<PAGE>

                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D. C. 20549

                             ---------------------
                                   FORM 10-Q

[X]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2001

                                       or

[_]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _________________  TO
_____________________.

                       Commission File Number 000-25977

                             ---------------------

                              LIQUID AUDIO, INC.
            (Exact name of registrant as specified in its charter)



              Delaware                                   77-0421089
-------------------------------------            --------------------------
   (State or other jurisdiction of                    (I.R.S. Employer
    incorporation or organization)                  Identification No.)



      2221 Broadway, Redwood City, CA                           94063
---------------------------------------------             -------------------
  (Address of  principal executive offices)                   (Zip Code)


                                (650) 549-2000
        ---------------------------------------------------------------
             (Registrant's telephone number, including area code)


Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) had been subject to such filing
requirements for the past 90 days.       X       Yes  _____________No
                                    -------------

As of April 30, 2001, there were 22,541,959 shares of registrant's Common Stock
outstanding.
<PAGE>

                               LIQUID AUDIO, INC.

                                     INDEX
<TABLE>
<CAPTION>

<S>                                                                                                          <C>
PART I. FINANCIAL INFORMATION..............................................................................   1
 ITEM 1.  FINANCIAL STATEMENTS.............................................................................   1
          Condensed Consolidated Balance Sheets as of March 31, 2001 and December 31, 2000
          Condensed Consolidated Statements of Operations for the three months ended March 31, 2001 and 2000
          Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2001 and 2000
          Notes To Condensed Consolidated Financial Statements
 ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS............................................................................  10
 ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.......................................  26
PART II. OTHER INFORMATION.................................................................................  27
 ITEM 1.  LEGAL PROCEEDINGS................................................................................  27
 ITEM 2.  CHANGES IN SECURITIES AND USE OF PROCEEDS........................................................  27

 ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K.................................................................  28
SIGNATURES.................................................................................................  29
</TABLE>
<PAGE>

                        PART I.  FINANCIAL INFORMATION

ITEM 1.    FINANCIAL STATEMENTS

                              LIQUID AUDIO, INC.
                     CONDENSED CONSOLIDATED BALANCE SHEETS
                                (in thousands)

<TABLE>
<CAPTION>
                                                                                        March 31,              December 31,
                                                                                         2001                     2000
                                                                                  ------------------       ------------------
Assets                                                                                 (unaudited)               (audited)
<S>                                                                                     <C>                     <C>
Current assets:
   Cash and cash equivalents..................................................              $114,307                 $ 96,398
   Short-term investments.....................................................                   495                   27,378
   Accounts receivable from third parties, net................................                   794                      725
   Accounts receivable from related parties, net..............................                 1,143                    1,253
   Other current assets.......................................................                 1,288                    2,307
                                                                                            --------                 --------
   Total current assets.......................................................               118,027                  128,061
                                                                                            --------                 --------
Investment in strategic partner...............................................                 1,035                    1,089
Property and equipment, net...................................................                 8,185                    8,860
Other assets..................................................................                   200                      200
                                                                                            --------                 --------
       Total assets...........................................................              $127,447                 $138,210
                                                                                            ========                 ========
Liabilities and stockholders' equity
Current liabilities:
  Accounts payable............................................................              $  3,078                 $  3,314
  Accrued expenses and other current liabilities..............................                 4,301                    3,522
  Deferred revenue from third parties.........................................                   589                      440
  Deferred revenue from related parties.......................................                   986                      987
  Capital lease obligations, current portion..................................                   106                      120
  Equipment loan, current portion.............................................                   537                      589
                                                                                            --------                 --------
     Total current liabilities................................................                 9,597                    8,972
                                                                                            --------                 --------
Capital lease obligations, non-current portion................................                     6                       28
Equipment loan, non-current portion...........................................                    47                      143
Note payable to related party.................................................                   356                      393
                                                                                            --------                 --------
       Total liabilities......................................................                10,006                    9,536
                                                                                            --------                 --------
Stockholders' equity:
  Common stock................................................................                    23                       23
  Additional paid-in capital..................................................               202,858                  202,877
  Unearned compensation.......................................................                  (240)                    (333)
  Accumulated deficit.........................................................               (85,177)                 (73,910)
  Accumulated other comprehensive income......................................                   (23)                      17
                                                                                            --------                 --------
       Total stockholders' equity.............................................               117,441                  128,674
                                                                                            --------                 --------
       Total liabilities and stockholders' equity.............................              $127,447                 $138,210
                                                                                            ========                 ========
</TABLE>

     See accompanying notes to condensed consolidated financial statements

                                       1
<PAGE>

                              LIQUID AUDIO, INC.
                CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
              (in thousands, except per share amounts; unaudited)

<TABLE>
<CAPTION>
                                                                                        Three Months Ended
                                                                                              March 31,
                                                                                    ----------------------------
                                                                                        2001                2000
                                                                                    --------              ------
<S>                                                                                  <C>                 <C>
Net revenues:
 License......................................................................      $    290             $   231
 Services.....................................................................           425                 401
 Business development (related party).........................................           946               2,363
                                                                                    --------             -------
       Total net revenues.....................................................         1,661               2,995
                                                                                    --------             -------
Cost of net revenues:
 License......................................................................           159                  18
 Services.....................................................................           711                 521
 Non-cash cost of revenue.....................................................            83                   3
                                                                                    --------             -------
       Total cost of net revenues.............................................           953                 542
                                                                                    --------             -------
Gross profit..................................................................           708               2,453
Operating expenses:
 Sales and marketing..........................................................         4,656               3,497
 Non-cash sales and marketing.................................................             9                 105
 Research and development.....................................................         5,230               4,920
 Non-cash research and development............................................             9                  51
 General and administrative...................................................         3,194               1,908
 Non-cash general and administrative..........................................             5                  33
 Strategic marketing--equity instruments......................................           312                 561
                                                                                    --------             -------
       Total operating expenses...............................................        13,415              11,075
                                                                                    --------             -------
Loss from operations..........................................................       (12,707)             (8,622)
Other income (expense), net...................................................         1,659               2,314
Equity in net loss of investment..............................................          (219)               (216)
                                                                                    --------             -------
 Net loss.....................................................................      $(11,267)            $(6,524)
                                                                                    ========             =======

Net loss per share:
 Basic and diluted............................................................        $(0.50)             $(0.30)
                                                                                    ========             =======
 Weighted average shares......................................................        22,528              21,918
                                                                                    ========             =======

</TABLE>

    See accompanying notes to condensed consolidated financial statements

                                       2
<PAGE>

                              LIQUID AUDIO, INC.
                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                           (in thousands; unaudited)

<TABLE>
<CAPTION>
                                                                                           Three Months Ended March 31,
                                                                                       -----------------------------------
                                                                                            2001                  2000
                                                                                       -------------          ------------
<S>                                                                                      <C>                   <C>
Cash flows from operating activities:
  Net loss....................................................................              $(11,268)         $ (6,524)
  Adjustments to reconcile net loss to net cash used in operating
     activities:
     Depreciation and amortization............................................                 1,122               573
     Amortization of unearned compensation....................................                    24               192
     Allowance for doubtful accounts and sales returns reserve................                    18                23
     Equity in net loss of investments........................................                   219               216
     Strategic marketing-equity instruments...................................                   312               561
     Non-cash cost of revenue.................................................                    82                --
     Other....................................................................                   (37)              (14)
     Changes in assets and liabilities:
       Accounts receivable from third parties.................................                   (87)             (241)
       Accounts receivable from related parties...............................                   110                --
       Other assets...........................................................                   675                38
       Accounts payable.......................................................                  (236)              737
       Accrued expenses and other current liabilities.........................                   779             1,635
       Deferred revenue.......................................................                   148              (295)
                                                                                            --------          --------
       Net cash used in operating activities..................................                (8,139)           (3,099)
                                                                                            --------          --------
Cash flows from investing activities:
  Acquisition of property and equipment.......................................                  (446)           (2,032)
  Sales (purchases) of short-term investments, net............................                26,886           (87,180)
  Equity investment...........................................................                  (165)               --
                                                                                            --------          --------
       Net cash provided by (used in) investing activities....................                26,275           (89,212)
                                                                                            --------          --------
Cash flows from financing activities:
  Proceeds from issuance of common stock, net of repurchases..................                    --                23
  Payments made under capital leases..........................................                   (36)              (52)
  Payments made under equipment loan..........................................                  (148)             (146)
                                                                                            --------          --------
       Net cash used in financing activities..................................                  (184)             (175)
                                                                                            --------          --------
Effect of exchange rates on cash and cash equivalents.........................                   (43)               --
                                                                                            --------          --------
Net increase (decrease) in cash and cash equivalents..........................                17,909           (92,486)
Cash and cash equivalents at beginning of period..............................                96,398           138,692
                                                                                            --------          --------
Cash and cash equivalents at end of period....................................              $114,307          $ 46,206
                                                                                            ========          ========
Supplemental disclosures:
  Cash paid for interest......................................................              $     22          $     45
Non-cash investing and financing activities:
  Issuance of warrants in connection with strategic marketing
     agreements...............................................................              $     51          $    561
</TABLE>

     See accompanying notes to condensed consolidated financial statements

                                       3
<PAGE>

                              LIQUID AUDIO, INC.
             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (unaudited)

NOTE 1 - THE COMPANY AND BASIS OF PRESENTATION:

The Company

  Liquid Audio, Inc. (the "Company") was incorporated in California in January
1996 and reincorporated in Delaware in April 1999. In July 2000, the Company
established a wholly-owned subsidiary in the United Kingdom, Liquid Audio Europe
PLC, to develop sales in Europe. The Company was formed with the goal of
becoming the premier provider of software applications and services that enable
the secure delivery and sale of digital music over the Internet. The Company's
end-to-end solutions enable the secure distribution, promotion and sale of high
quality music files while providing consumers with the ability to access,
preview and purchase that music via the Internet.

Basis of presentation

  The accompanying unaudited condensed consolidated financial statements have
been prepared by the Company and reflect all adjustments, which are in the
opinion of management, necessary for a fair presentation of the interim periods
presented. The results of operations for the three months ended March 31, 2001
are not necessarily indicative of the results to be expected for any subsequent
quarter or for the year ending December 31, 2001. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with accounting principles generally accepted in the United States of
America have been condensed or omitted pursuant to the Securities and Exchange
Commission's rules and regulations. A condensed consolidated statement of
comprehensive loss has not been presented because the components of
comprehensive loss are not material.

  These unaudited condensed consolidated interim financial statements and notes
included herein should be read in conjunction with the Company's audited
consolidated financial statements and notes as included in the Company's Annual
Report on Form 10-K for the year ended December 31, 2000 as filed with the
Securities and Exchange Commission on March 30, 2001.

Reclassifications

  Certain reclassifications have been made to the prior periods' consolidated
financial statements to conform to the current period presentation. The
statement of operations reflects reclassifications to allocate the non-cash
compensation expense related to the issuance of stock options from a single line
presentation within operating expenses to the respective amounts in cost of net
revenues, sales and marketing, research and development and general and
administrative expense. The reclassifications had no effect on net loss,
stockholders' equity or cash flows.

Principles of Consolidation

  The financial statements include the accounts of the Company and its
subsidiary. Significant intercompany transactions and balances have been
eliminated.

Recent accounting pronouncements

  In December 1999, the Securities and Exchange Commission ("SEC") issued Staff
Accounting Bulletin ("SAB") 101, "Revenue Recognition." SAB 101 outlines the
basic criteria that must be met to recognize revenue and provides guidance for
presentation of revenue and for disclosure related to revenue recognition
policies in financial statements filed with the SEC. In June 2000, the SEC
issued SAB 101B to defer the effective date of implementation of SAB 101 until
the fourth quarter of fiscal 2000. The adoption of SAB 101 did not have a
material impact on the Company's financial position or results of operations.

                                       4
<PAGE>

                              LIQUID AUDIO, INC.
             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (unaudited)

NOTE 2 - BALANCE SHEET COMPONENTS (IN THOUSANDS):

<TABLE>
<CAPTION>
                                                                                    March 31,            December 31,
                                                                                      2001                   2000
                                                                               -----------------      -----------------
<S>                                                                              <C>                    <C>
Accounts receivable from third parties, net:
   Accounts receivable.........................................................          $ 1,397                $ 1,313
   Less: allowance for doubtful accounts and sales returns reserve.............             (603)                  (588)
                                                                                         -------                -------
                                                                                         $   794                $   725
                                                                                         =======                =======
</TABLE>

  The allowance for doubtful accounts and sales returns reserve increased by
$18,000 and $271,000 for the three months ended March 31, 2001 and the year
ended December 31, 2000, respectively. Write-offs against the allowance for
doubtful accounts were $3,000 and $43,000 for the three months ended March 31,
2001 and the year ended December 31, 2000, respectively.

<TABLE>
<CAPTION>
                                                                                    March 31,            December 31,
                                                                                      2001                   2000
                                                                               -----------------      -----------------
<S>                                                                              <C>                    <C>
Property and equipment:
   Computer equipment and purchased software...................................          $12,230                $12,190
   Website and software development costs......................................              726                    399
   Furniture and fixtures......................................................              775                    774
   Leasehold improvements......................................................              708                    682
                                                                                         -------                -------
                                                                                          14,440                 14,045
   Less: accumulated depreciation and amortization.............................           (6,255)                (5,185)
                                                                                         -------                -------
                                                                                         $ 8,185                $ 8,860
                                                                                         =======                =======
</TABLE>

  Property and equipment includes $784,000 of equipment under capital leases at
March 31, 2001 and December 31, 2000. Accumulated depreciation and amortization
for equipment under capital leases was $748,000 and $734,000 at March 31, 2001
and December 31, 2000, respectively.

<TABLE>
<CAPTION>
                                                                                    March 31,           December 31,
                                                                                      2001                  2000
                                                                                -----------------     -----------------
<S>                                                                              <C>                   <C>
Accrued expenses and other current liabilities:
  Compensation and benefits....................................................           $2,226                $2,321
  Consulting and professional services.........................................            1,280                   475
  Accrued marketing expenses...................................................               74                    48
  Other........................................................................              720                   678
                                                                                          ------                ------
                                                                                          $4,300                $3,522
                                                                                          ======                ======
</TABLE>

NOTE 3 - RELATED PARTIES:

Investment in Liquid Audio Japan

  In April 1998, the Company signed an agreement with a strategic partner (the
"Strategic Partner") to establish a Japanese corporation, Liquid Audio Japan
("LAJ"). LAJ is the exclusive reseller and distributor of the Company's software
products in Japan. In March 1999, the Company purchased 18% of the issued and
outstanding shares in LAJ from the Strategic Partner for $378,000. Due to
significant doubt regarding recoverability and the significant losses that were
expected to be incurred during LAJ's initial operating periods, the initial
investment of $378,000 was immediately written off. The Company retains the
option, expiring on December 31, 2003, to purchase up to

                                       5
<PAGE>

20% of the capital of LAJ from the Strategic Partner, at the then fair market
value of LAJ's shares. The Company also has a put option whereby the Company can
require the Strategic Partner to purchase its shares in LAJ at the then fair
market value, if certain performance measures of LAJ, as defined, are not met.
The Company's purchase of shares in LAJ was funded by a loan from a related
entity of the Japanese Strategic Partner. This loan, denominated in Japanese
yen, is repayable on December 31, 2003. Interest on the loan bears interest at
0.5% above a Japanese bank's prime rate (2.6% at December 31, 2000) and is
payable quarterly. The loan is classified in the balance sheet as a non-current
note payable to a related party and recorded at the prevailing exchange rate at
March 31, 2001 and December 31, 2000.

  In December 1999, LAJ completed its initial public offering in Japan, which
raised total proceeds of approximately $28.3 million and resulted in the
Company's ownership in LAJ reducing to 6.92%. The Company booked an investment
in LAJ of $1,959,000, which was recorded as additional paid in capital as
prescribed by SAB Topic No. 5, "Miscellaneous Accounting," to reflect the
increase in the Company's share of LAJ's net assets. The Company's ownership
percentage was further reduced to 6.81% during the year ended December 31, 2000
due to an increase in LAJ's total outstanding shares.

  In March 2001, the Company exercised its option to purchase additional shares
of LAJ from the Strategic Partner for $165,000.  As a result, the Company's
ownership increased to 9.81%.

  The fair value of the Company's ownership in LAJ, based on the quoted trading
price, was approximately $7.1 million at March 31, 2001.

Investment in Liquid Audio Korea

  In December 1998, the Company signed an agreement with another strategic
partner to establish a Korean corporation, Liquid Audio Korea Co. Ltd. ("LAK"),
to develop a local business to enable the digital delivery of music to customers
in Korea. LAK is the exclusive reseller and distributor of the Company's
software products in Korea, under an agreement expiring on December 31, 2003.
The Company paid $400,000 for 40% of the outstanding common stock of LAK and
accounts for its investment in LAK using the equity method of accounting. The
investment of $400,000 was recorded as an offset to the business development
revenue recognized from LAK in December 1998. The Company is not recording its
share of additional losses beyond its investment since there is no obligation on
the part of the Company to pay LAK or any other party for those losses. If LAK
generates sufficient profits to recoup its initial operating losses, the Company
will re-instate the equity method of accounting. LAK stopped making its
contractual payments as scheduled. LAK is undergoing a recapitalization through
the addition of new investment partners so that it can continue making its
payments to the Company. Until such time contractual payments are resumed, the
Company is deferring recognition of revenue from LAK. The Company additionally
wrote off its loans of $470,000 to LAK as of December 31, 2000.

Liquid Audio Greater China

  In June 2000, the Company signed an agreement with a strategic partner to
establish a British Virgin Islands corporation, Liquid Audio Greater China
("LAGC"). LAGC is the exclusive reseller of the Company's products in Taiwan and
Hong Kong and will work to develop business services that enable the digital
delivery of music in those local markets. The Company owns 40% of the
outstanding common stock of LAGC and accounts for its investment in LAGC using
the equity method of accounting. LAGC stopped making its contractual payments in
late 2000 as scheduled. Until such time contractual payments are resumed, the
Company is deferring recognition of revenue from LAGC.

Liquid Audio South East Asia

  In September 2000, the Company signed an agreement with a strategic partner to
establish a Singaporean corporation, Liquid Audio South East Asia ("LASE"). LASE
will be the exclusive reseller of the Company's products in Singapore, Thailand,
Malaysia, Indonesia, Philippines, Australia and New Zealand and will work to
develop business services that enable the digital delivery of music in those
local markets. The Company will own 30% of the outstanding common stock of LASE
and will account for its investment in LASE using the equity method

                                       6
<PAGE>

of accounting. The strategic partner of LASE did not make its contractual
payments in late 2000 as scheduled. Until such time contractual payments are
resumed, the Company is deferring recognition of revenue from LASE.

Other transactions

Total business development revenues are summarized as follows (in thousands):

<TABLE>
<CAPTION>
                                                                                          Three Months Ended
                                                                                               March 31,
                                                                                    ------------------------------
                                                                                             2001             2000
                                                                                    -------------    -------------
<S>                                                                                   <C>              <C>
     Liquid Audio Japan and strategic partner.....................................          $ 946           $2,363
     Liquid Audio South East Asia and strategic partner...........................             --               --
     Liquid Audio Greater China and strategic partner.............................             --               --
     Liquid Audio Korea and strategic partner.....................................             --               --
                                                                                    -------------    -------------
                                                                                            $ 946           $2,363
                                                                                    =============    =============
</TABLE>

  Of the total fees earned from Liquid Audio Japan and strategic partner,
$946,000 and $2,196,000 were earned from Liquid Audio Japan and relate to
software licensing and maintenance fees in the three months ended March 31, 2001
and 2000, respectively, and $167,000 were earned from the strategic partner in
Liquid Audio Japan in the three months ended March 31, 2000, and relate to a
non-refundable service fee of $1,000,000 received in March 1999 and recognized
ratably over the one-year term of the service agreement. At March 31, 2001 and
December 31, 2000, fees billed or received in advance of recognition as business
development revenues were $986,000 and $987,000, respectively. These amounts are
classified as deferred revenue from related parties on the balance sheet.

NOTE 4 - NET LOSS PER SHARE:

  Basic and diluted net loss per share is computed by dividing the net loss
available to common stockholders for the period by the weighted average number
of common shares outstanding during the period. The calculation of diluted net
loss per share excludes potential common shares if the effect is anti-dilutive.
Potential common shares consist of unvested restricted common stock, incremental
common shares issuable upon the exercise of stock options and common shares
issuable upon the exercise of common stock warrants.

  The following table sets forth the computation of basic and diluted net loss
per share for the periods indicated (in thousands, except per share amounts):

<TABLE>
<CAPTION>
                                                                                             Three Months Ended
                                                                                                 March 31,
                                                                                    ---------------------------------
                                                                                          2001               2000
                                                                                    --------------      -------------
<S>                                                                                   <C>                 <C>
Numerator:
   Net loss....................................................................           $(11,267)           $(6,524)
                                                                                          ========            =======
Denominator:
  Weighted average shares......................................................             22,542             21,941
  Weighted average unvested common shares subject to repurchase................                (14)               (23)
                                                                                          --------            -------
     Denominator for basic and diluted calculation.............................             22,528             21,918
                                                                                          ========            =======
Net loss per share:
   Basic and diluted...........................................................           $  (0.50)           $ (0.30)
                                                                                          ========            =======
</TABLE>

                                       7
<PAGE>

  The following table sets forth potential shares of common stock that are not
included in the diluted net loss per share calculation above because to do so
would be anti-dilutive for the periods indicated (in thousands):

<TABLE>
<CAPTION>
                                                                                                Three Months Ended
                                                                                                    March 31,
                                                                                        --------------------------------
                                                                                                 2001               2000
                                                                                        -------------     --------------
    <S>                                                                                   <C>               <C>
    Common stock options...........................................................             2,745              1,670
    Common stock warrants..........................................................               875                609
    Unvested common stock subject to repurchase....................................                10                 95
</TABLE>

NOTE 5 - STRATEGIC MARKETING -- EQUITY AGREEMENTS:


  In June 1999, the Company signed an Advertising Agreement with Amazon.com,
Inc. ("Amazon.com") to collaborate on event-based advertising using the
Company's digital delivery services. In connection with this agreement, the
Company issued a fully vested warrant to purchase approximately 254,000 shares
of common stock to Amazon.com. The warrant was valued at $2,022,000 and was
recognized as strategic marketing-equity instruments expense ratably over the
one-year term of the agreement, which ended in June 2000. As a result, $506,000
was recognized as strategic marketing-equity instruments expense in the three
months ended March 31, 2000.

  In August 1999, the Company signed a Digital Audio Co-Marketing and
Distribution Agreement with Yahoo! to promote the distribution of digital music
on its web site. In connection with this agreement, the Company granted Yahoo!
three warrants totaling 250,000 shares of common stock. The first warrant for
83,334 shares vested immediately. The first warrant was valued at $903,000 and
was recognized ratably over the one-year term of the agreement as strategic
marketing-equity instruments expense. The second warrant for 83,333 shares
vested in August 2000. The second warrant was initially valued at $426,000 and
was recognized ratably over the one-year period ending at the vesting date as
strategic marketing-equity instruments expense. The second warrant was revalued
at each balance sheet date through the vesting date. As a result, the original
charge of $426,000 was reduced to $312,000 based on current market data. The
third warrant for 83,333 shares will vest in August 2001. The third warrant was
initially valued at $105,000 and is recognized ratably over the one-year period
ending at the vesting date. The third warrant will be revalued at each balance
sheet date through the vesting date based on current market data. In the three
months ended March 31, 2001, $0, $0 and $17,000 were recognized as strategic
marketing-equity instruments expense for the first, second and third warrants,
respectively. In the three months ended March 31, 2000, $223,000, $(168,000) and
$0 were recognized as strategic marketing-equity instruments expense for the
first, second and third warrants, respectively.

  In July 2000, the Company signed an agreement with Virgin Holdings, Inc.
("Virgin"), an affiliate of EMI Recorded Music, to promote the distribution of
digital music over the Internet using the Company's technology. Pursuant to this
agreement, the Company issued 150,000 shares of common stock to Virgin. These
shares were valued at $1,181,000 and are being recognized as strategic
marketing-equity instruments expense ratably over the one-year term of the
agreement. As a result, $295,000 was recognized as strategic marketing-equity
instruments expense in the three months ended March 31, 2001.

  In December 2000, the Company signed an agreement with BMG Entertainment to
obtain the right to distribute BMG sound recordings and related artwork through
kiosks. In connection with this agreement, the Company issued 50,000 shares of
common stock to BMG. These shares were valued at $195,000 and are being
recognized as non-cash cost of net revenues ratably over the one-year term of
the agreement. As a result, $49,000 was recognized as non-cash cost of net
revenues in the three months ended March 31, 2001. Additionally, the Company
granted a warrant for a total of 233,300 shares of common stock. Of the total,
77,768 shares vest in December 2001, and the cost will be remeasured each
quarter until a commitment for performance has been reached or the warrant
vests, based on current market data. At March 31, 2001, the 77,768 shares under
this warrant was valued at $143,000, of which $33,000 was recognized as non-cash
cost of net revenues. The unamortized portion will be remeasured at each balance
sheet date through the vesting date and amortized over the remaining vesting
period. If BMG renews the agreement after December 2001, the remaining shares
will vest at 6,481 shares per month commencing January 2002

                                       8
<PAGE>

for one year and 6,480 shares per month commencing January 2003 for one year.
Such shares will be valued at the fair market value of the Company's common
stock upon BMG renewing the agreement at each renewal date.

NOTE 6 - SUBSEQUENT EVENT:

  In May 2001, the Company announced a corporate restructuring program that
included a reduction in the number of employees of approximately forty percent
across all departments, a consolidation of its three Redwood City, California
offices in one facility and other expense management initiatives. The Company is
de-emphasizing its efforts in less productive, non-core business areas that do
not directly support secure digital download opportunities, including digital
music kiosks, music hosting for independent artists and labels, music clips
service and encoding services. The restructuring program is intended to reduce
expenses to preserve the Company's cash position while the digital music market
develops. The Company plans to focus on software licensing and digital music
delivery services that complement its secure digital download business. The
Company plans to support the emerging market for digital music subscriptions,
enabling major portals, online retailers and secure audio device manufacturers
to offer subscription-based digital music download services. This strategy
leverages and enhances both the Company's core digital download services and its
player software licensing business. A restructuring charge of approximately $3.5
to $4.0 million is expected to be recorded in the three months ended June 30,
2001.

                                       9
<PAGE>

ITEM  2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS

  The following Management's Discussion and Analysis contains forward-looking
statements within the meaning of Federal securities laws. You can identify these
statements because they use forward-looking terminology such as "may," "will,"
"expect," "anticipate," "estimate," "continue," "believe," "intend" or other
similar words. These words, however, are not the exclusive means by which you
can identify these statements. You can also identify forward-looking statements
because they discuss future expectations, contain projections of results of
operations or of financial conditions, characterize future events or
circumstances or state other forward-looking information. We have based all
forward-looking statements included in Management's Discussion and Analysis on
information currently available to us, and we assume no obligation to update any
such forward-looking statements. Although we believe that the expectations
reflected in such forward-looking statements are based on reasonable
assumptions, actual results could differ materially from those projected in the
forward-looking statements. Potential risks and uncertainty include, among
others, those set forth under the caption "Additional Factors Affecting Future
Results" included in this "Management's Discussion and Analysis of Financial
Condition and Results of Operations."

  While we believe that the discussion and analysis in this report is adequate
for a fair presentation of the information, we recommend that you read this
discussion and analysis with "Management's Discussion and Analysis" included in
our 2000 Form 10-K.

Overview

  We are a leading provider of software products and services that enable
artists, record companies and retailers to create, syndicate and sell music
digitally over the Internet. Our products and services are based on an open
technical architecture that is designed to support a variety of digital music
formats. From our inception in January 1996 through early 1997, we devoted
substantially all of our efforts to product development, raising capital and
recruiting personnel. We first generated revenues in the first quarter of 1997
through the licensing of our Liquifier Pro, Liquid Server and Liquid Player
software products. In November 1997, we introduced a subscription-based hosting
service for digital recorded music using our technology. In July 1998, to
enhance consumer access to the music we were hosting, we launched the Liquid
Music Network (LMN), a syndicated network that currently links over 1,000
affiliated music-related and music retailer websites.

  In early 1999, we began to place greater emphasis on developing and marketing
our digital music delivery services. Since that time, we have invested
significant resources to increase our distribution reach by expanding the LMN,
building our syndicated music catalog available for sale, actively participating
in standards initiatives and establishing our international presence. We also
have established international initiatives within the Pacific Rim and a
subsidiary in Europe to lay the groundwork for offering digital music download
services to consumers in these markets. As a provider of digital music delivery
services, we expect our revenue sources to expand beyond software license sales
to include sales of digital recorded music and digital music subscriptions.
Revenues from digital music sales and transaction fees from our music delivery
services represented less than 8%, 6% and 1% of total net revenues in the three
months ended March 31, 2001 and the twelve months ended December 31, 2000 and
1999, respectively. Our Liquid Music Network began offering syndicated music
through music retailer websites in the third quarter of 1999.

  To date, we have derived our revenues primarily from the licensing of software
products and service fees associated with business development contracts.
Business development revenues primarily consist of license and maintenance fees
from agreements under which we give our strategic related partners the right to
license and use our digital recorded music delivery technology. These U.S.
dollar-denominated, non-refundable fees are allocated among the various elements
of the contract based on vendor specific objective evidence (VSOE) of fair
value. When VSOE of fair value exist for the undelivered elements, primarily
maintenance, we account for the license portion based on the "residual method"
as prescribed by SOP No. 98-9, "Modification of SOP 97-2 with Respect to Certain
Transactions." When VSOE of fair value does not exist for the undelivered
elements, we recognize the total fee from a business development contract
ratably over the term of the contract. We also license our software products to
record companies, artists and websites. Software license revenues are recognized
when persuasive evidence of an arrangement exists, the fee is fixed and
determinable, collection is probable and delivery has occurred. Services

                                       10
<PAGE>

revenues from maintenance fees related to our licensed software products and
hosting fees from record companies and artists are recognized over the service
period, typically one year. We intend to increase our services revenues by
significantly expanding our music delivery services. Revenue derived from
hosting services include subscription fees from artists for encoding and storing
music files, e-commerce services and transaction reporting. Music delivery
services revenue include transaction fees from sales of digital recorded music
through our LMN website affiliates and fees from music retailers and websites
related to the sample digital music clips delivery service. Revenue from kiosk
sales consists of software licenses and services revenue from equipment and
kiosk-related services. We bear full credit risk with respect to substantially
all sales.

  Business development revenues as a percentage of total net revenues were 57%,
63% and 48% in the three months ended March 31, 2001 and the twelve months ended
December 31, 2000 and 1999, respectively. Liquid Audio Korea (LAK) stopped
making its contractual payments as scheduled. LAK is undergoing a
recapitalization through the addition of new investment partners so that it can
continue making its payments to us. Until such time contractual payments are
resumed, we are deferring recognition of revenue from LAK. In late 2000, Liquid
Audio Greater China and Liquid Audio South East Asia through our strategic
partner did not make their contractual payments as scheduled. We are pursuing
collection for the missed payments. No revenue will be recognized until payments
are on schedule. We may be unsuccessful in receiving any additional payments
from these customers.

  In the first quarter of 2001, approximately 57% of total net revenues came
from sales to one customer, Liquid Audio Japan. In 2000, approximately 53% of
total net revenues came from sales to two customers, Liquid Audio Japan and
Liquid Audio South East Asia through our strategic partner. In 1999,
approximately 73% of total net revenues came from sales to three customers,
Adaptec, Inc., Super Stage, Inc. and Liquid Audio Korea. International revenues
represented approximately 65%, 69% and 49% of total net revenues in the three
months ended March 31, 2001 and the twelve months ended December 31, 2000 and
1999, respectively. We expect international revenues will continue to represent
a significant portion of our total net revenues.

  In May 2001, we announced a corporate restructuring program that included a
reduction in the number of employees of approximately forty percent across all
departments, a consolidation of our three Redwood City, California offices in
one facility and other expense management initiatives. We are de-emphasizing our
efforts in less productive, non-core business areas that do not directly support
secure digital download opportunities, including digital music kiosks, music
hosting for independent artists and labels, music clips service and encoding
services. The restructuring program is intended to reduce expenses to preserve
our cash position while the digital music market develops. We plan to focus on
software licensing and digital music delivery services that complement our
secure digital download business. We plan to support the emerging market for
digital music subscriptions, enabling major portals, online retailers and secure
audio device manufacturers to offer subscription-based digital music download
services. This strategy leverages and enhances both our core digital download
services and our player software licensing business. We expect to record a
restructuring charge of approximately $3.5 to $4.0 million in the second quarter
of 2001.

  We have a limited operating history upon which investors may evaluate our
business and prospects. Since inception we have incurred significant losses, and
as of March 31, 2001 we had an accumulated deficit of approximately $85.2
million. We expect to incur additional losses and continued negative cash flow
from operations through at least 2002. Our revenues may not increase or even
continue at their current levels or we may not achieve or maintain profitability
or generate cash from operations in future periods. Our prospects must be
considered in light of the risks, expenses and difficulties frequently
encountered by companies in their early stages of development, particularly
companies in new and rapidly evolving markets such as the digital delivery of
recorded music. We may not be successful in addressing these risks, and our
failure to do so would harm our business.

                                       11
<PAGE>

Results of Operations
----------------------

  The following table sets forth, for the periods presented, certain data
derived from our unaudited condensed statement of operations as a percentage of
total net revenues.  The operating results in any period are not necessarily
indicative of the results that may be expected for any future period.

<TABLE>
<CAPTION>
                                                                                            Three Months Ended
                                                                                                 March 31,
                                                                                          ----------------------
                                                                                             2001           2000
<S>                                                                                          <C>            <C>
Net revenues:
 License...........................................................................            17%             8%
 Services..........................................................................            26             13
 Business development (related party)..............................................            57             79
                                                                                            -----          -----
   Total net revenues..............................................................           100            100
                                                                                            -----          -----
Cost of net revenues:
 License...........................................................................             9              1
 Services..........................................................................            43             17
 Non-cash cost of revenue..........................................................             5             --
                                                                                            -----          -----
   Total cost of net revenues......................................................            57             18
                                                                                            -----          -----
Gross profit.......................................................................            43             82
                                                                                            -----          -----

Operating expenses:
 Sales and marketing...............................................................           280            117
 Non-cash sales and marketing......................................................             1              4
 Research and development..........................................................           315            164
 Non-cash research and development.................................................             1              2
 General and administrative........................................................           192             64
 Non-cash general and administrative...............................................            --              1
 Strategic marketing-equity instruments............................................            19             18
                                                                                            -----          -----
   Total operating expenses........................................................           808            370
                                                                                            -----          -----
Loss from operations...............................................................          (765)          (288)
Other income (expense), net........................................................           100             77
Equity in net loss of investment...................................................           (13)            (7)
                                                                                            -----          -----
Net loss...........................................................................         (678)%         (218)%
                                                                                            =====          =====
</TABLE>


Three Months Ended March 31, 2001 and 2000

Total Net Revenues

  Total net revenues decreased 45% to $1.7 million for the three months ended
March 31, 2001 from $3.0 million in the comparable period of 2000.

  License.  License revenues increased 26% to $290,000 for the three months
ended March 31, 2001 from $231,000 in the comparable period of 2000. This
increase is due to Liquid Player license fees received under agreements with a
hardware manufacturer in which the manufacturer delivers a custom-branded
version of the software with certain of their compact disc recorder (CD-R)
devices they sell. These fees were higher than licensing fees related to digital
music kiosk sales and Secure Portable Player Protocol (SP3) technical
architecture and reference specification in the comparable quarter in 2000.

  Services.  Services revenues increased 6% to $425,000 for the three months
ended March 31, 2001 from $401,000 in the comparable period of 2000. This
increase was due primarily to increases in encoding services in the 2001 period.

                                       12
<PAGE>

  Business Development (Related Party).  Business development revenues decreased
60% to $946,000 for the three months ended March 31, 2001 from $2.4 million in
the comparable period of 2000. The decrease was due to lower software licensing
and related maintenance revenues recognized under the software license contract
with Liquid Audio Japan in the 2001 period. Revenue for both periods relate
solely to Liquid Audio Japan and its strategic partner.

Total Cost of Net Revenues

  Our gross profit decreased to approximately 43% of total net revenues for the
three months ended March 31, 2001 from approximately 82% of total net revenues
in the comparable period of 2000. Total cost of net revenues increased 76% to
$953,000 in the 2001 period from $542,000 in the 2000 period.

  License.  Cost of license revenues primarily consists of royalties paid to
third-party technology vendors and costs of documentation, duplication and
packaging. Cost of license revenues increased 783% to $159,000 for the three
months ended March 31, 2001 from $18,000 in the comparable period of 2000. Cost
of license revenues increased due to the addition of technology licenses in 2001
and product mix differences.

  Services.  Cost of services revenues primarily consists of compensation for
customer service, encoding and professional services personnel, kiosk-related
equipment and an allocation of our occupancy costs and other overhead
attributable to our services revenues. Cost of services revenues increased 36%
to $711,000 for the three months ended March 31, 2001 from $521,000 in the
comparable period of 2000. The increase in cost of services revenues was due to
the write-off of kiosk-related inventory due to de-emphasizing the kiosk product
line in connection with our announced corporate restructuring, and the addition
of encoding, customer service and professional services personnel.

  Non-Cash Cost of Revenues.  Non-cash cost of revenues consist of expenses
associated with the value of common stock and warrants issued to partners as
part of our content acquisition agreements and stock-based employee compensation
arrangements. Common stock expense is based on the fair value of the stock at
the time it was issued. Warrant expense is based on the estimated fair value of
the warrants based on the Black-Scholes option pricing model and the provisions
of EITF 96-18. In December 2000, we signed an agreement with BMG Entertainment
to obtain the right to distribute BMG sound recordings and related artwork
through kiosks. In connection with this agreement, we issued 50,000 shares of
common stock to BMG, valued at $195,000 and are being recognized ratably over
the initial one-year term of the agreement; as a result, $49,000 was recognized
as non-cash cost of revenues. Also in connection with this agreement, we granted
a warrant for a total of 233,300 shares of common stock. Of the total, 77,768
shares vest in December 2001, and the cost will be remeasured each quarter until
a commitment for performance has been reached or the warrant vests, based on
current market data. At March 31, 2001, the 77,768 shares under this warrant
were valued at $143,000, of which $33,000 was recognized as non-cash cost of
revenues. The unamortized portion will be remeasured at each balance sheet date
through the vesting date and amortized over the remaining vesting period. If BMG
renews the agreement after December 2001, the remaining shares will vest at
6,481 shares per month commencing January 2002 for one year and 6,480 shares per
month commencing January 2003 for one year. Such shares will be valued at the
fair market value of our common stock upon BMG renewing the agreement at each
renewal date. Stock compensation expense for customer service, encoding and
professional services personnel were $1,000 and $3,000 for the three months
ended March 31, 2001 and 2000, respectively. We expect quarterly amortization
related to these options to be less than $1,000 per quarter during 2001 and
annual amortization to be approximately $1,000 in 2002. These future
compensation charges would be reduced if any customer service, encoding or
professional services employee terminates employment prior to the expiration of
the employee's option vesting period.

Operating Expenses

  Sales and Marketing.  Sales and marketing expenses consist primarily of
compensation for our sales, marketing and business development personnel,
compensation for customer service and professional services personnel
attributable to sales and marketing activities, advertising, trade show and
other promotional costs, design and creation expenses for marketing literature
and our website and an allocation of our occupancy costs and other overhead.
Sales and marketing expenses increased 33% to $4.7 million for the three months
ended March 31, 2001

                                       13
<PAGE>

from $3.5 million in the comparable period of 2000. This increase was primarily
due to increases in the number of sales and marketing personnel, advertising and
promotional programs. We expect that sales and marketing expenses will decrease
in absolute dollars in future periods due to the corporate restructuring and
expense management initiatives.

  Research and Development.  Research and development expenses consist primarily
of compensation for our research and development, network operations and product
management personnel, payments to outside contractors and, to a lesser extent,
depreciation on equipment used for research and development and an allocation of
our occupancy costs and other overhead. Research and development expenses
increased 6% to $5.2 million for the three months ended March 31, 2001 from $4.9
million in the comparable period of 2000. This increase was primarily due to
increases in the number of personnel and outside contractors needed to enhance
our existing software products, develop and enhance our online services, develop
new products and services and build our external network and computer data
center infrastructure. We expect that research and development expenses will
decrease in absolute dollars in future periods due to the corporate
restructuring and expense management initiatives.

  General and Administrative.  General and administrative expenses consist
primarily of compensation for personnel and payments to outside contractors for
general corporate functions, including finance, information systems, human
resources, facilities, legal and general management, fees for professional
services, bad debt expense and an allocation of our occupancy costs and other
overhead. General and administrative expenses increased 67% to $3.2 million for
the three months ended March 31, 2001 from $1.9 million in the comparable period
of 2000. This increase was primarily due to legal fees related to patent
infringement claims against us (see Part II, Item 1 "Legal Proceedings"),
professional services fees and increases in the number of personnel and outside
contractors needed to support the growth of our business.  We expect that
general and administrative expenses will decrease in absolute dollars due to the
corporate restructuring and expense management initiatives.

  Strategic Marketing--Equity Instruments.  Strategic marketing-equity
instruments consist of expenses associated with the value of common stock and
warrants issued to partners as part of our strategic marketing agreements.
Common stock expense is based on the fair value of the stock at the time it was
issued. Warrant expense is based on the estimated fair value of the warrants
based on the Black-Scholes option pricing model and the provisions of EITF 96-
18. Strategic marketing-equity instruments expense was $312,000 and $561,000 in
the three months ended March 31, 2001 and 2000, respectively. In June 1999, we
signed an advertising agreement with Amazon.com to collaborate on event-based
advertising using our digital delivery services. In connection with this
agreement, we issued a fully vested warrant to purchase approximately 254,000
shares of common stock to Amazon.com. The warrant was valued at $2.0 million and
was recognized ratably over the one-year term of the agreement; as a result,
$506,000 was recognized as strategic marketing-equity instruments expense in the
three months ended March 31, 2000. In August 1999, we signed a Digital Audio Co-
Marketing and Distribution Agreement with Yahoo! to promote the distribution of
digital music on its web site. In connection with this agreement, we granted
Yahoo! three warrants totaling 250,000 shares of common stock. The first warrant
for 83,334 shares vested immediately. The first warrant was valued at $903,000
and was recognized ratably over the one-year term of the agreement. The second
warrant for 83,333 shares vested in August 2000. The second warrant was
initially valued at $426,000 and was recognized ratably over the one-year period
ending at the vesting date. The second warrant was revalued at each balance
sheet date through the vesting date. As a result, the original charge of
$426,000 was reduced to $312,000 based on current market data. The third warrant
for 83,333 shares will vest in August 2001. The third warrant was initially
valued at $105,000 and is recognized ratably over the one-year period ending at
the vesting date. The third warrant will be revalued at each balance sheet date
through the vesting date based on current market data. In the three months ended
March 31, 2001, $0, $0 and $17,000 were recognized as strategic marketing-equity
instruments expense for the first, second and third warrants, respectively. In
the three months ended March 31, 2000, $223,000, $(168,000) and $0 were
recognized as strategic marketing-equity instruments expense for the first,
second and third warrants, respectively. In July 2000, we signed an agreement
with Virgin Holdings, Inc., an affiliate of EMI Recorded Music, to promote the
distribution of digital music over the Internet using our technology. Pursuant
to this agreement, we issued 150,000 shares of common stock to Virgin. These
shares were valued at $1.2 million and are being recognized ratably over the
one-year term of the agreement. As a result, $295,000 was recognized as
strategic marketing-equity instruments expense in the three months ended March
31, 2001.

                                       14
<PAGE>

  Non-Cash Sales and Marketing, Research and Development and General and
Administrative.  Non-cash sales and marketing, research and development and
general and administrative expenses relate to stock-based employee compensation
arrangements. The total unearned compensation recorded by us from inception to
March 31, 2001 was $3.8 million. We recognized $23,000 and $189,000 of stock
compensation expense for the three months ended March 31, 2001 and 2000,
respectively. We expect quarterly amortization related to those options to be
between $66,000 and $40,000 per quarter during the remainder of 2001 and annual
amortization to be approximately $76,000 during 2002. These future compensation
charges would be reduced if any sales and marketing, research and development
and general and administrative employee terminates employment prior to the
expiration of the employee's option vesting period.

  Other Income (Expense), Net.  Interest income consists of earnings on our
cash, cash equivalents and short-term investments. Interest expense consists of
expenses related to our financing obligations, which include borrowings under
equipment loans and capital lease obligations. Other income (expense), net
decreased to $1.7 million for the three months ended March 31, 2001 from $2.3
million in the comparable period of 2000. This decrease was primarily due to
interest received on higher average cash and cash equivalent balances in the
2000 period resulting from proceeds of the initial and follow-on public
offerings of our common stock in July 1999 and December 1999, respectively.

  Equity in Net Loss of Investment.  Equity in net loss of investment consist of
our share of losses from our investment in a related party using the equity
method of accounting under a 3-month lag. Equity in net loss of investment was
$219,000 and $216,000 for the three months ended March 31, 2001 and 2000,
respectively. The expenses represent our share of the loss of Liquid Audio
Japan.

Liquidity and Capital Resources

  Since inception, we have financed our operations primarily through the initial
and follow-on public offerings of common stock, private placements of our
preferred stock, equipment financing, lines of credit and short-term loans. As
of March 31, 2001, we had raised $65.9 million and $93.7 million through our
initial and follow-on public offerings of common stock, respectively, and $29.8
million through the sale of our preferred stock. At March 31, 2001, we had
approximately $114.8 million of cash, cash equivalents and short-term
investments.

  Net cash used in operating activities was $8.1 million and $3.1 million for
the three months ended March 31, 2001 and 2000, respectively. Net cash used for
operating activities in the 2001 period was primarily the result of net losses
from operations, depreciation and amortization of $1.1 million, amortization of
unearned compensation of $24,000, strategic marketing-equity instruments charges
of $312,000, non-cash cost of revenue of $82,000, an increase in the allowance
for doubtful accounts and sales returns reserve by $18,000, equity investment
losses of $219,000, other charges of $(37,000) and a net increase in working
capital items by $1.4 million. The net increase in working capital items include
a decrease in accounts receivable by $23,000, decrease in other assets by
$675,000, decrease in accounts payable by $236,000, increase in accrued expenses
and other liabilities by $779,000 and an increase in deferred revenue by
$148,000. Net cash used for operating activities in the 2000 period was
primarily the result of net losses from operations, depreciation and
amortization of $573,000, amortization of unearned compensation of $192,000,
strategic marketing-equity instruments charges of $561,000, an increase in the
allowance for doubtful accounts and sales returns reserve by $23,000, equity
investment losses of $216,000, other charges of $(14,000) and a net increase in
working capital items by $1.9 million. The net increase in working capital items
include an increase in accounts receivable by $241,000, decrease in other assets
by $38,000, increase in accounts payable by $737,000, increase in accrued
expenses and other liabilities by $1.6 million and a decrease in deferred
revenue by $295,000.

  Net cash provided by (used in) investing activities was $26.3 million and
$(89.2) million for the three months ended March 31, 2001 and 2000,
respectively. Net cash provided by (used in) investing activities in each of
these periods was related to net sales (purchases) of short-term investments and
the acquisition of property and equipment in both periods.

                                       15
<PAGE>

  Net cash used financing activities was $184,000 and $175,000 for the three
months ended March 31, 2001 and 2000, respectively. The net cash used in
financing activities for both periods is due primarily to payments made under
our equipment loan and capital leases.

  We had a bank equipment loan facility that provided for advances of up to $3.0
million through November 1999. Borrowings under the equipment loan facility are
repayable in monthly installments over three years and bear interest at the
bank's prime interest rate plus 0.25%. Borrowings are secured by the related
equipment and other assets. Under the equipment loan facility, we had borrowed
amounts totaling $1.8 million through March 31, 2001. We also have lease
financing agreements that provide for the lease of computers and office
equipment of up to $1.0 million. As of March 31, 2001, we had borrowed $737,000
under the lease financing agreements. Our other significant commitments consist
of obligations under non-cancelable operating leases, which totaled $2.3 million
as of March 31, 2001 and are payable in monthly installments through 2005 and a
note payable to related party in the amount of $356,000 that was issued in the
three months ended March 31, 1999. The note payable to related party is
repayable in Japanese yen and bears interest at 0.5% above a Japanese bank's
prime rate. The principal is due on December 31, 2003, with quarterly interest
payments.

  We have no material commitments for capital expenditures or strategic
investments and anticipate a decline in the rate of capital expenditures. We may
use cash to acquire or license technology, products or businesses related to our
current business. In addition, we anticipate that we will experience a decline
in our operating expenses for the foreseeable future and that our operating
expenses will be a material use of our cash resources.

  We believe that existing cash and cash equivalents and financing available
under lease agreements will be sufficient to meet our anticipated cash needs for
working capital and capital expenditures for the foreseeable future, although we
may seek to raise additional capital during that period. The sale of additional
equity or convertible debt securities could result in additional dilution to our
stockholders. There can be no assurance that financing will be available in
amounts or on terms acceptable to us, if at all.

Market Risk

  At March 31, 2001, we had an investment portfolio of money market funds,
commercial securities and U.S. Government bonds including those classified as
short-term investments of $114.8 million. We had a related party loan at March
31, 2001 of $356,000, which was denominated in Japanese yen and bore interest at
0.5% above a Japanese bank's prime rate. These instruments, like all fixed
income instruments, are subject to interest rate risk. The fixed income
portfolio will fall in value and the strategic related partner note payable
interest would increase if there were an increase in interest rates. If market
interest rates were to increase immediately and uniformly by 10% from levels as
of December 31, 2000, the decline of the fair value of the fixed income
portfolio and strategic related partner note payable would not be material.

  As a global concern, we face exposure to adverse movements in foreign currency
exchange rates. These exposures may change over time as business practices
evolve and could seriously harm our financial results. Substantially all of our
international sales are currently denominated in U.S. dollars. An increase in
the value of the U.S. dollar relative to foreign currencies could make our
products and services more expensive and therefore, reduce the demand for our
products and services. Reduced demand for our products and services could
seriously harm our financial results. Currently, we do not hedge against any
foreign currencies and as a result, could incur unanticipated gains or losses.

                                       16
<PAGE>

ADDITIONAL FACTORS AFFECTING FUTURE RESULTS

Our Limited Operating History in the New Market of Digital Delivery of Music
over the Internet Increases the Possibility that the Value of Your Investment
Will Decline

  We incorporated in January 1996. We did not start generating revenues until
the first quarter of 1997. In early 1999 we began to place greater emphasis on
developing and marketing our digital music delivery services. Accordingly, we
are still in the early stages of development and have only a limited operating
history upon which you can evaluate our business. You should evaluate our
chances of financial and operational success in light of the risks,
uncertainties, expenses, delays and difficulties associated with starting a new
business, many of which may be beyond our control.

We Have a History of Losses, We Expect Losses to Continue and We Might Not
Achieve or Maintain Profitability

  Our accumulated deficit as of March 31, 2001 was approximately $85.2 million.
We had net losses of approximately $24.2 million and $33.7 million in 1999 and
2000, respectively, and $11.3 million in the three months ended March 31, 2001.
Given the level of our planned operating and capital expenditures, we expect to
continue to incur losses and negative cash flows through at least 2002. Even if
we ultimately do achieve profitability, we may not be able to sustain or
increase profitability on a quarterly or annual basis. If our revenues grow more
slowly than we anticipate, or if our operating expenses exceed our expectations
and cannot be adjusted accordingly, our business will be harmed.

Fluctuations in Our Quarterly Revenues and Operating Results Might Lead to
Reduced Prices for Our Stock

  Our quarterly results of operations have varied in the past, and you should
not rely on quarter-to-quarter comparisons of our results of operations as an
indication of our future performance. In some future periods, our results of
operations are likely to be below the expectations of public market analysts and
investors. In this event, the price of our common stock would likely decline.
Factors that have caused our results to fluctuate in the past and that are
likely to affect us in the future include the following:

  .  competition for consumers from traditional retailers as well as providers
     of online music services;

  .  the announcement and introduction of new products and services by us and
     our competitors;

  .  our ability to increase the number of websites that will use our platform
     for digital music delivery;

  .  the timing of our partners' introduction of new products and services for
     digital music sales; and

  .  variability and length of the sales cycle associated with our product and
     service offerings.

  In addition, other factors may also affect us, including:

  .  market adoption and growth of sales of digitally downloaded recorded music
     over the Internet;

  .  our ability to attract significant numbers of music recordings to be
     syndicated in our format;

  .  our ability to provide reliable and scalable service, including our ability
     to avoid potential system failures;

  .  market acceptance of new and enhanced versions of our products and
     services; and

  .  the price and mix of products and services we offer.

  Some of these factors are within our control and others are outside of our
  control.

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Several of Our Customers Have Had Limited Operating Histories, Are Unprofitable
and Might Have Difficulty Meeting Their Payment Obligations to Us

  Several of our significant customers, including our international partners
Liquid Audio Japan, Liquid Audio Korea, Liquid Audio Greater China and Liquid
Audio South East Asia through our strategic partner, have had limited operating
histories and have not achieved profitability. We believe that this will be true
of other customers in the future. As of March 31, 2001, 24% and 76% of our trade
accounts receivable and receivables from related parties, respectively, or
$188,000 and $873,000, respectively, were more than 30 days past due. You should
evaluate the ability of these companies to meet their payment obligations to us
in light of the risks, expenses and difficulties encountered by companies with
limited operating histories. If one or more of our customers were unable to pay
for our services in the future, or paid more slowly than we anticipate,
recognition of revenue might be delayed and our business might be harmed.

If Our Relationships with Our International Partners Terminate, Our Revenues
Might Decline

  We derive a portion of our revenues from business development fees from
relationships with our international partners, including Liquid Audio Korea,
Liquid Audio Japan, Liquid Audio Greater China and Liquid Audio South East Asia
through our strategic partner. These relationships vary in size and scope. If
one of these relationships does not generate a similar amount of revenue in
subsequent periods or if a party is unable to make its scheduled payments to us,
then our business could be harmed. Furthermore, the commercial terms for these
relationships could cause our revenues to vary from period-to-period, which
might result in unpredictability of our revenues.

Our Revenues Would Be Negatively Effected by the Loss of a Significant Customer

  We have derived, and we believe that we will continue to derive, a substantial
portion of our net revenues from a limited number of customers and projects. Our
ten largest customers for 1999, 2000 and the three months ended March 31, 2001
represented approximately 86%, 78% and 91%, respectively, of our total net
revenues. The loss of any significant customer or any significant reduction of
total net revenues generated by significant customers, without an increase in
revenues from other sources, would harm our business. The volume of products or
services we sell to specific customers is likely to vary year to year, and a
major customer in one year may not use our services in a subsequent year. A
customer's decision not to use our services in a subsequent year might harm our
business.

If Standards for the Secure, Digital Delivery of Recorded Music Are Not Adopted,
the Piracy Concerns of Record Companies and Artists Might Not Be Satisfied, and
They Might Not Use Our Platform for Digital Delivery of Their Music

  Because other digital recorded music formats, such as MP3, do not contain
mechanisms for tracking the source or ownership of digital recordings, users are
able to download and distribute unauthorized or "pirated" copies of copyrighted
recorded music over the Internet. This piracy is a significant concern to record
companies and artists, and is the reason many record companies and artists are
reluctant to digitally deliver their recorded music over the Internet. The
Secure Digital Music Initiative (SDMI) is a committee formed by the Recording
Industry Association of America (RIAA) to propose a standard format for the
secure digital delivery and use of recorded music. If a standard format is not
adopted, however, unsecure copies of recorded music may continue to be available
on the Internet, and record companies and artists might not permit the digital
delivery of their music. Additionally, as long as pirated recordings are
available, many consumers will choose free pirated recordings rather than paying
for legitimate recordings. Accordingly, if a standard format for the secure
digital delivery of music is not adopted, our business might be harmed.

  We have designed our current products to be adaptable to different music
industry and technology standards. Numerous standards in the marketplace,
however, could cause confusion as to whether our products and services are
compatible. If a competitor were to establish the dominant industry standard,
our business would be harmed.

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<PAGE>

We Might Need Additional Capital in the Future and Additional Financing Might
Not Be Available

  We currently anticipate that our available cash resources and financing
available under existing lease agreements will be sufficient to meet our
anticipated working capital and capital expenditure requirements for the
foreseeable future. However, we may need to raise additional funds through
public or private debt or equity financing in order to:

  .  take advantage of opportunities, including more rapid international
     expansion or acquisitions of complementary businesses or technologies;

  .  develop new products or services; or

  .  respond to competitive pressures.

  Any additional financing we may need may not be available on terms favorable
to us, or at all. If adequate funds are not available or are not available on
acceptable terms, we might not be able to take advantage of unanticipated
opportunities, develop new products or services, or otherwise respond to
unanticipated competitive pressures, and our business could be harmed. Our
forecast of the period of time through which our financial resources will be
adequate to support our operations is a forward-looking statement that involves
risks and uncertainties, and actual results could vary materially as a result of
a number of factors, including those set forth in this "Additional Factors
Affecting Future Results" section.

Our Future Success Depends on Our Key Personnel

  Our future success depends to a significant extent on the continued service of
our key technical, sales and senior management personnel and their ability to
execute our growth strategy. The loss of the services of any of our senior level
management, or other key employees, could harm our business. Our future
performance will depend, in part, on the ability of our executive officers to
work together effectively. Our executive officers may not be successful in
carrying out their duties or running our company. Any dissent among executive
officers could impair our ability to make strategic decisions quickly in a
rapidly changing market.

  Our future success also depends on our ability to attract, retain and motivate
highly skilled employees. Competition for employees in our industry is intense.
Although we provide compensation packages that include incentive stock options,
cash incentives and other employee benefits, the volatility and current market
price of our common stock may make it difficult for us to attract, assimilate
and retain highly qualified employees in the future. We have from time to time
in the past experienced, and we expect to continue to experience in the future,
difficulty in hiring and retaining highly skilled employees with appropriate
qualifications.

We Depend on Proprietary Rights to Develop and Protect Our Technology

  Our success and ability to compete substantially depends on our internally
developed technologies and trademarks, which we protect through a combination of
patent, copyright, trade secret and trademark laws. Patent applications or
trademark registrations may not be approved. Even if they are approved, our
patents or trademarks may be successfully challenged by others or invalidated.
If our trademark registrations are not approved because third parties own these
trademarks, our use of these trademarks would be restricted unless we enter into
arrangements with the third-party owners, which might not be possible on
commercially reasonable terms or at all.

  The primary forms of intellectual property protection for our products and
services internationally are patents and copyrights. Patent protection
throughout the world is generally established on a country-by-country basis. To
date, we have applied for four patents outside the United States. Copyrights
throughout the world are protected by several international treaties, including
the Berne Convention for the Protection of Literary and Artistic Works. Despite
these international laws, the level of practical protection for intellectual
property varies among countries. In particular, United States government
officials have criticized countries such as China and Brazil for inadequate
intellectual property protection. If our intellectual property is infringed in
any country without a high level of intellectual property protection, our
business could be harmed.

                                       19
<PAGE>

  We generally enter into confidentiality or license agreements with our
employees, consultants and corporate partners, and generally control access to
and distribution of our technologies, documentation and other proprietary
information. Despite our efforts to protect our proprietary rights from
unauthorized use or disclosure, parties may attempt to disclose, obtain or use
our solutions or technologies. The steps we have taken may not prevent
misappropriation of our solutions or technologies, particularly in foreign
countries where laws or law enforcement practices may not protect our
proprietary rights as fully as in the United States.

  We have licensed, and we may license in the future, certain proprietary rights
to third parties. While we attempt to ensure that the quality of our brand is
maintained by our business partners, they may take actions that could impair the
value of our proprietary rights or our reputation. In addition, these business
partners may not take the same steps we have taken to prevent misappropriation
of our solutions or technologies.

We Face and Might Face Intellectual Property Infringement Claims that Might Be
Costly to Resolve

  From time to time, we receive letters from corporations and other entities
suggesting that we review patents to which they claim rights or claiming that we
infringe on their patent rights. Such claims may result in our being involved in
litigation. Although we do not believe we infringe the proprietary rights of any
party, we cannot assure you that parties will not assert additional claims in
the future or that any claims will not be successful. We could incur substantial
costs and diversion of management resources to defend any claims relating to
proprietary rights, which could harm our business. In addition, we are obligated
under certain agreements to indemnify the other party for claims that we
infringe on the proprietary rights of third parties. If we are required to
indemnify parties under these agreements, our business could be harmed. If
someone asserts a claim against us relating to proprietary technology or
information, we might seek licenses to this intellectual property. We might not
be able to obtain licenses on commercially reasonable terms, or at all. The
failure to obtain the necessary licenses or other rights might harm our
business. See "Other Information--Legal Proceedings."

Companies Might Not Develop or Consumers Might Not Adopt Devices That Will Play
Digitally Downloaded Music

  We believe that the market for digitally recorded music delivered over the
Internet will not develop significantly until consumers are able to enjoy this
music other than solely through the use of a personal computer. Several consumer
electronics companies have introduced or announced plans to introduce devices
that will allow digital music delivered over the Internet to be played away from
the personal computer. If companies fail to introduce additional devices,
consumers do not adopt these devices or our products and services are
incompatible with these devices, our business would be harmed. In addition,
digital music can be transferred to a compact disc, but that transfer requires a
compact disc recorder (CD-R). Many desktop computer manufacturers offer CD-Rs in
their computers. If companies do not continue to offer CD-Rs in their computers,
consumers do not adopt CD-Rs or our products and services are incompatible with
CD-Rs, our business might be harmed.

If We Do Not Increase the Number of Websites that Use Our Platform, Our Business
Will Not Grow

  In order to grow our business, we need to increase the number of websites,
including websites operated by music retailers, that use our technology and our
syndicated content to digitally deliver recorded music. To increase the number
of websites, we must do the following:

  .  offer competitive products and services that meet industry standards;

  .  attract more music content;

  .  make it easy and cost-effective for music-related websites to sell digital
     music;

  .  develop relationships with online retailers, music websites, online
     communities, broadband providers and Internet broadcasters; and

  .  develop relationships with international music websites, retailers and
     broadband providers.

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<PAGE>

  Any failure to achieve one or more of these objectives would harm our
business. We may not be successful in achieving any of these objectives.

If Artists and Record Labels Are Not Satisfied that They Can Securely, Digitally
Deliver Their Music Over the Internet, We Might Not Have Sufficient Content to
Attract Consumers

  Our success depends on our ability to aggregate a sufficient amount and
variety of digital recorded music for syndication. In particular, until a
significant number of artists and their record labels adopt a strategy of
digitally delivering music over the Internet, the growth of our business might
be limited. We currently do not create our own content; rather, we rely on
record companies and artists for digital recorded music to be syndicated using
our format. We believe record companies will remain reluctant to distribute
their recorded music digitally unless they are satisfied that the digital
delivery of their music over the Internet will not result in the unauthorized
copying and distribution of that music. If record companies do not believe that
recorded music can be securely delivered over the Internet, they will not allow
the digital distribution of their recorded music and we might not have
sufficient content to attract consumers. If we cannot offer a sufficient amount
and variety of digital recorded music for syndication, our business might be
harmed.

Due to the Many Factors that Influence Market Acceptance, Consumers Might Not
Accept Our Platform

  Our success will depend on growth in consumer acceptance of our platform as a
method for digital delivery of recorded music over the Internet. Factors that
might influence market acceptance of our platform include the following, over
which we have little or no control:

  .  the availability of sufficient bandwidth on the Internet to enable
     consumers to download digital recorded music rapidly and easily;

  .  the willingness of consumers to invest in computer technology that
     facilitates the downloading of digital music;

  .  the cost of time-based Internet access;

  .  the number, quality and variety of digital recordings available for
     purchase through our system relative to those available through other
     online digital delivery companies, digital music websites, music swapping
     or sharing websites or through traditional physical delivery of recordings;

  .  the availability of portable devices to which digital recorded music can be
     transferred;

  .  the fidelity and quality of the sound of the digital recorded music; and

  .  the level of consumer comfort with the process of downloading and paying
     for digital music over the Internet, including ease of use and lack of
     concern about transaction security.

The Market for Digital Delivery of Music Over the Internet is Highly
Competitive, and if We Cannot Compete Effectively, Our Ability to Generate
Meaningful Revenues Would Suffer Dramatically

  Competition among companies in the business of digital delivery of music over
the Internet is intense. If we do not compete effectively or if we experience
pricing pressures, reduced margins or loss of market share resulting from
increased competition, our business might be harmed.

  Competition is likely to increase as new companies enter the market and
current competitors expand their products and services or merge with other
competitors. Many of these potential competitors are likely to enjoy substantial
competitive advantages, including the following:

  .  larger audiences;

  .  larger technical, production and editorial staffs;

                                       21
<PAGE>

  .  greater brand recognition;

  .  access to more recorded music content;

  .  a more established Internet presence;

  .  a larger advertiser base; and

  .  substantially greater financial, marketing, technical and other resources.


New Competitors Could Enter the Industry with Alternative Business Models,
Which, if Successful, Could Harm Our Business

  New companies may enter our market with alternative business models. For
example, companies may provide free music downloading from a website, earning
revenues on an advertising or subscription basis. This model could be more
attractive to consumers. If we are unable to compete with such companies or
adapt our business model, products or services to a more consumer-favorable
model, our business could be harmed.

If Our Platform Does Not Provide Sufficient Rights Reporting Information, Record
Companies and Artists Are Unlikely to Digitally Deliver Their Recorded Music
Using Our Platform

  Record companies and artists must be able to track the number of times their
recorded music is downloaded so that they can make appropriate payments to music
rights organizations, such as the American Society of Composers, Authors and
Publishers, Broadcast Music Incorporated and SESAC, Inc. If our products and
services do not accurately or completely provide this rights reporting
information, record companies and artists might not use our platform to
digitally deliver their recorded music, and our business might be harmed.

Our Business Might Be Harmed if We Fail to Price Our Products and Services
Appropriately

  The price of Internet products and services is subject to rapid and frequent
change. We may be forced, for competitive or technical reasons, to reduce or
eliminate prices for certain of our products or services. If this happens, our
business might be harmed.

Our Business Might Be Harmed if Challenges Against Intellectual Property Laws by
New Digital Music Delivery Technologies Are Successful

  New music sharing technologies allowing users to locate and download copies of
digital music stored on the hard drives of other users without payment have been
introduced into the market. Because some digital recorded music formats, such as
MP3, do not contain mechanisms for tracking the source of ownership of digital
recordings, users are able to download copies of copyrighted recorded music over
the Internet without being required to compensate the owners of these
copyrights. These downloads are a significant concern to record companies and
artists. The Recording Industry Association of America has filed a suit seeking
a permanent injunction against the use of these file-sharing technologies for
exchange of copyrighted works. Several recording artists have also taken action
against companies providing music sharing technology. If the injunction is
denied, and it is determined that this file sharing technology is non-
infringing, record companies and artists may limit their use of the Internet to
sell and distribute their copyrighted materials. Even if the technology is
determined to be infringing, it may be difficult to prevent this type of file
sharing because of the non-centralized character of these technologies. As long
as free shared copies are available, legally or illegally, consumers may choose
not to pay for downloads from retail and other music delivery sites in our
Liquid Music Network, which could harm our business.

We Might Not Be Able to Scale Our Technology Infrastructure to Meet Demand for
Our Products and Services

  Our success will depend on our ability to scale our technology infrastructure
to meet the demand for our products and services. Adding this new capacity will
be expensive, and we might not be able to do so successfully. In

                                       22
<PAGE>

addition, we might not be able to protect our new or existing data centers from
unexpected events as we scale our systems. To the extent that we do not address
any capacity constraints effectively, our business would be harmed.

We Might Not Be Successful in Our Attempts to Keep Up With Rapid Technological
Change and Evolving Industry Standards

  The markets for our products and services are characterized by rapidly
changing technology, evolving industry standards, changes in customer needs,
emerging competition, and frequent new product and service introductions. Our
future success will depend, in part, on our ability to:

  .  use leading technologies effectively;

  .  continue to develop our strategic and technical expertise;

  .  enhance our current products and services;

  .  develop new products and services that meet changing customer needs;

  .  advertise and market our products and services; and

  .  influence and respond to emerging industry standards and other
     technological changes.

  This must be accomplished in a timely and cost-effective manner. We may not be
successful in effectively using new technologies, developing new products or
services or enhancing our existing products or services on a timely basis. These
new technologies or enhancements may not achieve market acceptance. Our pursuit
of necessary technological advances may require substantial time and expense.
Finally, we may not succeed in adapting our services to new technologies as they
emerge.

We Might Not Be Successful in the Development and Introduction of New Products
and Services

  We depend in part on our ability to develop new or enhanced products and
services in a timely manner and to provide new products and services that
achieve rapid and broad market acceptance. We may fail to identify new product
and service opportunities successfully and develop and bring to market new
products and services in a timely manner. In addition, product innovations may
not achieve the market penetration or price stability necessary for
profitability.

  As the online medium continues to evolve, we plan to leverage our technology
by introducing complementary products and services as additional sources of
revenue. Accordingly, we may change our business model to take advantage of new
business opportunities, including business areas in which we do not have
extensive experience. For example, we will continue to devote significant
resources to the development of digital music delivery services, as well as our
software licensing business. If we fail to develop these or other businesses
successfully, our business would be harmed.

We Might Experience Delays in the Development of New Products and Services

  We must continue to innovate and develop new versions of our software to
remain competitive in the market for digital delivery of recorded music
solutions. Our software products and services development efforts are inherently
difficult to manage and keep on schedule. Our failure to manage and keep those
development projects on schedule might harm our business.

Our Products and Services Might Contain Errors

  We offer complex products and services. They may contain undetected errors
when first introduced or when new versions are released. If we market products
and services that have errors or that do not function properly, then we may
experience negative publicity, loss of or delay in market acceptance, or claims
against us by customers, any of which might harm our business.

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<PAGE>

We Might Have Liability for the Content of the Recorded Music That We Digitally
Deliver

  Because we digitally deliver recorded music to third parties, we might be sued
for negligence, copyright or trademark infringement or other reasons. These
types of claims have been brought, sometimes successfully, against providers of
online products and services in the past. Others could also sue us for the
content that is accessible from our website through links to other websites.
These claims might include, among others, claims that by hosting, directly or
indirectly, the websites of third parties, we are liable for copyright or
trademark infringement or other wrongful actions by these third parties through
these websites. Our insurance may not adequately protect us against these types
of claims and, even if these claims do not result in liability, we could incur
significant costs in investigating and defending against these claims.

  We have taken steps to prevent these claims. For example, we have arrangements
with companies that use our hosting services that will allow us to delete
potentially infringing or misappropriating materials quickly and securely. We
also have put into place indemnification agreements with music content
providers, where practicable. Under the Digital Millenium Copyright Act of 1999,
Internet service providers are insulated from several types of these claims,
upon compliance with the requirement that they appoint an agent to receive
claims relating to their service, and we have appointed an agent.

System Failures or Delays Might Harm Our Business

  Our operations depend on our ability to protect our computer systems against
damage from fire, water, power loss, telecommunications failures, computer
viruses, vandalism and other malicious acts, and similar unexpected adverse
events. Our corporate headquarters are located in northern California.
California is currently experiencing power outages due to a shortage in the
supply of power within the state. Although we maintain a comprehensive disaster
recovery plan, if the power outages increase in severity, they could disrupt our
operations. Interruptions or slowdowns in our services have resulted from the
failure of our telecommunications providers to supply the necessary data
communications capacity in the time frame we required, as well as from
deliberate acts. Despite precautions we have taken, unanticipated problems
affecting our systems could in the future cause temporary interruptions or
delays in the services we provide. Our customers might become dissatisfied by
any system failure or delay that interrupts our ability to provide service to
them or slows our response time. Sustained or repeated system failures or delays
would affect our reputation, which would harm our business. Slow response time
or system failures could also result from straining the capacity of our software
or hardware due to an increase in the volume of products and services delivered
through our servers. While we carry business interruption insurance, it might
not be sufficient to cover any serious or prolonged emergencies, and our
business might be harmed.

We Might Be Unable to License or Acquire Technology

  We rely on certain technologies that we license or acquire from third parties,
including Dolby Laboratories Licensing Corporation, Fraunhofer Institut, RSA
Data Security, Inc. and Thomson Consumer Electronics Sales GmbH. These
technologies are integrated with our internally developed software and used in
our products, to perform key functions and to enhance the value of our platform.
These third-party licenses or acquisitions may not continue to be available to
us on commercially reasonable terms or at all. Any inability to acquire these
licenses or software on commercially reasonable terms might harm our business.

Difficulties Presented by International Economic, Political, Legal, Accounting
and Business Factors Could Harm Our Business in International Markets

  A key component of our strategy is to expand into international markets. The
following risks are inherent in doing business on an international level and we
have little or no control over them:

  .  unexpected changes in regulatory requirements;

  .  export restrictions;

  .  export controls relating to encryption technology;

                                       24
<PAGE>

  .  longer payment cycles;

  .  problems in collecting accounts receivable;

  .  political and economic instability; and

  .  potentially adverse tax consequences.

  In addition, other factors that may also affect us and over which we have some
control include the following:

  .  difficulties in staffing and managing international operations;

  .  differences in music rights reporting structures; and

  .  seasonal reductions in business activity.

  We have entered into individual agreements in Japan, Korea, greater China and
south east Asia, and we may enter into similar arrangements in the future in
other countries. We also established a wholly-owned subsidiary in the United
Kingdom. One or more of the factors listed above may harm our present or future
international operations and, consequently, our business.

Our Management and Internal Systems Might Be Inadequate to Handle the Potential
Growth of Our Personnel

  To manage future growth, our management must continue to improve our
operational and financial systems and expand, train, retain and manage our
employee base. Our management may not be able to manage our growth effectively.
If our systems, procedures and controls are inadequate to support our
operations, our expansion would be halted and we could lose our opportunity to
gain significant market share. Any inability to manage growth effectively may
harm our business.


                         Risks Related to Our Industry

Internet Security Concerns Could Hinder E-Commerce

  A significant barrier to e-commerce and communications over the Internet has
been the need for secure transmission of confidential information. Internet
usage may not increase at the rate we expect unless some of those concerns are
adequately addressed and found acceptable by the market. Internet usage could
also decline if any well-publicized compromise of security occurs. We may incur
significant costs to protect against the threat of security breaches or to
alleviate problems caused by these breaches. Protections may not be available at
a reasonable price or at all. If a third person were able to misappropriate a
user's personal information, users could bring claims against us.

Imposition of Sales and Other Taxes On E-Commerce Transactions Might Hinder E-
Commerce

  We do not collect sales and other taxes when we sell our products and services
over the Internet. State or local governments may seek to impose sales tax
collection obligations on out-of-state companies, such as ours, which engage in
or facilitate e-commerce. A number of proposals have been made at the state and
local level that would impose additional taxes on the sale of products and
services through the Internet. These proposals, if adopted, could substantially
impair the growth of e-commerce and could reduce our opportunity to derive
profits from e-commerce. Moreover, if any state or local government or foreign
country were to successfully assert that we should collect sales or other taxes
on the exchange of products and services on our system, our business might be
harmed.

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<PAGE>

  In 1998, Congress passed the Internet Freedom Act, which imposes a three-year
moratorium on state and local taxes on Internet-based transactions. We cannot
assure you that this moratorium will be extended. Failure to renew this
moratorium would allow various states to impose taxes on e-commerce, which might
harm our business.

Demand for Our Products and Services Might Decrease if Growth in the Use of the
Internet Declines

  Our future success substantially depends upon the continued growth in the use
of the Internet. The number of users on the Internet may not increase and
commerce over the Internet may not become more accepted and widespread for a
number of reasons, including the following, over which we have little or no
control:

  .  actual or perceived lack of security of information, such as credit card
     numbers;

  .  lack of access and ease of use;

  .  inconsistent quality of service and lack of availability of cost-effective,
     high speed service;

  .  possible outages due to damage to the Internet;

  .  excessive governmental regulation; and

  .  uncertainty regarding intellectual property rights.

  If the necessary infrastructure, products, services or facilities are not
developed, or if the Internet does not grow as a commercial medium, our business
would be harmed.

Government Regulation of the Internet Might Harm Our Business

  The applicability to the Internet of existing laws governing issues such as
property ownership, libel and personal privacy is uncertain. In addition,
governmental authorities may seek to further regulate the Internet with respect
to issues such as user privacy, pornography, acceptable content, e-commerce,
taxation, and the pricing, characteristics and quality of products and services.
Finally, the global nature of the Internet could subject us to the laws of a
foreign jurisdiction in an unpredictable manner. Any new legislation regulating
the Internet could inhibit the growth of the Internet and decrease the
acceptance of the Internet as a communications and commercial medium, which
might harm our business.

  In addition, the growing use of the Internet has burdened the existing
telecommunications infrastructure and has caused interruptions in telephone
service. Telephone carriers have petitioned the government to regulate the
Internet and impose usage fees on Internet service providers. Any regulations of
this type could increase the costs of using the Internet and impede its growth,
which could in turn decrease the demand for our services or otherwise harm our
business.


ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

  See "Market Risk" in Part I, Item 2, Management's Discussion and Analysis of
Financial Condition and Results of Operations.

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<PAGE>

                          PART II.  OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

  In February 2000, Sightsound, Inc. notified one of our customers that it
intended to add the customer as a party to a pending patent litigation in the
United States District Court for the Eastern District of Pennsylvania
(Pittsburgh).  The litigation alleges infringement of unspecified claims of
three patents (United States Patent Nos. 5,191,573; 5,675,734 and 5,996,440).
Damages have not been specified. Our customer has agreed to be added to the
case, subject to a revision in the trial schedule. Our customer has requested
indemnification, including defense costs, from us, based upon the terms of our
contract with them. Based on this request, we are negotiating an agreement with
our customer under which we would (i) assume control of the defense, (ii) pay
the expenses of the defense and (iii) reserve certain rights as to
indemnification. During negotiation of this agreement we have agreed to assume
the costs of the defense for our customer. These costs could be significant.
There is no assurance that we will enter into this agreement. If we do not reach
an agreement with our customer and the defense is not successful, our customer
might seek full indemnification from us for the damages, if any. There can be no
assurance regarding the outcome of the litigation. If there is a finding of
infringement, we may be required to indemnify our customer as to the full amount
of the damages.

  On March 31, 2000, Intouch Group, Inc. (Intouch) filed a lawsuit against us in
the Northern District of California alleging patent infringement. On April 26,
2000, Intouch filed an amended complaint, which was served on us shortly
thereafter. The complaint names us and Amazon.com International, Inc.,
Listen.com, Inc., Entertaindom LLC, Discovermusic.com, Inc. and Muze, Inc. It
alleges that we infringe or induce infringement of, the claims of United States
Patent Nos. 5,237,157 and 5,963,916 by operating a website and/or a kiosk that
allows interactive previewing of portions of pre-recorded music products. The
complaint seeks unspecified damages and injunctive relief. On May 30, 2000, we
filed our answer to Intouch's first amended complaint. The action is currently
in discovery, and the trial date has been set for January 11, 2002. We believe
that we have meritorious defenses to Intouch's claims and we intend to
vigorously defend against such claims. However, we cannot assure you that we
will be successful in defending these lawsuits. If there is a finding of
infringement, we might be required to pay substantial damages to Intouch and
could be enjoined from selling any of our products or services that are held to
infringe Intouch's patents unless and until we are able to negotiate a license
from them.

  On August 14, 2000, a former employee filed a charge of discrimination with
the California Department of Fair Employment and Housing against us, and several
of our employees and former employees. The charge alleges sexual harassment and
unlawful retaliation. While we believed the charge was without merit, we reached
an out-of-court settlement in April 2001 with the former employee whereby we
agreed to pay her $40,000.

   From time to time we receive letters from corporations or other business
entities notifying us of alleged infringement of patents held by them or
suggesting that we review patents to which they claim rights. These corporations
or entities often indicate a willingness to discuss licenses to their patent
rights.


ITEM 2.  CHANGES IN SECURITIES AND USE OF PROCEEDS

  The effective date of our first registration statement, filed on Form S-1
under the Securities Act of 1933 (No. 333-82521) relating to our initial public
offering of common stock, was July 8, 1999. A total of 4,800,000 shares of
common stock were sold at a price of $15.00 per share to an underwriting
syndicate led by Lehman Brothers Inc., BancBoston Robertson Stephens Inc. and
U.S. Bancorp Piper Jaffray Inc. Offering proceeds, net of aggregate expenses of
approximately $6.1 million, were approximately $65.9 million.

  The effective date of our second registration statement, filed on Form S-1
under the Securities Act of 1933 (No. 333-91541) relating to our follow-on
public offering of common stock, was December 14, 1999. A total of 2,946,076
shares of Common Stock were sold at a price of $33.63 per share to an
underwriting syndicate led by Lehman Brothers, BancBoston Robertson Stephens
Inc., U.S. Bancorp Piper Jaffray, Dain Rauscher Wessells and Fidelity Capital
Markets. An additional 503,924 shares of Common stock were sold on behalf of
selling stockholders as part of the same offering. Offering proceeds to us, net
of aggregate expenses of approximately $5.4 million, were

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<PAGE>

approximately $93.7 million. Offering proceeds to selling shareholders, net of
expenses of approximately $847,000, were approximately $16.1 million.

  From the time of receipt through March 31, 2001, our proceeds were applied
toward general corporate purposes, including the purchase of temporary
investments consisting of cash, cash equivalents and short-term investments,
working capital and capital expenditures, enhancing research and development and
attracting key personnel.


ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

  (a)  Exhibits

  None.

   (b)  Reports on Form 8-K

  None.

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<PAGE>

                              LIQUID AUDIO, INC.

                                  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 the
undersigned thereunto duly authorized.


DATE:    May 15, 2001         LIQUID AUDIO, INC.


                              /s/ Gerald W. Kearby
                              -------------------------------------------------
                              GERALD W. KEARBY
                              President, Chief Executive Officer and Director
                              (Principal Executive Officer)


                              /s/ Michael R. Bolcerek
                              -------------------------------------------------
                              MICHAEL R. BOLCEREK
                              Senior Vice President and Chief Financial Officer
                              (Principal Financial and Accounting Officer)

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