##### Table of Contents

---




UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D. C. 20549





---




FORM 10-Q/A


(Amendment No. 1)





| | x |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2002 | 
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------ | 




OR





| |  ̈ |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM
 TO
. | 
| | - |  | ----------------------------------------------------------------------------------------------------------------------------- | 




Commission File Number 000-25977





---




LIQUID AUDIO, INC.


(Exact name of registrant as specified in its charter)





Delaware

77-0421089(State or other jurisdiction of

(I.R.S. Employerincorporation or organization)

Identification No.)





800 Chesapeake Drive, 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.    Yes  x    No  ̈





As of July 31, 2002, there were 22,758,322 shares of registrants Common Stock outstanding.





---



---

##### Table of Contents

LIQUID AUDIO, INC.





INDEX





PART I.    
FINANCIAL INFORMATION

1ITEM 1.

FINANCIAL STATEMENTS (unaudited)

1Condensed Consolidated Balance Sheets as of June 30, 2002 and December 31, 2001

1Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2002 and 2001

2Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2002 and 2001

3Notes to Condensed Consolidated Financial Statements

4ITEM 2.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

13ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

34PART II.    
OTHER INFORMATION

35ITEM 1.

LEGAL PROCEEDINGS

35ITEM 2.

CHANGES IN SECURITIES AND USE OF PROCEEDS

36ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

37ITEM 5.

OTHER INFORMATION

37ITEM 6.

EXHIBITS AND REPORTS ON FORM 8-K

37SIGNATURES

40




---

##### Table of Contents

PART I.    FINANCIAL INFORMATION





ITEM 1.    FINANCIAL STATEMENTS





LIQUID AUDIO, INC.





CONDENSED CONSOLIDATED BALANCE SHEETS


(in thousands; unaudited)





June 30, 2002


December 31, 2001AssetsCurrent assets:Cash and cash equivalents

$
81,018


$
91,594Accounts receivable, net


115



130Other current assets


718



1,099Total current assets


81,851



92,823Restricted cash


826



826Property and equipment, net


2,391



3,603Other assets


73



163Total assets

$
85,141


$
97,415Liabilities and stockholders equityCurrent liabilities:Accounts payable

$
1,110


$
1,107Accrued liabilities


2,140



3,821Deferred revenue


109



122Capital lease obligations


11



28Equipment loan






169Note payable to related party


376



343Total current liabilities


3,746



5,590Stockholders equity:Common stock


23



23Additional paid-in capital


203,065



202,969Unearned compensation


(9
)


(43
)Accumulated other comprehensive loss


(55
)


(30
)Accumulated deficit


(121,629
)


(111,094
)Total stockholders equity


81,395



91,825Total liabilities and stockholders equity

$
85,141


$
97,415




1




---

##### Table of Contents

LIQUID AUDIO, INC.





CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


(in thousands, except per share amounts; unaudited)





Three Months Ended June
30,


Six Months Ended June 30,2002


2001


2002


2001Net revenues:License

$
40


$
194


$
76


$
484Services


111



362



210



787Business development (related party)






468







1,414Total net revenues


151



1,024



286



2,685Cost of net revenues:License


84



128



181



287Services


174



364



302



1,075Non-cash cost of revenue


36



98



69



181Total cost of net revenues


294



590



552



1,543Gross profit (loss)


(143
)


434



(266
)


1,142Operating expenses:Sales and marketing


1,027



3,061



2,185



7,717Non-cash sales and marketing


(32
)


(72
)


(21
)


(63
)Research and development


2,914



4,731



5,937



9,961Non-cash research and development


3



(26
)


8



(17
)General and administrative


1,905



3,078



3,011



6,272Non-cash general and administrative






(21
)






(16
)Strategic marketingequity instruments






340







652Restructuring






3,672







3,672Total operating expenses


5,817



14,763



11,120



28,178Loss from operations


(5,960
)


(14,329
)


(11,386
)


(27,036
)Other income (expense), net


318



1,176



851



2,835Net loss in equity investment






(881
)






(1,100
)Net loss

$
(5,642
)

$
(14,034
)

$
(10,535
)

$
(25,301
)Net loss per share:Basic and diluted

$
(0.25
)

$
(0.62
)

$
(0.46
)

$
(1.12
)Weighted average shares


22,737



22,593



22,723



22,563




2




---

##### Table of Contents

LIQUID AUDIO, INC.





CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(in thousands; unaudited)





Six Months Ended June 30,2002


2001Cash flows from operating activities:Net loss

$
(10,535
)

$
(25,301
)Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization


1,279



2,193Amortization of unearned compensation


(13
)


(101
)Allowance for doubtful accounts and sales returns reserve






1,055Net loss in equity investment






1,100Strategic marketing-equity instruments






652Non-cash cost of revenue


69



186Loss on disposal of and write-down of property and equipment






1,742Changes in assets and liabilities:Accounts receivable from third parties


15



379Accounts receivable from related parties






(257
)Other assets


471



176Accounts payable


3



(1,047
)Accrued liabilities


(1,681
)


457Deferred revenue from third parties


(13
)


(139
)Deferred revenue from related parties






(111
)Net cash used in operating activities


(10,405
)


(19,016
)Cash flows from investing activities:Acquisition of property and equipment


(67
)


(689
)Proceeds from sale of fixed assets






25Sales (purchases) of short-term investments, net






27,384Equity investment






(165
)Net cash provided by (used in) investing activities


(67
)


26,555Cash flows from financing activities:Proceeds from issuance of common stock, net of repurchases


74



163Payments made under capital leases


(17
)


(79
)Payments made under equipment loan


(169
)


(295
)Net cash used in financing activities


(112
)


(211
)Effect of exchange rates on cash and cash equivalents


8



(81
)Net increase (decrease) in cash and cash equivalents


(10,576
)


7,247Cash and cash equivalents at beginning of period


91,594



96,398Cash and cash equivalents at end of period

$
81,018


$
103,645Supplemental disclosures:Cash paid for interest

$
11


$
40Non-cash investing and financing activities:Issuance of warrants in connection with strategic marketing agreements

$
69


$
151




3




---

##### Table of Contents

LIQUID AUDIO, INC.





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(unaudited)





NOTE 1THE COMPANY AND SUMMARY OF
SIGNIFICANT ACCOUNTING POLICIES:





The Company





Liquid Audio, Inc. (the Company) was incorporated in California in January 1996 and reincorporated in Delaware in April 1999.
In July 2000, the Company established a wholly-owned subsidiary in the United Kingdom, Liquid Audio Europe PLC, which reregistered in August 2001 as Liquid Audio Europe Limited, to develop sales in Europe. The Company was formed with the goal of
becoming the premier provider of software applications and services that enable the secure delivery and sale of digital music over the Internet. The Companys end-to-end solutions enable the secure distribution, promotion and sale of high
quality music files while providing consumers with the ability to access, preview and purchase that music via the Internet.





Basis of presentation





The accompanying unaudited condensed consolidated financial
statements have been prepared by the Company and reflect all adjustments, which are in the opinion of management, necessary for a fair presentation of the interim periods presented. The results of operations for the three months ended June 30, 2002
are not necessarily indicative of the results to be expected for any subsequent quarter or for the year ending December 31, 2002. Certain information and footnote disclosures normally included in financial statements prepared in accordance with
accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the Securities and Exchange Commissions rules and regulations.





These unaudited condensed consolidated interim financial statements and notes included herein should be read in conjunction with the Companys audited consolidated
financial statements and notes as included in the Companys Annual Report on Form 10-K for the year ended December 31, 2001 as filed with the Securities and Exchange Commission (the SEC) on March 29, 2002.





Liquidity and capital resources





The Company has incurred losses and negative cash flows from operations for every year since inception. For the six months ended June 30, 2002, the Company incurred a net loss of approximately $10.5
million and negative cash flows from operations of $10.4 million. As of June 30, 2002, the Company had an accumulated deficit of approximately $121.6 million. The Company expects to incur operating losses and negative cash flows through at least
2003. Failure to generate sufficient revenues, raise additional capital or reduce spending could adversely affect the Companys ability to achieve its intended business objectives.





Reclassifications





Certain reclassifications have been made to the prior periods consolidated financial statements to conform to the current period presentation. The reclassifications had no effect on net loss, stockholders equity or cash
flows.





Principles of consolidation





The financial statements include the accounts of the Company and its subsidiary. Significant intercompany transactions and balances have been eliminated. Investments in
entities in which the Company can exercise significant influence, but are less than majority owned and not otherwise controlled by the Company, are accounted for under the equity method.





Restricted cash




4




---

##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)


(unaudited)







At June 30, 2002, the Company had a cash balance of $826,000 in the
form of certificates of deposit, which were restricted from withdrawal. The amount serves as collateral to a letter of credit issued by the Companys bank to the Companys lessor as security deposit on a long-term lease.





Revenue recognition





Software license revenues are recognized when persuasive evidence of an arrangement exists, delivery has occurred, no significant Company obligations with regard to implementation or integration exist,
the fee is fixed or determinable and collection is probable as prescribed in SOP No. 97-2, Software Revenue Recognition. For arrangements with multiple elements, the total fee from the arrangement is allocated among each element based
upon vendor specific objective evidence (VSOE) of fair value. When VSOE of fair value exist for the undelivered elements, primarily maintenance, the Company accounts for the license portion based on the residual method as
prescribed by SOP No. 98-9, Modification of SOP 97-2 with Respect to Certain Transactions. When VSOE of fair value does not exist for the undelivered elements, the total fee from the arrangement is recognized ratably over the period of
the contract. The Company recognizes revenue allocated to maintenance ratably over the contract period, which is generally twelve months.





Business development revenue primarily consists of license and maintenance fees from agreements under which the Company gives its strategic partners the right to license and use the Companys digital recorded music
delivery technology. These U.S. dollar-denominated, non-refundable fees are allocated among the various elements of the contract based on VSOE of fair value. When VSOE of fair value exist for the undelivered elements, primarily maintenance, the
Company accounts for the license portion based on the residual method as prescribed by SOP No. 98-9. When VSOE of fair value does not exist for the undelivered elements, the total fee from the business development arrangement is
recognized ratably over the period of the contract. The total fee from business development arrangements is recognized when payment becomes due if extended payment terms exist, assuming all other criteria are met. Extended payment terms are defined
as payment terms outside the Companys customary business practice, generally greater than 90 days. Revenue is not recognized if the strategic partners stop making their contractual payments.





The Company also generates license and service revenues from digital music kiosk sales and hosting 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 the
Companys website affiliates and fees from music retailers and websites related to the sample digital music clips delivery service. Revenue from kiosk sales consist of software licenses and services revenue from equipment and kiosk-related
services. The Company bears full credit risk with respect to substantially all sales.





Recent accounting
pronouncement





In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets. SFAS No. 144 addresses significant issues relating to the implementation of SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, and develops a
single accounting method under which long-lived assets that are to be disposed of by sale are measured at the lower of book value or fair value less cost to sell. Additionally, SFAS No. 144 expands the scope of discontinued operations to include all
components of an entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. SFAS No. 144 is effective for financial statements
issued for fiscal years beginning after December 15, 2001 and its provisions are to be applied prospectively. The adoption of SFAS No. 144 did not have an impact on the Companys financial position and results of operations.




5




---

##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)


(unaudited)







In July 2002, the FASB issued SFAS No. 146, Accounting for
Costs Associated with Exit or Disposal Activities. SFAS No. 146 nullifies the guidance of the Emerging Issues Task Force (EITF) in EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and
Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). Under EITF Issue No. 94-3, an entity recognized a liability for an exit cost on the date that the entity committed itself to an exit plan. In SFAS No. 146,
the FASB acknowledges that an entitys commitment to a plan does not, by itself, create a present obligation to other parties that meets the definition of a liability and requires that a liability for a cost that is associated with an exit or
disposal activity be recognized when the liability is incurred. It also establishes that fair value is the objective for the initial measurement of the liability. SFAS No. 146 will be effective for exit or disposal activities that are initiated
after December 31, 2002. The Company does not expect an impact on its financial position and results of operating from the adoption of SFAS No. 146.





In the first quarter of 2002, the Company adopted Emerging Issues Task Force (EITF) Issue No. 00-14, Accounting for Certain Sales Incentives, EITF Issue No. 00-25, Vendor
Income Statement Characterization of Consideration Paid to a Reseller of the Vendor s Products, EITF Issue No. 00-22, Accounting for Points and Certain Other Time-or Volume-Based Sales Incentive Offers and Offers for Free Products or
Services to be Delivered in the Future and EITF Issue No. 01-09, Accounting for Consideration Given by Vendor to a Customer or a Reseller of the Vendor s Products which all address certain aspects of sales incentives. The adoption
of these EITFs did not have a material impact on the Companys financial position and results of operations.





NOTE 2BALANCE
SHEET COMPONENTS:





The components of accounts receivable from third parties, net are as follows (in
thousands):





June 30, 2002


December 31, 2001Accounts receivable from third parties, net:Accounts receivable

$
435


$
455Less: allowance for doubtful accounts


(320
)


(325
)$
115


$
130





The allowance for doubtful accounts decreased by $0 and $(51,000)
for the six months ended June 30, 2002 and 2001, respectively. Write-offs against the allowance for doubtful accounts were $5,000 and $48,000 for the six months ended June 30, 2002 and 2001, respectively.





The components of accounts receivable from related parties, net are as follows (in thousands):





June 30, 2002

December 31, 2001Accounts receivable from related parties, net:Accounts receivable

$


$
1,555Less: allowance for doubtful accounts





(1,555
)$


$






The allowance for doubtful accounts increased by $0 and $1,004,000
for the six months ended June 30, 2002 and 2001, respectively. Write-offs against the allowance for doubtful accounts were $1,555,000 and $0 for the six months ended June 30, 2002 and 2001, respectively.




6




---

##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)


(unaudited)







The components of property and equipment are as follows (in
thousands):





June 30, 2002


December 31, 2001Property and equipment:Computer equipment and purchased software

$
11,075


$
11,016Website and software development costs


235



235Furniture and fixtures


555



555Leasehold improvements


607



59912,472



12,405Less: Accumulated depreciation and amortization


(10,081
)


(8,802
)$
2,391


$
3,603





Property and equipment includes $99,000 of equipment under capital
leases at June 30, 2002 and December 31, 2001. Accumulated depreciation and amortization for equipment under capital leases was $99,000 and $95,000 at June 30, 2002 and December 31, 2001, respectively. Depreciation expense for the six months ended
June 30, 2002 and 2001 was $1,080,000 and $1,934,000, respectively. Amortization expense for purchased software, website and software development costs for the six months ended June 30, 2002 and 2001 was $199,000 and $259,000, respectively.
Unamortized purchased software, website and software development costs was $508,000 and $672,000 at June 30, 2002 and December 31, 2001, respectively.





The components of accrued liabilities are as follows (in thousands):





June 30, 2002

December 31, 2001Accrued liabilities:Compensation and benefits

$
1,085

$
1,124Consulting and professional services


294


1,357Restructuring (Note 7)


31


523Other


730


817$
2,140

$
3,821





NOTE 3RELATED PARTIES:





Investments in related parties





The Company owns 4.31% of the outstanding shares of Cyber Music Entertainment (CME), formerly Liquid Audio Japan (LAJ), and accounts for its investment under the equity method of accounting. The investment was
written down to its fair value of $0 at December 31, 2001.





Licensing and reseller agreements with Liquid Audio
Korea Co. Ltd., Liquid Audio Greater China and Liquid Audio South East Asia through the strategic partner were terminated in 2001. No revenue was recorded in the six months ended June 30, 2002 and $1,414,000 was recorded in the six months ended June
30, 2001.





Total business development revenue





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




7




---

##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)


(unaudited)







Three Months Ended June 30,

Six Months Ended June 30,2002

2001

2002

2001Cyber Music Entertainment and strategic partner

$


$


$


$
946Liquid Audio Greater China and strategic partner





468





468$


$
468

$


$
1,414





The total fees earned from Cyber Music Entertainment and Liquid
Audio Greater China relate to software licensing and maintenance fees in the periods indicated.





NOTE 4COMPREHENSIVE LOSS:





Comprehensive loss includes net loss and other comprehensive income (loss). Other comprehensive income (loss)
includes accumulated translation adjustments. The components of comprehensive loss are as follows (in thousands):





Three Months Ended June 30,


Six Months Ended June 30,2002


2001


2002


2001Comprehensive loss:Net loss

$
(5,642
)

$
(14,034
)

$
(10,535
)

$
(25,301
)Foreign currency translation adjustments


(32
)


(3
)


(25
)


(49
)Unrealized gain on investments














6$
(5,674
)

$
(14,037
)

$
(10,560
)

$
(25,344
)





NOTE 5NET LOSS PER SHARE:





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





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





Three Months Ended June 30,


Six Months Ended June 30,2002


2001


2002


2001Numerator:Net loss

$
(5,642
)

$
(14,034
)

$
(10,535
)

$
(25,301
)Denominator:Weighted average shares


22,738



22,602



22,724



22,572Weighted average unvested common shares subject to repurchase


(1
)


(9
)


(1
)


(9
)Denominator for basic and diluted calculation


22,737



22,593



22,723



22,563Net loss per share:Basic and diluted

$
(0.25
)

$
(0.62
)

$
(0.46
)

$
(1.12
)




8




---

##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)


(unaudited)







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):





Three Months Ended

Six Months EndedJune 30,

June 30,2002

2001

2002

2001Common stock options

2,604

3,233

2,604

3,233Common stock warrants

748

875

748

875Unvested common stock subject to repurchase

1

9

1

93,353

4,117

3,353

4,117





NOTE 6STRATEGIC MARKETINGEQUITY AGREEMENTS:





In March and April 1999, the Company granted fully vested warrants to purchase 12,000 shares of common stock at $6.56 per share. These
warrants were valued at $95,000 using the Black-Scholes option pricing model and were recognized as strategic marketing-equity instruments expense. At June 30, 2002, warrants to purchase 10,200 shares of common stock are outstanding and expire in
April 2004.





In June 1999, the Company signed an Advertising Agreement with Amazon.com, Inc.
(Amazon.com) to collaborate on event-based advertising using the Companys digital delivery services. In connection with this agreement, the Company issued a fully vested warrant to purchase approximately 254,000 shares of common
stock to Amazon.com. The warrant was valued at $2,022,000 and was recognized as strategic marketing-equity instruments expense ratably over the one-year term of the agreement, which ended in June 2000. At June 30, 2002, warrants to purchase
approximately 254,000 shares of common stock are outstanding and expire in June 2004.





In August 1999, the Company
signed a Digital Audio Co-Marketing and Distribution Agreement with Yahoo! to promote the distribution of digital music on its web site. In connection with this agreement, the Company granted Yahoo! three warrants to purchase a total of 250,000
shares of common stock. The first warrant for 83,334 shares vested immediately. The first warrant was valued at $903,000 and was recognized ratably over the one-year term of the agreement as strategic marketing-equity instruments expense. The second
warrant for 83,333 shares vested in August 2000. The second warrant was initially valued at $426,000 and was recognized ratably over the one-year period ending at the vesting date as strategic marketing-equity instruments expense. The second warrant
was revalued at each balance sheet date through the vesting date. As a result, the original charge of $426,000 was reduced to $312,000 based on market data during the vesting period. The third warrant for 83,333 shares vested in August 2001. The
third warrant was initially valued at $105,000 and was recognized ratably over the one-year period ending at the vesting date. The third warrant was revalued at each balance sheet date through the vesting date. As a result, the original charge of
$105,000 was reduced to $54,000 based on market data during the vesting period. In the six months ended June 30, 2001, $61,000 was recognized as strategic marketing-equity instruments expense for the third warrant. At June 30, 2002, warrants to
purchase 83,334 and 166,666 shares of common stock are outstanding and expire in September 2002 and 2003, respectively.





In July 2000, the Company signed an agreement with Virgin Holdings, Inc. (Virgin), an affiliate of EMI Recorded Music, to promote the distribution of digital music over the Internet using the Companys technology.
Pursuant to this agreement, the Company issued 150,000 shares of common stock to Virgin. These shares were valued at $1,181,000 and were recognized as strategic marketing-equity instruments expense ratably over the one-year term of the agreement. As
a result, $591,000 was recognized as strategic marketing-equity instruments expense in the six months ended June 30, 2001.




9




---

##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)


(unaudited)







In December 2000, the Company signed an agreement with BMG
Entertainment to obtain the right to distribute BMG sound recordings and related artwork through kiosks. In connection with this agreement, the Company issued 50,000 shares of common stock to BMG. These shares were valued at $195,000 and which was
recognized as non-cash cost of net revenues ratably over the one-year term of the agreement. As a result, $96,000 was recognized as non-cash cost of net revenues in the six months ended June 30, 2001. Additionally, the Company granted warrants to
purchase a total of 233,300 shares of common stock. Of the total, warrants to purchase 77,768 shares vested in December 2001, and the cost was remeasured each quarter until a commitment for performance was reached or the warrant vested based on
market data. At December 4, 2001, the 77,768 shares under this warrant were valued at $175,000, of which $90,000 was recognized as non-cash cost of net revenues in the six months ended June 30, 2001. The remaining warrants to purchase common shares
vest at 6,481 shares per month commencing December 2001 for one year and 6,480 shares per month commencing December 2002 for one year. We recorded a total of $36,000 as non-cash cost of revenue in the six months ended June 30, 2002 related to the
remaining warrants. Such warrants will be valued at the fair market value of the Companys common stock on each reporting date. At June 30, 2002, warrants to purchase 116,654 shares of common stock are outstanding and expire in December 2005.





NOTE 7RESTRUCTURING:





In May 2001, the Company adopted a corporate restructuring program to reduce expenses to preserve the Companys cash position while the digital music market develops. The restructuring included a
worldwide workforce reduction, a consolidation of three Redwood City, California offices into one facility and other expense management initiatives. A restructuring charge of $4,497,000 was recorded in operating expense in the twelve months ended
December 31, 2001.





The restructuring charge included involuntary employee separation costs of $1,116,000 for 79
employees worldwide, 20 in sales and marketing, 32 in research and development, 13 in general and administrative and 6 in operations functions in the U.S., and 2 in sales and marketing, 3 in research and development and 3 in operations functions
outside the U.S.





Lease costs of $1,214,000 were accrued pertaining to the estimated future obligations for
non-cancelable lease payments for excess facilities that were vacated due to reductions in workforce.





Asset
impairment costs of $2,167,000 were recorded, primarily for property and equipment, furniture and fixtures, computer software and leasehold improvements for assets no longer in use from de-emphasized business lines, reductions in workforce and
excess facilities.





A summary of the restructuring cost is outlined as follows (in thousands):





Severance and Benefits


Facilities


Asset Impairments


TotalSeverance and benefits

$
1,116


$



$



$
1,116Accrued lease costs






1,214







1,214Property and equipment impairment










2,167



2,167Total


1,116



1,214



2,167



4,497Cash paid


(1,116
)


(691
)






(1,807
)Non-cash










(2,167
)


(2,167
)Restructuring reserve balance at December 31, 2001






523







523Cash paid






(492
)






(492
)Restructuring reserve balance at June 30, 2002

$



$
31


$



$
31




10




---

##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)


(unaudited)







Remaining cash expenditures related to net lease expense due to the
consolidation of facilities will be paid over the lease terms through the fourth quarter of 2002.





NOTE 8CONTINGENCIES AND LEGAL
PROCEEDINGS:





On July 23, 2002, MM Companies, Inc. (formerly musicmaker.com, Inc.) filed an action in Delaware
Chancery Court against the Company, each member of the Companys board of directors, and Alliance Entertainment Corp. The complaint alleges that the directors of the Company and Alliance violated their fiduciary duties by entering into the
merger and approving the Merger Agreement, and that the Companys directors further violated their fiduciary duties by making certain changes to the Companys shareholders rights plan. Alliance is alleged to have aided and abetted the
alleged breaches of fiduciary duty by the Companys directors. According to the complaint, the plaintiff is seeking, among other things, to (i) invalidate the Merger Agreement, (ii) prevent the Company or Alliance from taking any actions to
effectuate or enforce the Merger Agreement, the merger of the Company or Alliance, or the self tender-offer, (iii) direct the Companys board of directors to restore the trigger of the Companys shareholders rights plan to 15%,
(iv) prevent enforcement of the Companys shareholders rights plan to the extent it prohibits the plaintiff and other stockholders from cooperating to assist in the solicitation of proxies for the Companys annual meeting, (v) damages for
incidental injuries, and (vi) costs and expenses, including attorneys fee and experts fees. In connection with its complaint, MM Companies, Inc. filed a motion for a preliminary injunction and a motion for expedited proceedings. On July
31, 2002, MM Companies, Inc. withdrew its motion for a preliminary injuction and for expedited proceedings, and stated that it would file an amended complaint. To date, no amended complaint has been filed. If MM Companies, Inc. elects to pursue its
claims in this matter, the Company intends to vigorously defend the action.





On May 30, 2002, musicmaker.com, Inc.
filed an action in the Delaware Chancery Court to obtain certain stockholder information. The Company has since provided the requested stockholder information to musicmaker.com, Inc. and, as a result, this action is moot.





On May 3, 2002, musicmaker.com filed an action in the Delaware Chancery Court, pursuant to Title 8 Delaware Code section 211, seeking to
compel the Company to hold an annual meeting of stockholders. The Company moved to dismiss on the grounds that the court lacked subject matter jurisdiction as 13 months had not elapsed since the Companys last annual stockholder meeting, held
on June 1, 2001. On May 10, 2002, the board of directors set July 1, 2002 as the date for the 2002 Annual meeting and the Companys motion to dismiss was held in abeyance. On June 13, 2002, the Company publicly announced the execution of the
original merger agreement and announced that, in light of the merger, the Companys board of directors had determined to postpone the 2002 annual meeting. The next day, musicmaker.com filed an amended complaint requesting that the court order
the Company to hold its annual meeting on July 1, 2002. The court allowed the parties to take expedited discovery and scheduled a hearing for July 15, 2002. At the hearing and by Order dated July 24, 2002, the court granted the Companys
request that the annual meeting be scheduled for September 26, 2002 so that the vote on the election of directors and the vote on the issuance of the Companys stock in the merger could proceed on the same day.





In October 2001, two lawsuits were filed in Delaware Chancery Court naming the Company and certain of its officers and directors as
defendants. Both actions related to the Companys response to recent acquisition offers and purported to be class actions brought on behalf of the Companys shareholders. On February 1, 2002, the two complaints were consolidated into a
single action, titled In Re Liquid Audio, Inc., Shareholders Litigation, Consolidated Civil Action No. 19212-NC. That action was brought against Gerald W. Kearby, Silvia Kessel, Ann L. Winblad and the Company. The complaint alleges that
defendants had breached their fiduciary duties owed to the Companys shareholders in connection with the Companys response to acquisition offers from Steel Partners II, LLP and an investor group formed by musicmaker.com, Inc. The
complaint seeks, among other things, a court order barring the Company from adopting or maintaining measures that would make the Company less attractive as a takeover candidate or, alternatively, awarding compensatory damages to the purported
plaintiff class. To date, the Company has not responded to the complaint, nor has the court set a date for discovery cutoff or trial. The Company intends to vigorously defend the action. There is no assurance concerning the outcome of this action,
or whether it will have a material effect on the Companys financial condition or business operations.





On or
about September 27, 2001, Network Commerce, Inc. (NCI) filed a Complaint against the Company in the United States District Court for the Western District of Washington (Seattle). The suit alleges that the Company infringes the claims of
United States Patent No. 6,073,124. NCI requests that the Company be enjoined from its allegedly infringing activities and seeks unspecified damages. The Company was served with the Complaint on November 2, 2001 and subsequently submitted its answer
and included counterclaims.





On August 23, 2001, the Company received a demand letter
from a former employees legal counsel alleging claims for sexual harassment and retaliation. On September 13, 2001, the former employee filed a charge with the California Department of Fair Employment and Housing alleging such claims against
the Company and one of its former employees. The Company completed an investigation and believes that there is no merit to the former employees allegations. In May 2002, the parties entered into a final settlement regarding this matter. The
settlement did not have a material impact on the Companys financial position or results of operations.





On
July 20, 2001, a putative securities class action, captioned Murowa Financial v. Liquid Audio, Inc. et al., Civil Action No. 01-CV-6661, was filed against the Company, certain of the Companys officers and directors (the Individual
Defendants) and three underwriters in the Companys initial public offering (the IPO), in the United States District Court for the Southern District of New York. The Complaint seeks unspecified damages on behalf of a purported
class of purchasers of the Companys common stock between July 8, 1999 and December 6, 2000. Several complaints substantially identical to Murowa were later filed against the Company, the Individual Defendants, and several of the IPO
underwriters in the Southern District of New York. These cases were consolidated under Civil Action No. 01-CV-6661. On April 19, 2002, an amended complaint was filed in this consolidated action, titled In re Liquid Audio, Inc. Initial Public
Offering Securities Litigation. The amended complaint generally alleges that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in the Companys initial public offering
and secondary offering of securities. The complaint brings claims for violation of several provisions of the federal securities laws against those underwriters, and also contains claims against the Company and certain of its directors and officers.
Various plaintiffs have filed similar actions asserting virtually identical allegations against more than 300 other companies. The lawsuit and all other IPO allocation securities class actions currently pending in the Southern District
of New York have been assigned to Judge Shira A. Scheindlin for coordinated pretrial proceedings. The Company believes that it has meritorious defenses to the claims and intends to vigorously defend against such claims.





On or about April 7, 2000, Sightsound, Inc. (Sightsound) filed an amended complaint against one of the Companys
customers in the United States District Court for the Western District of Pennsylvania. The suit alleges that the Companys customer infringes one or more of three patents (United States Patent Nos. 5,191,573; 5,675,734 and 5,996,440).
Sightsound claims damages of $20 million plus an unspecified royalty. The Company has entered into an agreement with the Companys customer agreeing to assume control of the defense and pay the defense costs, while reserving the Companys
rights as to indemnification obligations. The customer filed an answer to the amended complaint on April 27, 2000, denying the material allegations of the complaint, and asserting counterclaims for declaratory judgment of non-infringement and patent
invalidity. Following a claims construction hearing in 2001 and an initial report and recommendation on claim construction by the magistrate judge in February 2002 (which ruling is on appeal to the district judge), the Company renegotiated its
agreement with the Companys customer concerning the defense of the case going forward. The Company has now ceded control of the defense of the case to the customer/Bertelsmann AG (the customers ultimate owner), and is splitting the costs
of the defense with the customer/Bertelsmann AG. The Company is still reserving its rights as to indemnification issues. A trial date had been set for September 28, 2001 in the matter, but that date will be reset after the Court rules on the claim
construction and other pending matters.





NOTE 9MERGER:





On June 12, 2002, the Company signed a definitive merger agreement with Alliance Entertainment Corp. (Alliance), a privately-held home entertainment product
distribution, fulfillment and infrastructure company. On July 14, 2002, the Company and Alliance executed an amended and restated merger agreement that modified certain terms of the previously announced merger agreement.





April Acquisition Corp. was recently incorporated in Delaware solely for the purpose of the merger, and is a wholly-owned subsidiary of
the Company. It does not conduct any business and has no material assets. Upon completion of the merger, April Acquisition Corp. will be merged with and into Alliance, and Alliance will continue as the surviving corporation of the merger and a
wholly-owned subsidiary of the Company. Upon completion of the merger, each outstanding share of Alliance common stock will be converted into the right to receive a number of shares of the Companys stock which will result in the former
stockholders of Alliance holding 74% of the outstanding voting power of the combined organization after the merger, without giving effect to any then outstanding options or warrants.





The Company and Alliance expect to complete the merger when all of the conditions to completions of the merger contained in the merger agreement have been satisfied or
waived. The merger will become effective upon the filing of a certificate of merger with the Delaware Secretary of State under applicable Delaware law. The Company and Alliance are working toward satisfying the conditions to the merger, and hope to
complete the merger as soon as practicable following the annual stockholder meeting, to be held on September 26, 2002.





In connection with the merger, the Company will make an offer to purchase 10,000,000 shares of its common stock at a purchase price of $3.00 per share. If more than 10,000,000 shares of
the Companys common stock are tendered, the Company will purchase 10,000,000 shares of its common stock on a pro rata basis from those stockholders tendering shares. The tender offer will expire on the day of the Companys stockholder
meeting. Consummation of the tender offer is conditioned upon, among other things, approval of the issuance of the Companys stock in the merger by the Companys stockholders at the annual stockholder meeting. The approval of the issuance
of the Companys stock in the merger will require the affirmative vote of a majority of the outstanding shares of the Companys common stock voting at the annual stockholder meeting.





The merger agreement provides that upon completion of the merger, the board of directors of the Company will be comprised of members
designated by the Company to constitute one-third (1/3) of the board. Members designated by Alliance will
constitute two-thirds (2/3) of the board.





The merger agreement provides that the Company and Alliance may agree by mutual written consent to terminate the merger agreement at any time before the completion of
the. Under certain circumstances, either Alliance or the Company may unilaterally terminate the merger agreement. In certain of these circumstances, a termination fee will be payable by the Company to Alliance if the merger agreement is terminated.
The amount of the termination fee will depend on the circumstances giving rise to the termination and may be up to $3,000,000. Under the terms of the merger agreement, the Company will pay a $3,000,000 termination fee to Alliance if:





| |  |  | the Company or Alliance terminates the merger agreement because the merger was not consummated by December 31, 2002, and within 12 months after such
termination, the Company enters into a definitive agreement with respect to, or consummates, any acquisition proposal;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | Alliance terminates the merger agreement because a triggering event occurred prior to the approval of the issuance of the Companys stock in
the merger by the required vote of the Companys stockholders; or
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | the Company terminates the merger agreement because it enters into a definitive agreement related to an offer from a third party superior to the merger
agreement.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------



11




---

##### Table of Contents



LIQUID AUDIO, INC.





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)


(unaudited)







Under the terms of the merger agreement, the Company will pay to
Alliance a $1,000,000 termination fee in the event either Alliance or the Company terminates the merger agreement because the required vote of the Companys stockholders for the issuance of the Companys stock in the merger shall have not
been obtained at a meeting of the Companys stockholders or if Alliance or the Company terminates the merger agreement because the SEC shall have declined to grant an exemption from the requirements of Rule 102 of Regulation M in connection
with the tender offer and the merger and counsel has not advised the Company that it may proceed in the absence of such exemption. If within 12 months after such termination, the Company enters into a definitive agreement with respect to, or
consummates, any acquisition proposal, the Company will pay to Alliance an additional fee of $750,000. If within 6 months after such termination, the Company completes a liquidation or dissolution, the Company will pay to Alliance an additional fee
of $750,000.





The Company also announced that its board of directors approved an amendment to its Preferred Stock
Rights Agreement to revise the beneficial ownership threshold at which a person or group of persons becomes an acquiring person and triggers certain provisions under the Preferred Stock Rights Agreement. As revised, a person or group
would become an acquiring person if that person or group becomes the beneficial owner of 10 percent or more of the outstanding shares of the Companys common stock. Prior to such amendment, the beneficial ownership threshold was 15
percent.





A Registration Statement on Form S-4 was filed with the SEC on July 23, 2002, setting forth the terms of
the merger and putting up for vote the issuance of new shares of common stock and other routine matters at the Companys annual meeting of stockholders.




12




---

##### Table of Contents




|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. Examples of such forward-looking statements include, but are not limited to: statements about future expectations; statements
containing projections of results of operations or of financial conditions; statements characterizing future events or circumstances; statements about the pending merger of the Company and Alliance Entertainment Crop. (the Merger) and
statements about the market acceptance of our products and services. Such forward-looking statements involve risks and uncertainties, including, but not limited to, those risks and uncertainties relating to the costs and benefits associated with the
Merger, the growth and viability of the digital music market, the adoption of security standards for digital music, the acceptance of our platform by consumers, our ability to obtain content and our history of losses. 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, but are not limited to, those set forth
under the caption Additional Factors Affecting Future Results included in this Managements Discussion and Analysis of Financial Condition and Results of Operations.





While we believe that the discussion and analysis in this report is adequate for a fair presentation of the information, we recommend that you read this discussion and
analysis in conjunction with Managements Discussion and Analysis included in our Annual Report on Form 10-K for the year ended December 31, 2001 filed with the Securities Exchange Commission (SEC).





Overview





We are a leading provider of software products and services that enable artists, record companies and retailers to create, syndicate and sell music digitally over the Internet. Our products and services are based on an open technical
architecture that is designed to support a variety of digital music formats. From our inception in January 1996 through early 1997, we devoted substantially all of our efforts to product development, raising capital and recruiting personnel. We
first generated revenues in the first quarter of 1997 through the licensing of our Liquifier Pro, Liquid Server and Liquid Player software products. In November 1997, we introduced a subscription-based hosting service for digital recorded music
using our technology. In July 1998, to enhance consumer access to the music we were hosting, we launched the Liquid Music Network (LMN), a syndicated network of leading 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. As a provider of digital music delivery services, we expect our revenue sources to expand beyond software license sales to include sales of digital recorded music and digital music subscriptions. Revenues from digital music sales and
transaction fees from our music delivery services represented less than 7%, 6% and 1% of total net revenues in 2001, 2000 and 1999, respectively. Our Liquid Music Network began offering syndicated music through music retailer websites in the third
quarter of 1999.





Business Development Revenue





Business development revenues as a percentage of total net revenues were 61%, 63% and 48% in 2001, 2000 and 1999, respectively. Liquid Audio Korea (LAK), Liquid
Audio Greater China (LAGC), Liquid Audio South East Asia (LASE) through our strategic partner, Epi Entertainment Group, Ltd., and Liquid Audio Japan (LAJ) stopped making their contractual payments as scheduled in
the third quarter of 2000, fourth quarter of 2000, first quarter of 2001 and the second quarter of 2001, respectively, due to deterioration of their financial condition and lack of funds available to meet their contractual payment obligations. We
have been unsuccessful in receiving any additional contractual payments from these customers, and, as a result of the financial condition of these customers, we do not anticipate that such customers will be a source of additional revenue or that we
will receive payments owed for existing contractual arrangements.





In June 2001, we and LAJ mutually
agreed to terminate the licensing and reseller agreements (the Agreements) between us. As a result, LAJ renamed its company to Cyber Music Entertainment (CME) and no longer distributes our technology nor utilizes our digital
distribution platform to offer services to the Japanese music market. Effective September 30, 2001, CME ceased using our trademarks, including the company name, and returned all of our products, technology and licenses. We do not believe we have any
outstanding obligations in connection with the Agreements. As a result, we recognized the remaining deferred revenue balance of $890,000, which had been paid in cash, from CME in the three months ended September 30, 2001. In October 2001, we
established a new office in Tokyo to build new relationships with label, retail and consumer electronic companies directly.




13




---

##### Table of Contents




In September 2001, we notified LAK, LAGC and LASE through our strategic
partner of their defaults under the licensing and reseller agreements between us and the aforementioned companies due to their failures to make contractual payments as scheduled. LAK, LAGC and our strategic partner of LASE did not cure the defaults
during the cure periods. Accordingly, we exercised our rights to terminate the licensing and reseller agreements. Outstanding accounts receivable from LAK, LAGC and our strategic partner of LASE have been fully reserved, and no revenue from LAK,
LAGC or LASE through our strategic partner was recorded in the three months ended September 30, 2001. We do not believe we have any outstanding obligations in connection with the Agreements. As a result, we recognized the remaining deferred revenue
balance of $569,000, which had been paid in cash, from LAGC in the three months ended December 31, 2001.





Corporate
Restructuring





In May 2001, we adopted a corporate restructuring program to reduce expenses to
preserve our cash position while the digital music market develops. The restructuring included a worldwide workforce reduction of approximately 40% of our workforce across all functional areas, a consolidation of three Redwood City, California
offices into one facility and other expense management initiatives. We have de-emphasized our efforts in less productive, non-core business areas that do not directly support secure digital download opportunities, including digital music kiosks,
music hosting for independent artists and labels, music clips service and encoding services. We plan to continue to focus on software licensing and digital music delivery services that complement our secure digital download business. We plan to
support the emerging market for digital music subscriptions, enabling major portals, online retailers and secure audio device manufacturers to offer subscription-based digital music download services. This strategy leverages and enhances both our
core digital download services and our player software licensing business. At June 30, 2002, we have a remaining $31,000 restructuring accrual balance related to estimated future obligations for non-cancelable lease payments for excess facilities
that were vacated due to reductions in workforce. This accrual will be paid over the lease terms through the fourth quarter of 2002.





The Merger with Alliance





On June 12, 2002, we signed a definitive merger agreement
with Alliance Entertainment Corp. (Alliance), a privately-held home entertainment product distribution, fulfillment and infrastructure company. On July 14, 2002, we and Alliance executed an amended and restated merger agreement that
modified certain terms of the previously announced merger agreement. We and Alliance believe that the combination of our two businesses will permit us to develop effective and efficient means to deliver services to our customers.





April Acquisition Corp. was recently incorporated in Delaware solely for the purpose of the merger, and is our wholly-owned
subsidiary. It does not conduct any business and has no material assets. Upon completion of the merger, April Acquisition Corp. will be merged with and into Alliance, and Alliance will continue as the surviving corporation of the merger and our
wholly-owned subsidiary. Upon completion of the merger, each outstanding share of Alliance common stock will be converted into the right to receive a number of shares of our stock which will result in the former stockholders of Alliance holding 74%
of the outstanding voting power of the combined organization after the merger, without giving effect to any then outstanding options or warrants.





We and Alliance expect to complete the merger when all of the conditions to completions of the merger contained in the merger agreement have been satisfied or waived. The merger will
become effective upon the filing of a certificate of merger with the Delaware Secretary of State under applicable Delaware law. We and Alliance are working toward satisfying the conditions to the merger, and hope to complete the merger as soon as
practicable following the annual stockholder meeting, to be held on September 26, 2002.





In connection with
the merger, we will make an offer to purchase 10,000,000 shares of our common stock at a purchase price of $3.00 per share. If more than 10,000,000 shares of our common stock are tendered, we will purchase 10,000,000 shares of our common stock on a
pro rata basis from those stockholders tendering shares. The tender offer will expire on the day of our stockholder meeting. Consummation of the tender offer is conditioned upon, among other things, approval of the issuance of our stock in the
merger by our stockholders at the annual stockholder meeting. The approval of the issuance of our stock in the merger will require the affirmative vote of a majority of the outstanding shares of the our common stock voting at the annual stockholder
meeting.





The merger agreement provides that upon completion of the merger, our board of
directors will be comprised of members designated by us to constitute one-third (1/3) of the board. Members
designated by Alliance will constitute two-thirds (2/3) of the board.





The merger agreement provides that we and Alliance may agree by mutual written consent to terminate the merger agreement at any time
before the completion of the merger. Under certain circumstances, either Alliance or we may unilaterally terminate the merger agreement. In certain of these circumstances, a termination fee will be payable by us to Alliance if the merger agreement
is terminated. The amount of the termination fee will depend on the circumstances giving rise to the termination and may be up to $3.0 million. Under the terms of the merger agreement, we will pay a $3.0 million termination fee to Alliance if:





| |  |  | we or Alliance terminate the merger agreement because the merger was not consummated by December 31, 2002, and within 12 months after such termination, we enter
into a definitive agreement with respect to, or consummate, any acquisition proposal;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



14




---

##### Table of Contents




| |  |  | Alliance terminates the merger agreement because a triggering event occurred prior to the approval of the issuance of our stock in the merger by the
required vote of our stockholders; or
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | we terminate the merger agreement because we enter into a definitive agreement related to an offer from a third party superior to the merger agreement.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------




Under the terms of the merger agreement, we will pay to Alliance a $1.0 million termination
fee in the event either Alliance or we terminate the merger agreement because the required vote of our stockholders for the issuance of our stock in the merger shall have not been obtained at a meeting of our stockholders or if Alliance or we
terminate the merger agreement because the SEC shall have declined to grant an exemption from the requirements of Rule 102 of Regulation M in connection with the tender offer and the merger and counsel has not advised us that we may proceed in the
absence of such exemption. If within 12 months after such termination, we enter into a definitive agreement with respect to, or consummate, any acquisition proposal, we will pay to Alliance an additional fee of $750,000. If within 6 months after
such termination, we complete a liquidation or dissolution, we will pay to Alliance an additional fee of $750,000.





We also announced that our board of directors approved an amendment to our Preferred Stock Rights Agreement to revise the beneficial ownership threshold at which a person or group of persons becomes an acquiring person
and triggers certain provisions under the Preferred Stock Rights Agreement. As revised, a person or group would become an acquiring person if that person or group becomes the beneficial owner of 10 percent or more of the outstanding
shares of our common stock. Prior to such amendment, the beneficial ownership threshold was 15 percent.





A
Registration Statement on Form S-4 was filed with the SEC on July 23, 2002, setting forth the terms of the merger and putting up for vote the issuance of new shares of common stock and other routine matters at our annual meeting of stockholders.





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 June 30, 2002 we had an accumulated deficit of approximately $121.6 million. We expect to incur additional losses and continued negative cash flow from operations through at least 2003. Our
revenues may not increase or even continue at their current levels and 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.




15




---

##### Table of Contents




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.





Three Months Ended June
30,


Six Months Ended June 30,2002


2001


2002


2001Net revenues:License

26
%

19
%

27
%

18
%Services

74


35


73


29Business development (related party)




46





53Total net revenues

100


100


100


100Cost of net revenues:License

56


12


63


11Services

115


36


106


40Non-cash cost of revenue

24


10


24


7Total cost of net revenues

195


58


193


58Gross profit (loss)

(95
)

42


(93
)

42Operating expenses:Sales and marketing

679


299


763


287Non-cash sales and marketing

(21
)

(7
)

(7
)

(2
)Research and development

1,930


462


2,076


371Non-cash research and development

2


(3
)

3


(1
)General and administrative

1,262


301


1,053


234Non-cash general and administrative




(2
)




(1
)Strategic marketing-equity instruments




33





24Restructuring




358





137Total operating expenses

3,852


1,441


3,888


1,049Loss from operations

(3,947
)

(1,399
)

(3,981
)

(1,007
)Other income (expense), net

211


114


297


106Net loss in equity investment




(86
)




(41
)Net loss

(3,736
)%

(1,371
)%

(3,684
)%

(942
)%





Three Months Ended June 30, 2002 and 2001





Total Net Revenues





Total net revenues decreased 85% to $151,000 for the three months ended June 30, 2002 from $1.0 million in the comparable period of 2001.





License.    License revenues consist of fees from licensing our software products to third parties. License revenues decreased
79% to $40,000 for the three months ended June 30, 2002 from $194,000 in the comparable period of 2001. This decrease was due to lower Liquid Player software licensing resulting from the expiration of an OEM bundling agreement with a major consumer
electronics company and the transitioning of our Liquid Player software licensing strategy from bundling, for a per-unit fee, with OEM products in the 2001 period, to bundling for free with OEM products in exchange for potential future upgrade
licensing revenues from consumers of those OEM products in the 2002 period. We compete with other companies that offer music player software for free to OEMs, and such arrangements usually limit the bundling of a music player to only one vendor.
Accordingly, there is no assurance that we will be able to displace existing bundling arrangements that OEMs may have with our competitors.





Services.    Services revenues consist of maintenance fees related to our licensed software products, hosting fees, encoding, music delivery and transaction
fees, promotion and advertising services and kiosk-related equipment sales from third parties. Services revenues decreased 69% to $111,000 for the three months ended June 30, 2002 from $362,000 in the comparable period of 2001. This decrease was due
to decrease in maintenance fees resulting from lower software license fees, decrease in encoding services from the expiration of a contract with Microsoft, decrease in promotion and advertising services resulting from the softness in the Internet
advertising market, disappearance of revenue from Liquid Muze Previews service due to the termination of the agreement with Muze, decrease of hosting fees from the de-emphasis of music hosting for independent artists and labels in connection with
our corporate restructuring and decrease in kiosk-related equipment sales from the de-emphasis in digital music kiosks in connection with our corporate restructuring.




16




---

##### Table of Contents




Business Development (Related Party).    Business
development revenues consist of license and maintenance fees from agreements under which we give our strategic related partners the right to license and use our digital recorded music delivery technology. Business development revenues decreased to
$0 for the three months ended June 30, 2002 from $468,000 in the comparable period of 2001. The decrease was due to the termination of our agreements in 2001 with Liquid Audio Japan, Liquid Audio Korea, Liquid Audio Greater China and Liquid Audio
South East Asia through our strategic partner, Epi Entertainment Group, Ltd. Revenue for the 2001 period relates to software licensing and related maintenance revenues earned from Liquid Audio Japan and Liquid Audio Greater China. We do not expect
to derive significant revenue from business development arrangement in the foreseeable future.





In the three
months ended June 30, 2002, approximately 12% of total net revenues came from sales to one customer, Country Music Hall of Fame. In the three months ended June 30, 2001, approximately 47% of total net revenues came from sales to one customer, Liquid
Audio Greater China. International revenues represented approximately 14% and 48% of total net revenues in the three months ended June 30, 2002 and 2001, respectively.





Total Cost of Net Revenues





Our gross profit (loss) decreased to approximately (95)% of total net revenues for the three months ended June 30, 2002 from approximately 42% of total net revenues in the comparable period of 2001. Total cost of net revenues
decreased 50% to $294,000 in the 2002 period from $590,000 in the 2001 period.





License.    Cost of license revenues consists of royalties paid to third-party technology vendors and costs of documentation, duplication and packaging. Cost of license revenues decreased 34% to $84,000 for
the three months ended June 30, 2002 from $128,000 in the comparable period of 2001. Cost of license revenues decreased due to lower license revenues and product mix differences, partially offset by royalties for additional third-party technologies.





Services.    Cost of services revenues consists of compensation for customer
service, encoding and professional services personnel, kiosk-related equipment and an allocation of our occupancy costs and other overhead attributable to our services revenues. Cost of services revenues decreased 52% to $174,000 for the three
months ended June 30, 2002 from $364,000 in the comparable period of 2001. The decrease in cost of services revenues was due to the reduction in the number of encoding, customer service and professional services personnel from 28 to 8 due to our
corporate restructuring and expense management initiatives.





Non-Cash Cost of
Revenues.    Non-cash cost of revenues consists of expenses associated with the value of common stock and warrants issued to partners as part of our content acquisition agreements and stock-based employee compensation
arrangements. Common stock expense is based on the fair value of the stock at the time it was issued. Warrant expense is based on the estimated fair value of the warrants based on the Black-Scholes option pricing model and the provisions of EITF
96-18. In December 2000, we signed an agreement with BMG Entertainment (BMG) to obtain the right to distribute BMG sound recordings and related artwork through kiosks. In connection with this agreement, we issued 50,000 shares of common
stock to BMG, valued at $195,000 and which was recognized ratably over the initial one-year term of the agreement; as a result, $49,000 was recognized as non-cash cost of revenues in the three months ended June 30, 2001. Also in connection with this
agreement, we granted a warrant for a total of 233,300 shares of common stock. Of the total, warrants to purchase 77,768 shares vested in December 2001, and the cost was remeasured each quarter until a commitment for performance was reached or the
warrant vested, based on market data. At December 4, 2001, the 77,768 shares under this warrant were valued at $175,000, of which $55,000 was recognized as non-cash cost of revenues for the three months ended June 30, 2001. The remaining warrants to
purchase common shares vest at 6,481 shares per month commencing December 2001 for one year and 6,480 shares per month commencing December 2002 for one year. We recorded a total of $36,000 as non-cash cost of revenue in the three months ended June
30, 2002 related to the remaining warrants. Such warrants are valued at the fair market value of our common stock at each vesting date. Stock compensation expense for customer service, encoding and professional services personnel were $0 and
$(6,000) in the three months ended June 30, 2002 and 2001, respectively. We have fully amortized stock compensation expense related to these personnel in 2001, and accordingly no future expense related to these stock options will be incurred.




17




---

##### Table of Contents




Operating Expenses





Sales and Marketing.    Sales and marketing expenses consist of compensation for our sales, marketing and business development
personnel, compensation for customer service and professional services personnel attributable to sales and marketing activities, advertising, trade show and other promotional costs, design and creation expenses for marketing literature and our
website and an allocation of our occupancy costs and other overhead. Sales and marketing expenses decreased 66% to $1.0 million for the three months ended June 30, 2002 from $3.1 million in the comparable period of 2001. This decrease was due to the
reduction in compensation and related expenses of approximately $770,000 from decreases in the number of sales and marketing personnel from 59 to 19 due to our corporate restructuring and expense management initiatives, shared project costs with
Radio & Records of approximately $676,000, tradeshows of approximately $111,000, travel and entertainment of approximately $110,000, depreciation and amortization of approximately $110,000 and allocation of occupancy costs and other overhead of
approximately $192,000.





Research and Development.    Research and development
expenses consist 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 decreased 38% to $2.9 million for the three months ended June 30, 2002 from $4.7 million in the comparable period of 2001. This decrease was due to the reduction
in compensation and related expenses of approximately $1.1 million from decreases in the number of personnel from 88 to 51 and outside contractors due to our corporate restructuring and expense management initiatives, travel and entertainment of
approximately $100,000, depreciation and amortization of approximately $243,000 and allocation of occupancy costs and other overhead of approximately $183,000.





General and Administrative.    General and administrative expenses consist 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 decreased 38% to $1.9 million for the three months ended June 30, 2002 from $3.1 million in the comparable period of 2001. This decrease was due to the reduction in compensation and related expenses of approximately $365,000
from decreases in the number of personnel from 31 to 17 and outside contractors due to our corporate restructuring and expense management initiatives and a decrease in legal fees of approximately $322,000 from lower legal activity in patent
infringement matters in the 2002 period and decrease in bad debt expense of approximately $1.0 million, partially offset by fees paid to an investment banker of $400,000.





Strategic MarketingEquity Instruments.    Strategic marketing-equity instruments consist of expenses associated with the value of common
stock and warrants issued to partners as part of our strategic marketing agreements. Common stock expense is based on the fair value of the stock at the time it was issued. Warrant expense is based on the estimated fair value of the warrants based
on the Black-Scholes option pricing model and the provisions of EITF 96-18. Strategic marketing-equity instruments expense was $0 and $340,000 in the three months ended June 30, 2002 and 2001, respectively. In August 1999, we signed a Digital Audio
Co-Marketing and Distribution Agreement with Yahoo! to promote the distribution of digital music on its web site. In connection with this agreement, we granted Yahoo! three warrants to purchase a total of 250,000 shares of common stock. The first
warrant for 83,334 shares vested immediately. The first warrant was valued at $903,000 and was recognized ratably over the one-year term of the agreement. The second warrant for 83,333 shares vested in August 2000. The second warrant was initially
valued at $426,000 and was recognized ratably over the one-year period ending at the vesting date. The second warrant was revalued at each balance sheet date through the vesting date. As a result, the original charge of $426,000 was reduced to
$312,000 based on market data during the vesting period. The third warrant for 83,333 shares vested in August 2001. The third warrant was initially valued at $105,000 and was recognized ratably over the one-year period ending at the vesting date.
The third warrant was revalued at each balance sheet date through the vesting date. As a result, the original charge of $105,000 was reduced to $54,000 based on market data during the vesting period. In the three months ended June 30, 2001, $0, $0
and $45,000 were recognized as strategic marketing-equity instruments expense for the first, second and third warrants, respectively. In July 2000, we signed an agreement with Virgin Holdings, Inc. (Virgin), an affiliate of EMI Recorded
Music, to promote the distribution of digital music over the Internet using our technology. Pursuant to this agreement, we issued 150,000 shares of common stock to Virgin. These shares were valued at $1.2 million and recognized ratably over the
one-year term of the agreement. As a result, $295,000 was recognized as strategic marketing-equity instruments expense in the three months ended June 30, 2001.





Non-Cash Sales and Marketing, Research and Development and General and Administrative.    Non-cash sales and marketing, research and development and
general and administrative expenses relate to stock-based employee compensation arrangements. The total unearned compensation recorded by us from inception to June 30, 2002 was $3.5 million. We recognized $(28,000) and $(119,000) of stock
compensation expense for the three months ended




18




---

##### Table of Contents




June 30, 2002 and 2001, respectively. We expect quarterly amortization related to those options to be
between $5,000 and $3,000 per quarter during the remainder of 2002. These future compensation charges would be reduced if sales and marketing, research and development and general and administrative employees who hold the applicable options
terminate employment prior to the expiration of their option vesting period.





Restructuring.    Restructuring charge relates to costs associated with our corporate restructuring program adopted in May 2001. The $3.7 million charge in the three months ended June 30, 2001 consists of
involuntary employee separation costs of $1.1 million, lease costs of $824,000 pertaining to estimated future obligations for non-cancelable lease payments for excess facilities that were vacated due to reductions in workforce, and asset impairment
costs of $1.7 million for property and equipment, furniture and fixtures, computer software and leasehold improvements no longer in use from de-emphasized product lines, reductions in workforce and excess facilities.





Other Income (Expense), Net.    Interest income consists of earnings on our cash, cash equivalents and
short-term investments. Interest expense consists of expenses related to our financing obligations, which include borrowings under equipment loans and capital lease obligations. Other income (expense), net decreased to $318,000 for the three months
ended June 30, 2002 from $1.2 million in the comparable period of 2001. The decrease was due to lower average cash and cash equivalent balances resulting from cash used in operating activities, and lower interest rates.





Loss in Equity Investment.    Loss in equity investment consists of our share of losses from our investment
in a related party accounted for using the equity method of accounting. Loss in equity investment was $0 and $881,000 for the three months ended June 30, 2002 and 2001, respectively. The net balance of our investments in Cyber Music Entertainment
has been reduced to zero at December 31, 2001. We have discontinued recording losses from our investment in Cyber Music Entertainment as we have no contractual or planned obligation to provide funding to Cyber Music Entertainment.





Six Months Ended June 30, 2002 and 2001





Total Net Revenues.Total net revenues decreased 89% to $286,000 for the six months ended June 20, 2002 from $2.7 million in the comparable period of 2001.





License.License revenues decreased 84% to $76,000 for the six months ended June 30,
2002 from $484,000 in the comparable period of 2001. This decrease was due to lower Liquid Player software licensing resulting from the expiration of an OEM bundling agreement with a major consumer electronics company and the transitioning of our
Liquid Player software licensing strategy from bundling, for a per-unit fee, with OEM products in the 2001 period, to bundling for free with OEM products in exchange for potential future upgrade licensing revenues from consumers of those OEM
products in the 2002 period. We compete with other companies that offer music player software for free to OEMs, and such arrangements usually limit the bundling of a music player to only one vendor. Accordingly, there is no assurance that we will be
able to displace existing bundling arrangements that OEMs may have with our competitors.





Services.Services revenues decreased 73% to $210,000 for the six months ended June 30, 2002 from $787,000 in the comparable period of 2001. This decrease was due to decrease in maintenance fees
resulting from lower software license fees, decrease in encoding services from the expiration of a contract with Microsoft, decrease in promotion and advertising services resulting from the softness in the Internet advertising market, disappearance
of revenue from Liquid Muze Previews service due to the termination of the agreement with Muze, decrease of hosting fees from the de-emphasis of music hosting for independent artists and labels in connection with our corporate restructuring and
decrease in kiosk-related equipment sales from the de-emphasis in digital music kiosks in connection with our corporate restructuring.





Business Development (Related Party).Business development revenues decreased to $0 for the six months ended June 30, 2002 from $1.4 million in the
comparable period of 2001. The decrease was due to the termination of our agreements in 2001 with Liquid Audio Japan, Liquid Audio Korea, Liquid Audio Greater China and Liquid Audio South East Asia through its strategic partner, Epi Entertainment
Group, Ltd. Revenue for the 2001 period relates to software licensing and related maintenance revenues earned from Liquid Audio Japan and Liquid Audio Greater China. We do not expect to derive significant revenue from business development
arrangements in the foreseeable future. In the first six months of 2002, approximately 11% of total net revenues came from sales to one customer, Sanyo.





In the first six months of 2001, approximately 53% of total net revenues came from sales to two customers, Cyber Music Entertainment and Liquid Audio Greater China. International revenues represented
approximately 14% and 59% of total net revenues in the six months ended June 30, 2002 and 2001, respectively.





Total Cost of Net Revenues.Our gross profit (loss) decreased to approximately (93)% of total net revenues for the six months ended June 30, 2002 from approximately 42% of total net revenues in the
comparable period of 2001. Total cost of net revenues decreased 64% to $552,000 in the 2002 period from $1.5 million in the 2001 period.





License.Cost of license revenues decreased 37% to $181,000 for the six months ended June 30, 2002 from $287,000 in the comparable period of 2001. Cost of license revenues
decreased due to lower license revenues, partially offset by royalties for additional third-party technologies of approximately $93,000.




19




---

##### Table of Contents




Services.Cost of services revenues decreased
72% to $302,000 for the six months ended June 30, 2002 from $1.1 million in the comparable period of 2001. The decrease in cost of services revenues was due to the reduction in compensation and related expenses of approximately $701,000 from the
decrease in the number of encoding, customer service and professional services personnel from 33 to 8 due to our corporate restructuring and expense management initiatives and the write-down of kiosk inventory of approximately $212,000 in the 2001
period due to our de-emphasis in the digital music kiosk business area due to the corporate restructuring.





Non-Cash Cost of Revenues.    Non-cash cost of revenues were $69,000 for the six months ended June 30, 2002 and $181,000 in the comparable period of 2001.





Operating Expenses





Sales and Marketing.    Sales and marketing expenses decreased 72% to $2.2 million for the six months ended June 30, 2002 from $7.7 million in the comparable period of 2001. This
decrease was due to the reduction in compensation and related expenses of approximately $2.1 million from decreases in the number of sales and marketing personnel from 62 to 19 due to the corporate restructuring and expense management initiatives,
shared project costs with Radio & Records of approximately $1.2 million, advertising and promotional programs of approximately $227,000, tradeshows of approximately $307,000, travel and entertainment of approximately $335,000, depreciation and
amortization of approximately $224,000, customer service and professional services personnel attributable to sales and marketing activities of approximately $375,000, legal fees of approximately $117,000 and allocation of occupancy costs and other
overhead of approximately $401,000.





Research and Development.Research and
development expenses decreased 40% to $5.9 million for the six months ended June 30, 2002 from $10.0 million in the comparable period of 2001. This decrease was due to the reduction in compensation and related expenses of approximately $2.8 million
from decreases in the number of personnel from 86 to 51 and outside contractors due to the corporate restructuring and expense management initiatives, travel and entertainment of approximately $172,000, depreciation and amortization of approximately
$449,000 and allocation of occupancy costs and other overhead of approximately $368,000.





General and
Administrative.General and administrative expenses decreased 52% to $3.0 million for the six months ended June 30, 2002 from $6.3 million in the comparable period of 2001. This decrease was due to the reduction in
compensation and related expenses of approximately $1.0 million from decreases in the number of personnel from 37 to 17 and outside contractors due to the corporate restructuring and expense management initiatives and a decrease in legal fees of
approximately $1.5 million from lower legal activity in patent infringement matters in the 2002 period and decrease in bad debt expense of approximately $1.0 million.





Strategic MarketingEquity Instruments.    Strategic marketing-equity instruments expense was $0 for the six months ended June 30, 2002 and
$652,000 in the comparable period in 2001.





Non-Cash Sales and Marketing, Research and Development and
General and Administrative.The total unearned compensation recorded by us from inception to June 30, 2002 was $3.5 million. We recognized $13,000 and $96,000 of stock compensation expense for the six months ended June 30,
2002 and 2001, respectively. We expect quarterly amortization related to those options to be between $5,000 and $3,000 per quarter during the remainder of 2002. These future compensation charges would be reduced if sales and marketing, research and
development and general and administrative employees who hold the applicable options terminate employment prior to the expiration of their option vesting period.





Restructuring.The $3.7 million charge in the six months ended June 30, 2001 consists of involuntary employee separation
costs of $1.1 million, lease costs of $824,000 pertaining to estimated future obligations for non-cancelable lease payments for excess facilities that were vacated due to reductions in workforce, and asset impairment costs of $1.7 million for
property and equipment, furniture and fixtures, computer software and leasehold improvements no longer in use from de-emphasized product lines, reductions in workforce and excess facilities.





Other Income (Expense), Net.Other income (expense), net decreased to $851,000 for the six months ended June 30, 2002 from $2.8
million in the comparable period of 2001. The decrease was due to lower average cash and cash equivalent balances resulting from cash used in operating activities, and lower interest rates.





Loss in Equity Investment.Our share of losses was $0 and $1.1 million for the six months ended June 30, 2002 and 2001, respectively.
The net balance of our investments in Cyber Music Entertainment has been reduced to zero at December 31, 2001. We have discontinued recording losses from our investment in Cyber Music Entertainment as we have no contractual or planned obligation to
provide funding to Cyber Music Entertainment.





Liquidity and Capital Resources





Since inception, we have financed our operations primarily through the initial and follow-on public offerings of common stock, private
placements of our preferred stock, equipment financing, lines of credit and short-term loans. As of June 30, 2002, we had raised $65.9 million and $93.7 million through our initial and follow-on public offerings of common stock, respectively, and
$29.8 million through the sale of our preferred stock. At June 30, 2002, we have approximately $81.0 million of cash and cash equivalents.




20




---

##### Table of Contents




Net cash used in operating activities was $10.4 million and $19.0 million for
the six months ended June 30, 2002 and 2001, respectively. Net cash used for operating activities in the 2002 period was the result of net losses from operations of $10.5 million, depreciation and amortization of $1.3 million, amortization of
unearned compensation of $(13,000), non-cash cost of revenue of $69,000 and a net decrease in working capital items of $1.2 million. The net decrease in working capital items include a decrease in accounts receivable of $15,000, decrease in other
assets of $471,000, increase in accounts payable of $3,000, decrease in accrued liabilities of $1.7 million and a decrease in deferred revenue of $13,000. Net cash used for operating activities in the 2001 period was the result of net losses from
operations of $25.3 million, depreciation and amortization of $2.2 million, amortization of unearned compensation of $(101,000), strategic marketingequity instruments charges of $652,000, non-cash cost of revenue of $186,000, an increase in
the allowance for doubtful accounts and sales returns reserve of $1.1 million, loss in equity investment of $1.1 million, loss on disposal of and write-down of property and equipment of $1.7 million and a net decrease in working capital items of
$542,000. The net decrease in working capital items include an increase in accounts receivable of $122,000, decrease in other assets of $176,000, decrease in accounts payable of $1.0 million, increase in accrued liabilities of $457,000 and a
decrease in deferred revenue of $250,000.





Net cash provided by (used in) investing activities was $(67,000)
and $26.6 million for the six months ended June 30, 2002 and 2001, respectively. Net cash used in investing activities in the 2002 period was primarily due to acquisition of property and equipment. Net cash provided by investing activities in the
2001 period was primarily due to net sales of short-term investments of $27.4 million, partially offset by acquisition of property and equipment of $689,000.





Net cash used in financing activities was $112,000 and $211,000 for the six months ended June 30, 2002 and 2001, respectively. The net cash used in financing activities for both periods is due
primarily to payments made under our equipment loan and capital leases.





We had a bank equipment loan facility
that provided for advances of up to $3.0 million through November 1999. Borrowings under the equipment loan facility were repayable in monthly installments over three years and bore interest at the banks prime interest rate plus 0.25%.
Borrowings were collateralized by the related equipment and other assets. Under the equipment loan facility, we had borrowed amounts totaling $1.8 million through June 30, 2002, and no amounts are outstanding as of June 30, 2002. Our other
significant commitments consist of obligations under non-cancelable operating leases, which totaled $6.4 million, net of rental income of $21,000, as of June 30, 2002 and are payable in monthly installments through 2005 and a note payable to related
party in the amount of $376,000 that was issued in the three months ended March 31, 1999. The note payable to related party is repayable in Japanese yen and bears interest at 0.5% above a Japanese banks prime rate. The principal is due on
December 31, 2003, with quarterly interest payments. The terms of the strategic related partner note payable require us to make quarterly interest payments. At June 30, 2002, we were not in compliance with the interest payment requirement. We are
currently applying for a waiver from the strategic related partner with respect to our non-compliance with making quarterly interest payments. To obtain a waiver, we may have to make payments of all interest due to date and additional default
interest of 10% on unpaid amounts outstanding, which has been accrued at June 30, 2002. As a result of our default of these payments, the strategic related partner has a right to accelerate payment of all amounts outstanding under the note payable
and demand immediate full payment of all amounts due, including outstanding interest and penalties. Accordingly, we have classified the outstanding balance under the note payable as a current liability. If we are successful in obtaining a waiver
from the strategic partner, then the note payable will be reclassified as a long-term liability.





In the past,
we derived a significant portion of our revenues from business development fees from relationships with our international partners, including Liquid Audio Japan, Liquid Audio Korea, Liquid Audio Greater China and Liquid Audio South East Asia through
our strategic partner, Epi Entertainment Group, Ltd. We terminated our relationships with these partners in 2001. Consequently, we do not expect additional revenue or cash payments will be generated from them. At June 30, 2002, we held 4.31% of the
outstanding stock of Cyber Music Entertainment (CME), formerly Liquid Audio Japan, and had written down our investment to $0 under the equity method of accounting.





We have no material commitments for capital expenditures or strategic investments and anticipate a low rate of capital expenditures. We may use cash to acquire or license
technology, products or businesses related to our current




21




---

##### Table of Contents




business. In addition, we anticipate that we will experience low or no growth or a decline in our
operating expenses for the foreseeable future and that our operating expenses will be a material use of our cash resources.





Future payments due under debt and lease obligations as of June 30, 2002 are as follows (in thousands):





Note Payable to Related Party

Equipment Loan

Capital Leases

Operating Leases

Total2002

$
376

$


$
12

$
1,202

$
1,5902003











2,100


2,1002004











2,163


2,1632005











904


904$
376

$


$
12

$
6,369

$
6,757





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





Market Risk





No material changes exist to our market risk
during the six months ended June 30, 2002. For additional information, refer to Managements Discussion and Analysis of Financial Condition and Results of Operations included in our Form 10-K for the year ended December 31, 2001
filed with the SEC.




22




---

##### Table of Contents




ADDITIONAL FACTORS AFFECTING FUTURE RESULTS





Before deciding to invest in us or to maintain or increase your investment, you should carefully consider the risks described below, in addition to the other
information contained in this report and in our other filings with the SEC, including our Annual Report on Form 10-K filed March 29, 2002 and our Registration Statement on Form S-4 filed July 23, 2002. The risks and uncertainties described below are
not the only ones facing us. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business operations. If any of these risks actually occur, our business, financial condition or
results of operations could be seriously harmed. In that event, the market price of our common stock could decline and you may lose all or part of your investment. References to the combined organization in this section entitled
Additional Factors Affecting Future Results refer to Liquid Audio, Inc. and Alliance Entertainment Corp. as a combined entity following the proposed merger between the two companies, as more fully described under Item
2Managements Discussion of Financial Condition and Results of Operations.





If the Merger with Alliance Does Not
Occur, We Will Not Receive the Expected Benefits of the Merger





The completion of the merger is subject to a
number of conditions, including the approval of both our and Alliance stockholders. If one of the conditions to complete the merger is not satisfied or waived, then the merger may not be completed.





If the merger is not completed, the expected benefits of the merger will not be realized. In addition, in anticipation of the completion
of the merger, we have implemented certain changes to our business operations, including a reduction in our workforce. As a result, if the merger is not completed, we may not have sufficient employees to continue our current operations. Failure to
complete the merger could have a material adverse effect on our future business, financial condition and operating results.





In the event that the proposed merger with Alliance is terminated by us or if our stockholders fail to approve the proposed merger, we may be obligated to pay a termination fee of up to $3.0 million.





The Combined Organization May Not Realize the Expected Benefits from the Merger and the Market Price of Our Stock May Decline as a Result of the Merger





We believe that the merger of Alliance and us will result in benefits to the combined organization that
outweigh the costs and expenses related to the merger and increase stockholder value. Achieving these benefits, however, will depend on a number of factors, including:





| |  |  | effectively and efficiently integrating the operations, information systems and personnel of the two companies to achieve operating efficiencies;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | beneficially exploiting the increased complexity and diversity of operations of the combined organization;
| | - |  | ----------------------------------------------------------------------------------------------------------




| |  |  | retaining key management, marketing, sales and technical personnel;
| | - |  | -------------------------------------------------------------------




| |  |  | averting the potential diversion of managements attention from other business concerns to the combination of the companies;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------




| |  |  | retaining key customers;
| | - |  | ------------------------




| |  |  | increasing the combined organizations customer base and product sales;
| | - |  | -----------------------------------------------------------------------




| |  |  | keeping step with industry trends and technological advances;
| | - |  | -------------------------------------------------------------




| |  |  | adjusting to changing market conditions;
| | - |  | ----------------------------------------



23




---

##### Table of Contents




| |  |  | successfully pursuing anticipated revenue opportunities in emerging channels of distribution; and
| | - |  | -------------------------------------------------------------------------------------------------




| |  |  | effectively addressing unanticipated problems or legal liabilities.
| | - |  | -------------------------------------------------------------------




In addition, successful integration of the operations of us and Alliance may place a significant burden on the management and internal resources of the combined
organization. The diversion of managements attention and any difficulties encountered in the transition and integration process could have a material adverse effect on the future business, financial condition and operating results of the
combined organization.





Our Stockholders May Not Realize a Benefit from the Merger Commensurate with the Ownership Dilution They Will
Experience in Connection with the Merger





If the combined organization is unable to realize the strategic and
financial benefits currently anticipated from the merger, our stockholders will have experienced substantial dilution of their ownership interest without receiving any commensurate benefit. In connection with the merger, we will issue shares of our
stock representing 74% of our voting power following the merger. In addition, the exercise of options assumed by us in the merger will further dilute the ownership interests of our current stockholders.





The Tender Offer and the Merger Will Require Substantial Expenditures





We estimate that we will incur aggregate pre-tax costs of approximately $6.6 million associated with the merger, as well as severance costs relating to employees, in
addition to the $30 million that will be paid upon completion of the tender offer, assuming that 10 million shares of our common stock are tendered. In addition, the combined organization expects to incur certain costs in connection with the
integration of the two companies. Such costs cannot now be reasonably estimated, because they depend on future decisions to be made by management of the combined organization, but they could be material. These costs and expenses will affect results
of operations in the quarter in which the merger is completed. Even if the merger is not completed, we will incur our portion of these total costs and expenses, other than the cost of paying the consideration for shares of our common stock tendered
in the tender offer. Additionally, if the merger is terminated, we will incur termination fees under certain conditions. See If the Merger with Alliance Does Not Occur, We Will Not Receive the Expected Benefits of the Merger.





The Nasdaq National Market May Delist Our Common Stock Following the Merger





The Nasdaq staff may determine that the proposed merger would constitute a reverse merger under National Association of Securities Dealers Rule 4330(f).
Following the announcement of the merger in June 2002, we received correspondence from the Nasdaq staff indicating that the staff believes that the merger may result in a change of control that would require us to submit an initial listing
application following the consummation of the merger and, at the time of the application, meet all of the criteria applicable to a company initially requesting inclusion in The Nasdaq National Market. The Nasdaq staff has subsequently indicated that
it intends to find that the merger will result in a change of control and that it will constitute a reverse merger. If the Nasdaq staff determines that a change of control has occurred, we will be required to satisfy the requirements, for initial
inclusion on The Nasdaq National Market in order for our common stock to remain listed on The Nasdaq National Market. Currently, we would not satisfy these requirements, and it is unlikely such requirements will be satisfied following the
consummation of the merger. If we do not meet these requirements upon completion of the merger, we anticipate that our common stock will be delisted from The Nasdaq National Market following the completion of the merger. If we are delisted from The
Nasdaq National Market System, we may be allowed to transfer our securities from The Nasdaq National Market to The Nasdaq SmallCap Market.





Any of the foregoing may adversely impact our stock price, as well as our liquidity and the ability of our stockholders to purchase and sell our shares in an orderly manner, or at all. Furthermore, a delisting of our shares
could damage our general business reputation and impair our ability to raise additional funds. Any of the foregoing events could have a material adverse effect on our business, financial condition and operating results.





We Have Never Been Profitable, and Alliance Has Recently Incurred Net Losses, and You Cannot Be Sure that We or the Combined Organization Will Achieve
Profitability




24




---

##### Table of Contents




In each of the years we have been in business, we have experienced net losses.
Our net losses were approximately $33.7 million and $37.2 million in 2000 and 2001, respectively, and $10.5 million for the six months ended June 30, 2002. Alliance had net income for the year ended December 31, 2001 but experienced a net loss of
approximately $1.0 million for the three months ended March 31, 2002. We expect that our business will continue to incur net losses for the remainder of the 2002 fiscal year. There can be no assurance that our business or the combined organization
will achieve profitability.





Several of Our Customers Might Have Difficulty Meeting Their Payment Obligations to Us





As of June 30, 2002, 70% or $327,000 of our accounts receivable from third parties were more than 30 days past due. You should
evaluate the ability of these companies to meet their payment obligations to us in light of the risks, expenses and difficulties encountered by such companies. If one or more of our customers were unable to pay for our services in the future, or
paid more slowly than we anticipate, recognition of revenue might be delayed and our operating results will 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, such as our subscription-based service offering and server-based license offering, in a timely manner and to provide new products and services that achieve rapid and broad market acceptance.
We may fail to identify new product and service opportunities successfully and develop and bring to market new products and services in a timely manner. In addition, product innovations may not achieve the market penetration or price stability
necessary for profitability.





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





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





Competition among companies in the business
of digital delivery of music over the Internet is intense. We expect that present competitors will increase competitive pressure in the market for digital delivery of music.





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





| |  |  | larger audiences;
| | - |  | -----------------




| |  |  | larger technical, production and editorial staffs;
| | - |  | --------------------------------------------------




| |  |  | 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.
| | - |  | --------------------------------------------------------------------------



25




---

##### Table of Contents




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 and operating results would be harmed.





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. We hold sixteen existing patents and currently have twelve patents pending in the United
States and eleven patents pending in other countries. Our existing patents expire between October 2015 and March 2019. We have had claims allowed on none of our patent applications. We are presently pursuing the registration of our trademarks. Our
patent applications or trademark registrations in the United States 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 in the United
States are not approved because third parties own these trademarks, our use of these trademarks would be restricted unless we enter into arrangements with the third-party owners, which might not be possible on commercially reasonable terms or at
all.





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





Because we digitally deliver recorded music and other music products to third parties, the we might be subject to litigation based on
claims of negligence, copyright, trademark infringement, patent infringement or other intellectual property rights. In the past, these types of claims have been brought, sometimes successfully, against our competitors and, in particular, providers
of online products and services. 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. With respect to distribution of video and music product generally, substantially all such products sold are
subject to copyright laws and licenses that limit the manner and geographic area in which these products may be sold and provide royalties to the copyright owners. Any sales of these products in violation of these laws and licenses by anyone in the
chain of distribution, including our suppliers, may subject us to monetary damages and confiscation of the products. 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 and diversion of management resources in investigating and defending against these claims, which could harm our business.




26




---

##### Table of Contents




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





Additionally, Muze, Inc. has sued Alliance alleging that Alliances marketing of the AMG business violates Californias unfair business practice statutes and
federal antitrust law. We cannot estimate the total potential liability to which the combined organization might be exposed as a result of these suits. If these suits result in a judgment against Alliance, its business and results of operations, and
that of the combined organization, could be materially adversely affected.





The Growth of Our Business is Dependent on Development of
Devices that Play Digitally Downloaded Music that Achieve Mass Customer Acceptance.





The market for digitally
recorded music delivered over the Internet is relatively new and may not achieve mass customer acceptance. Several consumer electronics companies have introduced devices that allow digital music delivered over the Internet to be played away from the
personal computer. However, if additional devices such as wireless broadband devices and in-home connected set-top boxes are not developed or do not achieve mass customer acceptance or our products and services are incompatible with these devices,
our business may not grow or could be otherwise harmed.





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





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





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




| |  |  | the willingness of consumers to invest in computer technology that facilitates the downloading of digital music;
| | - |  | ----------------------------------------------------------------------------------------------------------------




| |  |  | the cost of time-based Internet access;
| | - |  | ---------------------------------------




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




| |  |  | the availability of portable devices to which digital recorded music can be transferred;
| | - |  | ----------------------------------------------------------------------------------------




| |  |  | the fidelity and quality of the sound of the digital recorded music; and
| | - |  | ------------------------------------------------------------------------




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




It is too soon to determine whether consumers will accept our platform
as their primary application to download, manage and play digital music. A lack of customer acceptance would harm our business and operating results.




27




---

##### Table of Contents




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, record companies and artists are unable to prevent users from downloading and
distributing unauthorized or pirated copies of copyrighted recorded music in these formats over the Internet. This piracy is a significant concern to record companies and artists, and is the primary reason many record companies and
artists are reluctant to digitally deliver their recorded music over the Internet. If record companies and artists do not adopt a standard format, however, it may permit unsecure copies of recorded music to continue to be available on the Internet,
and as a result 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 and operating results 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. It is too soon to determine whether our standard will be adopted as the dominant industry standard, if a standard
is so adopted.





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





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





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





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





We Might Not Have Sufficient Content to Attract Consumers if Artists and Record Labels Are Not Satisfied That They Can Profitably Digitally Deliver Their
Music Over the Internet or if Record Labels Enter Into License Agreements with Our Competitors





Our success
depends on our ability to aggregate a sufficient amount and variety of digital recorded music for syndication. 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 distribution platform. 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




28




---

##### Table of Contents




Internet will result in overall profitability. If record companies do not believe that recorded music
can be profitably delivered over the Internet or that such delivery will cannibalize sales through other channels, they may 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 will be harmed.





The major U.S. record companies have recently formed ventures for the licensing of their digital music subscription services to online music service providers. BMG Entertainment, EMI, Real Networks and Warner Music Group have formed
a venture called MusicNet. Also, Universal Music Group (an unit of Vivendi Universal) and Sony Music Entertainment have formed a venture called pressplay. Musicnet and pressplay have recently launched their services, and may
license their services to other third party online music service providers. If our competitors obtain licenses for digital music subscription services from MusicNet and pressplay and we are unable to obtain similar content provided by those services
on commercially reasonable terms, these competitors may be able to develop a more compelling consumer product and our business could be harmed.





We Might Be Unable to License or Acquire Technology





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





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





We have recently decided to focus on providing a
subscription-based service offering and a licensing-based offering for our customers. We have limited experience in pricing such new models, and failure to properly price and adjust these new pricing models may result in a loss of customers which
would have an adverse effect on our business and operating results. Moreover, 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 we are forced to reduce or eliminate prices, it would diminish our revenues and impact our margins, which will harm our business.





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.





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





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





| |  |  | use leading technologies effectively;
| | - |  | -------------------------------------




| |  |  | continue to develop our strategic and technical expertise;
| | - |  | ----------------------------------------------------------




| |  |  | enhance our current products and services;
| | - |  | ------------------------------------------




| |  |  | develop new products and services that meet changing customer needs;
| | - |  | --------------------------------------------------------------------




| |  |  | advertise and market our products and services; and
| | - |  | ---------------------------------------------------



29




---

##### Table of Contents




| |  |  | influence and respond to emerging industry standards and other technological changes.
| | - |  | -------------------------------------------------------------------------------------




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





We Might Not Be 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.





Our Products and Services Might
Contain Errors





We offer complex products and services that 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 and results of operations.





System Failures or Delays Might Harm Our Business





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





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





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





| |  |  | the timing of individual software licenses to customers;
| | - |  | --------------------------------------------------------




| |  |  | 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;
| | - |  | -----------------------------------------------------------------------------------------




| |  |  | distribution of the player through OEM and retail partners;
| | - |  | -----------------------------------------------------------



30




---

##### Table of Contents




| |  |  | the upgrade percentage of our promotional player to the paid Player Plus version;
| | - |  | ---------------------------------------------------------------------------------




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




| |  |  | the timing of our partners introduction of new products and services for digital music sales; and
| | - |  | --------------------------------------------------------------------------------------------------




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




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





| |  |  | market adoption and growth of sales of digitally downloaded recorded music over the Internet;
| | - |  | ---------------------------------------------------------------------------------------------




| |  |  | legal developments with respect to copyright law and downloadable music;
| | - |  | ------------------------------------------------------------------------




| |  |  | our ability to attract significant numbers of music recordings to be syndicated in our format;
| | - |  | ----------------------------------------------------------------------------------------------




| |  |  | our ability to provide reliable and scalable service, including our ability to avoid potential system failures;
| | - |  | ---------------------------------------------------------------------------------------------------------------




| |  |  | market acceptance of new and enhanced versions of our products and services; and
| | - |  | --------------------------------------------------------------------------------




| |  |  | the price and mix of products and services we offer.
| | - |  | ----------------------------------------------------




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





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





| |  |  | take advantage of opportunities, including 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.




31




---

##### Table of Contents




Our Charter Documents and Delaware Law May Impede Or Discourage A Takeover, Which Could Lower Our
Stock Price





Provisions of our restated certificate of incorporation and bylaws, and provisions of Delaware
law, may have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of us. For example, we have a classified board of directors which may tend to discourage a third
party from making a tender offer or otherwise attempting to obtain control of us and may maintain the incumbency of our board of directors, as the classification of the board of directors increases the difficulty of replacing a majority of the
directors. These provisions may have the effect of deferring hostile takeovers, delaying changes in our control or management, or may make it more difficult for stockholders to take certain corporate actions. Consequently, these provisions could
limit the price that certain investors might be willing to pay in the future for shares of our common stock.





Our Rights Plan May
Impede Or Discourage a Takeover, Which Could Lower Our Stock Price





Our board of directors has approved a
shareholders rights plan, which was amended recently on July 14, 2002. The rights will become exercisable the tenth day after a person or group announces acquisition of 10% or more of our common stock or announces commencement of a tender or
exchange offer the consummation of which would result in ownership by the person or group of 10% or more of our common stock. If the rights become exercisable, the holders of the rights (other than the person acquiring 10% or more of our common
stock) will be entitled to acquire, in exchange for the rights exercise price, shares of our common stock or shares of any company in which we are merged, with a value equal to twice the rights exercise price. The rights may have the
effect of rendering more difficult or discouraging an acquisition of the Company deemed undesirable by the board of directors. As a result, the rights could limit the price that certain investors might be willing to pay in the future for shares of
our common stock.




32




---

##### Table of Contents

Risks Related to Our Industry





Internet Security Concerns Could Hinder E-Commerce





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





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





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.





The growing use of the Internet has also
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.





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





In 1998, Congress passed the Internet Tax Freedom Act, which imposed a three-year moratorium on state and local taxes on Internet-based transactions. The moratorium was scheduled to expire in October 2001. Recently, Congress extended
the Internet Tax Freedom Act until November 1, 2003. We cannot assure you that this moratorium will be extended beyond November 1, 2003. Failure to extend this moratorium beyond that date would allow various states to impose taxes on e-commerce,
which might harm our business.





In February 2002, European Finance Ministers announced that beginning July 2003
Value Added Tax (VAT) will be imposed on services delivered electronically over the Internet from suppliers outside the European Union (EU). The tax may substantially impair the growth of e-commerce in the EU and may reduce
our opportunity to derive e-commerce in the EU, and our business could 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 damage to the Internet;
| | - |  | -----------------------------------------------




| |  |  | excessive governmental regulation; and
| | - |  | --------------------------------------




| |  |  | uncertainty regarding intellectual property rights.
| | - |  | ---------------------------------------------------




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




33




---

##### Table of Contents




Government Regulation of the Internet Might Harm Our Business





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





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





ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





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




34




---

##### Table of Contents




PART II. OTHER INFORMATION





ITEM 1.    LEGAL PROCEEDINGS





On July 23, 2002, MMC
filed an action in Delaware Chancery Court against us, each member of our board of directors, and Alliance Entertainment Corp. The complaint alleges that our directors violated their fiduciary duties by entering into the merger and approving the
merger agreement, and that our directors further violated their fiduciary duties by making certain changes to our shareholders rights plan. Alliance is alleged to have aided and abetted the alleged breaches of fiduciary duty by our directors.
According to the complaint, the plaintiff is seeking, among other things, to (i) invalidate the merger agreement, (ii) prevent us or Alliance from taking any actions to effectuate or enforce the merger agreement, the merger of us or Alliance, or the
self tender-offer, (iii) direct our board of directors to restore the trigger of our shareholders rights plan to 15%, (iv) prevent enforcement of our shareholders rights plan to the extent it prohibits the plaintiff and other
stockholders from cooperating to assist in the solicitation of proxies for our annual meeting, (v) damages for incidental injuries, and (vi) costs and expenses, including attorneys fee and experts fees. In connection with its complaint,
MMC filed a motion for a preliminary injunction and a motion for expedited proceedings. On July 31, 2002, MMC withdrew its motion for a preliminary injunction and for expedited proceedings, and stated that it would file an amended complaint. To
date, no amended complaint has been filed. If MMC elects to pursue its claims in this matter, we intend to vigorously defend the action.





On May 3, 2002, MMC filed an action in the Delaware Chancery Court, pursuant to Title 8 Delaware Code section 211, seeking to compel us to hold an annual meeting of stockholders. We moved to dismiss on
the grounds that the court lacked subject matter jurisdiction as 13 months had not elapsed since our last annual stockholder meeting, held on June 1, 2001. On May 10, 2002, the board of directors set July 1, 2002 as the date for the 2002 Annual
meeting and our motion to dismiss was held in abeyance. On June 13, 2002, we publicly announced the execution of the original merger agreement and announced that, in light of the merger, our board of directors had determined to postpone the 2002
annual meeting. The next day, MMC filed an amended complaint requesting that the court order us to hold our annual meeting on July 1, 2002. The court allowed the parties to take expedited discovery and scheduled a hearing for July 15, 2002. At the
hearing, the court granted our request that the annual meeting be scheduled for September 26, 2002 so that the vote on the election of directors and the vote on the issuance of us stock in the merger could proceed on the same day.





In November 2001, two lawsuits were filed in Delaware Chancery Court naming us and certain of our officers and directors as
defendants. Both actions related to our response to recent acquisition offers and purported to be class actions brought on behalf of our stockholders. On February 1, 2002, the two complaints were consolidated into a single action, titled In Re
Liquid Audio, Inc., Shareholders Litigation, Consolidated Civil Action No. 19212-NC. That action was brought against Gerald W. Kearby, Silvia Kessel, Ann L. Winblad and us. The complaint alleges that defendants had breached their fiduciary
duties owed to our stockholders in connection with our response to acquisition offers from Steel Partners II, LLP and an investor group formed by MMC (formerly known as musicmaker.com). The complaint seeks, among other things, a court order barring
us from adopting or maintaining measures that would make us less attractive as a takeover candidate or, alternatively, awarding compensatory damages to the purported plaintiff class. To date, we have not responded to the complaint, nor has the court
set a date for discovery cutoff or trial. We intend to vigorously defend the action. There is no assurance concerning the outcome of either action, or whether either action would have a material effect on our financial condition or business
operations.





On or about September 27, 2001, Network Commerce, Inc.
(NCI) filed a complaint against us in the United States District Court for the Western District of Washington (Seattle). The suit alleges that we infringe the claims of United States Patent No. 6,073,124. NCI requests that we be enjoined
from our allegedly infringing activities and seeks unspecified damages. We were served with the complaint on November 2, 2001 and subsequently submitted an answer to the complaint that included counterclaims. We also filed a motion for summary
judgment in November 2001. In March 2002, our motion for summary judgment was denied and in August 2002, we filed an amended motion for summary judgment. A hearing on the motion has been scheduled in September 2002.





On August 23, 2001, we received a demand letter from a former employees legal counsel alleging claims
for sexual harassment and retaliation. On September 13, 2001, the former employee filed a charge with the California Department of Fair Employment and Housing alleging such claims against us and one of our former employees. We completed an
investigation and believe that there is no merit to the former employees allegations. In May 2002, the parties entered into a final settlement regarding this matter. The settlement did not have a material impact on our financial position or
results of operations.




35




---

##### Table of Contents




On July 20, 2001, a putative securities class action, captioned
Murowa Financial v. Liquid Audio, Inc. et al., Civil Action No. 01-CV-6661, was filed against us, certain of our officers and directors (the Individual Defendants) and three underwriters in our initial public offering (the
IPO), in the United States District Court for the Southern District of New York. The Complaint seeks unspecified damages on behalf of a purported class of purchasers of our common stock between July 8, 1999 and December 6, 2000. Several
complaints substantially identical to Murowa were later filed against us, the Individual Defendants, and several of the IPO underwriters in the Southern District of New York. These cases have been consolidated under Civil Action No. 01-CV-6661.
These complaints generally allege that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in our initial public offering and secondary offering of securities. The complaints bring
claims for violation of several provisions of the federal securities laws against those underwriters, and also against us and certain of our directors and officers. Various plaintiffs have filed similar actions asserting virtually identical
allegations against more than 300 other companies. The lawsuit and all other IPO allocation securities class actions currently pending in the Southern District of New York have been assigned to Judge Shira A. Scheindlin for coordinated
pretrial proceedings. We believe that we have meritorious defenses to the claims and intend to vigorously defend against such claims.





On or about April 7, 2000, Sightsound, Inc. (Sightsound) filed an amended complaint against one of our customers in the United States District Court for the Eastern District of Pennsylvania
(Pittsburgh). The suit alleges that our customer infringes one or more of three patents (United States Patent Nos. 5,191,573; 5,675,734 and 5,996,440). Sightsound claims damages of $20 million plus an unspecified royalty. We have entered into an
agreement with our customer whereby we have agreed to assume control of the defense and pay the defense costs, while reserving our rights as to indemnification obligations. The customer filed an answer to the amended complaint on April 27, 2000
denying the material allegations of the complaint, and asserting counterclaims for declaratory judgment of non-infringement and patent invalidity. Following a claims construction hearing in 2001 and an initial report and recommendation on claim
construction by the magistrate judge in February, 2002 (which ruling is on appeal to the district judge), we renegotiated our agreement with the customer concerning the defense of the case going forward. We have now ceded control of the defense of
the case to the customer/Bertelsmann AG (the customers ultimate owner), and are splitting the costs of the defense with the customer/Bertelsmann AG. We are still reserving our rights as to indemnification issues. A trial date had been set for
September 28, 2001 in the matter, but that date will be reset after the Court rules on the claim construction appeal and other pending matters.





On March 31, 2000, Intouch Group, Inc. (Intouch) filed a lawsuit against us in the United States District Court for the Northern District of California alleging patent infringement. The
Complaint names us, Amazon.com, Inc., Listen.com, Inc., Entertaindom LLC, DiscoverMusic.com, Inc. and Muze, Inc. It alleges that these parties infringe, or induce infringement of, the claims of United States Patent Nos. 5,237,157 (the
157 patent) and 5,963,916 (the 916 patent) by operating a web site and/or a kiosk that allows interactive previewing of pre-recorded music products. The Complaint seeks unspecified damages and injunctive relief. We
answered Intouchs first amended complaint, denying the material allegations of the amended complaint, and asserting counterclaims for declaratory judgment of non-infringement, patent invalidity and inequitable conduct. In May 2001, the parties
reached an agreement in principle to settle Intouchs claims on the 157 patent. On February 6, 2002, the parties executed a final settlement regarding the 916 patent. Pursuant to the settlement, the terms of which are confidential,
Intouch has dismissed its suit with prejudice as to us and granted us a nonexclusive license on the 916 patent. The settlement did not have a material impact on our financial position or results of operations.





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





ITEM 2.    CHANGES IN SECURITIES AND USE OF PROCEEDS





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




36




---

##### Table of Contents




The effective date of our second registration statement, filed on Form S-1 under
the Securities Act of 1933 (No. 333-91541) relating to our follow-on public offering of common stock, was December 14, 1999. A total of 2,946,076 shares of Common Stock were sold at a price of $33.63 per share to an underwriting syndicate led by
Lehman Brothers Inc., BancBoston Robertson Stephens Inc., U.S. Bancorp Piper Jaffray Inc., Dain Rauscher Wessells and Fidelity Capital Markets. An additional 503,924 shares of Common stock were sold on behalf of selling stockholders as part of the
same offering. Offering proceeds to us, net of aggregate expenses of approximately $5.4 million, were approximately $93.7 million. Offering proceeds to selling shareholders, net of expenses of approximately $847,000, were approximately $16.1
million.





From the time of receipt through June 30, 2002, our proceeds were applied toward general corporate
purposes, including the purchase of temporary investments consisting of cash, cash equivalents and short-term investments, working capital and capital expenditures, enhancing research and development and attracting key personnel.





On July 14, our board of directors approved an amendment to our Preferred Stock Rights Agreement to revise the beneficial
ownership threshold at which a person or group of persons becomes an acquiring person and triggers certain provisions under the Preferred Stock Rights Agreement. As revised, a person or group would become an acquiring person
if that person or group becomes the beneficial owner of 10 percent or more of the outstanding shares of our common stock. Prior to such amendment, the beneficial ownership threshold was 15 percent.





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





There were no submissions of matters to a vote of securities holders during the quarter ended June 30, 2002.





ITEM
5.    
OTHER INFORMATION





In accordance with Section 10A(i)(2) of the Securities Exchange Act
of 1934, as added by Section 202 of the Sarbanes-Oxley Act of 2002 (the Act), we are required to disclose the non-audit services approved by our Audit Committee to be performed by PricewaterhouseCoopers LLP, our external auditor.
Non-audit services are defined in the Act as services other than those provided in connection with an audit or a review of our financial statements. The Audit Committee has ratified and approved the engagement of, and terms of engagement of,
PricewaterhouseCoopers LLP for the following non-audit services: (1) assistance with tax compliance and the preparation of federal and state income tax returns; and (2) financial due diligence in connection with our proposed merger with Alliance
Entertainment Corp.





ITEM 6.    EXHIBITS AND REPORTS ON FORM 8-K





(a)  Exhibits





Exhibit No.

Exhibit Title2.1

Amended and Restated Agreement and Plan of Merger, dated as of July 14, 2002, by and among Liquid Audio, Inc., April
Acquisition Corp. and Alliance Entertainment Corp. (9)3.1

Certificate of Incorporation as currently in effect (1)3.2

Bylaws as currently in effect (4)4.1

Preferred Stock Rights Agreement, dated as of August 7, 2001, between Liquid Audio, Inc. and Mellon Investor
Services LLC, including the Certificate of Designation, the form of Rights Certificate and the Summary of Rights attached thereto as Exhibits A, B and C respectively (6)4.2

Specimen Common Stock Certificate of Registrants (1)4.3

Second Amended and Restated Investor Rights Agreement dated July 31, 1998 (1)4.4

First Amendment to the Preferred Stock Rights Agreement, dated as of July 14, 2002 (8)10.1

Form of Indemnification Agreement entered into between the registrant and each of its directors and executive
officers (1)10.2

1996 Equity Incentive Plan (1)10.3

1999 Employee Stock Purchase Plan (1)10.4

Licensing Agreement with SESAC dated May 21, 1998 (1)10.5+

Software Cross License Agreement with Adaptec, Inc. dated June 12, 1998 (1)10.6

Form of Liquid Music Network Agreement (1)10.7+

Letter Agreement with Compaq Computer Corporation dated March 23, 1998 (1)10.8+

LA Agreement with Real Networks, Inc. dated April 26, 1998 (1)10.9+

Binary Software License Agreement with Precept Software, Inc. dated September 30, 1997 (1)10.10+

Patent License Agreement with Fraunhofer-Gesellschaft, zur Förderung der angewandten Forschung e.V. dated
August 14, 1998 (1)10.11+

Software License Agreement with Fraunhofer-Gesellschaft, zur Förderung der angewandten Forschung e.V. dated
August 14, 1998 (1)10.12+

OEM Master License Agreement with RSA Data Security, Inc. dated July 18, 1997 (1)




37




---

##### Table of Contents




Exhibit No.

Exhibit Title10.13+

Agreement in Principle with N2K, Inc. dated February 12, 1997 (1)10.14+

Patent License Agreement with Dolby Laboratories Licensing Corporation, dated May 3, 1996 (1)10.15+

Adjustment to Patent and License Agreement with Dolby Laboratories Licensing Corporation, dated September 18, 1997
(1)10.16+

Source Code, Trademark and Know-How License Agreement with Dolby Laboratories Licensing Corporation dated May 3,
1996 (1)10.17

Founders Restricted Stock Purchase Agreement (with amendments) with Gerald W. Kearby dated April 25, 1996
(1)10.18

Founders Restricted Stock Purchase Agreement (with amendments) with Philip R. Wiser dated April 25, 1996
(1)10.19

Founders Restricted Stock Purchase Agreement (with amendments) with Robert G. Flynn dated April 25, 1996
(1)10.20

Master Equipment Lease No. 0044 (with amendments) with Phoenix Leasing Incorporated dated as of October 15, 1996
(1)10.21

Summary Plan Description of 401(K) Plan (1)10.22

Loan and Security Agreement with Silicon Valley Bank dated April 16, 1998 (1)10.23

Loan and Security Agreement with Silicon Valley Bank dated November 16, 1998 (1)10.24

Lease Agreement with Master Lease, a Division of Tokai Financial Services, dated March 3, 1998 (1)10.25

Lease Agreement with John Anagnostou Realty and Michael J. Monte, dated February 16, 1999, for property located at
2221 Broadway, Redwood City, California (1)10.26

Lease and Service Agreement with Alliance Business Centers, dated August 17, 1998, and Office Rider dated February
1, 1999, for property located at 599 Lexington Avenue, New York, New York (1)10.27

Lease Agreement with New Retail Concepts Ltd., dated September 1, 1998, for property located at 21 Bridge Square,
Westport, Connecticut (1)10.28

Commercial Lease with Jim and Jeannette Beeger, dated November 3, 1998, for property located at 820 Winslow Street,
Redwood City, California (1)10.29

Commercial Lease with John Anagnostou Realty, dated October 9, 1997, for property located at 810 Winslow Street,
Redwood City, California (1)10.30+

Software Reseller Agreement with Liquid Audio Japan, dated as of August 9, 1998 (1)10.31+

Shareholder Agreement with Super Stage, Inc., Liquid Audio Japan, Inc., ITOCHU Corporation, and Hikari Tsushin,
Inc., dated March 31, 1999 (1)10.32

Loan Agreement with Super Factory, Inc., dated March 31, 1999 (1)10.33+

Share Sale and Purchase and Option Agreement with Super Stage, Inc., dated March 31, 1999 (1)10.34+

Shareholders Agreement with SKM Limited and Liquid Audio Korea Co. Ltd. dated December 31, 1998 (1)10.35+

Software Reseller and Services Agreement with Liquid Audio Korea Co. Ltd. dated December 31, 1998 (1)10.36

Consulting Agreement with Liquid Audio Korea Co. Ltd. dated December 31, 1998 (1)10.37

Reserved10.38

Guaranty issued to Liquid Audio, Inc. by SKM Limited dated December 31, 1998 (1)10.39

Software License Agreement with Intel Corporation dated May 4, 1999 (1)10.40

Liquid Remote Inventory Fulfillment Systems(1)10.41+

OEM Agreement with Sanyo Electric Co., Ltd. dated June 2, 1999 (1)10.42

Amazon.com/Liquid Audio Advertising Agreement, including exhibits, dated as of June 9, 1999 (1)10.43

Online Program Agreement with Muze, Inc., dated as of February 9, 1999 (1)10.44

Letter Agreement By and Between Texas Instrument Incorporated, dated as of January 29, 1999 (1)10.45+

OEM Agreement with Toshiba Corporation, dated June 9, 1999(1)10.46

Stock Option Agreement with Gary J. Iwatani, dated November 10, 1997 (1)10.47

Letter Agreement with Virgin Holdings, Inc., an affiliate of EMI Recorded Music, dated June 16, 1999
(1)10.48

Commercial Lease with George Anagnostou, dated August 1, 1999, for property located at 2317 Broadway, Redwood City,
California (2)




38




---

##### Table of Contents




Exhibit No.

Exhibit Title10.49+

Amended and Restated License Agreement with Liquid Audio Japan, Inc., dated January 1, 2000 (3)10.50

2000 Nonstatutory Stock Option Plan (4)10.51

Letter Agreement with Virgin Holdings, Inc., an affiliate of EMI Recorded Music, dated July 10, 2000
(5)10.52

Voting and Conversion Agreement, dated as of June 12, 2002, between AEC Associates LLC and Liquid Audio, Inc.
(10)10.53

Amendment to the Voting and Conversion Agreement, dated as of June 12, 2002 (9)10.54

Employment Agreement for Robert G. Flynn (9)10.55

Employment Agreement for Gerald W. Kearby (9)11.1

Statement regarding computation of per share earnings (7)99.1

Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, As Adopted
Pursuant To Section 906 Of The Sarbanes Oxley Act Of 2002


---

|+ |  | confidential treatment received as to certain portions
|- |  | ------------------------------------------------------

|(1) |  | incorporated by reference to the Registration Statement on Form S-1 and all amendments thereto, Registration No. 333-77707, filed with the Securities and
Exchange Commission on May 4, 1999 and declared effective July 8, 1999
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) |  | incorporated by reference to the Registration Statement on Form S-1 and all amendments thereto, Registration No. 333-91541, filed with the Securities and
Exchange Commission on November 23, 1999 and declared effective December 14, 1999
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) |  | incorporated by reference to the Form 10-Q filed with the Securities and Exchange Commission on May 15, 2000
|--- |  | ------------------------------------------------------------------------------------------------------------

|(4) |  | incorporated by reference to the Form 10-Q filed with the Securities and Exchange Commission on August 14, 2000
|--- |  | ---------------------------------------------------------------------------------------------------------------

|(5) |  | incorporated by reference to the Form 10-Q filed with the Securities and Exchange Commission on November 13, 2000
|--- |  | -----------------------------------------------------------------------------------------------------------------

|(6) |  | incorporated by reference to Exhibits of the Form 8-A filed with the Securities and Exchange Commission on August 15, 2001
|--- |  | --------------------------------------------------------------------------------------------------------------------------

|(7) |  | this exhibit has been omitted because the information is shown in the financial statements or notes thereto
|--- |  | -----------------------------------------------------------------------------------------------------------

|(8) |  | incorporated by reference to Exhibits of the Form 8-A12G/A filed with the Securities and Exchange Commission on July 16, 2002
|--- |  | -----------------------------------------------------------------------------------------------------------------------------

|(9) |  | incorporated by reference to Exhibits of the Form 8-K filed with the Securities and Exchange Commission on July 18, 2002
|--- |  | ------------------------------------------------------------------------------------------------------------------------

|(10) |  | incorporated by reference to the Registration Statement on Form S-4 and all amendments thereto, Registration No. 33396925, filed with the Securities and
Exchange Commission on July 23, 2002
|---- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




(b)    Reports on Form 8-K





On June 13, 2002, we filed a report on Form 8-K which announced that we and Alliance Entertainment Corp. have
signed a definitive merger agreement. A copy of the merger agreement was attached and incorporated by reference therein.




39




---

##### Table of Contents




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:    September 16, 2002



LIQUID AUDIO, INC./s/    GERALD W.
KEARBYGerald W. Kearby President, Chief
Executive Officer and Director (Principal Executive Officer)/s/    MICHAEL R.
BOLCEREKMichael R. Bolcerek Senior Vice
President and Chief Financial Officer (Principal Financial and Accounting Officer)




40




---

##### Table of Contents




Liquid Audio, Inc.


Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002


(Securities Exchange
Act of 1934, § 13a-14)





I, Gerald W. Kearby, certify that:





1.    I have reviewed this quarterly report on Form 10-Q of Liquid Audio, Inc.;





2.    Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made,
in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;





3.    Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of
operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report.





Date:    September 16, 2002





/S/    GERALD W. KEARBYGerald W. Kearby President, Chief Executive Officer and Director





I, Michael R. Bolcerek, certify that:





1.    I have reviewed this quarterly report on Form 10-Q of Liquid Audio, Inc.;





2.    Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material
fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;





3.    Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report.





Date:    September 16, 2002





/S/    MICHAEL R. BOLCEREKMichael R. Bolcerek Senior Vice President and Chief Financial Officer




41