 31 |   |
|       |       | —                                      |       | 43 |   |
| Total      |       | $                                           | 838        |   | $ | 241 |   |

 

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Income taxes differ fromthe amount computed using a tax rate of 34% as a result of the following:
|                                                                     | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                          | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| ** **                                                          | ** ** | ** **                                  | ** ** | **(Restated)** | ** ** |
| ** **                                                          | ** ** | **(in thousands)**                     | ** ** |
| ** **                                                          | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Computed  expected tax benefit                                      |       | $                                           | (1,388     | ) | $ | (4,105 | ) |
| State and local  income taxes, net of federal income tax benefit    |       | 117                                         |       | 25 |   |
| Amortization of  non-cash financing costs                           |       | 861                                         |       | 1,108 |   |
| Adjustments to  deferred tax assets                                 |       | 1,053                                       |       | 6,688 |   |
| Stock-based  compensation                                           |       | 656                                         |       | — |   |
| Permanent  adjustments caused by warrant and derivative liabilities |       | (1,807                                      | )          | 10,641 |   |
| Other                                                               |       | 10                                          |       | 25 |   |
|                                                                |       | (498                                        | )          | 14,382 |   |
| Valuation  allowance                                                |       | 1,336                                       |       | (14,141 | ) |
| Total income tax  expense                                           |       | $                                           | 838        |   | $ | 241 |   |

 

The tax effects oftemporary differences that give rise to significant portions of the deferredtax assets and liabilities at December 31, 2006 and 2005 are as follows:
|                                   | ** ** | **December 31,**   | ** ** |
|-----------------------------------|------------|-------------------------|------------|
| ** **                        | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                        | ** ** | ** **              | ** ** | **(Restated)** | ** ** |
| ** **                        | ** ** | **(in thousands)** | ** ** |
| ** **                        | ** ** | ** **              | ** ** | ** ** | ** ** |
| Deferred tax  liabilities:        |       |                    |       |   |   |
| State income taxes                |       | $                       | 3,311      |   | $ | 3,237 |   |
| Depreciation                      |       | 541                     |       | 63 |   |
| Total deferred tax liabilities    |       | 3,852                   |       | 3,300 |   |
|                              |       |                    |       |   |   |
| Deferred tax  assets:             |       |                    |       |   |   |
| Net operating loss carryforwards  |       | 46,722                  |       | 48,022 |   |
| Amortization of intangible assets |       | 2,151                   |       | 640 |   |
| Non-deductible accrued expenses   |       | 1,776                   |       | 193 |   |
| Other                             |       | 220                     |       | 127 |   |
| Total deferred tax assets         |       | 50,869                  |       | 48,982 |   |
| Valuation allowance               |       | (47,281                 | )          | (45,946 | ) |
| Net deferred assets               |       | 3,588                   |       | 3,036 |   |
| Net deferred tax  liabilities     |       | $                       | 264        |   | $ | 264 |   |

 

At December 31,2006, the Company had net operating loss carryforwards of approximately$111,000,000 for Federal income tax purposes expiring beginning in 2020 andCalifornia state net operating loss carryforwards of approximately $102,000,000expiring beginning in 2008.

In assessing thepotential realization of deferred tax assets, management considers whether itis more likely than not that some portion or all of the deferred tax assetswill be realized.  The ultimaterealization of deferred tax assets (primarily net operating loss carryforwards)is dependent upon the Company attaining future taxable income during theperiods in which those temporary differences become deductible.  As of December 31, 2006 and 2005, managementwas unable to determine if it is more likely than not that the Company’sdeferred tax assets will be realized and has therefore recorded an appropriatevaluation allowance against deferred tax assets at such dates.

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

As aresult of the profitable operations of MediaDefender during the year endedDecember 31, 2006 and 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 $838,000and $241,000, respectively, for the years ended December 31, 2006 and2005, respectively.

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12.  RELATEDPARTY TRANSACTIONS

iMusic:

During the year endedDecember 31, 2003, the Company reduced the activity of its iMusic record labeland executed an agreement with GC Music, LLC (“GC Music”) pursuant to which theCompany assigned its rights and obligations to six unreleased artists inexchange for a cash payment of $100,000 applied as a reduction to prioradvances related to the six artists and a profit interest in the projects.  GC Music was partially owned by a formerofficer and director of the Company.  TheCompany retained the distribution rights to the albums previously releasedunder the original terms of its distribution agreements with its other signedartists, but did not intend to sign any additional artists or release anyadditional albums domestically or internationally under the iMusic label, andtherefore expected very minimal sales activity subsequent to thetransaction.  At December 31, 2006and 2005, the Company provided a sufficient reserve for remaining contractobligations and estimated product returns. Effective August 14, 2006, the Company entered into a TerminationAgreement and Release with GC Music that settled all of the Company’sobligations to GC Music for a one-time cash payment of $25,000.

Office Sub-Lease:

From the third quarter of2003 through March 2006, the Company’s administrative offices were located inan office leased by Radar Pictures, Inc., a company owned by Ted Field,the Chairman of the Board of Directors of the Company, pursuant to amonth-to-month arrangement.  For the yearended December 31, 2005, the Company accrued $90,000 to RadarPictures, Inc. as rent and facilities usage expense.  On February 28, 2005, the Company paidRadar Pictures, Inc. accrued rent through December 31, 2004.Commencing January 1, 2005, the Company began paying rent at a rate of $7,500per month for these facilities.  TheCompany relocated to new office facilities in March 2006.

TransactionsRelated to MediaDefender Acquisition:

Inconjunction with the acquisition of MediaDefender, the Company issued 1,109,032shares of common stock and a seven-year warrant to purchase 114,985 shares ofcommon stock with an exercise price of $1.55 per share to WNT07 Holdings,LLC.  The managers of WNT07 Holdings, LLCare Eric Pulier and Teymour Boutros-Ghali, both of whom were at the time of theissuance of the consideration and currently are members of the Company’s Boardof Directors.  The shares and warrantswere issued as consideration for services provided by Mr. Pulier andMr. Boutros-Ghali as consultants to the Company in connection with theacquisition of MediaDefender (see Note 4).

OnJuly 28, 2005, the Company entered into a Non-Competition Agreement withWNT07 Holdings, LLC, Eric Pulier and Teymour Boutros-Ghali (collectively, the “Advisors”).  The Non-Competition Agreement prohibits anyof the Advisors (i) from engaging in certain competitive businessactivities and (ii) from soliciting existing employees of the Company orits subsidiaries.  The covenants not tocomplete or solicit expire on the earlier of April 1, 2007 or the date oftermination of Advisor’s services with the Company.

TheCompany also acknowledged the terms of Non-Competition Agreements entered intoon July 28, 2005 by MediaDefender and Randy Saaf andOctavio Herrera, formerly principals and stockholders of MediaDefender andcurrently both executive officers of the Company’s wholly-owned subsidiary,MediaDefender.  The Non-CompetitionAgreements prohibit Mr. Saaf and Mr. Herrera from (i) engagingin certain competitive 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 term of four yearsand shall continue to remain in force and effect in the event theabove-referenced Employment Agreements are terminated prior to the end of thefour-year term of the Non-Competition Agreements.  In consideration, Mr. Saaf andMr. Herrera were each entitled to a cash payment of $525,000 fromMediaDefender on December 31, 2006, which payments were timely made.

RandySaaf and Octavio Herrera each invested $2,250,000 in the Sub-Debt Financing onthe same terms and conditions as the other Sub-Debt Financing investors (seeNote 5).

TransactionsInvolving Officers and Directors:

Effectiveas of January 1, 2006, the Company entered into a one-year consultingagreement with Eric Pulier, a director of the Company, through WNT ConsultingGroup, a California limited liability company wholly-owned by Mr. Pulier (“WNT”).  The consulting agreement was approved by thedisinterested members of the Company’s Board of Directors.  Effective January 12, 2007, the partiesmutually agreed to terminate this consulting agreement, which had automaticallyrenewed for a second one-year term through December 31, 2007.  Under theterms of the original consulting agreement, Mr. Pulier received a base fee of$10,000 per month, certain other mandatory payments, and was also eligible toreceive cash bonuses on the achievement of certain specified milestones.  Mr. Pulierhad also agreed to waive all stock options and other stock-based compensationgranted to outside members of the Company’s Board of Directors during the termof his original consulting agreement. The termination agreement provided for aone-time cash payment to Mr. Pulier (through WNT) in the amount of $100,000(which was paid in January 2007), in consideration for the termination of theconsulting agreement and an acknowledgement and complete release of any and allclaims related to unpaid compensation, bonus amounts or other out-of-pocketexpenses (in cash or otherwise) that may have been owed by the Company as ofJanuary 12, 2007.

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Mr. Pulier willcontinue to serve as a member of the Company’s Board of Directors.  Thetermination agreement was approved by the Compensation Committee of the Company’sBoard of Directors.

On January 12, 2007, the Company entered into a newconsulting agreement with Mr. Pulier (through WNT).  During the term ofthe new consulting agreement, which commenced January 12, 2007 and continues ineffect until any party provides ten days prior written notice to the otherparties of its intention to terminate, Mr. Pulier will provide non-exclusiveconsulting and advisory services to the Company outside of the ordinary courseof his services as a member of the Board of Directors.  In consideration,Mr. Pulier (through WNT) is entitled to receive hourly compensation at the rateof $500 per hour.  Any consulting request made by the Company must beapproved in advance by all parties prior to commencement of services.  Thenew consulting agreement was approved by the Compensation Committee of theCompany’s Board of Directors.

On November 28, 2006, the Company acknowledged theterms of a release of claims (the “Release”) entered into by Nicholas Turner,the Company’s former Vice President, Business Development.  Pursuant tothe terms of the Release, Mr. Turner has agreed to fully waive any and allclaims that he may have against the Company, including any such claims relatedto the terms of his employment or otherwise, if any, that may have arisen priorto the execution date of the Release.  The Company further acknowledgedthat the effective date of Mr. Turner’s resignation as the Company’s VicePresident, Business Development was August 31, 2006.

The Company and Mr. Turner also entered into anindependent contractor agreement dated November 28, 2006 (the “ContractorAgreement”), in order to provide for Mr. Turner’s temporary continued serviceswith the Company.  The Contractor Agreement was scheduled to remain ineffect for a period of eight months, commencing as of September 1, 2006 (the “Term”);provided, that, the Contractor Agreement could be terminated prior to the endof the Term by Mr. Turner for any reason or by the Company (i) for “cause,”(ii) the death or disability of Mr. Turner or (iii) for any reason at itsoption effective as of December 31, 2006 by making a one-time cash payment to Mr.Turner of $30,000 in the aggregate (the “Early Termination Option”).  TheContractor Agreement prohibited Mr. Turner from engaging in certain competitivebusiness activities and from soliciting existing employees, customers, clientsor vendors of the Company or its subsidiaries. The covenants not to compete or solicit expire on the later of April 30,2007 and the date of termination of Mr. Turner’s consulting services with theCompany.  In consideration, Mr. Turnerwas entitled to receive from the Company a base fee of $12,500 for the firstfour-month period (comprised of $5,000 in cash and $7,500 in the form of ashort-term loan, which would be forgiven on April 30, 2007 if Mr. Turner hascomplied with the provisions of the covenants not to compete or solicit) and$7,500 per month during the second four-month period (including a recoupableadvance), as well as certain commission and bonus amounts, assuming achievementof specified milestones.  The ContractorAgreement was approved by the Compensation Committee of the Company’s Board ofDirectors.

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

AtDecember 31, 2005, the Company accrued $100,000 with respect to board feesto two independent directors and $40,000 with respect to a discretionary bonusto its former Vice President, Business Development, which were paid in2006.  During the year endedDecember 31, 2005, the Company accrued and paid bonuses of $75,000 and$50,000, respectively, to its Chief Executive Officer and Chief FinancialOfficer, respectively.

For the year ended December 31, 2006, eachnon-employee member of the Company’s Board of Directors received a cashretainer of $15,000, and (excluding Mr. Pulier) a grant of stock optionshaving a value (based upon the appropriate Black-Scholes option valuationmethodology) equal to $35,000.  The strike price for the options was seton the date of grant and the options vested entirely on December 31,2006.  In addition, each director that serves on a Committee of the Boardof Directors received, for each committee served, an additional cash retainerof $10,000, and (excluding Mr. Pulier) a grant of stock options having avalue equal to $15,000, having the same terms and conditions as options grantedto all non-employee members of the Board of Directors generally.  The stock option grants were made on July 7,2006 under the 2006 Equity Plan (see Note 14).

Fred Davis, who joined the Company’s Board ofDirectors in November 2005, and who did not receive any board compensation in2005, was considered a new director in 2006, and received a one-time grant ofstock options having a value equal to $25,000, a three-year vesting term andotherwise having the same terms and conditions as options granted to allnon-employee members of the Board of Directors generally.

During the year ended December 31, 2006, the Companyincurred legal fees of approximately $45,000 to Davis Shapiro Lewit &Hayes, LLP, a law firm in which Fred Davis, a director of the Company, is apartner.

During2005, the Company completed the implementation of a new business initiative tocreate global awareness of the ARTISTdirect brand and increase traffic to theCompany’s web-site.

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Throughrelationships previously developed by the Company’s senior management in themusic and entertainment industry, the Company began to develop opportunitiesfor major corporations to sponsor cause-based programs in various parts of theworld in conjunction with music and entertainment celebrities.  The Company believed that this effort wouldenhance the global reputation of the Company through associations with leadingperformers and entertainers, which could then be expected to drive brandawareness and traffic to the Company’s digital media properties.  During the year ended December 31, 2005,the Company received a fee advance of $35,000 from an international non-profitorganization with respect to the first such project.  This fee advance was budgeted to fund initialplanning and oversight and accordingly, one-half was paid to the Company’sChief Executive Officer and one-half was paid to the Company’s former ExecutiveVice President as a co-producer’s fee. Total costs incurred with respect to this project during the year endedDecember 31, 2005 were $46,000, excluding the aforementioned $35,000 ofco-producer’s fees paid.

SeeNotes 1, 4, 13 and 16 for information with respect to additional related partytransactions.

13. STOCKHOLDERS’ DEFICIENCY

Amendments to Certificate of Incorporation:

On November 7, 2005,the Company filed with the Secretary of State of the State of Delaware a Certificateof Amendment of its Certificate of Incorporation to increase the authorizednumber of shares of its common stock from 15,000,000 shares to 60,000,000shares.

On June 26, 2006, 2006,the Company filed with the Secretary of State of the State of Delaware aCertificate of Amendment of its Certificate of Incorporation to eliminate5,000,000 shares of authorized but unissued shares of preferred stock.

Stock-Based Transactions During the Year EndedDecember 31, 2006:

On May 6, 2005, the Company issued to aconsultant a stock option to purchase an aggregate of 22,000 shares of theCompany’s common stock pursuant to the Company’s 1999 Employee Stock OptionPlan, exercisable for a period of five years at $1.00 per share, the marketprice on the date of the grant, pursuant to a short-term consultingagreement.  The option was subject to milestones, one of which waspartially attained during the year ended December 31, 2006, as a result ofwhich 10,000 shares vested during such period.  The fair value of thevested portion of this option of $35,000, calculated pursuant to theBlack-Scholes option-pricing model, was charged to operations during the yearended December 31, 2006.

During the year ended December 31, 2006, the Companyissued 97,287 shares of common stock upon the exercise of stock optionspreviously issued to employees and consultants, and received cash proceeds ofapproximately $80,000.

During the year ended December 31, 2006, the Companyprovided short-term extensions of the exercise period for options held by twoformer employees.  The fair value of suchextensions of $44,000, calculated pursuant to the Black-Scholes option-pricingmodel, was charged to operations during the year ended December 31, 2006.

During the year ended December 31, 2006, the Companyissued to a consultant stock options on a monthly basis to purchase 35,000shares of the Company’s common stock pursuant to the Company’s 2006 EquityIncentive Plan, exercisable for a period of five years at prices ranging from$2.35 to $2.95 per share, the market price on the date of each grant, pursuantto a short-term consulting agreement. The options were fully vested at the date of issuance.  The aggregate fair value of the options of$76,000, calculated pursuant to the Black-Scholes option-pricing model, wascharged to operations during the year ended December 31, 2006.  The assumptions used in the Black-Scholesoption-pricing model to calculate the fair value of the options were asfollows:
| Stock price on date of grant            |   | $2.35 – 2.90 |   |
|-----------------------------------------|--------|-------------------|--------|
| Risk-free  interest rate                |   | 4.89 – 4.97  | %      |
| Volatility                              |   | 99.8 – 102.1 | %      |
| Dividend yield                          |   | 0                 | %      |
| Weighted average  expected life (years) |   | 4.92 – 5.00  |   |
| Weighted average fair  value of option  |   | $1.79 – 2.25 |   |

 

During the year ended December 31, 2006, the Companyissued 2,203,870 shares of common stock upon the conversion of $3,416,000 ofsubordinated convertible notes payable.  As a result, $1,345,000 wascharged to operations during the year ended December 31, 2006, consisting ofrelated deferred financing costs of $263,000 and debt discount costs of$1,082,000.

Effective April 19, 2006, Libra FE, LP exercised itswarrants on a cashless basis at $2.00 per share, resulting in the issuance of123,864 shares of common stock.

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

On October 19, 2006, an investor in the Sub-Debtfinancing exercised a portion of its warrants to purchase 79,839 shares ofcommon stock at $1.43 per share, resulting in the issuance of 79,839 shares ofcommon stock in exchange for cash proceeds of $114,170.

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

As a result of the $0.15 warrant exercise price reductionoffered to the investors in the Senior Financing, the Company recorded a chargeto operations for the aggregate fair value of such exercise price reductions of$423,000 relating to the warrants held and exercised by the Senior Financinginvestors in April 2006.

As a result of the $0.12 warrant exercise pricereduction provided to the investors in the Sub-Debt Financing, the Companyrecorded a charge to operations for the aggregate fair value of such exerciseprice reductions of $218,000 relating to the warrants held by the investors inthe Sub-Debt Financing.

On July 7, 2006, in conjunction with the previouslyadopted 2006 board compensation program, the Company granted stock optionsunder the 2006 Equity Plan approved by the Company’s stockholders at its 2006Annual Meeting to five non-officer members of its Board of Directors to acquirean aggregate of 91,551 shares of common stock, exercisable for a period of fiveyears at $3.35 per share, the closing price of the Company’s common stock asquoted on the OTC Bulletin Board on the date of grant.  The stock optionswere fully vested on December 31, 2006. The aggregate fair value of such stock options, calculated pursuant tothe Black-Scholes option-pricing model, was $260,000, which was charged tooperations during the year ended December 31, 2006.  The assumptions used in the Black-Scholesoption-pricing model to calculate the fair value of the options were asfollows:
| Stock price on date of grant            |   | $     | 3.35   |   |
|-----------------------------------------|--------|-------|--------|--------|
| Risk-free  interest rate                |   | 5.05  | %      |
| Volatility                              |   | 122.0 | %      |
| Dividend yield                          |   | 0     | %      |
| Weighted average  expected life (years) |   | 5.0   |   |
| Weighted average fair  value of option  |   | $     | 2.84   |   |

 

On October 9, 2006, the Company entered into aneighteen-month non-exclusive consulting agreement with Wood River Ventures, LLCand Jonathan Dolgen for consulting and advisory services with respect to thebusiness and operations of the Company (see Note 16).  The consultingagreement provides for a stock award valued at $112,500, consisting of 34,615shares of common stock based on the Company’s closing stock price on October10, 2006 of $3.25 per share to be issued under the Company’s 2006 EquityIncentive Plan.  The shares vest pro rata over the eighteen-month periodof the consulting agreement, beginning on October 10, 2006 and thereaftermonthly on the first day of each month of the term of the consulting agreementthrough March 2008.  In accordance withETIF 96-18, “Accounting for Equity Instruments That Are Issued to Other ThanEmployees for Acquiring, or in Conjunction with Selling, Goods or Services”,the shares granted under this consulting agreement are valued each month basedon the closing market price on the first day of each month to determine theamount to be recorded as a charge to operations over the eighteen-month term ofthe consulting agreement.  Accordingly,during the year ended December 31, 2006, the Company issued 5,769 shares ofcommon stock under this consulting agreement and recorded a related charge tooperations of $19,000.

Stock-Based Transactions During the Year EndedDecember 31, 2005:

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

On March 29, 2005,the Company issued to its employees stock options to purchase an aggregate of205,150 shares of the Company’s common stock pursuant to the Company’s 1999Employee Stock Option Plan exercisable for a period of seven years at $0.79 pershare, the market price on the date of grant. The stock options vested quarterly through September 30, 2006.

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The fair value of these options, calculated pursuantto the Black-Scholes option-pricing model, was determined to be $140,000, ofwhich $28,000 was recorded as stock-based compensation cost in 2006.

On May 6, 2005, theCompany issued to three consultants stock options to purchase an aggregate of78,000 shares of the Company’s common stock pursuant to the Company’s 1999Employee Stock Option Plan exercisable for a period of five years at $1.00 pershare, the market price on the date of the grant, pursuant to short-term consultingagreements with a duration of approximately one year.  The fair value of these options, calculatedpursuant to the Black-Scholes option-pricing model, was determined to be$79,000, of which $60,000 was charged to operations during the year ended December 31,2005 and $19,000 was recorded as deferred compensation at December 31,2005, and charged to operations during the year ended December 31, 2006.

On May 6, 2005, theCompany issued to a consultant a stock option to purchase an aggregate of22,000 shares of the Company’s common stock pursuant to the Company’s 1999Employee Stock Option Plan exercisable for a period of five years at $1.00 pershare, the market price on the date of the grant, pursuant to a short-termconsulting agreement.  The option wassubject to milestones, one of which was partially attained during the yearended December 31, 2005.  The fairvalue of the vested portion of this option of $13,000, calculated pursuant tothe Black-Scholes option-pricing model, was charged to operations during theyear ended December 31, 2005.

Effective as ofJuly 28, 2005, the Company agreed to issue to each of its two independentdirectors at that time a stock option to purchase 85,000 shares of the Company’scommon stock exercisable for a period of seven years at 85% of the averageclosing price of the Company’s common stock for the 30 trading day period priorto July 28, 2005 and the 30 trading day period subsequent to July 28,2005.  The stock options were issued atan exercise price of $1.95 per share on September 9, 2005, which was inexcess of the fair value of the common stock issued in the MediaDefendertransaction, and were fully vested at issuance. The fair value of each of these options, calculated pursuant to theBlack-Scholes option-pricing model, was determined to be $245,650.

In conjunction with theacquisition of MediaDefender, effective July 28, 2005, the Company grantedstock options to each of Randy Saaf, MediaDefender’s Chief Executive Officer,and Octavio Herrera, Media Defender’s President, to purchase 200,000 shares ofcommon stock, exercisable for a period of five years at $3.00 per share, whichwas in excess of the fair value of the common stock issued in the MediaDefendertransaction.  These options vestquarterly over three and one-half years. The fair value of each of these options, calculated pursuant to theBlack-Scholes option-pricing model, was determined to be $546,000, of which$312,000 was recorded as stock-based compensation cost in 2006.

In conjunction with the acquisition of MediaDefender,effective July 28, 2005, the Company granted stock options to JonathanDiamond, its Chief Executive Officer, to purchase 2,753,098 shares of commonstock, exercisable for a period of five years at $1.55 per share, which was inexcess of the fair value of the common stock issued in the MediaDefendertransaction.  Options with respect to1,045,000 shares are scheduled to vest over three years and options withrespect to 1,708,098 shares are scheduled to vest based on specifiedperformance milestones.  The fair valueof the time-vested options, calculated pursuant to the Black-Scholesoption-pricing model, was determined to be $2,936,450, of which $979,000 wasrecorded as stock-based compensation cost in 2006.

In conjunction with the acquisition of MediaDefender,effective July 28, 2005, the Company granted stock options to RobertWeingarten, its Chief Financial Officer, to purchase 550,000 shares of commonstock, exercisable for a period of five years at $1.55 per share, which was inexcess of the fair value of the common stock issued in the MediaDefendertransaction.  Options with respect to275,000 shares are scheduled to vest over three years and options with respectto 275,000 shares are scheduled to vest based on specified performance milestones.  The fair value of the time-vested options,calculated pursuant to the Black-Scholes option-pricing model, was determinedto be $772,750, of which $258,000 was recorded as stock-based compensation costin 2006.

In conjunction with the acquisition of MediaDefender,the Company issued 1,109,032 shares of common stock and a warrant to purchaseup to 114,985 shares of common stock with an exercise price of $1.55 per shareto WNT07 Holdings, LLC.  The managers ofWNT07 Holdings, LLC are Eric Pulier and Teymour Boutros-Ghali, both of whomwere at the time of the issuance of the consideration and currently are membersof the Company’s Board of Directors.  Theshares and warrants were issued as consideration for services provided byMr. Pulier and Mr. Boutros-Ghali as consultants to the Company withrespect to the MediaDefender acquisition. 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 valuation report preparedby an independent valuation firm.  Theaggregate value of $1,669,855 was allocated $333,971 (20%) to a covenant not tocompete and $1,335,884 (80%) to the costs that the Company incurred to acquireMediaDefender, based on management’s estimate of the relative values, as confirmedby the independent valuation firm.  Theamount allocated to the covenant not to compete is being amortized throughApril 1, 2007.

During the year ended December 31, 2005, the Companyissued 250,000 shares of common stock upon the conversion of $386,221 ofsubordinated convertible notes payable, including 825 shares as payment foraccrued interest related to the principal converted.  As a result,$161,000 was charged to operations during the year ended December 31, 2005,consisting of related deferred financing costs of $42,000 and debt discountcosts of $119,000.

Effective July 29,2005, the Company cancelled 322,902 shares of common stock held in treasurywith a carrying cost of $3,442,000.

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14.  STOCK-BASED PLANS

2004 CONSULTANT STOCKPLAN

EffectiveSeptember 29, 2004, the Company’s Board of Directors adopted theARTISTdirect, Inc. 2004 Consultant Stock Plan (the “Consultant Plan”) inorder for the Company to be able to compensate consultants, at the option ofthe Company, who provide bona fide services to the Company not in connectionwith capital raising or promotion of the Company’s securities.  The Consultant Plan will expire onSeptember 29, 2014, and provides for the issuance of up to 500,000 sharesof common stock to consultants at fair market value.  On January 13, 2005, the Company filed aRegistration Statement on Form S-8 with the Securities and ExchangeCommission to register the 500,000 shares of common stock for future issuanceunder the Consultant Plan.  As ofDecember 31, 2006, no shares had been issued under the Consultant Plan.

2006 EQUITY INCENTIVEPLAN

The Company’s stockholders approved theARTISTdirect, Inc. 2006 Equity Incentive Plan (the “2006 Equity Plan”) atthe Company’s Annual Meeting of Stockholders held on June 19, 2006 (the “AnnualMeeting”).  The Board of Directors of the Company had previously approvedthe 2006 Equity Plan in April 2006.  A total of 1,500,000 new sharesof the Company’s common stock have initially been reserved for issuance underthe 2006 Equity Plan.  Awards under the 2006 Equity Plan may be granted toany of the Company’s employees, directors, officers, consultants or those ofthe Company’s affiliates.  Awards may consist of stock options (bothincentive stock options and non-statutory stock options), stock awards, stockappreciation rights and cash awards.  An incentive stock option may begranted under the 2006 Equity Plan only to a person who, at the time of thegrant, is an employee of the Company or a parent or subsidiary of theCompany.  During the year ended December31, 2006, the Company issued 34,615 shares of common stock pursuant to aconsulting agreement (see Notes 13 and 16) and options to purchase 126,551shares of common stock.  As of December31, 2006, 1,338,834 shares remained available for future option grant.

A summary of stock option activity under the 2006Equity Plan during the year ended December 31, 2006 is as follows:
|                                                | ** ** | **Options Outstanding** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | **Number  of Shares**   | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|                                           |       |                         |       |   |   |
| Options  outstanding at December 31, 2005 |       | —                       |       | $ | — |   |
| Granted                                        |       | 126,551                      |       | 3.20 |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled                                      |       |                         |       | — |   |
| Options outstanding at  December 31, 2006 |       | 126,551                      |       | $ | 3.20 |   |

 

The following tablesummarizes information regarding options outstanding and options exercisable atDecember 31, 2006 under the 2006 Equity Plan:

|                          | ** ** | **Options Outstanding and Exercisable** | ** ** |
|--------------------------|------------|--------------------------------------------------------|------------|
| ** **               | ** ** | ** **                                             | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| ** **               | ** ** | ** **                                             | ** ** | **Average** | ** ** | **Weighted** | ** ** |
| ** **               | ** ** | ** **                                             | ** ** | **Remaining** | ** ** | **Average** | ** ** |
| ** **               | ** ** | **Number**                                             | ** ** | **Contractual** | ** ** | **Exercise** | ** ** |
| **Exercise Prices** | ** ** | **of Shares**                                     | ** ** | **Life** | ** ** | **Price** | ** ** |
|                     |       |                                                   |       |   |   |   |   |
|                     | $          | 2.35                                                   |       |   | 5,000 |   | 4.92 |   | $ | 2.35 |   |
|                     | $          | 2.90                                                   |       |   | 30,000 |   | 4.92 |   | $ | 2.90 |   |
|                     | $          | 3.35                                                   |       |   | 91,551 |   | 4.52 |   | $ | 3.35 |   |
|                     | $          | 2.35-$3.35                                             |       |   | 126,551 |   | 4.63 |   | $ | 3.20 |   |

 

The weightedaverage grant date fair value of stock options issued in 2006 was $2.66 pershare.

The intrinsicvalue of exercisable but unexercised in-the-money options at December 31, 2006was $0.

1999 EMPLOYEE STOCKOPTION PLAN

In October 1999, theCompany implemented the 1999 Employee Stock Option Plan (the “Employee Plan”).  The Employee Plan was not approved by thepublic stockholders of the Company.

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The Employee Plan has currently reserved 1,098,004shares of the Company’s common stock for issuance to employees, non-employeemembers of the board of directors and consultants.  This share reserve automatically increases onthe first trading day in January each calendar year by an amount equal to2% of the total number of shares of the Company’s common stock outstanding onthe last trading day of December in the prior calendar year, but in noevent will this annual increase exceed 87,500 shares.  No option may have a term in excess often years.  The options generally vestwithin three years.  As of December 31,2006, 135,955 shares remained available for future option grant.

A summary of stock optionactivity under the Employee Plan during the years ended December 31, 2005and 2006 is as follows:
|                                                | ** ** | **Options Outstanding** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | **Number of  Shares**   | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                                           |       |                         |       |   |   |
| Options  outstanding at December 31, 2004 |       | 111,154                      |       | $ | 15.18 |   |
| Granted                                        |       | 875,150                      |       | 1.87 |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled                                      |       | (17,686                      | )          | 1.31 |   |
| Options  outstanding at December 31, 2005 |       | 968,618                      |       | 3.57 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | (97,287                      | )          | 0.79 |   |
| Cancelled                                      |       | (6,569                       | )          | 0.79 |   |
| Options outstanding at  December 31, 2006 |       | 864,762                      |       | $ | 3.88 |   |

 

The following table summarizesinformation regarding options outstanding and options exercisable atDecember 31, 2006 under the Employee Plan:
|                          | ** **   | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|--------------------------|--------------|------------------------------|------------|------------------------------|------------|
| ** **               | ** **   | ** **                   | ** ** | **Weighted**                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **               | ** **   | ** **                   | ** ** | **Average**                  | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **               | ** **   | ** **                   | ** ** | **Remaining**                | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **               | ** **   | **Number**                   | ** ** | **Contractual**              | ** ** | **Exercise** | ** ** | **Number** | ** ** | **Exercise** | ** ** |
| **Exercise Prices** | ** **   | **of Shares**           | ** ** | **Life**                     | ** ** | **Price** | ** ** | **of Shares** | ** ** | **Price** | ** ** |
|                     |         |                         |       |                         |       |   |   |   |   |   |   |
| $                        | 0.79         |                         |       | 102,333                      |       | 5.24 |   | $ | 0.79 |   | 102,333 |   | $ | 0.79 |   |
| $                        | 1.00         |                         |       | 82,500                       |       | 3.35 |   | $ | 1.00 |   | 82,500 |   | $ | 1.00 |   |
| $                        | 1.95         |                         |       | 170,000                      |       | 5.69 |   | $ | 1.95 |   | 170,000 |   | $ | 1.95 |   |
| $                        | 3.00         |                         |       | 400,000                      |       | 3.57 |   | $ | 3.00 |   | 161,905 |   | $ | 3.00 |   |
| $                        | 4.80         |                         |       | 33,332                       |       | 2.78 |   | $ | 4.80 |   | 33,332 |   | $ | 4.80 |   |
| $                        | 5.10         |                         |       | 10,000                       |       | 2.77 |   | $ | 5.10 |   | 10,000 |   | $ | 5.10 |   |
| $                        | 7.50         |                         |       | 58,603                       |       | 1.83 |   | $ | 7.50 |   | 58,603 |   | $ | 7.50 |   |
| $                        | 40.00        |                         |       | 1,025                        |       | 0.44 |   | $ | 40.00 |   | 1,025 |   | $ | 40.00 |   |
| $                        | 139.28       |                         |       | 6,969                        |       | 0.24 |   | $ | 139.28 |   | 6,969 |   | $ | 139.28 |   |
| $                        | 0.79-$139.28 |                         |       | 864,762                      |       | 3.98 |   | $ | 3.88 |   | 626,667 |   | $ | 4.22 |   |

 

The intrinsicvalue of exercisable but unexercised in-the-money options at December 31, 2006was $339,000. The intrinsic value of options exercised during the year endedDecember 31, 2006 was $283,000.

The followingtable summarizes information regarding the Company’s non-vested options underthe Employee Plan as of December 31, 2005 and 2006, and the changes during2006:

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

 

As of December 31,2006, unrecognized compensation cost related to unvested stock options will be chargedto operations as follows (amounts are in thousands):
| **Years Ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2007                                         |       | $          | 312        |   |
| 2008                                         |       | 312        |       |
| 2009                                         |       | 26         |       |
| Total                                        |       | $          | 650        |   |

 

1999 ARTIST AND ARTIST ADVISOR OPTION PLAN

In June 1999, and as amended in October 1999and March 2000, the Company adopted the 1999 Artist and Artist AdvisorStock Option Plan (the “Advisor Plan”). The Advisor Plan was not approved by the public stockholders of theCompany.  The Advisor Plan has currentlyreserved 402,159 shares of common stock for issuance to artists for whom theCompany entered into agreements related to online and e-commerce activities andtheir agents, business managers, attorneys and other advisors.  This share reserve automatically increases onthe first trading day in January each calendar year by an amount equal to1% of the total number of shares of the Company’s common stock outstanding onthe last trading day of December in the prior calendar year, but in noevent will this annual increase exceed 37,500 shares.  As of December 31, 2006, 372,295 sharesremained available for future option grants. The options expire seven years from the date of grant and vestinggenerally varies between one to three years. No new option grants under this plan were made during 2005 or 2006.

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A summary of stockoption activity under the Advisor Plan during the years ended December 31,2005 and 2006 is as follows:
|                                                | ** ** | **Options Outstanding** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | **Number  of Shares**   | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|                                           |       |                         |       |   |   |
| Options  outstanding at December 31, 2004 |       | 35,536                       |       | $ | 123.29 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled                                      |       | —                       |       | — |   |
| Options  outstanding at December 31, 2005 |       | 35,536                       |       | 123.29 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled                                      |       | (5,672                       | )          | 39.00 |   |
| Options outstanding at  December 31, 2006 |       | 29,864                       |       | $ | 139.28 |   |

 

The followingtable summarizes information regarding options outstanding and optionsexercisable under the Advisor Plan at December 31, 2006:
|                          | ** ** | **Options Outstanding and Exercisable** | ** ** |
|--------------------------|------------|--------------------------------------------------------|------------|
| **Exercise Prices** | ** ** | **Number  of Shares**                             | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|                     |       |                                                   |       |   |   |   |   |
| $139.28                  |       | 29,864                                                 |       | 0.24 |   | $ | 139.28 |   |
|                          |            |                                                        |            |  |  |  |  |  |

 

The intrinsicvalue of exercisable but unexercised in-the-money options at December 31, 2006was $0.

1999 ARTIST STOCK PLAN

In June 1999,and as amended in October 1999, the Company adopted the 1999 Artist StockPlan (the “Artist Plan”).  The ArtistPlan was not approved by the public stockholders of the Company.  The Artist Plan currently has reserved848,004 shares of common stock for issuance to artists for whom the Companyentered into agreements related to their online and e-commerce activities.  This share reserve automatically increases onthe first trading day in January each calendar year by an amount equal to2% of the total number of shares of the Company’s common stock outstanding onthe last trading day of December in the prior calendar year, but in noevent will this annual increase exceed 87,500 shares.  As of December 31, 2006, 837,629 sharesremained available for future option grants. The options expire seven years from the date of grant and vestinggenerally varies between one to three years. No new option grants under this plan were made during 2005 or 2006.

A summary of stockoption activity under the Artist Plan during the years ended December 31,2005 and 2006 is as follows:
|                                                | ** ** | **Options Outstanding** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | **Number  of Shares**   | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|                                           |       |                         |       |   |   |
| Options  outstanding at December 31, 2004 |       | 23,874                       |       | $ | 83.15 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled                                      |       | —                       |       | — |   |
| Options  outstanding at December 31, 2005 |       | 23,874                       |       | 83.15 |   |
| Granted                                        |       | —                       |       | — |   |
| Exercised                                      |       | —                       |       | — |   |
| Cancelled                                      |       | (13,499                      | )          | 40.00 |   |
| Options outstanding at  December 31, 2006 |       | 10,375                       |       | $ | 139.28 |   |

 

104

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The followingtable summarizes information regarding options outstanding and optionsexercisable under the Artist Plan at December 31, 2006:
|                          | ** ** | **Options Outstanding and Exercisable** | ** ** |
|--------------------------|------------|--------------------------------------------------------|------------|
| **Exercise Prices** | ** ** | **Number  of Shares**                             | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|                     |       |                                                   |       |   |   |   |   |
| $139.28                  |       | 10,375                                                 |       | 0.20 |   | $ | 139.28 |   |
|                          |            |                                                        |            |  |  |  |  |  |

 

The intrinsicvalue of exercisable but unexercised in-the-money options at December 31, 2006was $0.

1999 EMPLOYEE STOCKPURCHASE PLAN

InOctober 1999, the Company adopted the 1999 Employee Stock Purchase Planthat initially reserved 50,000 shares of common stock for issuance under thisplan.  As of December 31, 2006, thisplan had 200,000 shares reserved for issuance, of which 187,831 shares remainedavailable for future issuances.  Thisshare reserve automatically increases on the first trading day inJanuary each calendar year, by an amount equal to 1% of the total numberof shares of the Company’s common stock outstanding on the last trading day ofDecember in the prior calendar year, but in no event will this annualincrease exceed 25,000 shares.  Terms ofthe plan permit eligible employees to purchase common stock through payrolldeduction of up to 15% of each 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.  During the years endedDecember 31, 2005 and 2006, no shares were issued under this plan.

NON-PLAN OPTIONSOUTSTANDING

Effective September 29, 2003, the Company issuedto Jonathan V. Diamond, the Company’s Chief Executive Officer, a non-plan,non-qualified stock option to purchase 259,659 shares of common stockexercisable through August 15, 2010 at $0.85 per share, which was theapproximate fair market value of the common stock on the date of grant.  The option vested over a period of threeyears from the date of grant, and was fully vested in 2006.  The fair value of the stock option,determined pursuant to the Black-Scholes option-pricing model, was $221,000, ofwhich $36,000 was charged to operations in 2006.

Effective March 29, 2004, the Company issued toRobert N. Weingarten, the Company’s Chief Financial Officer, a non-plan,non-qualified stock option to purchase 120,000 shares at $0.50 per share, whichwas not less than the fair market value on the date of grant, exercisablethrough March 29, 2011.  The optionvests and becomes exercisable in a series of thirty-six successive equalmonthly installments from March 29, 2004 through March 29, 2007.  The fair value of the stock option,determined pursuant to the Black-Scholes option-pricing model, was $42,000, ofwhich $14,000 was charged to operations in 2006.

Effective May 31, 2001, the Company issued toFrederick W. (Ted) Field, the Company’s Chairman and former ChiefExecutive Officer, a non-qualified stock option to purchase 302,370 shares ofcommon stock exercisable at $7.50 per share through May 30, 2008.  The option vested over a period of five yearsfrom June 29, 2001, and was fully vested in 2006.  The fair value of the stock option,determined pursuant to the Black-Scholes option-pricing model, was $2,006,000,of which $201,000 was charged to operations in 2006.

15.  401(K) PLAN

The Company hasadopted the Cash or Deferred Profit Sharing Plan and Trust underSection 401(k) of the Internal Revenue Code (the “401(k) Plan”).  Under the 401(k) Plan, participatingemployees may defer a percentage (not to exceed 15%) of their eligiblepretax earnings up to the Internal Revenue Service’s annual contributionlimit.  All employees of the Company whoare 21 years or older and who complete three months of service are eligible toparticipate in the 401(k) Plan.  TheCompany does not match contributions by participants to the 401(k) Plan.  Accordingly, there is no related expense forthe years ended December 31, 2006 and 2005.

105

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16.  COMMITMENTS AND CONTINGENCIES

LEASE COMMITMENTS

OnJanuary 30, 2006, the Company entered into a sub-lease agreement for newoffice facilities in Santa Monica, California, effective February 2, 2006through November 30, 2011, to house the operations of ADI andMediaDefender.  In connection with thesub-lease agreement, the Company provided an irrevocable standby bank letter ofcredit for $180,000 as security for the Company’s obligations under thesub-lease agreement, which was secured by cash of $180,000, which wasclassified as restricted cash in the Company’s balance sheet.  Pursuant to the terms of the sub-leaseagreement, the letter of credit was reduced to $90,000 during February 2007.

This lease contains predetermined fixed increases inthe minimum rental rate during the initial lease term.  The Company began to recognize the relatedrent expense on a straight-line basis on the effective date of the lease.  The Company records the difference betweenthe amount charged to expense and the rent paid as deferred rent on the Company’sbalance sheet.

Future cashpayments under such operating lease are as follows (amounts are in thousands):
| Years Ending December 31, | ** ** | ** ** | ** ** |
|------------------------------------------|------------|------------|------------|
|                                     |       |       |       |
| 2007                                     |       | $          | 464        |   |
| 2008                                     |       | 470        |       |
| 2009                                     |       | 485        |       |
| 2010                                     |       | 499        |       |
| 2011                                     |       | 471        |       |
|                                     |       | $          | 2,389      |   |

 

Rent expense underoperating leases for the years ended December 31, 2006 and 2005 was$468,000 and $100,000, respectively, including $19,000 and $90,000 to a relatedparty in 2006 and 2005, respectively (see Note 12).

EMPLOYMENT AGREEMENTS

On July 28, 2005, the Company entered into anEmployment Agreement with Jonathan Diamond, the Company’s Chief ExecutiveOfficer. During the term of the Employment Agreement, which shall continuethrough December 31, 2008, Mr. Diamond will earn a base salary of noless than $350,000 per annum, plus certain specified perquisites that include amonthly car allowance. Mr. Diamond is also eligible to receive an annualdiscretionary bonus of up to 100% of base salary, as determined by theCompensation Committee of the Board of Directors or, if none, the Board ofDirectors, and an annual performance bonus of up to 100% of base salary if theCompany achieves defined earnings before interest, taxes, depreciation andamortization in fiscal 2007 ($12,000,000 - $14,400,000) and fiscal 2008 ($15,000,000- $18,000,000). Mr. Diamond shall also be entitled to receive stockoptions at the discretion of the Company’s Board of Directors. In the eventMr. Diamond is terminated “without cause,” he shall be entitled to receive12 months of severance pay at the rate of 100% of his monthly salary, anyperformance bonus due for the year in which termination occurs and all stockoptions subject to time vesting shall be deemed fully vested andexercisable.   On June 19, 2006 and July31, 2006, the Company entered into agreements with Mr. Diamond to incorporatenon-material modifications into the Employment Agreement.

On July 28, 2005, the Company entered into anEmployment Agreement with Robert Weingarten, the Company’s Chief FinancialOfficer. During the term of the Employment Agreement, which shall continuethrough December 31, 2008, Mr. Weingarten will earn a base salary ofno less than $195,000 per annum, plus certain specified perquisites thatinclude a monthly car allowance. Mr. Weingarten is also eligible to receivean annual discretionary bonus of up to 100% of base salary, as determined bythe Compensation Committee of the Board of Directors or, if none, the Board ofDirectors, and an annual performance bonus of up to 100% of base salary if theCompany achieves defined earnings before interest, taxes, depreciation andamortization in fiscal 2007 ($12,000,000 - $14,400,000) and fiscal 2008($15,000,000 - $18,000,000). Mr. Weingarten shall also be entitled toreceive stock options at the discretion of the Company’s Board of Directors. Inthe event Mr. Weingarten is terminated “without cause,” he shall beentitled to receive 12 months of severance pay at the rate of 100% of hismonthly salary, any performance bonus due for the year in which terminationoccurs and all stock options subject to time vesting shall be deemed fullyvested and exercisable.  On June 19, 2006and July 31, 2006, the Company entered into agreements with Mr. Weingarten toincorporate non-material modifications into the Employment Agreement.

In accordance with the MediaDefender transaction, theCompany acknowledged the terms of Employment Agreements entered into onJuly 28, 2005 by MediaDefender with each of Randy Saaf, who serves asChief Executive Officer of MediaDefender, and Octavio Herrera, who serves asPresident of MediaDefender. Mr. Saaf and Mr. Herrera will each earn abase salary of no less than $350,000 per annum during the initial term of theagreements, which shall continue until December 31, 2008, and are alsoentitled to receive performance bonuses of up to $350,000 if MediaDefenderachieves defined operating earnings before interest, taxes, depreciation andamortization (calculated using the same accounting methods and policies asMediaDefender has historically used) exceeding $7,000,000 and $7,500,000 infiscal 2007 and fiscal 2008, respectively. Mr. Saaf and Mr. Herrera are each entitled to receive twelvemonths of severance pay at the rate of 100% of their monthly salary and the prorata portion of the performance bonus referenced above if they are terminated “withoutcause.”

106

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Inaddition, the Company granted stock options to purchase 200,000 shares ofcommon stock to each of Mr. Saaf and Mr. Herrera, exercisable for aperiod of five years at $3.00 per share and vesting quarterly over a period ofthree and one-half years.  On July 28,2006, the Company entered into agreements with Mr. Saaf and Mr. Herrera toincorporate non-material modifications into the Employment Agreements.

Future paymentsunder employment agreements are as follows (amounts are in thousands):
| Years Ending December 31, | ** ** | ** ** | ** ** |
|------------------------------------------|------------|------------|------------|
|                                     |       |       |       |
| 2007                                     |       | $          | 1,743      |   |
| 2008                                     |       | 1,515      |       |
| 2009                                     |       | 33         |       |
|                                     |       | $          | 3,291      |   |

 

CONSULTING AGREEMENTS

On October 9, 2006, the Company entered into aneighteen-month non-exclusive consulting agreement with Wood River Ventures, LLCand Jonathan Dolgen for consulting and advisory services with respect to thebusiness and operations of the Company.  The consulting agreement providesfor an aggregate cash fee of $187,500, payable quarterly in six installments of$31,250, and a stock award valued at $112,500, consisting of 34,615 shares ofcommon stock based on the Company’s closing stock price on October 10, 2006 of$3.25 per share to be issued under the Company’s 2006 Equity IncentivePlan.  The shares vest pro rata over the eighteen-month period of theconsulting agreement, beginning on October 10, 2006 and thereafter monthly onthe first day of each month of the term of the consulting agreement throughMarch 2008.  Accordingly, during the yearended December 31, 2006, the Company issued 5,769 shares of common stock underthis consulting agreement with a fair value of $19,000, which was charged tooperations in 2006 (see Note 13).

On October 1,2006, the Company entered into a one-year non-exclusive consulting agreementwith an entity for business development consulting services.  The consulting agreement provides for anaggregate cash fee of $108,000, consisting of an initial payment of $18,000 anda base fee payable monthly in twelve installments of $7,500, and stock options,consisting of an initial award of options to acquire 25,000 shares of commonstock, and subsequent awards of options to acquire 5,000 shares of common stockon the last day of each month of the term of the consulting agreement throughSeptember 30, 2007.  The stock optionsare fully vested when issued. Accordingly, during the year ended December 31, 2006, the Company issuedoptions to acquire 35,000 shares of common stock under this consultingagreement with a fair value of $76,000, which was charged to operations in 2006(see Note 13).

LITIGATION

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

17.  REPORTABLE SEGMENTS

Information withrespect to the Company’s operating segments for the years ended December 31,2006 and 2005 is presented below.  Duringthe years ended December 31, 2006 and 2005, the Company’s continuingoperations consisted of three reportable segments:  e-commerce, media and anti-piracy andfile-sharing marketing services.

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

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

107

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The followingtable summarizes net revenue and Adjusted EBITDA by operating segment for theyears ended December 31, 2006 and 2005. Corporate expenses consist of general operating expenses that are notdirectly related to the operations of the segments.  A reconciliation of Net Loss to AdjustedEBITDA is also provided.

 
| ** **                                                         | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                         | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| ** **                                                         | ** ** | ** **                                  | ** ** | **(Restated)** | ** ** |
| ** **                                                         | ** ** | **(in thousands)**                     | ** ** |
|                                                               |       |                                        |       |   |   |
| Net Revenue:                                                       |       |                                        |       |   |   |
| E-commerce                                                         |       | $                                           | 2,649      |   | $ | 2,665 |   |
| Media                                                              |       | 5,670                                       |       | 5,297 |   |
| Anti-piracy and  file-sharing marketing services                   |       | 15,743                                      |       | 6,009 |   |
|                                                               |       | $                                           | 24,062     |   | $ | 13,971 |   |
|                                                               |       |                                        |       |   |   |
| Adjusted EBITDA:                                                   |       |                                        |       |   |   |
| E-commerce                                                         |       | $                                           | 6          |   | $ | 157 |   |
| Media                                                              |       | 1,919                                       |       | 2,198 |   |
| Anti-piracy and  file-sharing marketing services                   |       | 8,935                                       |       | 3,851 |   |
|                                                               |       | 10,860                                      |       | 6,206 |   |
| Corporate:                                                         |       |                                        |       |   |   |
| General and  administrative expenses                               |       | (4,672                                      | )          | (2,969 | ) |
| Estimated  liquidated damages under registration rights agreements |       | (3,777                                      | )          | — |   |
|                                                               |       | $                                           | 2,411      |   | $ | 3,237 |   |

 
| ** **                                                                                                                                                                                   | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                                                                   | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| ** **                                                                                                                                                                                   | ** ** | ** **                                  | ** ** | **(Restated)** | ** ** |
| ** **                                                                                                                                                                                   | ** ** | **(in thousands)**                     | ** ** |
|                                                                                                                                                                                         |       |                                        |       |   |   |
| Reconciliation of  Adjusted EBITDA to Net Loss:                                                                                                                                              |       |                                        |       |   |   |
| Adjusted EBITDA  per segments                                                                                                                                                                |       | $                                           | 2,411      |   | $ | 3,237 |   |
| Stock-based  compensation                                                                                                                                                                    |       | (2,281                                      | )          | (73 | ) |
| Depreciation and  amortization                                                                                                                                                               |       | (554                                        | )          | (205 | ) |
| Amortization of  intangible assets                                                                                                                                                           |       | (3,752                                      | )          | (1,562 | ) |
| Amortization of  deferred financing costs                                                                                                                                                    |       | (858                                        | )          | (402 | ) |
| Reduction in  exercise price of warrants                                                                                                                                                     |       | (641                                        | )          | — |   |
| Write-off of  unamortized discount on debt and deferred financing costs due to conversion  of subordinated convertible notes payable and principal payments on senior  secured notes payable |       | (1,624                                      | )          | (45 | ) |
| Interest income                                                                                                                                                                              |       | 126                                         |       | 29 |   |
| Other income,  net                                                                                                                                                                           |       | 57                                          |       | — |   |
| Interest  expense, including amortization of discount on debt of $3,142 and 1,486 in  2006 and 2005, respectively                                                                            |       | (5,852                                      | )          | (2,873 | ) |
| Change in fair  value of warrant liability                                                                                                                                                   |       | 1,124                                       |       | (10,735 | ) |
| Change in fair  value of derivative liability                                                                                                                                                |       | 7,792                                       |       | (20,043 | ) |
| Provision for  income taxes                                                                                                                                                                  |       | (838                                        | )          | (241 | ) |
| Loss from  discontinued operations of ARTISTdirect Records, LLC                                                                                                                              |       | —                                      |       | (271 | ) |
| Gain from sale  of ARTISTdirect Records, LLC (substantially all non-cash)                                                                                                                    |       | —                                      |       | 21,079 |   |
| Net loss                                                                                                                                                                                     |       | $                                           | (4,890     | ) | $ | (12,105 | ) |

 

108

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The followingtable summarizes assets as of December 31, 2006 and 2005.  Assets by segment are those assets used in oremployed by the operations of each segment. Corporate assets are principally made up of cash and cash equivalents,short-term investments, prepaid expenses, computer equipment, leaseholdimprovements and other assets.

 
|                                                 | ** ** | **December 31,**   | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                                      | ** ** | ** **              | ** ** | **(Restated)** | ** ** |
| ** **                                      | ** ** | **(in thousands)** | ** ** |
| ** **                                      | ** ** | ** **              | ** ** | ** ** | ** ** |
| Assets:                                         |       |                    |       |   |   |
| Corporate                                       |       | $                       | 2,791      |   | $ | 4,963 |   |
| E-commerce                                      |       | 1,383                   |       | 941 |   |
| Media                                           |       | 3,730                   |       | 1,931 |   |
| Anti-piracy and file-sharing marketing services |       | 47,068                  |       | 46,934 |   |
|                                            |       | $                       | 54,972     |   | $ | 54,769 |   |

 

18.  QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)

The followingtable sets forth unaudited quarterly results of operations for the years endedDecember 31, 2006 and 2005. Information with respect to the three months ended September 30, 2005,December 31, 2005, March 31, 2006, June 30, 2006 and September 30, 2006, andthe year ended December 31, 2005, has been restated (see Note 1).  This unaudited quarterly information has beenderived from the Company’s unaudited financial statements and, in the Company’sopinion, includes all adjustments, including normal recurring adjustments,necessary for a fair presentation of the information for the periodscovered.  The operating results for anyquarter are not necessarily indicative of the operating results for any futureperiod.
| ** **                                   | ** ** | **Three Months Ended**                                   | ** ** | **Year Ended**     | ** ** |
|----------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                   | ** ** | **March 31,  2006**                                           | ** ** | **June 30,  2006** | ** ** | **September 30,  2006** | ** ** | **December 31,  2006** | ** ** | **December31,  2006** | ** ** |
| ** **                                   | ** ** | **(Restated)**                                                     | ** ** | **(Restated)**          | ** ** | **(Restated)** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | **(in thousands, except for share data)** | ** ** |
|                                         |       |                                                               |       |                    |       |   |   |   |   |   |   |
| Net revenue                                  |       | $                                                                  | 5,273      |                    | $          | 5,969 |   | $ | 6,393 |   | $ | 6,427 |   | $ | 24,062 |   |
| Gross profit                                 |       | $                                                                  | 2,189      |                    | $          | 2,888 |   | $ | 3,032 |   | $ | 2,573 |   | $ | 10,682 |   |
|                                         |       |                                                               |       |                    |       |   |   |   |   |   |   |
| Net income (loss)                            |       | $                                                                  | (23,077    | )                       | $          | 10,094 |   | $ | 839 |   | $ | 7,254 |   | $ | (4,890 | ) |
|                                         |       |                                                               |       |                    |       |   |   |   |   |   |   |
| Net income (loss) per  common share:         |       |                                                               |       |                    |       |   |   |   |   |   |   |
| Basic                                        |       | $                                                                  | (3.94      | )                       | $          | 0.37 |   | $ | 0.03 |   | $ | 0.26 |   | $ | (0.56 | ) |
| Diluted                                      |       | $                                                                  | (3.94      | )                       | $          | 0.34 |   | $ | 0.03 |   | $ | 0.13 |   | $ | (0.56 | ) |
|                                         |       |                                                               |       |                    |       |   |   |   |   |   |   |
| Weighted average common  shares outstanding: |       |                                                               |       |                    |       |   |   |   |   |   |   |
| Basic                                        |       | 5,857,520                                                          |       | 8,990,595               |       | 27,933,889 |   | 27,994,343 |   | 8,764,038 |   |
| Diluted                                      |       | 5,857,520                                                          |       | 29,857,883              |       | 30,543,558 |   | 32,022,687 |   | 8,764,038 |   |

 

109

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|                                                     | ** ** | **Three Months Ended**                                   | ** ** | ** **              | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                          | ** ** | **March 31,  2005**                                           | ** ** | **June 30,  2005** | ** ** | **September 30,  2005** | ** ** | **December 31,  2005** | ** ** | **Year Ended  December 31, 2005** | ** ** |
| ** **                                          | ** ** | ** **                                                         | ** ** | ** **              | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| ** **                                          | ** ** | **(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 |   | $ | (18,364 | ) | $ | (14,778 | ) | $ | (32,913 | ) |
| Income from  discontinued operations                |       | 20,808                                                             |       | —                  |       | — |   | — |   | 20,808 |   |
| Net income  (loss)                                  |       | $                                                                  | 20,433     |                    | $          | 604 |   | $ | (18,364 | ) | $ | (14,778 | ) | $ | (12,105 | ) |
|                                                |       |                                                               |       |                    |       |   |   |   |   |   |   |
| Net income  (loss) per common share – basic:   |       |                                                               |       |                    |       |   |   |   |   |   |   |
| From continuing operations                          |       | $                                                                  | (0.11      | )                       | $          | 0.17 |   | $ | (4.33 | ) | $ | (3.20 | ) | $ | (8.29 | ) |
| From discontinued operations                        |       | 5.94                                                               |       | 0.00                    |       | (0.00 | ) | 0.00 |   | 5.24 |   |
| Total                                               |       | $                                                                  | 5.83       |                    | $          | 0.17 |   | $ | (4.33 | ) | $ | (3.20 | ) | $ | (3.05 | ) |
|                                                |       |                                                               |       |                    |       |   |   |   |   |   |   |
| Net income  (loss) per common share – diluted: |       |                                                               |       |                    |       |   |   |   |   |   |   |
| From continuing operations                          |       | $                                                                  | (0.11      | )                       | $          | 0.15 |   | $ | (4.33 | ) | $ | (3.20 | ) | $ | (8.29 | ) |
| From discontinued operations                        |       | 5.94                                                               |       | 0.00                    |       | (0.00 | ) | 0.00 |   | 5.24 |   |
| Total                                               |       | $                                                                  | 5.83       |                    | $          | 0.15 |   | $ | (4.33 | ) | $ | (3.20 | ) | $ | (3.05 | ) |
|                                                |       |                                                               |       |                    |       |   |   |   |   |   |   |
| Weighted average  common shares outstanding:        |       |                                                               |       |                    |       |   |   |   |   |   |   |
| Basic                                               |       | 3,502,117                                                          |       | 3,502,117               |       | 4,241,472 |   | 4,611,149 |   | 3,969,145 |   |
| Diluted                                             |       | 3,502,117                                                          |       | 3,927,844               |       | 4,241,472 |   | 4,611,149 |   | 3,969,145 |   |

 

19.  SUBSEQUENT EVENTS (UNAUDITED)

Pursuant to a Forbearance and Consent Agreement datedas of April 17, 2007, the investors in the Senior Financing agreed to forbearfrom the exercise of their rights and remedies under the Senior Financingdocuments as a result of the events of default with respect to theunavailability of the Company’s registration statement, as well as certainother events of default that currently exist or may come into existence duringthe forbearance period, through May 31, 2007, in exchange for a cash payment of$250,000.  Any payments made by theCompany under the Forbearance and Consent Agreement will be credited againstaccrued registration delay cash penalties or any other amounts that are or maybecome due and payable.  The Company hasthe right to extend the Forbearance and Consent Agreement through June 30, 2007by an additional cash payment of $125,000 on or before May 31, 2007.

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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 exhibit 3.1 to current  report on Form 8-K filed June 22, 2006).                                                                                          |
|            |       |                                                                                                                                                                                                                                                                            |
| 3.2             |       | Amended and Restated Bylaws of ARTISTdirect, Inc.  (incorporated by reference to current report on Form 8-K filed on April  18, 2006).                                                                                                                                     |
|            |       |                                                                                                                                                                                                                                                                            |
| 4.1             |       | 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 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). |

 

E-1

----

 
| EXHIBIT  NUMBER | ** ** | **DESCRIPTION**                                                                                                                                                                                                                                                                                                                                                                                    |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 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).                                                                                                                                                                                   |
|            |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 4.22            |       | Waiver to Convertible Subordinated Notes by and  among ARTISTdirect, Inc. and the holders identified on the signature page  thereto, entered into as of November 7, 2006 (incorporated by reference  to Exhibit 10.1 to current report on Form 8-K filed on November 13,  2006).                                                                                               |
|            |       |                                                                                                                                                                                                                                                                                                                                                                                               |
| 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).                                                                                                                                                                                             |

 

E-2

----

 
| EXHIBIT  NUMBER | ** ** | **DESCRIPTION**                                                                                                                                                                                                                                                                                                                             |
|-----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **      | ** ** | ** **                                                                                                                                                                                                                                                                                                                                  |
| 10.10           |       | Letter Agreement, dated as of May 1, 2003, by  and between ARTISTdirect, Inc. and Frederick W. Field to amend the  Employment Agreement dated May 31, 2001 between ARTISTdirect, Inc. and  Mr. Field (incorporated by reference to quarterly report on  Form 10-Q filed August 14, 2003).                     |
|            |       |                                                                                                                                                                                                                                                                                                                                        |
| 10.11           |       | Letter Agreement, dated as of May 1, 2003, by  and between ARTISTdirect Records, L.L.C. and Frederick W. Field to amend  the Employment Agreement dated May 31, 2001 between ARTISTdirect  Records, L.L.C. and Mr. Field (incorporated by reference to quarterly  report on Form 10-Q filed August 14, 2003). |
|            |       |                                                                                                                                                                                                                                                                                                                                        |
| 10.13           |       | Notice of Grant of Stock Option dated as of  September 29, 2003 by and between ARTISTdirect, Inc. and Jon Diamond  (incorporated by reference to quarterly report on Form 10-Q filed  November 14, 2003).                                                                                                                    |
|            |       |                                                                                                                                                                                                                                                                                                                                        |
| 10.14           |       | Settlement, Release and Termination of Lease  Agreement dated as of September 8, 2003, by and between  5670 Wilshire L.P. and ARTISTdirect, Inc. (incorporated by reference to  quarterly report on Form 10-Q filed on November 14, 2003).                                                                              |
|            |       |                                                                                                                                                                                                                                                                                                                                        |
| 10.15           |       | Termination Agreement and Mutual Release by Keith  Yokomoto and ARTISTdirect, Inc. dated as of December 31, 2003  (incorporated by reference to annual report on Form 10-K filed on  May 17, 2004).                                                                                                                          |
|            |       |                                                                                                                                                                                                                                                                                                                                        |
| 10.16           |       | Form of Director Indemnification Agreement  (incorporated by reference to registration statement on Form S-1/A filed  January 27, 2000).                                                                                                                                                                                               |
|            |       |                                                                                                                                                                                                                                                                                                                                        |
| 10.17           |       | Form of Officer Indemnification Agreement  (incorporated by reference to registration statement on Form S-1/A filed  January 27, 2000).                                                                                                                                                                                                |
|            |       |                                                                                                                                                                                                                                                                                                                                        |
| 10.18           |       | ARTISTdirect, Inc. 1999 Employee Stock Option Plan  (incorporated by reference to registration statement on Form S-1/A filed  January 27, 2000).                                                                                                                                                                                       |
|            |       |                                                                                                                                                                                                                                                                                                                                        |
| 10.19           |       | ARTISTdirect, Inc. Artist Plan (incorporated by  reference to registration statement on Form S-1/A filed January 27, 2000).                                                                                                                                                                                                                 |
|            |       |                                                                                                                                                                                                                                                                                                                                        |
| 10.20           |       | ARTISTdirect, Inc. Artist and Artist Advisor Plan  (incorporated by reference to registration statement on Form S-1/A filed  January 27, 2000).                                                                                                                                                                                             |
|            |       |                                                                                                                                                                                                                                                                                                                                        |
| 10.21           |       | ARTISTdirect, Inc. 2004 Consultant Stock Plan  (incorporated by reference to registration statement on Form S-8 filed  January 13, 2005).                                                                                                                                                                                                   |
|            |       |                                                                                                                                                                                                                                                                                                                                        |
| 10.22           |       | Notice of Grant of Stock Option dated as of  March 29, 2004 by and between ARTISTdirect, Inc. and Robert N.  Weingarten (incorporated by reference to quarterly report on Form 10-Q  filed August 20, 2004).                                                                                                            |
|            |       |                                                                                                                                                                                                                                                                                                                                        |
| 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).                                                                                                                                    |

 

E-3

----

 
| EXHIBIT  NUMBER | ** ** | **DESCRIPTION**                                                                                                                                                                                                                                                                                                                               |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **      | ** ** | ** **                                                                                                                                                                                                                                                                                                                                    |
| 10.30           |       | Note and Warrant Purchase Agreement, dated  July 28, 2005, by and among ARTISTdirect, Inc., the investors indicated  on the schedule of buyers thereto and U.S. Bank National Association, as  Collateral Agent for the Senior Financing investors (incorporated by  reference to current report on Form 8-K filed August 3, 2005). |
|            |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.31           |       | Security Agreement, dated July 28, 2005, by and  among ARTISTdirect, Inc. and its subsidiaries and U.S. Bank National  Association, as Collateral Agent for the Senior Financing investors  (incorporated by reference to current report on Form 8-K filed August 3,  2005)                                                         |
|            |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.32           |       | Pledge Agreement, dated July 28, 2005, by and  among ARTISTdirect, Inc. and U.S. Bank National Association, as Collateral  Agent for the Senior Financing investors (incorporated by reference to current  report on Form 8-K filed August 3, 2005).                                                                                |
|            |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.33           |       | Form of Copyright Security Agreement (incorporated  by reference to current report on Form 8-K filed August 3, 2005).                                                                                                                                                                                                                    |
|            |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.34           |       | Patent Security Agreement, dated July 28, 2005,  by and among MediaDefender, Inc. and U.S. Bank National Association, as  Collateral Agent for the Senior Financing investors (incorporated by  reference to current report on Form 8-K filed August 3, 2005).                                                                      |
|            |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.35           |       | Trademark Security Agreement, dated July 28,  2005, by and among ARTISTdirect, Inc. and U.S. Bank National Association, as  Collateral Agent for the benefit of the Senior Financing investors  (incorporated by reference to current report on Form 8-K filed August 3,  2005).                                                    |
|            |       |                                                                                                                                                                                                                                                                                                                                          |
| 10.36           |       | Subsidiary Guaranty, dated July 28, 2005, made  by ARTISTdirect, Inc. and its subsidiaries in favor of U.S. Bank National  Association, as Collateral Agent for the Senior Financing investors  (incorporated by reference to current report on Form 8-K filed August 3,  2005).                                                    |
| ** **      | ** ** | ** **                                                                                                                                                                                                                                                                                                                                    |
| 10.37           |       | Securities Purchase Agreement, dated July 28,  2005, entered into by and among ARTISTdirect, Inc. and the Sub-debt Financing  investors (incorporated by reference to current report on Form 8-K filed  August 3, 2005).                                                                                                            |
|            |       |                                                                                                                                                                                                                                                                                                                                          |
| 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).                                                                                                                                                                 |

 

E-4

----

 
| EXHIBIT  NUMBER | ** ** | **DESCRIPTION**                                                                                                                                                                                                                                                                                                                           |
|-----------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **      | ** ** | ** **                                                                                                                                                                                                                                                                                                                                |
| 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).                                                                                 |
|            |       |                                                                                                                                                                                                                                                                                                                                      |
| 10.48           |       | Consulting Agreement entered into as of May 15,  2006 by and between ARTISTdirect, Inc., Eric Pulier and WNT Consulting Group  (incorporated by reference to current report on Form 8-K filed  May 17, 2006).                                                                                                              |
|            |       |                                                                                                                                                                                                                                                                                                                                      |
| 10.49           |       | Acknowledgement and Amendment No. 2 to  Employment Agreement dated June 19, 2006 by and between ARTISTdirect,  Inc. and Jonathan V. Diamond (incorporated by reference to  Exhibit 10.1 to current report on Form 8-K filed on June 22,  2006).                                                             |
|            |       |                                                                                                                                                                                                                                                                                                                                      |
| 10.50           |       | Acknowledgement and Amendment No. 2 to  Employment Agreement dated June 19, 2006 by and between ARTISTdirect,  Inc. and Robert N. Weingarten (incorporated by reference to Exhibit 10.2  to current report on Form 8-K filed on June 22, 2006).                                                             |
|            |       |                                                                                                                                                                                                                                                                                                                                      |
| 10.51           |       | Amendment, dated July 28, 2006, to Employment,  Confidentiality and Non-Competition Agreement by and between ARTISTdirect,  Inc. and Randy Saaf (incorporated by reference to Exhibit 10.1 to  current report on Form 8-K filed on August 1, 2006).                                                                   |
|            |       |                                                                                                                                                                                                                                                                                                                                      |
| 10.52           |       | Amendment, dated July 28, 2006, to Employment,  Confidentiality and Non-Competition Agreement by and between ARTISTdirect,  Inc. and Octavia Herrera (incorporated by reference to Exhibit 10.2 to  current report on Form 8-K filed on August 1, 2006).                                                              |
|            |       |                                                                                                                                                                                                                                                                                                                                      |
| 10.53           |       | Amendment No. 3, dated July 31, 2006, to  Employment Agreement by and between ARTISTdirect, Inc. and Jonathan V.  Diamond (incorporated by reference to Exhibit 10.3 to current report on  Form 8-K filed on August 1, 2006).                                                                               |
|            |       |                                                                                                                                                                                                                                                                                                                                      |
| 10.54           |       | Amendment No. 2, dated July 31, 2006, to  Employment Agreement by and between ARTISTdirect, Inc. and Robert N.  Weingarten (incorporated by reference to Exhibit 10.4 to current report  on Form 8-K filed on August 1, 2006).                                                                              |
|            |       |                                                                                                                                                                                                                                                                                                                                      |
| 10.55           |       | Waiver to Note and Warrant Purchase Agreement by and  among ARTISTdirect, Inc. and the purchasers identified on the signature page  thereto, entered into as of November 7, 2006 (incorporated by reference to  Exhibit 10.1 to current report on Form 8-K filed on November 13, 2006).                                                   |
|            |       |                                                                                                                                                                                                                                                                                                                                      |
| 10.56           |       | Assignment by and between ARTISTdirect, Inc., JLF  Partners I, LP, JLF Partners II, LP and JLF Offshore Fund, Ltd. and The  Longview Fund, LP, effective as of November 8, 2006, and as acknowledged by Grushko  & Mittman, PC (incorporated by reference to Exhibit 10.2 to current  report on Form 8-K filed on November 13, 2006). |
|            |       |                                                                                                                                                                                                                                                                                                                                      |
| 10.57           |       | Supplemental Agreement and Acknowledgement by and  between ARTISTdirect, Inc. and The Longview Fund, LP, effective as of November  8, 2006 (incorporated by reference to Exhibit 10.3 to current report on Form  8-K filed on November 13, 2006.                                                                                          |
|            |       |                                                                                                                                                                                                                                                                                                                                      |
| 10.58           |       | Release of Claims dated as of November 28, 2006 by  Nicholas Turner (incorporated by reference to Exhibit 10.1 to current report  on Form 8-K filed on November 30, 2006).                                                                                                                                                                |
|            |       |                                                                                                                                                                                                                                                                                                                                      |
| 10.59           |       | Independent Contractor Agreement dated as of  November 28, 2006 by and between ARTISTdirect, Inc. and Nicholas Turner  (incorporated by reference to Exhibit 10.2 to current report on Form 8-K  filed on November 30, 2006).                                                                                                             |
|            |       |                                                                                                                                                                                                                                                                                                                                      |
| 10.60           |       | Consulting Agreement entered into as of January 12,  2007 by and between ARTISTdirect, Inc., WNT Consulting Group and Eric Pulier  (incorporated by reference to Exhibit 10.1 to current report on Form 8-K  filed on January 17, 2007).                                                                                                  |
|            |       |                                                                                                                                                                                                                                                                                                                                      |
| 10.61           |       | Termination Agreement entered into as of January 12,  2007 by and between ARTISTdirect, Inc., WNT Consulting Group and Eric Pulier  (incorporated by reference to Exhibit 10.2 to current report on Form 8-K  filed on January 17, 2007).                                                                                                 |

 

E-5

----

 
| EXHIBIT  NUMBER | ** ** | **DESCRIPTION**                                                                                                                                                                                          |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                                                                     |
| 10.62           |       | Offer of Employment between ARTISTdirect, Inc. and  Rene Rousselet approved as of February 2, 2007 (incorporated by reference to  Exhibit 10.1 to current report on Form 8-K filed on February 6, 2007). |
|            |       |                                                                                                                                                                                                     |
| 14.1            |       | Code of Business Conduct and Ethics (incorporated by  reference to current report on Form 8-K filed June 22, 2006).                                                                            |
|            |       |                                                                                                                                                                                                     |
| 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 (see signature page).                                                                                                                                                                  |
|            |       |                                                                                                                                                                                                     |
| 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.                                                                                                              |
|            |       |                                                                                                                                                                                                     |
| 31.2(a)         |       | Certifications of the Principal Accounting Officer under  Section 302 of the Sarbanes-Oxley Act.                                                                                                         |
|            |       |                                                                                                                                                                                                     |
| 32.1            |       | Certifications of the Chief Executive Officer under  Section 906 of the Sarbanes-Oxley Act.                                                                                                              |
|            |       |                                                                                                                                                                                                     |
| 32.2            |       | Certifications of the Chief Financial Officer under  Section 906 of the Sarbanes-Oxley Act.                                                                                                              |
|            |       |                                                                                                                                                                                                     |
| 32.2(a)         |       | Certifications of the Principal Accounting Officer under  Section 906 of the Sarbanes-Oxley Act.                                                                                                         |

 

E-6

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