**SECURITIES AND EXCHANGECOMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-QSB**

 

(Mark One)
| **ý** | **Quarterly  report under Section 13 or 15(d) of the Securities Exchange Act of 1934**                                                                                                                                   |
|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       | **For the quarterly period ended  September 30, 2004**                                                                                                                                                                   |
|       |                                                                                                                                                                                                                          |
| **o**      | **Transition  report under Section 13 or 15(d) of the Exchange Act**                                                                                                                                                     |
|       | **For the transition period from                  To                 ** |
|       |                                                                                                                                                                                                                          |
|       | **Commission file number  0-26192**                                                                                                                                                                                 |

 

**MakeMusic! Inc.**

(Exact Name of Small BusinessIssuer as Specified in its Charter)

 

| **Minnesota**                                                                        | **41-1716250**                         |
|--------------------------------------------------------------------------------------|----------------------------------------|
| (State or  Other Jurisdiction of  Incorporation or Organization)                     | (I.R.S.  Employer  Identification No.) |
|                                                                                 |                                   |
| **6210  Bury Drive  Eden Prairie, Minnesota 55346-1718**                             |
| (Address of  Principal Executive Offices)                                            |
|                                                                                 |
| **(952)  937-9611**                                                                  |
| (Issuer’s  Telephone Number, Including Area Code)                               |
|                                                                                 |                                   |
|                                                                                 |
| (Former  Name, Former Address and Former Fiscal Year,  if Changed Since Last Report) |

 

Check whether the issuer:  (1) filed all reports required to be filed bySection 13 or 15(d) of the Exchange Act during the past 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90 days.

 

Yes  ý    No  o

 

As of October 20, 2004, there were3,381,321 shares of Common Stock outstanding.

 

Transitional Small Business Disclosure Format (check one):

 

Yes  o    No  ý

 

 

----

 

**MakeMusic! Inc.**

 

**INDEX**

 
| ** ** | **PART I. FINANCIAL INFORMATION**                                                                                    | ** ** |
|------------|----------------------------------------------------------------------------------------------------------------------|------------|
|       |                                                                                                                 |       |
| Item 1.    | Condensed Consolidated Financial Statements                                                                          |       |
|       |                                                                                                                 |       |
|       | Condensed Consolidated Balance Sheets  September 30, 2004 and December 31, 2003                            |       |
|       |                                                                                                                 |       |
|       | Condensed Consolidated Statement of  Operations  Three and nine-month periods ended September 30, 2004 and 2003 |       |
|       |                                                                                                                 |       |
|       | Condensed Consolidated Statement of Cash  Flows  Nine-month periods ended September 30, 2004 and 2003           |       |
|       |                                                                                                                 |       |
|       | Notes to Condensed Consolidated Financial  Statements                                                                |       |
|       |                                                                                                                 |       |
| Item 2.    | Management’s  Discussion and Analysis or Plan of Operation.                                                     |       |
|       |                                                                                                                 |       |
| Item 3.    | Controls  and Procedures                                                                                             |       |
|       |                                                                                                                 |       |
| ** ** | **PART II. OTHER INFORMATION**                                                                                       | ** ** |
|       |                                                                                                                 |       |
| Item 6.    | Exhibits                                                                                                             |       |
|       |                                                                                                                 |       |
|       | Signatures                                                                                                           |       |
|       |                                                                                                                 |       |
|       | Exhibit Index                                                                                                        |       |

 

2

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**PART I**

 

**ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**MakeMusic!Inc.**

**CondensedConsolidated Balance Sheets**

*(Inthousands of U.S. dollars)*

 
| ** **                                                       | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                       | ** ** | **(unaudited)**              | ** ** | **(Note)**                  | ** ** |
| **Assets**                                                       |       |                         |       |                        |       |
| Current  assets:                                                 |       |                         |       |                        |       |
| Cash and  cash equivalents                                       |       | **$**                        | **1,815**  |                        | $          | 1,467 |   |
| Accounts  receivable, net                                        |       | **668**                      |       | 494                         |       |
| Inventories                                                      | ** ** | **341**                      |       | 273                         |       |
| Value added  tax receivable                                      | ** ** | **40**                       |       | 32                          |       |
| Prepaid  expenses and other current assets                       | ** ** | **142**                      |       | 175                         |       |
| Total  current assets                                            | ** ** | **3,006**                    |       | 2,441                       |       |
| Property and  equipment, net                                     | ** ** | **241**                      |       | 280                         |       |
| Goodwill,  net                                                   | ** ** | **3,630**                    |       | 3,630                       |       |
| Capitalized  software products                                   | ** ** | **438**                      |       | 599                         |       |
| Intangible  assets, net                                          | ** ** | **1,030**                    |       | 1,718                       |       |
| Other  non-current assets                                        | ** ** | **103**                      |       | 88                          |       |
| **Total  assets**                                                |       | **$**                        | **8,448**  |                        | $          | 8,756 |   |
|                                                             |       |                         |       |                        |       |
| **Liabilities  and shareholders’ equity**                   |       |                         |       |                        |       |
| Current  liabilities:                                            |       |                         |       |                        |       |
| Accounts  payable                                                | ** ** | **$**                        | **371**    |                        | $          | 417 |   |
| Accrued  compensation                                            | ** ** | **834**                      |       | 798                         |       |
| Accrued  expenses and other current liabilities                  | ** ** | **317**                      |       | 353                         |       |
| Current  portion of long-term debt and capital lease obligations | ** ** | **6**                        |       | 57                          |       |
| Reserve for  product returns                                     | ** ** | **299**                      |       | 355                         |       |
| Deferred  revenue                                                | ** ** | **568**                      |       | 660                         |       |
| Total  current liabilities                                       |       | **2,395**                    |       | 2,640                       |       |
|                                                             |       |                         |       |                        |       |
| Capital  lease obligations, net of current portion               | ** ** | **17**                       |       | 21                          |       |
|                                                             |       |                         |       |                        |       |
| Shareholders’  equity:                                      |       |                         |       |                        |       |
| Common stock                                                     | ** ** | **34**                       |       | 34                          |       |
| Additional  paid-in capital                                      | ** ** | **61,574**                   |       | 61,553                      |       |
| Accumulated  deficit                                             |       | **(55,529**                  | **)**      | (55,339                     | )          |
| Deferred  compensation                                           | ** ** | **(43**                      | **)**      | (153                        | )          |
| Total  shareholders’ equity                                 |       | **6,036**                    |       | 6,095                       |       |
| Total  liabilities and shareholders’ equity                 | ** ** | **$**                        | **8,448**  |                        | $          | 8,756 |   |

 

**NOTE:**          The Balance Sheetat December 31, 2003 has been derived from the audited financialstatements at that date but does not reflect all of the information andfootnotes required by accounting principles generally accepted in the UnitedStates for complete financial statements.

 

3

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**MakeMusic!Inc.**

**CondensedConsolidated Statements of Operations**

*(Inthousands of U.S. dollars, except per share data)*

(Unaudited)

 
| ** **                                   | ** ** | **Quarter Ended  September 30,** | ** ** | **Nine Months  Ended Sept. 30,** | ** ** |
|----------------------------------------------|------------|---------------------------------------|------------|----------------------------------|------------|
| ** **                                   | ** ** | **2004**                              | ** ** | **2003**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                         |       |                                  |       |                             |       |   |   |   |   |
| **NET  REVENUE**                             | ** ** | **$**                                 | **2,662**  | ** **                       | **$**      | 2,246 | ** ** | **$** | **8,260** |   | $ | 5,281 |   |
|                                         |       |                                  |       |                             |       |   |   |   |   |
| COST OF  REVENUES                            | ** ** | **433**                               |       | 514                              | ** ** | **1,457** |   | 1,218 |   |
|                                         |       |                                  |       |                             |       |   |   |   |   |
| GROSS PROFIT                                 |       | **2,229**                             | ** ** | 1,732                            | ** ** | **6,803** |   | 4,063 |   |
|                                         |       | ** **                            | ** ** |                             |       |   |   |   |   |
| OPERATING  EXPENSES:                         |       | ** **                            | ** ** |                             |       |   |   |   |   |
| Website  development expenses                |       | **159**                               | ** ** | 140                              | ** ** | **441** |   | 349 |   |
| Content and  product development expenses    |       | **588**                               | ** ** | 530                              | ** ** | **1,534** |   | 1,621 |   |
| Selling and  marketing expenses              |       | **820**                               | ** ** | 844                              | ** ** | **2,599** |   | 2,667 |   |
| **General  and administrative expenses**     |       | **776**                               | ** ** | 963                              | ** ** | **2,529** |   | 2,946 |   |
|                                         |       |                                  |       |                             |       |   |   |   |   |
| Total  operating expenses                    | ** ** | **2,343**                             |       | 2,477                            | ** ** | **7,103** |   | 7,583 |   |
|                                         |       |                                  |       |                             |       |   |   |   |   |
| LOSS FROM  OPERATIONS                        | ** ** | **(114**                              | )          | (745                             | **)**      | **(300** | ) | (3,520 | ) |
|                                         |       |                                  |       |                             |       |   |   |   |   |
| Interest  income/(expense), net              | ** ** | **2**                                 |       | (13                              | **)**      | **4** |   | (745 | ) |
| Gain on  forgiveness of debt                 |       | —                                |       | 542                              |       | — |   | 542 |   |
| Other  income/(expense), net                 |       | —                                |       | —                           | ** ** | **108** |   | (76 | ) |
| Net (loss)  before income tax                | ** ** | **(112**                              | )          | (216                             | **)**      | **(188** | ) | (3,799 | ) |
|                                         |       |                                  |       |                             |       |   |   |   |   |
| Income Tax                                   |       | —                                |       | —                           | ** ** | **(2** | ) | (2 | ) |
| Net loss                                     | ** ** | **$**                                 | **(112**   | )                                | $          | (216 | **)** | **$** | **(190** | ) | $ | (3,801 | ) |
|                                         |       |                                  |       |                             |       |   |   |   |   |
| **Basic  and diluted loss per common share** |       | **$**                                 | **(0.03**  | **)**                            | **$**      | (0.06 | ) | **$** | **(0.06** | ) | $ | (1.21 | ) |
| ** **                                   |       |                                  | ** ** | ** **                       | ** ** | ** ** |   |   |   |
| Weighted  average common shares outstanding  | ** ** | **3,380,762**                         |       | 3,356,330                        | ** ** | **3,367,894** |   | 3,147,939 |   |

 

4

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**MakeMusic!Inc.**

**CondensedConsolidated Statements of Cash Flows**

*(Inthousands of U.S. dollars)*

(Unaudited)

 
| ** **                                                                                 | ** ** | **Quarter Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2004**                              | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Operating  activities**                                                                  |       |                                  |       |                                      |       |   |   |   |   |
| Net loss                                                                                   | ** ** | **$**                                 | **(112**   | **)**                                     | $          | (216 | ) | **$** | **(190** | **)** | $ | (3,801 | ) |
| Adjustments  to reconcile net loss to net cash provided by (used in) operating activities: |       |                                  |       |                                      |       |   |   |   |   |
| Amortization  of intangible assets                                                         | ** ** | **318**                               |       | 341                                       | ** ** | **990** |   | 988 |   |
| Depreciation  and amortization of property and equipment                                   | ** ** | **47**                                |       | 67                                        | ** ** | **146** |   | 309 |   |
| Amortization  of deferred compensation                                                     | ** ** | **35**                                |       | 38                                        | ** ** | **110** |   | 118 |   |
| Interest on  bridge loan and discount                                                      | ** ** | **—**                            |       | 5                                         | ** ** | **—** |   | 723 |   |
| Issuance of  stock options and warrants for services                                       | ** ** | **2**                                 |       | 58                                        | ** ** | **7** |   | 60 |   |
| Forgiveness  of debt                                                                       | ** ** | **—**                            |       | (542                                      | )          | **—** |   | (542 | ) |
| Foreign  currency translation loss recorded                                                | ** ** | **—**                            | ** ** | **—**                                | ** ** | **—** |   | 145 |   |
| Increase  (decrease) in cash from:                                                         |       |                                  |       |                                      |       |   |   |   |   |
| Accounts  receivable                                                                       | ** ** | **115**                               |       | (167                                      | )          | **(173** | **)** | (115 | ) |
| Inventories                                                                                | ** ** | **(79**                               | **)**      | (68                                       | )          | **(69** | **)** | (44 | ) |
| Prepaid  expenses and other current assets                                                 | ** ** | **—**                            |       | 7                                         | ** ** | **3** |   | 41 |   |
| Accounts  payable                                                                          | ** ** | **(24**                               | **)**      | 209                                       | ** ** | **(46** | **)** | (184 | ) |
| Accrued  liabilities and product returns                                                   | ** ** | **(158**                              | **)**      | 204                                       | ** ** | **(60** | **)** | 72 |   |
| Deferred  revenue                                                                          | ** ** | **(40**                               | **)**      | 139                                       | ** ** | **(93** | **)** | 329 |   |
| Net cash  provided by (used in) operating activities                                       | ** ** | **104**                               |       | 75                                        | ** ** | **625** |   | (1,901 | ) |
|                                                                                       |       |                                  |       |                                      |       |   |   |   |   |
| **Net cash  used in investing activities**                                                 |       |                                  |       |                                      |       |   |   |   |   |
| Purchases of  property & equipment                                                     | ** ** | **(44**                               | **)**      | (46                                       | )          | **(107** | **)** | (113 | ) |
| Capitalized  development and other intangibles                                             | ** ** | **(30**                               | **)**      | (91                                       | )          | **(134** | **)** | (165 | ) |
| Net cash  used in investing activities                                                     | ** ** | **(74**                               | **)**      | (137                                      | )          | **(241** | **)** | (278 | ) |
|                                                                                       |       |                                  |       |                                      |       |   |   |   |   |
| **Net cash  (used in) provided by financing activities**                                   |       |                                  |       |                                      |       |   |   |   |   |
| Issuance of  common stock                                                                  | ** ** | **3**                                 | ** ** | **—**                                | ** ** | **15** |   | 2,119 |   |
| Proceeds  from long-term debt                                                              | ** ** | **—**                            |       | 497                                       | ** ** | **—** |   | 519 |   |
| Payments on  long-term debt and capital leases                                             | ** ** | **(2**                                | **)**      | (125                                      | )          | **(51** | **)** | (120 | ) |
| Net cash  provided by (used in) financing activities                                       | ** ** | **1**                                 |       | 372                                       | ** ** | **(36** | ) | 2,518 |   |
| Net increase  in cash and cash equivalents                                                 | ** ** | **31**                                |       | 310                                       | ** ** | **348** |   | 339 |   |
| Cash and  cash equivalents, beginning of period                                            | ** ** | **1,784**                             |       | 1,498                                     | ** ** | **1,467** |   | 1,469 |   |
| Cash and  cash equivalents, end of period                                                  | ** ** | **$**                                 | **1,815**  |                                      | $          | 1,808 | ** ** | **$** | **1,815** |   | $ | 1,808 |   |
|                                                                                       |       |                                  |       |                                      |       |   |   |   |   |
| **Supplemental  disclosure of cash flow information**                                      |       |                                  |       |                                      |       |   |   |   |   |
| Interest  paid                                                                             | ** ** | **$**                                 | **—** |                                      | $          | 13 | ** ** | **$** | **2** |   | $ | 36 |   |
| Tax                                                                                        | ** ** | **$**                                 | **—** |                                      | $          | — | ** ** | **$** | **2** |   | $ | 2 |   |

 

5

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**MakeMusic! Inc.**

** **

## **Notes to CondensedConsolidated Financial Statements**

## ** **

## **(Unaudited)**

## ** **

Note 1             **Accounting Policies. **The information furnished in thisreport is unaudited but reflects all adjustments that are necessary, in theopinion of management, for a fair statement of the results for the interimperiod.  The operating results for thenine months ended September 30, 2004 are not necessarily indicative of theoperating results to be expected for the full fiscal year.  These statements should be read inconjunction with the Company’s most recent Annual Report on Form 10-KSB.

 

Note 2             **PrivateFinancing****. **On March 3, 2003, the Company announced that it had completed aprivate placement of $3,015,000, which was approved by shareholders on February 24,2003.  Of this amount, $750,000represented proceeds received upon the sale of convertible bridge loans on September 30,2002.  According to the bridge loanagreement, holders of bridge loans were entitled to receive:  (i) warrants (“Original Warrants”) topurchase one additional share of common stock for each converted share for$0.10 if a private placement of at least $1.0 million was not completed by March 31,2003; or (ii) warrants to purchase one additional share of common stock foreach converted share for $0.50 per share if the requisite private placement wascompleted prior to March 31, 2003. In 2002, the value attributed to the Original Warrants was recorded as adebt discount and additional paid-in capital

 

Upon completion of the private placement, andconcurrent bridge loan conversion into 325,251 shares of common stock, theCompany issued warrants (“Conversion Warrants”) to holders of bridge loans topurchase shares of common stock for $0.50 per share.  These events resulted in $706,000 of interestexpense being recorded in the quarter ended March 31, 2003.  Of this amount, $356,000 was recorded torecognize the value attributed to the Conversion Warrants upon their issuanceand $350,000 was recorded to amortize in full the discount originally recorded(and remaining unamortized) on the bridge loan relating to their beneficialconversion feature.

 

In addition to the 325,251 shares issued tothe bridge loan holders, 707,823 shares were issued for the $2,265,000 millionreceived from investors at the full private placement price of $3.20.  As of September 30, 2004, 3,381,321shares of common stock were issued and outstanding.

 

6

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Note 3             **Net****Loss Per Share.**  Net loss per share was calculated by dividingthe net loss by the weighted average number of shares outstanding during theperiod.  The following table summarizesthe shares of stock included in calculating earnings per share for the quartersand nine months ended September 30, 2004 and 2003 in accordance with FASBStatement 128 (“FAS 128”), *Earnings perShare*:

 
| ** **                                                   | ** ** | **Quarter Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                   | ** ** | **2004**                              | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Weighted-average  common shares outstanding                  |       | 3,380,762                             |       | 3,356,330                                 |       | 3,367,894 |   | 3,147,939 |   |
| Dilutive  effect of stock options and warrants               |       | —                                |       | —                                    |       | — |   | — |   |
| Equivalent  average common shares outstanding – diluted |       | 3,380,762                             |       | 3,356,330                                 |       | 3,367,894 |   | 3,147,939 |   |

 

The computation of fully-diluted loss pershare excluded stock options and warrants to purchase 466,627 and 311,724shares as of September 30, 2004 and 2003, respectively.

 

Note 4                         **Income Tax (Expense) Benefit. ** The Company did not record a provision forincome tax in the three or nine months ended September 30, 2004 due to thefact the Company recorded net losses for such periods.  The only income tax expense recorded in thenine months ended September 30, 2004 was for minimum state income taxpayments.  Due to the uncertaintyregarding the realization of our Federal deferred income tax assets andspecifically the net operating loss carry-forwards, we have recorded avaluation allowance against our income tax benefit for 2003.

 

7

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Note 5             **StockOptions and Warrants. **TheCompany accounts for stock options under Accounting Principles Board OpinionNo. 25, under which the excess, if any, of the quoted market price at thedate of grant over the amount an employee must pay to acquire the stock isrecognized as compensation expense.  Thefollowing table displays pro forma net income and earnings per share as if thefair value based method of accounting had been applied, as required byStatement of Financial Accounting Standards No. 123, *Accounting for Stock-Based Compensation*and Statement ofAccounting Standards No. 148, *Accounting forStock-Based Compensation — Transition and Disclosure*:

 
| ** **                                 | ** ** | **Quarter Ended  September 30,**      | ** ** | **Nine Months Ended  September 30** | ** ** |
|--------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                                 | ** ** | **2004**                                   | ** ** | **2003**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                 | ** ** | **(In thousands, except per share  data)** | ** ** |
| Net loss as  reported                      | ** ** | **$**                                      | **(112**   | **)**                                    | $          | (216 | ) | **$** | **(190** | **)** | $ | (3,801 | ) |
| Stock  compensation recorded under APB 25  | ** ** | **36**                                     |       | 40                                       | ** ** | **111** |   | 131 |   |
| Stock  compensation recorded under FAS 123 | ** ** | **(81**                                    | )          | (151                                     | )          | **(295** | **)** | (318 | ) |
| Pro forma  net loss                        |       | **$**                                      | **(157**   | **)**                                    | $          | (327 | ) | **$** | **(374** | ) | $ | (3,988 | ) |
| Basic and  diluted net loss per share:     |       |                                       |       |                                     |       |   |   |   |   |
| As reported                                | ** ** | **$**                                      | **(0.03**  | **)**                                    | $          | (0.06 | ) | **$** | **(0.06** | **)** | $ | (1.21 | ) |
| Pro forma                                  |       | **$**                                      | **(0.05**  | **)**                                    | $          | (0.10 | ) | **$** | **(0.11** | **)** | $ | (1.27 | ) |

 

**ITEM 2****.****                             MANAGEMENT’SDISCUSSION AND ANALYSIS OR PLAN OF OPERATION**

 

### **Executive Overview**

### ** **

We are a world leader in music educationtechnology with a mission to enhance and transform the experience of making,teaching and learning music.  Among ourleading products are Finale®, the world’s best-selling music notation software,and SmartMusic®, the complete music practice system that features IntelligentAccompaniment® and the world’s largest interactive accompaniment library.

 

For over a decade, Finale has been the world’sbest-selling music notation software.  Webelieve it has transformed the very process by which composers, arrangers,musicians, teachers, students and publishers create, edit, audition, print andpublish musical scores.  In the world ofmusic software, Finale is the equivalent of Adobe® PageMaker®or Adobe® Illustrator® – it is what musicians use forpage layout of sheet music.

 

We have traditionally derived a substantialportion of our revenues from marketing and selling Finale and its relatednotation products, which generally are sold throughout the world in ninelanguages.  These products continue toprovide revenue through regular upgrade releases and customer renewal in theeducation market.  We continue to work ondeveloping their full potential internationally.

 

8

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Our continued focus on developing our marketopportunities and achieving positive operating cash flow has resulted in fiveconsecutive quarters of positive operating cash flow and growing revenues. Thestrength of our Finale 2004 product, which included the first version compliantwith Macintosh OS X released in January 2004, the timely release of ourFinale 2005 version, in both the Windows and Macintosh together on the samedisk for the first time, in August 2004, as well as an upgrade release ofour PrintMusic® software product, have helped us to be operatingcash positive in the first nine months of 2004. With the fourth quarter historically having better cash flow thanquarters one and two due to the annual release of the Finale upgrade andeducational customers purchasing products based on the school-year calendar, weexpect to be operating cash flow positive for the full year of 2004.

 

SmartMusic® is a complete,interactive, computer-based practice system for woodwinds, brass players,vocalists and strings.  SmartMusicenhances and transforms the process of practicing music by accompanyingmusicians while they practice — following their spontaneous tempo changes likea human accompanist.  Offered throughsubscription, SmartMusic gives musicians access to a library of more than 30,000professionally performed and recorded accompaniments.

 

We expect SmartMusic to act as our growth engineto take us beyond our traditional strength in notation software.  With its recurring revenues, SmartMusic is animportant part of our business with a subscription-based model that leveragesrelationships with music educators and their students.  We expect alliances with industry leadingpartners such as Hal Leonard and Conn-Selmer to provide significant growthopportunities beginning next year and growing over time.  While it is difficult to predict the volumeincrease these alliances may produce, we are confident that we will be readyfor the growth these relationships may present.

 

With Finale and SmartMusic, we have themarketing and development platform for building a growing business in musiceducation software.  We are exploringopportunities to introduce our existing products into new geographic marketsthrough our existing distribution partners and new relationships.  We are also exploring opportunities todevelop and launch new products based on our core music educationtechnologies:  the editing, display,printing and playback of music notation, pitch recognition, assessment,recording, and Intelligent Accompaniment.

 

As of September 30, 2004, losses fromoperations have resulted in an accumulated deficit of $55,529,000.

 

In our Form 10-KSB filed with the Securitiesand Exchange Commission for the year ended December 31, 2003, weidentified critical accounting policies and estimates for our business.

 

9

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### **Results of Operations**

 

Thefollowing table summarizes key operating information for the nine months ended September 30,2004 and 2003.

 
| ** **                                | ** ** | **Quarter Ended September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------|------------|--------------------------------------|------------|-------------------------------------------|------------|
| ** **                                | ** ** | **2004**                             | ** ** | **2003**                                  | ** ** | **%  Chg** | ** ** | **2004** | ** ** | **2003** | ** ** | **%  Chg** | ** ** |
| Notation  revenue                         |       | $                                    | 2,394      |                                      | $          | 2,038 |   | 17 |   | $ | 7,551 |   | $ | 4,835 |   | 56 |   |
| SmartMusic  revenue                       |       | 262                                  |       | 164                                       |       | 60 |   | 661 |   | 395 |   | 67 |   |
| Other  revenue                            |       | 6                                    |       | 44                                        |       | (86 | ) | 48 |   | 51 |   | (6 | ) |
| Net revenue                               |       | 2,662                                |       | 2,246                                     |       | 19 |   | 8,260 |   | 5,281 |   | 56 |   |
| Cost of  revenues                         |       | 433                                  |       | 514                                       |       | (16 | ) | 1,457 |   | 1,218 |   | 20 |   |
| Gross profit                              |       | 2,229                                |       | 1,732                                     |       | 29 |   | 6,803 |   | 4,063 |   | 67 |   |
| Percentage  of net sales                  |       | 84                                   | %          | 77                                        | %          |   |   | 83 | % | 77 | % |   |   |
|                                      |       |                                 |       |                                      |       |   |   |   |   |   |   |   |   |
| Website  development expense              |       | 159                                  |       | 140                                       |       | 14 |   | 441 |   | 349 |   | 26 |   |
| Content and  product development expenses |       | 588                                  |       | 530                                       |       | 11 |   | 1,534 |   | 1,621 |   | (5 | ) |
| Selling and  marketing expense            |       | 820                                  |       | 844                                       |       | (3 | ) | 2,599 |   | 2,667 |   | (3 | ) |
| General and  administrative expense       |       | 776                                  |       | 963                                       |       | (19 | ) | 2,529 |   | 2,946 |   | (14 | ) |
| Total  operating expense                  |       | 2,343                                |       | 2,477                                     |       | (5 | ) | 7,103 |   | 7,583 |   | (6 | ) |
| Operating  income (loss)                  |       | (114                                 | )          | (745                                      | )          | 85 |   | (300 | ) | (3,520 | ) | 91 |   |
| Other income  (expense)                   |       | 2                                    |       | 529                                       |       | (100 | ) | 110 |   | (281 | ) | 139 |   |
| Net income  (loss)                        |       | $                                    | (112       | )                                         | $          | (216 | ) | 48 |   | $ | (190 | ) | $ | (3,801 | ) | 95 |   |
|                                           |            |                                      |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

#### ***For the periods ended September 30, 2004 compared to the periodsended September 30, 2003.***

####  

***Net Revenues.*** The increase in notation revenue is due to the 2004 releases of ourFinale and PrintMusic software products. Finale 2004 was our best selling release for both the Windows andMacintosh versions.  Also, Finale 2004for Macintosh, the first version of Finale that is compatible with theMacintosh OS X operating system, was released in January 2004 compared toa July 2002 release of Finale 2003 for Macintosh.  Finale sales customarily are highest uponrelease of a new version, and sales decline throughout the year until the nextrelease.  Finale 2005 was released in August 2004with both Windows and Macintosh versions on a single disk.  PrintMusic sales were $274,000 in the quarterended September 30, 2004 and $794,000 for the nine months ended September 30,2004.  This is $148,000 and $297,000,respectively, greater than the corresponding periods of 2003.  In May of 2004, we released our first upgradeof PrintMusic in two years.  For thetrailing twelve months ended September 30, 2004, revenues from the Finalefamily of products were $9,403,000.  Thisrepresents growth of 41% over the corresponding trailing twelve-month period ayear earlier, which is higher than our historical annual growth trends forFinale software.

 

Inaddition, revenue for our SmartMusic subscription service, which was launchedin

 

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November 2001 forschools and June 2002 for home users, continues to grow.  SmartMusic revenue for the third quarterended September 30, 2004 increased by 60% over the third quarter of theprior year on the strength of subscription growth.  Total SmartMusic revenue includes revenuefrom the subscription service as well as the sale of accessories such asmicrophones and foot pedals.  Revenue forthe prior year also includes sales of SmartMusic applications andaccompaniments.  Applications andaccompaniments are no longer being sold separately with SmartMusic being distributedexclusively as monthly or annual subscriptions.

 

Thetotal number of SmartMusic subscriptions as of September 30, 2004 was morethan 29,700, generating an annual run rate (total revenue to be earned onsubscriptions over a twelve-month period) of $837,000, which represents a 54%increase over the annual run rate as of December 31, 2003 and an 85%increase over the run rate as of September 30, 2003.

 

SmartMusicsubscriptions and revenues fall into three main categories:  schools, school-sponsored homes, and regularhome subscriptions.  As of September 30,2004, we had approximately:

 

•                  More than2,800 schools subscribing to the SmartMusic service with over 8,250subscriptions.  This is a net increase ofapproximately 680 schools and 2,450 subscriptions since December 31,2003.  These schools’ subscriptionscorrespond to annual subscription revenue of $303,000 to be recognized over thesubscription period, of which $69,000 was recorded as revenue in the quarterended September 30, 2004.

•                  More than530 schools participating in the school-sponsored home subscription program,for a total of more than 19,650 school-sponsored home subscriptions generatingannual revenue of $368,000 as of September 30, 2004, with $82,000 recordedin the quarter ended September 30, 2004. This is an increase of approximately 200 schools and 9,250school-sponsored home subscriptions since December 31, 2003.

•                  More than1,830 regular home subscribers with annual revenue of $167,000, approximately580 more than at December 31, 2003, with$33,000recorded as revenue in the quarter ended September 30, 2004.

 

DeferredSmartMusic subscription revenue coming from the subscription programs, to berecognized over the balance of the current subscription period, was $387,000 asof September 30, 2004 compared to $251,000 at September 30, 2003, anincrease of $200,000, or 54%.  DeferredSmartMusic revenue represents the revenue yet to be recorded on currentsubscriptions.  This differs from the$837,000 run rate, which is the total revenue for twelve months on all combinedmonthly and annual subscriptions that are held by customers as of September 30,2004, because deferred revenue includes only annual subscriptions and is onlyfor the portion of the year remaining until the subscription period ends.  The run rate does not include any forecastsof new customers, but gives the annual revenue assuming that we maintain ourcurrent customers at their current subscription level.  We believe that the presentation of theannual run rate provides useful information to investors regarding the successof the subscription program by disclosing the amount of revenue that is earnedon an annual basis from all current customers, as opposed to deferred revenuethat shows only a portion of revenue or quarterly posted revenue that ishistorical information.  These financialmeasures should be considered in addition to, and not a substitute for,financial measures prepared in accordance with U.S. GAAP.

 

***Gross Profit. ***Gross profitof $2,229,000 for the quarter ended September 30, 2004 was $497,000, or29%, greater than the quarter ended September 30, 2003.  Gross profit of $6,803,000 for the nine-monthperiod ended September 30, 2004 was $2,740,000, or 67%, greater than thenine-month period ended September 30, 2003.  These increases are due to the increasedrevenues described above.  Gross marginsas a percentage of sales were higher than the

 

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corresponding 2003periods because most of the revenue increase over 2003 was generated by Finale,a relatively high margin product, and cost of sales includes fixed amortizationof capitalized software costs, which does not increase with sales increases.

 

***Website Development Expenses.***  Website development expenses consist primarilyof expenses related to improvement of the design and development of additionalfeatures for the Finale and SmartMusic websites and other underlying technologyinfrastructure.

 

***Content and Product DevelopmentExpenses.*** Content and product development expenses consist primarily of internalpayroll and payments to third parties for the development and ongoingmaintenance of Finale notation products and the SmartMusic subscription productand accompaniment library.  Year-to-date,we have reduced payroll and contract expenses from the prior year.  However, additional labor was used in thethird quarter ended September 30, 2004 to complete the programming forFinale 2005.  We will continue to developupgrades of the Finale family of products on a regular basis for the Macintoshand Windows platforms as well as upgrades to the SmartMusic application.

 

***Selling and Marketing Expenses.***  The year-to-date decrease in sales andmarketing expenses is due to reductions due to the consolidation of SmartMusicmarketing in Minnesota with the closing of the France office as of April 30,2003.  In addition, some marketingexpenses are lower due to a delay in the marketing of a SmartMusic upgrade.

 

***General and Administrative Expenses.*** General andadministrative expenses consist primarily of payroll and related expenses forexecutive and administrative personnel, professional services expenses,amortization of certain intangible assets with definite lives, facilities, andother general corporate expenses.  Thedecreases primarily relate to expense reductions resulting from the closing ofour France operations.

 

***Net Loss from Operations***.  We recorded a net loss from operations of$114,000 for the quarter ended September 30, 2004, compared with a netoperating loss of $745,000 for the quarter ended September 30, 2003.  Year-to-date, our operating loss of $300,000is 91% less than the year-to-operating loss of $3,520,000 as of September 30,2003.  The improvement in operating lossis due to higher gross profit resulting from the Finale and PrintMusic salesplus decreases in operating expenses from the closing of the France office.

 

***Net Income (Loss)***. We recorded a net loss of $112,000, or $0.03 per basic and dilutedshare, for the quarter ended September 30, 2004 compared to a net loss of$216,000, or $0.06 per basic and diluted share, for the quarter ended September 30,2003.  For the nine months ended September 30,2004, net loss of $190,000, or $0.06 per share, is $3,611,000 less than the netloss of $3,801,000, or $1.21 per share in the same period of 2003.  In addition to the improvement in net lossresulting from the increased revenues, 2003 nine-month results also include$706,000 of interest expense relating to the conversion of bridge loan debtinto equity in the quarter ended March 31, 2003 (see Note 2).

 

***Liquidity and Capital Resources*****.**  Net cash provided byoperating activities was $625,000 for the nine months ended September 30,2004, compared to $1,901,000 of cash used for operating activities in the ninemonths ended September 30, 2003. The increase in operating cash is provided by the decrease in the netloss resulting from the higher sales level. The amount of the decrease due to higher sales is partially offset by areduction in non-cash expenses, particularly a $718,000 non-cash interestexpense in 2003 related to the conversion of bridge loan debt to equity (seeNote 2).  The other significant itemreducing the cash impact of the lower net loss was a decrease of $93,000 in deferredrevenue compared to a $329,000 increase in deferred revenue for the nine monthsended September 30, 2003.  Notationdeferred revenue has

 

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decreased by $177,000since December 31, 2003 because $165,000 of revenue that was deferreduntil Finale was compliant with Macintosh OS X was realized when Finale 2004for Windows was delivered during 2004.

 

Wehave significantly improved operating cash flow over the last several quartersand the third quarter of 2004 is our fifth consecutive quarter of positiveoperating cash flow.  Our quarterlyrevenues are normally cyclical, with the first and second quarters beinghistorically lower than the third and fourth quarters.  The cyclical nature is mainly due to thetiming of Finale family upgrade releases, which typically occur in the third orfourth quarter.  However, with the laterthan normal release of Finale 2004 for Macintosh (in January 2004), thestrong sales of Finale 2004 for both Windows and Macintosh, the release ofFinale 2005 for both Windows and Macintosh in August 2004, and the releaseof a PrintMusic upgrade, revenues in the first three quarters of 2004 werehigher than historical trends.  Based onthe recent trend of increasing operating cash, the growth of SmartMusic subscriptions,and the release of Finale 2005, we expect to achieve positive cash flow for theyear 2004.  If we do not meet ouranticipated revenue levels due to a decrease in demand for our products,management is committed to expense reductions in sales and marketing and otherareas as necessary to ensure the conservation of adequate cash to continue tofinance operations.  If further expensereductions do not offset the decrease in revenue, we may have to seekadditional financing.  However,management believes that we have sufficient cash to finance operations for theforeseeable future.

 

**ITEM 3****.  CONTROLS AND PROCEDURES**

 

(a)*  Evaluation ofdisclosure controls and procedures*. After evaluating the effectiveness of our “disclosure controls andprocedures” (as defined in the Securities Exchange Act of 1934 (“Exchange Act”)Rules 13a-14 and 15d-14) as of the end of the period covered by this quarterlyreport, our chief executive officer and acting principal financial andaccounting officer, with the participation of our management, have concludedthat our disclosure controls and procedures are effective to ensure thatinformation that is required to be disclosed by us in reports that we fileunder the Exchange Act is recorded, processed, summarized and reported withinthe time periods specified in the rules of the Securities and Exchangecommission.

 

(b)*  Changes ininternal controls*.  There wereno changes in our internal controls over financial reporting that occurredduring the period covered by this report that have materially affected, or arereasonably likely to materially affect, our internal controls over financialreporting.

 

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***Cautionary Statements***

 

*This report may contain forward-looking statementswithin the meaning of the Private Securities Litigation Reform Act of 1995.Forward-looking statements provide current expectations or forecasts of futureevents and can be identified by the use of terminology such as “believe,” “estimate,”“expect,” “intend,” “may,” “could,” “will,” and similar words or expressions.Our forward-looking statements in this report generally relate to our abilityto generate positive cash flow, our expectations regarding increasing sales,the impact of strategic alliances, the timing of product updates, sufficiencyof and ability to obtain additional capital, product development, marketintroduction and sales efforts. Forward-looking statements cannot be guaranteed and actual results mayvary materially due to the uncertainties and risks, known and unknown,associated with such statements.  Wecaution investors that many important factors have affected, and in the futurecould affect, our actual results of operations and cause such results to differmaterially from those anticipated in forward-looking statements made in thisrelease and elsewhere by us or on our behalf. These factors include, but are not limited to, our possible need for andability to obtain additional capital; the market acceptance of our products;our dependence upon new product development effort; our dependence on releasingannual Finale upgrades; the maintenance of strategic relationships; the successof our SmartMusic subscription business; maintaining license agreements with alimited number of publishers; the limited and fluctuating sales of certain ofour products; the intense competition we face; the rapid technological changesand obsolescence in our industry; our dependence on key personnel and theproprietary nature of our technology; other general business and economicconditions; and those risks described from time to time in our reports to theSecurities and Exchange Commission (including our Annual Report on Form10-KSB).  It is not possible to foreseeor identify all factors that could cause actual results to differ from expectedor historic results.  As such, investorsshould not consider any list of such factors to be an exhaustive statement ofall of the risks, uncertainties or potentially inaccurate assumptions thatinvestors should take into account when making investment decisions.  Shareholders and other readers are cautionednot to place undue reliance on forward-looking statements, which speak only asof the date on which they are made.  Weundertake no obligation to update publicly or revise any forward-lookingstatements.*

 

## **PART  II**.  OTHER INFORMATION

## ** **

**Item 6.****           Exhibits.**

 

(a)  **Exhibits:**  See theattached exhibit index.

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
| Date November 4,  2004 | MAKEMUSIC INC.                                       |
|-----------------------------|------------------------------------------------------|
|                        |                                                 |
|                        |                                                 |
|                        | By:                                                  | /s/ William  R. Wolff |   |
|                        | William R. Wolff, Chief Executive Officer            |
|                        | (Principal Executive Officer)                        |
|                        |                                                 |   |
|                        |                                                 |   |
|                        | And:                                                 | /s/ Michael  L. Liston |   |
|                        | Michael L. Liston, Corporate Controller              |
|                        | (Acting Principal Financial and Accounting  Officer) |

 

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### **EXHIBIT INDEX**

### ** **

**Form10-QSB**

 

**Quarterended September 30, 2004**

 
| **Exhibit  No.** |       | **Description**                                                                                            |
|------------------|------------|------------------------------------------------------------------------------------------------------------|
| ** **       | ** ** | ** **                                                                                                 |
| **10.18**        |       | Employment Contract for William  R. Wolff.*                                                                |
| ** **       |       |                                                                                                       |
| **31.1**         |       | Certification of Chief Executive Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.  |
| ** **       |       |                                                                                                       |
| **31.2**         |       | Certification of Corporate Controller  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.     |
| ** **       |       |                                                                                                       |
| **32.1**         |       | Certification of Chief  Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of  2002. |
| ** **       |       |                                                                                                       |
| **32.2**         |       | Certification of Corporate  Controller Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.     |

 

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* Management agreement of compensatory plan or arrangement.

 

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