<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 SEPTEMBER 30, 1999

                                       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: _________________

                               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.)


810 Winslow Street, 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 October 31, 1999, there were 18,876,723 shares of registrant's Common
Stock outstanding.

                                       1
<PAGE>

                               LIQUID AUDIO, INC.

                                     INDEX
<TABLE>
<CAPTION>

<C>      <S>                                                                                            <C>
PART I. FINANCIAL INFORMATION..........................................................................   3


 Item 1.  Financial Statements.........................................................................   3
            Condensed Balance Sheet as of September 30, 1999 and December 31, 1998
            Condensed Statement of Operations for the three months ended September 30, 1999 and 1998,
                   and for the nine months ended September 30, 1999 and 1998
            Condensed Statement of Cash Flows for the nine months ended September 30, 1999 and 1998
            Notes To Condensed Financial Statements
 Item 2.  Management's Discussion and Analysis of Financial Condition and
                  Results of Operations................................................................  11
 Item 3.  Quantitative and Qualitative Disclosures About Market Risk...................................  33

PART II. OTHER INFORMATION.............................................................................  34

 Item 1. Legal Proceedings.............................................................................  34
 Item 2. Changes in Securities and Use of Proceeds.....................................................  34
 Item 3. Defaults Upon Senior Securities...............................................................  34
 Item 4. Submission of Matters to a Vote of Security Holders...........................................  34
 Item 5. Other Information.............................................................................  34
 Item 6. Exhibits and Reports on Form 8-K..............................................................  34

SIGNATURES.............................................................................................  35

INDEX TO EXHIBITS FOR FORM 10-Q........................................................................  36
 </TABLE>

                                       2
<PAGE>

PART I.  FINANCIAL INFORMATION

 Item 1. Financial Statements

                               Liquid Audio, Inc.
                            Condensed Balance Sheet
                  (in thousands, except share data; unaudited)

<TABLE>
<CAPTION>
                                                                                           September 30,         December 31,
                                                                                                1999                 1998
                                                                                         ---------------      ----------------
<S>                                                                                        <C>                  <C>
Assets
Current assets:

  Cash and cash equivalents..........................................................           $ 62,913              $ 14,143
  Short-term investments.............................................................              7,603                 3,001
  Accounts receivable, net...........................................................                183                   376
  Receivables from strategic related partners........................................                942                   615
  Other current assets...............................................................                917                   314
                                                                                           -------------        --------------
     Total current assets............................................................             72,558                18,449
                                                                                           -------------        --------------
Property and equipment, net..........................................................              4,320                 1,507
Other assets.........................................................................                117                    70
                                                                                           -------------        --------------
       Total assets..................................................................           $ 76,995              $ 20,026
                                                                                           =============        ==============
Liabilities, mandatorily redeemable convertible
preferred stock and warrants and stockholders'
equity (deficit)
Current liabilities:
  Accounts payable...................................................................           $  2,177              $    802
  Accrued expenses and other current
  liabilities........................................................................              2,361                   932
  Deferred revenue...................................................................              1,191                 1,177
  Capital lease obligations, current
  portion............................................................................                185                   197
  Equipment loan, current portion....................................................                589                   281
                                                                                           -------------        --------------
     Total current liabilities.......................................................              6,503                 3,389
                                                                                           -------------        --------------
Capital lease obligations, non-current
portion..............................................................................                231                   330
Equipment loan, non-current portion..................................................                879                   639
Note payable to strategic related partner............................................                425                    --
                                                                                           -------------        --------------
       Total liabilities.............................................................              8,038                 4,358
                                                                                           -------------        --------------
Series A, B and C mandatorily redeemable convertible
  preferred stock and warrants.......................................................                --                 29,801
                                                                                           -------------        --------------

Stockholders' equity (deficit):
  Common stock.......................................................................                 19                     4
  Additional paid-in capital.........................................................            102,362                 3,917
  Unearned compensation..............................................................             (1,371)               (2,035)
  Accumulated deficit................................................................            (32,053)              (16,019)
                                                                                           -------------        --------------
       Total stockholders' equity (deficit)..........................................             68,957               (14,133)
       Total liabilities, mandatorily redeemable convertible
          preferred stock and warrants and stockholders'.............................      -------------        --------------
          equity (deficit)...........................................................           $ 76,995              $ 20,026
                                                                                           =============        ==============

</TABLE>
           See accompanying notes to condensed financial statements

                                       3
<PAGE>

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

<TABLE>
<CAPTION>
                                                           Three Months Ended                          Nine Months Ended
                                                               September 30,                              September 30,
                                                  -------------------------------------      -------------------------------------
                                                        1999                  1998                 1999                  1998
                                                  ---------------      ----------------      ---------------      ----------------
<S>                                               <C>                  <C>                   <C>                  <C>
Net revenues:
 License......................................          $   476               $   374             $  1,129              $    808
 Services.....................................              177                   104                  367                   169
 Business development - strategic related
   partners...................................            1,132                   525                1,565                   750
                                                  -------------        --------------        -------------        --------------
       Total net revenues.....................            1,785                 1,003                3,061                 1,727
                                                  -------------        --------------        -------------        --------------
Cost of net revenues:
 License......................................               58                    63                  156                   175
 Services.....................................              324                    70                  649                   170
 Business development - strategic related
   partners...................................               66                    --                   68                    --
                                                  -------------        --------------        -------------        --------------
       Total cost of net revenues.............              448                   133                  873                   345
                                                  -------------        --------------        -------------        --------------
Gross profit..................................            1,337                   870                2,188                 1,382
Operating expenses:
 Sales and marketing..........................            2,533                   887                6,449                 2,676
 Research and development.....................            3,449                 1,028                7,710                 2,666
 General and administrative...................              741                   548                1,741                 1,155
 Strategic marketing--equity instruments......              826                    --                2,190                    --
 Stock compensation expense...................              330                   339                1,119                   882
                                                  -------------        --------------        -------------        --------------
       Total operating expenses...............            7,879                 2,802               19,209                 7,379
                                                  -------------        --------------        -------------        --------------
Loss from operations                                     (6,542)               (1,932)             (17,021)               (5,997)
Interest and other income, net................              722                   104                  986                    51
                                                  -------------        --------------        -------------        --------------
 Net loss.....................................          $(5,820)              $(1,828)            $(16,035)             $ (5,946)
                                                  =============        ==============        =============        ==============

Net loss per share:
 Basic and diluted............................           $(0.35)               $(0.74)              $(2.07)               $(2.67)
                                                  =============        ==============        =============        ==============
 Weighted average shares......................           16,821                 2,457                7,755                 2,227
                                                  =============        ==============        =============        ==============

</TABLE>

                                       4
<PAGE>

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

<TABLE>
<CAPTION>
                                                                               Nine Months Ended September 30,
                                                                          -------------------------------------
                                                                                     1999                  1998
                                                                          ---------------      ----------------
<S>                                                                        <C>                  <C>
Cash flows from operating activities:
  Net loss.............................................................          $(16,035)             $ (5,946)
  Adjustments to reconcile net loss to net cash used in operating
     activities:
     Depreciation and amortization.....................................               646                   262
     Amortization of unearned compensation.............................             1,119                   882
     Allowance for doubtful accounts...................................                33                   180
     Equity investment losses..........................................               378                    --
     Strategic marketing-equity instruments............................             2,190                    --
     Other.............................................................                49                    --
     Changes in assets and liabilities:
       Accounts receivable.............................................               160                  (278)
       Receivables from strategic related partners.....................              (327)                  (57)
       Other assets....................................................              (650)                 (197)
       Accounts payable................................................             1,375                   (60)
       Accrued expenses and other current liabilities..................             1,429                   291
       Deferred revenue................................................                14                   684
                                                                            -------------        --------------
       Net cash used in operating activities...........................            (9,619)               (4,239)
                                                                            -------------        --------------
Cash flows from investing activities:
  Acquisition of property and equipment................................            (3,422)                 (480)
  Sale of short-term investments.......................................            (4,602)               (1,005)
                                                                            -------------        --------------
       Net cash used in investing activities...........................            (8,024)               (1,485)
                                                                            -------------        --------------
Cash flows from financing activities:
  Proceeds from issuance of common stock...............................            66,013                     4
  Proceeds from issuance of mandatorily redeemable convertible
     preferred stock...................................................                --                21,554
  Payments made under capital leases...................................              (148)                  (76)
  Proceeds from equipment loan.........................................               846                    --
  Payments made under equipment loan...................................              (298)                   --
  Payments made under line of credit...................................                --                  (400)
  Proceeds from short-term loan........................................                --                 1,160
  Payments on short-term loan..........................................                --                (1,160)
                                                                            -------------        --------------
       Net cash provided by financing activities.......................            66,413                21,082
                                                                            -------------        --------------
Net increase in cash and cash equivalents..............................            48,770                15,358
Cash and cash equivalents at beginning of period.......................            14,143                 2,387
                                                                            -------------        --------------
Cash and cash equivalents at end of period.............................          $ 62,913              $ 17,745
                                                                            =============        ==============
Supplemental disclosures:
  Cash paid for interest...............................................          $    138              $    101
Non-cash investing and financing activities:
  Acquisition of property and equipment through capital leases.........          $     37              $    177
  Issuance of common stock to strategic partner........................          $  1,100              $  --
  Issuance of warrants to strategic partners...........................          $  1,090              $  --
  Equity investment with note payable..................................          $    378              $  --
</TABLE>

           See accompanying notes to condensed financial statements

                                       5
<PAGE>

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


NOTE 1 - THE COMPANY AND BASIS OF PRESENTATION:

   Liquid Audio, Inc. (the "Company") was incorporated in California in January
1996 and reincorporated in Delaware in April 1999 with the goal of becoming the
premier provider of software applications and services that enable the secure
delivery, promotion and sale of digital music over the Internet through online
retailers and music web sites.  To this end, the Company has developed an end-
to-end solution for promoting and distributing music over the Internet.  The
Company's solutions enable the secure distribution of high quality music files
while providing consumers with the ability to access, preview and purchase that
music via the Internet.

   In July 1999, the Company completed its initial public offering of common
stock.  A total of 4,800,000 shares were sold at $15.00 per share.  Net proceeds
to the Company, after deducting the underwriting discount and offering expenses,
were $65.9 million.

   The accompanying unaudited condensed financial statements have been prepared
in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Regulation S-X.
Accordingly, they do not include all of the information and footnotes required
by generally accepted accounting principles for complete financial statements.
In the opinion of management, all adjustments (consisting of normal recurring
adjustments) considered necessary for a fair presentation have been included.

   Certain reclassifications have been made to the prior periods' financial
statements to conform to the current period presentation.

NOTE 2 - BALANCE SHEET COMPONENTS (in thousands):

<TABLE>
<CAPTION>
                                                                       September 30,              December 31,
                                                                           1999                       1998
                                                                 ----------------------     ---------------------
<S>                                                              <C>                        <C>
Accounts receivable, net:
Accounts receivable............................................                 $ 339                     $ 607
Less: Allowance for doubtful accounts..........................                  (156)                     (231)
                                                                                -----                     -----
                                                                                $ 183                     $ 376
                                                                                =====                     =====
</TABLE>

   Write-offs against the allowance for doubtful accounts were $108,000 and
$34,000 for the nine months ended September 30, 1999 and the year ended December
31, 1998, respectively.

                                       6
<PAGE>

<TABLE>
<CAPTION>
                                                                       September 30,               December 31,
                                                                           1999                        1998
                                                                  ----------------------      ---------------------
<S>                                                               <C>                         <C>
Property and equipment:
   Computer equipment and purchased software....................               $ 4,673                     $1,460
   Furniture and fixtures.......................................                   488                        324
   Leasehold improvements.......................................                   411                        329
                                                                               -------                     ------
                                                                                 5,572                      2,113
   Less:  accumulated depreciation and amortization.............                (1,252)                      (606)
                                                                               -------                     ------
                                                                               $ 4,320                     $1,507
                                                                               =======                     ======
</TABLE>

   Property and equipment includes $766,000 and $729,000 of equipment under
capital leases at September 30, 1999 and December 31, 1998, respectively.
Accumulated depreciation and amortization for equipment under capital leases was
$544,000 and $352,000 at September 30, 1999 and December 31, 1998, respectively.

<TABLE>
<CAPTION>
                                                                September 30,                 December 31,
                                                                    1999                          1998
                                                             ----------------------     ----------------------
<S>                                                            <C>                        <C>
Accrued expenses and other current liabilities:
  Compensation and benefits..................................                $  975                      $ 345
  Consulting and professional services.......................                   449                        147
  Accrued marketing expenses.................................                   389                        162
  Other......................................................                   548                        278
                                                                             ------                      -----
                                                                             $2,361                      $ 932
                                                                             ======                      =====
</TABLE>

NOTE 3 - STRATEGIC RELATED PARTNERS:

   In April 1998, the Company signed an agreement with a 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.
The Company owns 18% of the outstanding common stock of LAJ and is accounting
for its investment in LAJ using the equity method of accounting.  In December
1998, the company signed an agreement with another strategic partner to
establish a Korean corporation, Liquid Audio Korea ("LAK"), to develop a local
business to enable the digital delivery of music to customers in Korea using the
Company's technology and products.  The Company owns 40% of the outstanding
common stock of LAK and is accounting for its investment in LAK using the equity
method of accounting.  In September 1999, the Company signed a letter of intent
with a strategic partner to form another Asian corporation to develop a local
business to enable the digital delivery of music to customers in Taiwan and Hong
Kong.  This letter of intent expires in December 1999.

   Business development revenues are as follows (in thousands):

<TABLE>
<CAPTION>
                                                                      Three Months Ended                    Nine Months Ended
                                                                         September 30,                        September 30,
                                                             ---------------------------------     --------------------------------
                                                                    1999               1998              1999               1998
                                                              --------------     --------------     -------------     --------------
 <S>                                                            <C>                <C>                <C>               <C>
Business development revenues:
  Consulting and other services.............................         $  910              $ 525            $1,243              $ 750
  License fees and other....................................            222                 --               322                 --
                                                                     ------              -----            ------              -----
                                                                     $1,132              $ 525            $1,565              $ 750
                                                                     ======              =====            ======              =====
</TABLE>

                                       7
<PAGE>

   At September 30, 1999, fees received in advan of recognition as business
development revenues were $555,000 and are classified as deferred revenue on the
balance sheet.  Of this amount, $417,000 will be recognized ratably as revenue
over the five months ending February 28, 2000.  The remaining balance represents
a deposit on future deliveries of products.

NOTE 4 - NET LOSS PER SHARE:

   The Company computes net loss per share in accordance with Statement of
Financial Accounting Standards No. 128, "Earnings per Share" ("SFAS No. 128")
and SEC Staff Accounting Bulletin No. 98 ("SAB No. 98").  Under the provisions
of SFAS No. 128 and SAB No. 98, 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, shares issuable upon conversion of the Series A, Series B and
Series C mandatorily redeemable convertible preferred stock and common shares
issuable upon the exercise of common and mandatorily redeemable convertible
preferred 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                         Nine Months Ended
                                                               September 30,                              September 30,
                                                  -------------------------------------      -------------------------------------
                                                         1999                 1998                  1999                 1998
                                                  ---------------      ----------------      ---------------      ----------------
<S>                                                 <C>                  <C>                   <C>                  <C>
Numerator:
  Net loss...................................             $(5,820)              $(1,828)            $(16,035)              $(5,946)
                                                          =======               =======             ========               =======
Denominator:
  Weighted average shares....................              17,396                 4,013                8,469                 3,923
  Weighted average unvested   common shares
   subject to   repurchase...................                (575)               (1,556)                (714)               (1,696)
                                                          -------               -------             --------               -------
  Denominator for basic and diluted
  calculation................................              16,821                 2,457                7,755                 2,227
                                                          =======               =======             ========               =======
Net loss per share:
  Basic and diluted..........................             $ (0.35)              $ (0.74)            $  (2.07)              $ (2.67)
                                                          =======               =======             ========               =======
</TABLE>

                                       8
<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>
                                                                                  September 30,
                                                                        --------------------------------
                                                                              1999              1998
                                                                        --------------    --------------
<S>                                                                       <C>               <C>
Series A mandatorily redeemable convertible preferred stock.........                --             3,050
Series B mandatorily redeemable convertible preferred stock.........                --             3,187
Series C mandatorily redeemable convertible preferred stock.........                --             3,507
Mandatorily redeemable convertible preferred stock warrants.........                --                20
Common stock options................................................             1,336               850
Common stock warrants...............................................               695                49
                                                                                 -----            ------
                                                                                 2,031            10,663
                                                                                 =====            ======
</TABLE>

NOTE 5 - STRATEGIC MARKETING -- EQUITY AGREEMENTS:

   In June 1999, the Company signed a strategic marketing agreement with
Amazon.com, Inc. ("Amazon.com").  Pursuant to this agreement, the Company issued
warrants to purchase approximately 381,000 shares of the Company's common stock
at $6.56 per share of which 254,000 shares vest immediately and 127,000 shares
vest over a twelve-month period commencing if and when the Company and
Amazon.com sign a definitive agreement to utilize the Company's technology for a
specific business program.  The warrants expire through June 2004.  With respect
to the immediately vested 254,000 shares, the Company has valued these shares at
approximately $2.0 million, based on the Black-Scholes pricing model and the
provisions of the Emerging Issues Task Force No. 96-18 "Accounting for Equity
Instruments that are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services" ("EITF 96-18"), which is being
recognized as strategic marketing-equity instruments expense over the term of
the related agreements, as appropriate.  With respect to the 127,000 shares,
which will vest over a twelve-month period, these shares will be valued at the
then fair market value of the Company's common stock if and when a commitment
for performance by Amazon.com has been reached or at a date when Amazon.com has
performed its contractual obligations under the agreement.

   In June 1999, the Company signed an agreement with Virgin Holdings, Inc., an
affiliate of EMI Recorded Music ("EMI") to facilitate the production of music
for delivery over the Internet utilizing the Company's technology.  Pursuant to
this agreement, the Company issued and delivered 100,000 shares of common stock
to EMI.  These shares were valued at $1.1 million and recognized as strategic
marketing-equity instruments expense during the three months ended June 30,
1999.

   In August 1999, the Company signed a marketing and distribution agreement
with an Internet portal to promote the digital distribution of digital music
and the Internet portal's web site.  Under the agreement, the Company agreed to
grant the Internet portal three warrants totaling 250,000 shares of common
stock, which has been accounted for in accordance with EITF 96-18. The first
warrant for 83,334 shares at $26.36 per share vests immediately and has been
valued by the Company using the Black-Scholes pricing model at $903,000, which
is being recognized ratably as strategic marketing-equity instruments expense
over a twelve-month period. The second warrant for 83,333 shares at $40.00 per
share vests in August 2000. The value of the warrant is being determined using
the Black-Scholes pricing model, which was

                                       9
<PAGE>

$1.9 million at September 30, 1999, and is being recognized ratably as
marketing-equity instruments expense over a twelve-month period and is being
remeasured each period by the Company until the warrant vests. The third
warrant, which may be issued if the relationships with the Internet portal is
extended beyond the first year, for 83,333 shares at $50.00 per share would
commence to vest in August 2000, at which time the Company will determine the
value of this warrant.

                                       10
<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" and in the "Risk Factors" section of our
Prospectus dated July 8, 1999.

   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 Registration Statement on Form S-1 dated July 8, 1999, including the
information contained in the form of the final Prospectus.

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 utilizing 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 300
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 to lay the groundwork for offering digital
music download services to consumers in these markets.

   To date, we have derived our revenues principally from the licensing of
software products and service fees associated with business development
contracts. We license our software products to record companies, artists and
websites. Software license revenues, net of a provision for estimated sales
returns, are recognized upon shipment of the product to the customer. We also
generate services revenues from maintenance fees related to our licensed
software products and hosting fees from record companies and

                                       11
<PAGE>

artists. We defer and recognize maintenance and hosting fees as service revenue
ratably over the life of the related contract, which is typically one year. We
intend to increase our services revenues by significantly expanding our hosting
and 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 Liquid Muze
Previews service for sample music clips. Business development revenues primarily
consist of fees from agreements under which we assist strategic related partners
with the development of businesses that use our digital recorded music delivery
technology. These U.S. dollar-denominated, non-refundable fees are based upon
agreements under which the strategic related partners are contractually
obligated to pay us consulting service fees and software license fees related to
the establishment of businesses in various countries. We recognize the fees as
they are earned; the specific timing of this recognition depends on the terms
and conditions of the particular contractual arrangements. We bear full credit
risk with respect to substantially all sales.

   We expense all research and development as incurred. Development costs
incurred in the period from achievement of technological feasibility, which we
define as the establishment of a working model, until the general availability
of this software to customers, have been short, and therefore software
development costs qualifying for capitalization have been insignificant.
Accordingly, we have not capitalized any software development costs to date.

   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 September 30, 1999 we had an accumulated deficit of approximately $32.1
million. We intend to continue to expend significant financial and management
resources on the development of additional products and services, sales and
marketing, improved technology and expanded operations. As a result, 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.

                                       12
<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           Nine Months Ended
                                                                             September 30,               September 30,
                                                                          ----------------------    -----------------------
                                                                              1999       1998          1999         1998
                                                                          -----------  ---------    -----------  ----------
<S>                                                                       <C>           <C>         <C>           <C>
Net revenues:
 License............................................................           27%            37%           37%           47%
 Services...........................................................           10             11            12            10
 Business development - strategic related partners..................           63             52            51            43
                                                                            -----          -----         -----         -----
   Total net revenues...............................................          100            100           100           100
                                                                            -----          -----         -----         -----
Cost of net revenues:
 License............................................................            3              6             5            10
 Services...........................................................           18              7            21            10
 Business development - strategic related partners..................            4             --             2            --
                                                                            -----          -----         -----         -----
   Total cost of net revenues.......................................           25             13            28            20
                                                                            -----          -----         -----         -----
Gross profit........................................................           75             87            72            80
                                                                            -----          -----         -----         -----

Operating expenses:
 Sales and marketing................................................          142             88           211           155
 Research and development...........................................          193            103           252           154
 General and administrative.........................................           42             55            57            67
 Strategic marketing-equity instruments.............................           46             --            72            --
 Stock compensation expense.........................................           18             34            36            51
                                                                            -----          -----         -----         -----
   Total operating expenses.........................................          441            280           628           427
                                                                            -----          -----         -----         -----
Loss from operations................................................         (366)          (193)         (556)         (347)
Interest and other income, net......................................           40             11            32             3
                                                                            -----          -----         -----         -----
Net loss............................................................        (326)%         (182)%        (524)%        (344)%
                                                                            =====          =====         =====         =====
</TABLE>

Three Months Ended September 30, 1999 and 1998

Total Net Revenues

   Total net revenues increased 78% to $1.8 million for the three months ended
September 30, 1999 from $1.0 million in the comparable period of 1998.

   License.  License revenues increased 27% to $476,000 for the three months
ended September 30, 1999 from $374,000 in the comparable period of 1998.  This
increase relates to additional Liquid Player license fees received under an
agreement with a customer.  Under this agreement, of which the term ends on
December 31, 1999, we receive total fees of $1.5 million, the timing of payments
of which is based on the delivery of a specific Liquid Player license.  Upon
delivery of this license in November 1998, $1.0 million was received and is
being recognized ratably over the 14 months ended December 31, 1999.  An
additional $500,000 was received in May 1999 and is being recognized ratably
over the 8 months ended December 31, 1999. Due to our shift in marketing
emphasis from software licensing to the delivery of

                                       13
<PAGE>

digital music services, however, revenues from licensing of our Liquifier Pro
and Liquid Server software decreased in the 1999 period from the 1998 period,
which partially offset the increase in Liquid Player revenues described above.

   Services.  Services revenues increased 70% to $177,000 for the three months
ended September 30, 1999 from $104,000 in the comparable period of 1998. This
increase was due to addition to revenues from promotion and advertising
services, Liquid Muze Previews service, and music sales in the 1999 period.

   Business Development - Strategic Related Partners.  Business development
revenues increased 116% to $1.1 million for the three months ended September 30,
1999 from $525,000 in the comparable period of 1998. Of the total business
development fees in the third quarter of 1999, $250,000 were earned from our
strategic partner in Japan and relate to a non-refundable fee of $1.0 million
that was received in March 1999 and is being recognized as services revenue
ratably over the 12-month term of the related agreement.  Additionally, $500,000
in services fees were earned from our Japanese strategic partner related to the
signing of a letter of intent to develop a local business in Taiwan and Hong
Kong, $372,000 were earned from Liquid Audio Korea consisting of consulting
services fees, software licensing and equipment sales, and $10,000 were earned
from other software licensing sales.  Services fees of $525,000 in the third
quarter of 1998 were earned principally under an agreement with our Korean
strategic partner.

   Four customers represented approximately 86% of total net revenues for the
three months ended September 30, 1999 and one customer represented approximately
50% of total net revenues in the comparable period of 1998.  International
revenues represented approximately 65% and 66% of total net revenues for the
three months ended September 30, 1999 and 1998, respectively.

Total Cost of Net Revenues

   Our gross profit decreased to approximately 75% of total net revenues for the
three months ended September 30, 1999 from approximately 87% of total net
revenues in the comparable period of 1998.

   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 was $58,000 for the three months ended
September 30, 1999 and $63,000 in the comparable period of 1998, a decrease of
8%. Cost of license revenues decreased due to product mix differences and the
cancellation of certain technology licenses in 1999.

   Services.  Cost of services revenues primarily consists of compensation for
customer service and encoding personnel and an allocation of our occupancy costs
and other overhead.  Cost of services revenues increased 363% to $324,000 for
the three months ended September 30, 1999 from $70,000 in the comparable period
of 1998. The increase in cost of services revenues was due primarily to the
addition of encoding and customer service personnel and higher depreciation due
to capital investments in network infrastructure.

   Business Development - Strategic Related Partners.  Cost of business
development revenues primarily consists of equipment and royalties paid to
third-party technology vendors.  Cost of business development revenues were
$66,000 for the three months ended September 30, 1999 and $0 for the comparable
period of 1998.

                                       14
<PAGE>

Operating Expenses

   Sales and Marketing.  Sales and marketing expenses consist primarily of
compensation for our sales, marketing and business development personnel,
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 186%
to $2.5 million for the three months ended September 30, 1999 from $887,000 in
the comparable period of 1998. 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 increase both in
absolute dollars and as a percentage of total net revenues in future periods due
to expanded efforts to market and promote our products and services both
domestically and internationally.

   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 236% to $3.4 million for the three months ended
September 30, 1999 from $1.0 million in the comparable period of 1998. 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 increase in absolute dollars in future
periods due to expanded investments in the development of enhanced and new
products and online services.

   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 35% to $741,000 for the
three months ended September 30, 1999 from $548,000 in the comparable period of
1998. This increase was primarily due to increases in the number of personnel
and outside contractors needed to support the growth of our business and
professional fees. General and administrative expenses declined as a percentage
of total net revenues. We expect that general and administrative expenses will
increase in absolute dollars as we hire additional personnel and incur
additional expenses relating to the anticipated growth of our business, such as
costs associated with increased infrastructure and our public company status.

   Strategic Marketing-Equity Instruments.  Common stock expense is based on the
estimated 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 $826,000 for the three months ended September 30,
1999 and $0 in the comparable period of 1998.  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 has been valued at approximately $2.0 million
and is being recognized ratably over the one-year term of the agreement, of
which $506,000 has been recognized as

                                       15
<PAGE>

strategic marketing-equity instruments expense in the three months ended
September 30, 1999. Under the Advertising Agreement with Amazon.com, an
additional warrant to purchase approximately 127,000 shares of common stock will
be granted to Amazon.com and will vest over a twelve-month period, if and when
we sign a definitive agreement with Amazon.com to utilize our technology for a
specific business program. These shares will be valued at the then fair market
value of our common stock, if and when a commitment for performance by
Amazon.com has been reached, or at a date when Amazon.com has performed its
contractual obligations under the agreement. In August 1999, we signed a Digital
Audio Co-Marketing and Distribution Agreement with Yahoo! Inc. ("Yahoo!") to
promote the distribution of digital music on its web site. In connection to this
agreement, we agreed to grant Yahoo! three warrants totaling 250,000 shares of
common stock. The first warrant for 83,334 shares vest immediately and is valued
at $903,000 and is being recognized ratably over the one-year term of the
agreement. The second warrant for 83,333 shares vests in August 2000, and is
being remeasured each period until the warrant vests, based on the fair market
value at the end of each period. At September 30, 1999, this warrant is valued
at $1.9 million, which is being recognized ratably over the one-year term of the
agreement. For the three months ended September 30, 1999, $104,000 and $216,000
were recognized as strategic marketing-equity instruments expense for the first
and second warrants, respectively. The third warrant, which may be issued if the
relationship with Yahoo! is extended beyond the first year, for 83,333 shares
would commence to vest in August 2000, at which time the warrant will be valued.

   Stock Compensation Expense.  Stock compensation expense relates to stock-
based employee compensation arrangements. Stock compensation expense is based on
the difference between the fair market value of our common stock and the
exercise price of options to purchase that stock on the date of the grant, and
is being recognized on an appropriate accelerated basis over the vesting periods
of the related options, usually four years. The total unearned compensation
recorded by us from inception to September 30, 1999 was $4.3 million.  We
recognized $330,000 and $339,000 of stock compensation expense for the three
months ended September 30, 1999 and 1998.  We expect quarterly amortization
related to those options to be approximately $250,000 for fourth quarter of 1999
and between $200,000 and $130,000 per quarter during 2000 and annual
amortization to be $330,000 during 2001 and $100,000 during 2002. These future
compensation charges would be reduced if any employee terminates employment
prior to the expiration of the employee's option vesting period.

   Interest and Other Income, 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, short-term loans and capital lease obligations. Interest and
other income, net increased to $722,000 for the three months ended September 30,
1999 from $104,000 in the comparable period of 1998. This increase was primarily
due to interest received on higher average cash and cash equivalent balances
resulting from proceeds of the initial public offering of our common stock in
July 1999, offset by interest paid on higher average financing obligation
balances resulting from additional capital leases and borrowings under the
equipment loans during 1999 and 1998.

Nine Months Ended September 30, 1999 and 1998

Total Net Revenues

   Total net revenues increased 77% to $3.1 million for the nine months ended
September 30, 1999 from $1.7 million in the comparable period of 1998.

                                       16
<PAGE>

   License.  License revenues increased 40% to $1.1 million for the nine months
ended September 30, 1999 from $808,000 in the comparable period of 1998.  Due to
our shift in marketing emphasis from software licensing to the delivery of
digital music services, revenues from licensing of our Liquifier Pro and Liquid
Server software decreased in the 1999 period from the 1998 period, which
partially offset the increase in Liquid Player revenues described above.

   Services.  Services revenues increased 117% to $367,000 for the nine months
ended September 30, 1999 from $169,000 in the comparable period of 1998. This
increase was due to increased maintenance and hosting fees and the addition of
revenues from promotion and advertising services, Liquid Muze Previews service,
and music sales in the 1999 period.

   Business Development - Strategic Related Partners.  Business development
revenues increased 109% to $1.6 million for the nine months ended September 30,
1999 from $750,000 in the comparable period of 1998. Of the total business
development fees in the first nine months of 1999, $583,000 were earned from our
strategic partner in Japan and relate to a non-refundable fee of $1.0 million
that was received and is being recognized as services revenue ratably over the
12-month term of the related agreement, an additional $500,000 in services fees
were earned from our Japanese strategic partner related to the signing of a
letter of intent to develop a local business in Taiwan and Hong Kong, $110,000
of software license sales to Liquid Audio Japan, and $372,000 were earned from
Liquid Audio Korea consisting of consulting services fees, software licensing
and equipment sales.  Services fees of $500,000 and $250,000 in the first nine
months of 1998 were earned under an agreement with our strategic partner in
Korea and from our strategic partner in Japan under a separate agreement,
respectively.

   Four customers represented approximately 82% of total net revenues for the
nine months ended September 30, 1999 and two customers represented approximately
42% of total net revenues in the comparable period of 1998.  International
revenues represented approximately 52% and 62% of total net revenues for the
nine months ended September 30, 1999 and 1998, respectively.

Total Cost of Net Revenues

   Our gross profit decreased to approximately 72% of total net revenues for the
nine months ended September 30, 1999 from approximately 80% of total net
revenues in the comparable period of 1998.

   License.  Cost of license revenues was $156,000 for the nine months ended
September 30, 1999 and $175,000 in the comparable period of 1998, a decrease of
11%. Cost of license revenues decreased due to product mix differences and the
cancellation of certain third-party technology licenses.

   Services.  Cost of services revenues increased 282% to $649,000 for the nine
months ended September 30, 1999 from $170,000 in the comparable period of 1998.
The increase in cost of services revenues was due primarily to the addition of
encoding and customer service personnel and higher depreciation due to capital
investments in network infrastructure.

   Business Development - Strategic Related Partners.  Cost of business
development revenues were $68,000 for the nine months ended September 30, 1999
and $0 for the comparable period of 1998.

                                       17
<PAGE>

Operating Expenses

   Sales and Marketing.  Sales and marketing expenses increased 141% to $6.4
million for the nine months ended September 30, 1999 from $2.7 million in the
comparable period of 1998. This increase was primarily due to increases in the
number of sales and marketing personnel, advertising and promotional programs.
The nine month period ended September 30, 1999 includes a $378,000 impairment
loss on our investment in Liquid Audio Japan.

   Research and Development.  Research and development expenses increased 189%
to $7.7 million for the nine months ended September 30, 1999 from $2.7 million
in the comparable period of 1998. 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.

   General and Administrative.  General and administrative expenses increased
51% to $1.7 million for the nine months ended September 30, 1999 from $1.2
million in the comparable period of 1998. This increase was primarily due to
increases in the number of personnel and outside contractors needed to support
the growth of our business and professional fees.

   Strategic Marketing-Equity Instruments.  Strategic marketing-equity
instruments expense was $2.2 million for the nine months ended September 30,
1999 and $0 in the comparable period of 1998. Strategic marketing-equity
instruments expense relates to common stock and warrants issued to our strategic
partners as part of marketing and content agreements with these partners.

   Stock Compensation Expense.  We recognized $1.1 million and $882,000 of stock
compensation expense for the nine months ended September 30, 1999 and 1998,
respectively.

   Interest and Other Income, Net. Interest and other income, net increased to
$986,000 for the nine months ended September 30, 1999 from $51,000 in the
comparable period of 1998. This increase was primarily due to interest received
on higher average cash and cash equivalent balances resulting from proceeds of
the initial public offering of common stock in July 1999, offset by interest
paid on higher average financing obligation balances resulting from additional
capital leases and borrowings under the equipment loans during 1999 and 1998.

Liquidity and Capital Resources
-------------------------------

   Since inception, we have financed our operations primarily through the
initial public offering of common stock, private placement of our preferred
stock, equipment financing, lines of credit and short-term loans. As of
September 30, 1999, we had raised $65.9 million through our initial public
offering of common stock, $29.8 million through the sale of our preferred stock
and had approximately $70.5 million of cash, cash equivalents and short-term
investments.

   Net cash used in operating activities was $9.6 million and $4.2 million for
the nine months ended September 30, 1999 and 1998, respectively. Net cash used
for operating activities in each of these periods was primarily the result of
net losses before non-cash charges, which include an equity investment loss in

                                       18
<PAGE>

Liquid Audio Japan and strategic marketing-equity instruments expense in the
1999 period, offset by increases in accounts payable and accrued expenses and
other current liabilities.

   Net cash used in investing activities was $8.0 million and $1.5 million for
the nine months ended September 30, 1999 and 1998, respectively. Net cash used
in investing activities was related to the acquisition of property and equipment
and purchases of short-term investments.

   Net cash provided by financing activities was $66.4 million and $21.1 million
for the nine months ended September 30, 1999 and 1998, respectively. The net
cash provided by financing activities for the first nine months of 1999 was due
primarily to the proceeds from our initial public offering of common stock. The
net cash provided by financing activities for the first nine months of 1998 was
due primarily to the proceeds from the private sales of our preferred stock.

   We have a bank revolving line of credit for up to $1.0 million based on 80%
of eligible accounts receivable. As of September 30, 1999, we had no borrowings
under the revolving line of credit. Any advances would bear interest at the
bank's prime interest rate and would be collateralized by substantially all of
our assets. We have a bank equipment loan facility that provides 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 September 30, 1999. We also
have lease financing agreements that provide for the lease of computers and
office equipment of up to $1.0 million. As of September 30, 1999, we had
borrowed $737,000 under the lease financing agreements. Our other significant
commitments consist of obligations under non-cancelable operating leases, which
totaled $880,000 as of December 31, 1998 and are payable in monthly installments
through 2002 and a strategic related partner note in the amount of $425,000 that
was issued in the three months ended March 31, 1999. The strategic related
partner note payable was issued to Super Factory, Inc., an entity affiliated
with our Japanese strategic partner, Super Stage Itochu, and 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.

   Although we have no material commitments for capital expenditures or
strategic investments, we anticipate an increase in the rate of capital
expenditures consistent with our anticipated growth in operations,
infrastructure and personnel. We anticipate that we will continue to add
computer hardware resources, deploy additional computer data centers worldwide
and expand our primary office facility during the next 12 months. We may also
use cash to acquire or license technology, products or businesses related to our
current business. In addition, we anticipate that we will continue to experience
significant growth 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 the net proceeds from our recently completed initial public
offering, together with existing cash and cash equivalents and our lines of
credit will be sufficient to meet our anticipated cash needs for working capital
and capital expenditures for at least the next 18 months, 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.

                                       19
<PAGE>

Market Risk Disclosure
----------------------

   At September 30, 1999, we had an investment portfolio of money market funds,
commercial securities and U.S. Government bonds including those classified as
short-term investments of $7.6 million. We had a strategic related partner loan
outstanding at September 30, 1999 of $425,000, 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, 1998 and September 30, 1999, the
decline of the fair value of the fixed income portfolio and strategic related
partner note payable would not be material.

Year 2000 Compliance
--------------------

   Many currently installed computer systems and software products worldwide are
coded to accept only two-digit entries to identify a year in the date code
field. Consequently, on January 1, 2000, many of these systems could fail or
malfunction because they are not able to distinguish between the year 1900 and
the year 2000. Accordingly, many companies, including ourselves and our
customers, potential customers, vendors and strategic partners, may need to
upgrade their systems to comply with applicable year 2000 requirements.

   Because we and our customers depend, to a very substantial degree, upon the
proper functioning of computer systems, a failure of these systems to correctly
recognize dates beyond January 1, 2000 could disrupt operations. Any disruptions
could harm our business. Additionally, our failure to provide year 2000
compliant solutions to our customers could result in financial loss,
reputational harm and legal liability to us. We believe that our products and
services are year 2000 compliant; however, our products and services are often
integrated with other systems that may not be compliant.

   In 1998, we formed a year 2000 assessment and contingency planning committee
to review both our information technology systems and our non-information
technology systems, and where necessary to plan for and supervise the
remediation of those systems. The committee is headed by our Chief Technology
Officer. We believe the committee has identified all of our critical hardware
and software systems. The providers of these systems have confirmed that they
are year 2000 compliant. We have conducted tests and expect to conduct
additional tests of these systems as part of our year 2000 efforts.

   We have initiated communication with our significant vendors to determine the
extent to which they are vulnerable to year 2000 issues. We have not yet
received sufficient information on year 2000 remediation plans of these vendors
to predict the outcome of their efforts.

   We estimate that our cost to become year 2000 compliant has been $150,000,
and we believe that any additional costs related to becoming year 2000 compliant
will not be material.

   We have not made a full assessment of the extent to which our customers might
be vulnerable to year 2000 issues. Likewise, we have not made a full assessment
of the extent to which other third parties with which we transact business have
determined their vulnerability to year 2000 issues.

                                       20
<PAGE>

   We are developing contingency plans for critical individual information
technology systems and non-information technology systems to address year 2000
risks not fully resolved by our year 2000 program. We believe that the year 2000
risk will not present significant operational problems for us. However, there
can be no assurance that our year 2000 program will prevent any harm to our
business.

   If our year 2000 program is inadequate and our business operations are
materially impacted, we could incur additional costs to recover any lost
information and replace affected systems. We believe that these systems could be
replaced without significant difficulty as replacement systems are generally
available on commercially reasonable terms. We also have regular data back-up
procedures that would assist in the recovery of lost business information.

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.

Fluctuations in our quarterly revenues and operating results might lead to
reduced prices for our stock

   Our quarterly results of operation 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 including 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:

                                       21
<PAGE>

   .  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;

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

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

We have a history of losses, we expect losses to continue and we might not
achieve or maintain profitability


   Our accumulated deficit as of September 30, 1999 was approximately $32.1
million.  We had net losses of approximately $8.5 million in 1998 and $16.0
million in the first nine months of 1999. 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.

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.

   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.

   We also intend to increase our expenditures on marketing the Liquid Audio
brand because we believe brand awareness will be critical to increasing our
affiliates and end-user awareness. Our increased marketing expenses may not
result in an increase of our brand awareness. Similarly, we may not achieve

                                       22
<PAGE>

increased revenues even if we are successful in increasing our brand awareness.
If we do not increase our revenues as a result of our branding and other
marketing efforts or if we otherwise fail to promote our brand successfully, our
business would be harmed.

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 and variety of digital recordings available for purchase
      through our system relative to those available through other online
      digital delivery companies, digital music 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

                                       23
<PAGE>

   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. Many of these potential
competitors are likely to enjoy substantial competitive advantages, including
the following:

   .  larger audiences;

   .  larger technical, production and editorial staffs;

   .  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.

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, pirated copies of recorded music will 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.

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

                                       24
<PAGE>

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.

If our relationships with our international partners terminate, our revenues
might decline

   We derive a portion of our revenues from business development fees generated
from relationships with our international partners, SK Group, Liquid Audio
Korea, Super Stage and Liquid Audio Japan. These relationships vary in size and
scope. If one of these relationships, or any other relationship that accounts
for a significant portion of our revenues in a given period, does not generate a
similar amount of revenue, or any, in subsequent periods, then our business
could be harmed. As a consequence, our revenues are not recurring from period-
to-period, which might result in unpredictability of our revenues.

Our revenues would be negatively affected 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 the four quarters of 1998 and the three
quarters of 1999 represented approximately 81%, 96%, 89%, 88%, 80%, 97%, and
93%, respectively, of our total net revenues.  The loss of Liquid Audio Japan,
Liquid Audio Korea or Adaptec, Inc. or any other significant customer or any
significant reduction of total net revenues generated by these or other
significant customers 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.

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 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

                                       25
<PAGE>

   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.

Companies might not develop or consumers might not adopt devices that will play
digitally downloaded music

   We believe that the market for digital 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.

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 developing 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 recently focused on, and will continue to
devote

                                       26
<PAGE>

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.

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 intend to appoint an agent.

   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.

Several of our customers have had limited operating histories, are unprofitable
and might have difficulty meeting their payment obligations to us

                                       27
<PAGE>

   Several of our significant customers, including our international partners
Liquid Audio Japan and Liquid Audio Korea, have had limited operating histories
and have not achieved profitability. We believe that this will be true of other
customers in the future. 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, our business might be harmed. As of
September 30, 1999, 20% of accounts receivable, or $262,000, was more than 30
days past due. We have provided adequate reserves for past due amounts.

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. 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
and RSA Data Security, Inc. 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 such licenses or software on
commercially reasonable terms might harm our business.

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 certain 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

                                       28
<PAGE>

packages that include incentive stock options, cash incentives and other
employee benefits, we may be unable to retain our key employees or to attract,
assimilate and retain other 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.

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.

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 not applied for any patents outside the United States. We may do
so in the future. 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.

   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

                                       29
<PAGE>

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

   In May 1999, Microtome, Inc. notified us that it believes our Liquifier Pro
Encoding Tool, when used in conjunction with our Liquid Music Player, infringes
two of its patents. In June 1999 and July 1999, we received letters from two
other corporations, each separately suggesting that we review patents to which
they claim rights. These claims may result in litigation. Although we do not
believe we infringe the proprietary rights of Microtome, Inc. or any other
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.

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;

   .  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.

                                       30
<PAGE>

   We have entered into individual agreements in Japan and Korea, and we may
enter into similar arrangements in the future in other countries. One or more of
the factors listed above may harm our present or future international operations
and, consequently, our business.

We might need additional capital in the future and additional financing might
not be available

   We currently anticipate that our available cash resources, combined with the
net proceeds from our recently completed public offering and financing available
under existing equipment loan and lease agreements, will be sufficient to meet
our anticipated working capital and capital expenditure requirements for the
next 18 months.  However, our resources may not be sufficient for these working
capital and capital expenditure requirements. 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.

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. States 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

                                       31
<PAGE>

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.

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 year 2000 difficulties or other 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 become a viable 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.

The price of our common stock is likely to be volatile and subject to wide
fluctuations

   The market prices of the securities of Internet-related companies have been
especially volatile and these securities may be overvalued. Thus, the market
price of our common stock is likely to be subject to wide fluctuations. If our
revenues do not grow or grow more slowly than we anticipate, or if operating or
capital expenditures exceed our expectations and cannot be adjusted accordingly,
or if some other event adversely affects us, the market price of our common
stock could decline. In addition, if the market for

                                       32
<PAGE>

Internet-related stocks or the stock market in general experiences a loss in
investor confidence or otherwise fails, the market price of our common stock
could fall for reasons unrelated to our business, results of operations and
financial condition. Investors might be unable to resell their shares of our
common stock at or above the offering price. In the past, companies that have
experienced volatility in the market price of their stock have been the subject
of securities class action litigation. If we were to become the subject of
securities class action litigation, it could result in substantial costs and a
diversion of management's attention and resources.

You might not be able to sell your stock if no market develops for our stock

   Prior to our recently completed public offering, you could not buy or sell
our common stock publicly.  If a market does not develop or is not sustained, it
may be difficult for you to sell your shares of common stock at a price that is
attractive to you or at all. The initial public offering price of the common
stock was determined through negotiations between the representatives of the
underwriters and us and may not be representative of the price that will be
sustained in the open market.

Provisions in our charter documents might deter acquisition bids for us

   We have adopted a classified board of directors and our stockholders are
unable to call special meetings of stockholders, to act by written consent, to
remove any director or the entire board of directors without cause, or to fill
any vacancy on the board of directors, and must meet advance notice requirements
for stockholder proposals. Our board of directors may also issue preferred stock
without any vote or further action by the stockholders. These provisions and
other provisions under Delaware law could make it more difficult for a third
party to acquire us, even if doing so would benefit our stockholders.

Our officers and directors exert substantial influence over us

   Our executive officers, our directors and entities affiliated with them
together beneficially own approximately 40.4% of our outstanding common stock
following our recently completed public offering.  As a result, these
stockholders will be able to exercise substantial influence over all matters
requiring approval by our stockholders, including the election of directors and
approval of significant corporate transactions. This concentration of ownership
may also have the effect of delaying or preventing a change in our control.

 ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

   Not applicable.

                                       33
<PAGE>

PART II.  OTHER INFORMATION

 ITEM 1.  LEGAL PROCEEDINGS

   None.

 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, as amended, (No. 333-77707) relating to our
initial public offering of common stock, was July 8, 1999.  A total of 4,200,000
shares of our common stock were sold to an underwriting syndicate which was
managed by Lehman Brothers, BancBoston Robertson Stephens and U.S. Bancorp Piper
Jaffray.  The offering commenced and was completed on July 9, 1999 at a price of
$15.00 per share.  The underwriting syndicate elected to exercise its over-
allotment option on July 20, 1999 for an additional 600,000 shares of our common
stock at $15.00 per share.  As a result of the initial public offering we
received gross proceeds of $72 million, $5.04 million of which was applied
toward the underwriting discount.  Other expenses related to the offering
totaled approximately $1.1 million.  Our net proceeds from this offering were
approximately $65.9 million, all of which were deposited into our accounts in
July 1999 following the close of the offering.  As of June 30, 1999, we had not
received or applied any of the offering proceeds.

 ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

   None.

 ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

   None.

 ITEM 5.  OTHER INFORMATION

   None.

 ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

   (a)    Exhibits

          EX-27.1 - Financial Data Schedule

   (b)    Reports on Form 8-K

          None.

                                       34
<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:  November 15, 1999         LIQUID AUDIO, INC.

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

                                 /s/ Gary J. Iwatani
                                 ----------------------------------------------
                                 GARY J. IWATANI
                                 Senior Vice President and Chief Financial
                                 Officer

                                       35
<PAGE>

                              LIQUID AUDIO, INC.

                        INDEX TO EXHIBITS FOR FORM 10-Q

                     FOR QUARTER ENDED SEPTEMBER 30, 1999


EXHIBIT NO.    EXHIBIT DESCRIPTION
-----------    -------------------

   27.1        Financial Data Schedule