Table of Contents
UNITED STATES
SECURITIES
AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
x
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QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
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FOR THE
QUARTERLY PERIOD ENDED JUNE 30, 2008
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o
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TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
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FOR THE
TRANSITION PERIOD FROM
TO
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Commission File Number:
000-30063
ARTISTdirect, Inc.
(Exact name of registrant as specified in its
charter)
Delaware
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95-4760230
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(State or other
jurisdiction of
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(I.R.S. Employer
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incorporation or
organization)
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Identification
Number)
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1601
Cloverfield Boulevard, Suite 400 South
Santa
Monica, California 90404
(Address of
principal executive offices) (Zip Code)
(310) 956-3300
(Registrants
telephone number, including area code)
Indicate
by check mark whether the registrant has (1) 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) has been subject to
such filing requirements for the past 90 days. Yes
x
No
o
Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer or a smaller reporting company (as
defined in Rule 12b-2 of the Exchange Act).
Large accelerated filer
o
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Accelerated filer
o
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Non-accelerated filer
o
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Smaller reporting company
x
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Indicate
by check mark whether the registrant is a shell company (as defined in Rule 12b-2
of the Exchange Act). Yes
o
No
x
As
of July 31, 2008, the Company had 10,344,666 shares of common stock, par
value $0.01 per share, issued and outstanding.
Documents
incorporated by reference: None.
Table of Contents
In
addition to historical information, this Quarterly Report on Form 10-Q (Quarterly
Report) for ARTISTdirect, Inc. (ARTISTdirect or the Company) contains
forward-looking statements within the meaning of the United States Private
Securities Litigation Reform Act of 1995, including statements that include the
words may, will, believes, expects, anticipates, or similar
expressions. These forward-looking
statements may include, among others, statements concerning the Companys
expectations regarding its business, growth prospects, revenue trends,
operating costs, accounting, working capital requirements, competition, results
of operations, financing needs and constraints, impairment of assets, and other
statements of expectations, beliefs, future plans and strategies, anticipated
events or trends, and similar expressions concerning matters that are not
historical facts. The forward-looking
statements in this Quarterly Report involve known and unknown risks,
uncertainties and other factors that could cause the Companys actual results,
performance or achievements to differ materially from those expressed or
implied by the forward-looking statements contained herein.
Each
forward-looking statement should be read in context with, and with an
understanding of, the various disclosures concerning the Companys business
made elsewhere in this Quarterly Report, as well as other public reports filed
by the Company with the United States Securities and Exchange Commission. Investors should not place undue reliance on
any forward-looking statement as a prediction of actual results or
developments. Except as required by
applicable law or regulation, the Company undertakes no obligation to update or
revise any forward-looking statement contained in this Quarterly Report.
Table of Contents
ARTISTdirect, Inc.
and Subsidiaries
Condensed
Consolidated Balance Sheets
(amounts in thousands,
except for share data)
|
|
June 30,
2008
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|
December 31,
2007
|
|
|
|
(Unaudited)
|
|
|
|
Assets
|
|
|
|
|
|
Current
assets:
|
|
|
|
|
|
Cash
and cash equivalents
|
|
$
|
3,445
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|
$
|
4,268
|
|
Restricted
cash
|
|
266
|
|
280
|
|
Accounts
receivable, net of allowance for doubtful accounts of $409
at June 30, 2008 and $418 at December 31, 2007
|
|
4,126
|
|
8,168
|
|
Income
taxes refundable
|
|
887
|
|
1,147
|
|
Prepaid
expenses and other current assets
|
|
460
|
|
351
|
|
Total
current assets
|
|
9,184
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|
14,214
|
|
|
|
|
|
|
|
Property
and equipment
|
|
4,676
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|
4,452
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|
Less
accumulated depreciation and amortization
|
|
(3,166
|
)
|
(2,614
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)
|
Property
and equipment, net
|
|
1,510
|
|
1,838
|
|
|
|
|
|
|
|
Other
assets:
|
|
|
|
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|
Intangible
assets:
|
|
|
|
|
|
Customer
relationships, net
|
|
63
|
|
440
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|
Proprietary
technology, net
|
|
211
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|
1,478
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|
Non-competition
agreements, net
|
|
284
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|
416
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|
Goodwill
|
|
5,500
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|
31,085
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|
Total
intangible assets, net
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|
6,058
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|
33,419
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Deferred
financing costs, net
|
|
816
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1,243
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Deposits
|
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20
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|
20
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Total
other assets
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|
6,894
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34,682
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|
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$
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17,588
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$
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50,734
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(continued)
1
Table of Contents
ARTISTdirect, Inc.
and Subsidiaries
Condensed Consolidated
Balance Sheets (continued)
(amounts in thousands,
except for share data)
|
|
June 30,
2008
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December 31,
2007
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|
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|
(Unaudited)
|
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Liabilities
and Stockholders Equity (Deficiency)
|
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|
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|
Current
liabilities:
|
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Accounts
payable
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$
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893
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$
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1,539
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Accrued
expenses
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1,076
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1,885
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Accrued
interest payable
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|
5,121
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3,352
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Deferred
revenue
|
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230
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|
230
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|
Income
taxes payable
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|
200
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|
200
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|
Liquidated
damages payable under registration rights agreements, net
of payments
|
|
1,972
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|
2,382
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|
Warrant
liability
|
|
64
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|
164
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|
Derivative
liability
|
|
25
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|
313
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|
Senior
secured notes payable, net of discount of $406 at June 30, 2008
and $651 at December 31, 2007 (in default)
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12,588
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12,656
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Subordinated
convertible notes payable, net of discount of $2,583 at
June 30, 2008 and $3,892 at December 31, 2007 (in default)
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25,075
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|
23,766
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|
Total
current liabilities
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|
47,244
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|
46,487
|
|
|
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Long-term
liabilities:
|
|
|
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Deferred
rent
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173
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186
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|
Financing
agreements
|
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19
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|
Total
long-term liabilities
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173
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|
205
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Commitments
and contingencies
|
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Stockholders
equity (deficiency):
|
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Common
stock, $0.01 par value - Authorized - 60,000,000 shares
|
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|
|
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Issued
and outstanding - 10,344,666 shares at June 30, 2008 and
10,338,896 shares at December 31, 2007
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|
103
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|
103
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|
Additional
paid-in-capital
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|
236,212
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|
235,407
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|
Accumulated
deficit
|
|
(266,144
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)
|
(231,468
|
)
|
Total
stockholders equity (deficiency)
|
|
(29,829
|
)
|
4,042
|
|
|
|
$
|
17,588
|
|
$
|
50,734
|
|
See accompanying
notes to condensed consolidated financial statements.
2
Table of Contents
ARTIST direct, Inc.
and Subsidiaries
Condensed Consolidated Statements of Operations
(Unaudited)
(amounts in
thousands, except for share data)
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|
Three Months Ended
June 30,
|
|
Six Months Ended
June 30,
|
|
|
|
2008
|
|
2007
|
|
2008
|
|
2007
|
|
|
|
|
|
|
|
|
|
|
|
Net
revenue:
|
|
|
|
|
|
|
|
|
|
E-commerce
|
|
$
|
92
|
|
$
|
509
|
|
$
|
198
|
|
$
|
1,003
|
|
Media
|
|
1,082
|
|
2,054
|
|
2,287
|
|
3,165
|
|
Anti-piracy
and file-sharing marketing services
|
|
1,546
|
|
4,030
|
|
4,436
|
|
7,871
|
|
Total
net revenue
|
|
2,720
|
|
6,593
|
|
6,921
|
|
12,039
|
|
Cost
of revenue:
|
|
|
|
|
|
|
|
|
|
E-commerce
|
|
85
|
|
515
|
|
185
|
|
1,025
|
|
Media
|
|
705
|
|
993
|
|
1,384
|
|
1,593
|
|
Anti-piracy
and file-sharing marketing services
|
|
2,315
|
|
2,309
|
|
4,775
|
|
4,514
|
|
Total
cost of revenue
|
|
3,105
|
|
3,817
|
|
6,344
|
|
7,132
|
|
Gross
profit (loss)
|
|
(385
|
)
|
2,776
|
|
577
|
|
4,907
|
|
Operating
expenses:
|
|
|
|
|
|
|
|
|
|
Sales
and marketing
|
|
506
|
|
508
|
|
971
|
|
886
|
|
General
and administrative, including stock-based compensation of $108 and $533 for
the three
months ended June 30, 2008 and 2007,
respectively, and $805 and $988 for the six
months ended June 30, 2008 and 2007,
respectively
|
|
1,311
|
|
2,957
|
|
4,416
|
|
5,508
|
|
Development
and engineering
|
|
117
|
|
196
|
|
234
|
|
313
|
|
Goodwill
impairment
|
|
25,585
|
|
|
|
25,585
|
|
|
|
Write-off
of fixed assets
|
|
|
|
97
|
|
|
|
97
|
|
Total
operating costs
|
|
27,519
|
|
3,758
|
|
31,206
|
|
6,804
|
|
Loss
from operations
|
|
(27,904
|
)
|
(982
|
)
|
(30,629
|
)
|
(1,897
|
)
|
Other
income (expense):
|
|
|
|
|
|
|
|
|
|
Interest
income
|
|
12
|
|
45
|
|
42
|
|
101
|
|
Interest
expense
|
|
(2,190
|
)
|
(2,068
|
)
|
(4,310
|
)
|
(3,928
|
)
|
Loss
on foreign currency transactions
|
|
|
|
(8
|
)
|
|
|
(14
|
)
|
Other
income
|
|
225
|
|
|
|
270
|
|
|
|
Reduction
in liquidated damages payable under
registration rights agreements
|
|
|
|
719
|
|
|
|
719
|
|
Change
in fair value of warrant liability
|
|
35
|
|
(95
|
)
|
100
|
|
1,131
|
|
Change
in fair value of derivative liability
|
|
117
|
|
(887
|
)
|
288
|
|
4,354
|
|
Amortization
of deferred financing costs
|
|
(209
|
)
|
(210
|
)
|
(419
|
)
|
(417
|
)
|
Write-off
of unamortized discount on debt and
deferred financing costs resulting from
principal payments on senior secured notes
payable
|
|
|
|
|
|
(26
|
)
|
|
|
Income
(loss) before income taxes
|
|
(29,914
|
)
|
(3,486
|
)
|
(34,684
|
)
|
49
|
|
Provision
for (benefit from) income taxes
|
|
2
|
|
|
|
(8
|
)
|
|
|
Net
income (loss)
|
|
$
|
(29,916
|
)
|
$
|
(3,486
|
)
|
$
|
(34,676
|
)
|
$
|
49
|
|
|
|
|
|
|
|
|
|
|
|
Net
income (loss) per common share:
|
|
|
|
|
|
|
|
|
|
Basic
|
|
$
|
(2.89
|
)
|
$
|
(0.34
|
)
|
$
|
(3.35
|
)
|
$
|
0.00
|
|
Diluted
|
|
$
|
(2.89
|
)
|
$
|
(0.34
|
)
|
$
|
(3.35
|
)
|
$
|
0.00
|
|
|
|
|
|
|
|
|
|
|
|
Weighted
average common shares outstanding:
|
|
|
|
|
|
|
|
|
|
Basic
|
|
10,344,666
|
|
10,194,214
|
|
10,344,666
|
|
28,040,266
|
|
Diluted
|
|
10,344,666
|
|
10,194,214
|
|
10,344,666
|
|
30,151,568
|
|
See accompanying notes to
condensed consolidated financial statements.
3
Table of Contents
ARTISTdirect, Inc. and
Subsidiaries
Condensed Consolidated
Statement of Stockholders Equity (Deficiency) (Unaudited)
(amounts in thousands, except for share data)
|
|
Common Stock
|
|
Additional
Paid-In
|
|
Accumulated
|
|
Total
Stockholders
|
|
|
|
Shares
|
|
Amount
|
|
Capital
|
|
Deficit
|
|
Equity (Deficiency)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance at
January 1, 2008
|
|
10,338,896
|
|
$
|
103
|
|
$
|
235,407
|
|
$
|
(231,468
|
)
|
$
|
4,042
|
|
Stock-based
compensation
|
|
|
|
|
|
786
|
|
|
|
786
|
|
Common stock
issued for consulting services
|
|
5,770
|
|
|
|
19
|
|
|
|
19
|
|
Net loss
|
|
|
|
|
|
|
|
(34,676
|
)
|
(34,676
|
)
|
Balance at
June 30, 2008
|
|
10,344,666
|
|
$
|
103
|
|
$
|
236,212
|
|
$
|
(266,144
|
)
|
$
|
(29,829
|
)
|
See accompanying
notes to condensed consolidated financial statements.
4
Table of Contents
ARTISTdirect, Inc.
and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(amounts in thousands)
|
|
Six Months Ended
June 30,
|
|
|
|
2008
|
|
2007
|
|
|
|
|
|
|
|
Cash flows from
operating activities:
|
|
|
|
|
|
Net income
(loss)
|
|
$
|
(34,676
|
)
|
$
|
49
|
|
Adjustments to
reconcile net income (loss) to net cash provided by
(used in) operating activities:
|
|
|
|
|
|
Depreciation and
amortization
|
|
4,283
|
|
4,218
|
|
Provision for
doubtful accounts
|
|
(9
|
)
|
10
|
|
Stock-based
compensation
|
|
805
|
|
988
|
|
Goodwill
impairment
|
|
25,585
|
|
|
|
Change in fair
value of warrant liability
|
|
(100
|
)
|
(1,131
|
)
|
Change in fair
value of derivative liability
|
|
(288
|
)
|
(4,354
|
)
|
Reduction in
liquidated damages payable under registration rights
agreements
|
|
|
|
(719
|
)
|
Write-off of
unamortized discount on debt and deferred financing
costs resulting from principal payments on senior secured notes
payable
|
|
26
|
|
|
|
Write-off of
fixed assets
|
|
|
|
97
|
|
Sub-total
|
|
(4,374
|
)
|
(842
|
)
|
Changes in
operating assets and liabilities:
|
|
|
|
|
|
(Increase)
decrease in -
|
|
|
|
|
|
Accounts
receivable
|
|
4,051
|
|
369
|
|
Finished goods
inventory
|
|
|
|
36
|
|
Prepaid expenses
and other current assets
|
|
(109
|
)
|
(351
|
)
|
Income taxes
refundable
|
|
260
|
|
(330
|
)
|
Increase
(decrease) in -
|
|
|
|
|
|
Accounts payable
|
|
(646
|
)
|
(213
|
)
|
Accrued expenses
|
|
(809
|
)
|
384
|
|
Accrued interest
payable
|
|
1,769
|
|
1,625
|
|
Deferred revenue
|
|
|
|
423
|
|
Deferred rent
|
|
(13
|
)
|
(6
|
)
|
Income taxes
payable
|
|
|
|
(348
|
)
|
Financing
agreements
|
|
(19
|
)
|
(17
|
)
|
Liquidated
damages payable under registration rights agreements
|
|
(410
|
)
|
(500
|
)
|
Net cash
provided by (used in) operating activities
|
|
(300
|
)
|
230
|
|
|
|
|
|
|
|
Cash flows from
investing activities:
|
|
|
|
|
|
Purchases of
property and equipment
|
|
(224
|
)
|
(241
|
)
|
Net cash used in
investing activities
|
|
(224
|
)
|
(241
|
)
|
|
|
|
|
|
|
Cash flows from
financing activities:
|
|
|
|
|
|
Proceeds from
exercise of stock options
|
|
|
|
17
|
|
Principal
payments on senior secured notes payable
|
|
(313
|
)
|
|
|
Decrease in
restricted cash
|
|
14
|
|
87
|
|
Net cash
provided by (used in) financing activities
|
|
(299
|
)
|
104
|
|
|
|
|
|
|
|
Cash and cash
equivalents:
|
|
|
|
|
|
Net increase
(decrease)
|
|
(823
|
)
|
93
|
|
Balance at
beginning of period
|
|
4,268
|
|
5,602
|
|
Balance at end
of period
|
|
$
|
3,445
|
|
$
|
5,695
|
|
(continued)
5
Table of
Contents
ARTISTdirect, Inc.
and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(continued)
(amounts in
thousands)
|
|
Six Months Ended
June 30,
|
|
|
|
2008
|
|
2007
|
|
|
|
|
|
|
|
Supplemental
disclosure of cash flow information:
|
|
|
|
|
|
Cash paid for -
|
|
|
|
|
|
|
|
Interest
|
|
$
|
915
|
|
$
|
757
|
|
Income taxes
|
|
$
|
2
|
|
$
|
678
|
|
See accompanying
notes to condensed consolidated financial statements.
6
Table of Contents
ARTISTdirect, Inc.
and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Unaudited)
Three
Months and Six Months Ended June 30, 2008 and 2007
1. ORGANIZATION AND BUSINESS ACTIVITIES
ARTISTdirect, Inc., a Delaware corporation, is a digital media entertainment company that, through its ARTISTdirect Internet Group, Inc. subsidiary, conducts its media and e-commerce business operations through an online music network and, through its MediaDefender, Inc. subsidiary, is a provider of anti-piracy solutions in the internet-piracy-protection (IPP) industry. The ARTISTdirect Network consists of the Companys website (www.artistdirect.com) and a network of related music and entertainment websites appealing to music fans, artists and marketing partners that offers multi-media content, music news and information, communities organized around shared music interests, music-related specialty commerce, and digital music services. The Company is headquartered in Santa Monica, California. Unless the context indicates otherwise, ARTISTdirect, Inc. and its subsidiaries are referred to herein as the Company.
Going Concern:
As a result of
communications with the Staff of the Securities and Exchange Commission in
2006, in particular regarding the application of accounting rules and
interpretations related to embedded derivatives associated with the Companys
subordinated convertible notes payable issued in July 2005, the Company
determined that it was necessary to restate certain previously issued financial
statements.
As a result, in December 2006,
the Company was required to suspend the use of its then effective registration
statement for the holders of its senior and subordinated indebtedness. In addition to this initial default, the
Company has since entered into other events of default which continue to be in
effect as of June 30, 2008. During
2007 and 2008, the Company entered into a series of forbearance agreements with
the investors in the senior notes with respect to these defaults.
As a result of the
requirement to restate previously issued financial statements, which resulted
in the recording of an embedded derivative liability, the reclassification of
the senior and subordinated indebtedness to current liabilities, and the
recording of liquidated damages payable under registration rights agreements,
the Company was not in compliance with certain of its financial covenants under
both the Senior Financing and the Sub-Debt Financing at December 31,
2006. Notwithstanding such developments,
the Company would have been out of compliance with certain of its financial
covenants at December 31, 2007 and subsequently.
Pursuant to a series of Forbearance and Consent
Agreements with the investors in the Senior Financing, such investors agreed to
forbear from the exercise of their rights and remedies under the Senior
Financing documents as a result of the events of default which were then in
existence during the period, from April 17, 2007 through February 20,
2008, in exchange for aggregate cash payments of $1,000,000 in 2007 and
$494,423 in February 2008. The
payments made by the Company under the Forbearance and Consent Agreements were
credited against the registration delay cash penalties and interest on the
penalties resulting from the Companys default under the various agreements
between the Company and the Senior Financing investors. On March 17, 2008, the Company entered
into a Forbearance and Consent Agreement with the investors in the Companys
Senior Debt Financing, which was effective as of February 20, 2008,
whereby the investors agreed to forbear
from exercising any of their rights and remedies under the Senior Financing
transaction documents through December 31, 2008 in exchange for an
adjustment in the interest rate associated with the Senior Notes from 11.25% to
15.0% per annum, provided the loan is repaid prior to September 30, 2008,
or 16.0% per annum (retroactive to February 20, 2008), if the loan remains
outstanding subsequent to that date.
In addition, as a result
of a significant deterioration in MediaDefenders business operations and
prospects during the latter part of June 2008, including less than
anticipated revenues in 2008 from MediaDefenders new advertising initiatives
and a significant further erosion of demand for MediaDefenders core internet
anti-piracy services by the entertainment industry, the Companys operations
and cash flows have been materially and negatively impacted. Accordingly, at
June 30, 2008, the Company recorded a non-cash charge to operations to
reflect the impairment of MediaDefender goodwill of $25,585,000, based on the
Companys conclusion that the current carrying value of the MediaDefender
segment goodwill of $31,085,000 was substantially and permanently impaired at
June 30, 2008.
7
Table of Contents
The registration delay
penalties and ongoing default interest charges are continuing to have a
significant and material negative impact on the Companys operations and cash
flows. The Company is exploring various
alternatives to resolve the defaults under its senior and secured debt
obligations, but is unable to predict the outcome of such negotiations. On February 7, 2008, the Company
retained the services of Salem Partners, LLC to serve as a financial advisor to
the Company in connection with the sale, merger, consolidation, reorganization
or other business combination and the restructuring of the material terms of
the Companys senior notes and/or subordinated convertible notes. To the extent that the Company is unable to
complete a sale or merger or restructure its senior and subordinated debt
obligations in a satisfactory manner and/or the lenders begin to exercise
additional remedies to enforce their rights, the Company will not have
sufficient cash resources to maintain its operations. In such event, the Company may be required to
consider a formal or informal restructuring or reorganization, including a
filing under Chapter 11 of the United States Bankruptcy Code.
The accompanying
consolidated financial statements have been prepared in conformity with
accounting principles generally accepted in the United States of America, which
contemplate continuation of the Company as a going concern. As a result of the foregoing, the Companys
independent registered public accounting firm, in its report on the Companys
2007 consolidated financial statements, expressed substantial doubt about the
Companys ability to continue as a going concern. The consolidated financial statements do not
include any adjustments relating to the recoverability and classification of
recorded asset amounts or the amounts and classification of liabilities that
could result from the outcome of this uncertainty.
2. BASIS OF PRESENTATION
Principles of
Consolidation:
The
accompanying condensed financial statements include the consolidated accounts
of ADI and its subsidiaries in which it has controlling financial
interests. All intercompany accounts and
transactions have been eliminated for all periods presented.
Interim Financial
Information:
The interim condensed
consolidated financial statements are unaudited, but in the opinion of management
of the Company, contain all adjustments, which include normal recurring
adjustments, necessary to present fairly the financial position at June 30,
2008, the results of operations for the three months and six months ended June 30,
2008 and 2007, and the cash flows for the six months ended June 30, 2008
and 2007. The condensed consolidated
balance sheet as of December 31, 2007 is derived from the Companys
audited financial statements as of that date.
Certain information and
footnote disclosures normally included in financial statements that have been
presented in accordance with generally accepted accounting principles have been
condensed or omitted pursuant to the rules and regulations of the
Securities and Exchange Commission with respect to interim financial
statements, although management of the Company believes that the disclosures
contained in these financial statements are adequate to make the information
presented therein not misleading. For
further information, refer to the consolidated financial statements and notes
thereto included in the Companys Annual Report on Form 10-KSB for the
fiscal year ended December 31, 2007, as amended, as filed with the
Securities and Exchange Commission.
The Companys results of
operations for the three months and six months ended June 30, 2008 are not
necessarily indicative of the results of operations to be expected for the full
fiscal year ending December 31, 2008.
Estimates:
In preparing financial
statements in conformity with generally accepted accounting principles,
management is required to make estimates and assumptions that affect the
reported amounts of assets and liabilities, the disclosure of contingent assets
and liabilities at the date of the financial statements, and the reported
amounts of revenues and expenses during the reporting period. Some of the more significant estimates
include the allowance for bad debts, impairment of intangible assets and
long-lived assets, stock-based compensation, income tax accruals, the valuation
allowance on deferred tax assets, and the change in fair value of the warrant
liability and derivative liability.
Actual results could differ materially from those estimates.
Reclassification:
Certain amounts have been
reclassified from their presentation in 2007 to conform to the current
years presentation. Such
reclassifications did not have any effect on income (loss) from operations or
net income (loss).
8
Table
of Contents
Net Income (Loss) Per Common
Share:
T
he Company
calculates net income (loss) per common share in accordance with Statement of
Financial Accounting Standards No. 128, Earnings Per Share (SFAS No. 128),
and EITF 03-6, Participating Securities and the Two-Class Method under
FASB Statement No. 128. EITF 03-6
clarifies the use of the two-class method of calculating earnings per share
as originally prescribed in SFAS No. 128 and provides guidance on how to
determine whether a security should be considered a participating security.
The Company has determined that its convertible
subordinated notes payable are a participating security, as each note holder is
entitled to receive any dividends paid and distributions made to the common
stockholders as if the note had been converted into common stock on the record
date. The participatory shares are
included in the weighted average shares outstanding as of the beginning of each
period in calculating the basic weighted average shares outstanding.
Under the two-class method, basic
income (loss) per common share is computed by dividing net income (loss)
applicable to common stockholders by the weighted-average number of common
shares outstanding for the reporting period.
Diluted income (loss) per common share is computed using the more
dilutive of the two-class method or the if-converted method. Net losses are not allocable to the holders
of the subordinated convertible notes payable.
Diluted income (loss) per share gives effect to all potentially dilutive
securities, including stock options, senior and sub-debt warrants, and
convertible subordinated notes payable, unless their effect is anti-dilutive.
The calculation of
diluted weighted average common shares outstanding for the six months ended June 30,
2007 is based on the average of the closing price of the Companys common stock
during such period. The calculation of
diluted loss per share for the three months ended June 30, 2008 and 2007
and the six months ended June 30, 2008 excluded the effect from the
conversion of subordinated convertible notes payable and the exercise of stock
options and senior and sub-debt warrants since their effect would have been
anti-dilutive. The calculation of
diluted income per share for the six months ended June 30, 2007 excluded
the effect from the conversion of subordinated convertible notes payable and
the exercise of stock options and warrants aggregating approximately 1,200,856
shares and 433,333 shares of common stock, respectively, since their effect
would have been anti-dilutive.
Issued but unvested
shares of common stock are excluded from the calculation of basic earnings per
share, but are included in the calculation of diluted earnings per share, to
the extent that they are not anti-dilutive.
9
Table of Contents
A reconciliation of the numerator and denominator used
in the calculation of basic and diluted net (loss) income per share for each
period presented is as follows (amounts in thousands, except for share data):
|
|
Three months ended June 30,
|
|
Six months ended June 30,
|
|
|
|
2008
|
|
2007
|
|
2008
|
|
2007
|
|
|
|
|
|
|
|
|
|
|
|
Numerator:
|
|
|
|
|
|
|
|
|
|
Net income
(loss), as reported
|
|
$
|
(29,916
|
)
|
$
|
(3,486
|
)
|
$
|
(34,676
|
)
|
$
|
49
|
|
|
|
|
|
|
|
|
|
|
|
Allocation of
net income (loss):
|
|
|
|
|
|
|
|
|
|
Basic:
|
|
|
|
|
|
|
|
|
|
Net income
(loss) applicable to common stockholders
|
|
$
|
(29,916
|
)
|
$
|
(3,486
|
)
|
$
|
(34,676
|
)
|
$
|
18
|
|
Net income
(loss) applicable to subordinated convertible notes payable
|
|
|
|
|
|
|
|
31
|
|
|
|
|
|
|
|
|
|
|
|
Net income
(loss)
|
|
$
|
(29,916
|
)
|
$
|
(3,486
|
)
|
$
|
(34,676
|
)
|
$
|
49
|
|
|
|
|
|
|
|
|
|
|
|
Diluted:
|
|
|
|
|
|
|
|
|
|
Net income
(loss) applicable to common stockholders
|
|
$
|
(29,916
|
)
|
$
|
(3,486
|
)
|
$
|
(34,676
|
)
|
$
|
20
|
|
Net income
(loss) applicable to subordinated convertible notes payable
|
|
|
|
|
|
|
|
29
|
|
|
|
|
|
|
|
|
|
|
|
Net income
(loss)
|
|
$
|
(29,916
|
)
|
$
|
(3,486
|
)
|
$
|
(34,676
|
)
|
$
|
49
|
|
|
|
|
|
|
|
|
|
|
|
Denominator:
|
|
|
|
|
|
|
|
|
|
Weighted average
shares of common stock outstanding
|
|
10,344,666
|
|
10,194,214
|
|
10,344,666
|
|
10,196,214
|
|
Weighted average
shares of common stock attributable to subordinated convertible notes payable
|
|
|
|
|
|
|
|
17,844,052
|
|
Weighted average
shares of common stock used in calculating basic net income (loss) per common
share
|
|
10,344,666
|
|
10,194,214
|
|
10,344,666
|
|
28,040,266
|
|
Weighted average
shares of common stock issuable upon exercise of outstanding stock options,
based on the treasury stock method
|
|
|
|
|
|
|
|
1,309,100
|
|
Weighted average
shares of common stock issuable upon exercise of subordinated convertible
notes payable warrants, based on the treasury stock method
|
|
|
|
|
|
|
|
802,202
|
|
Weighted average
shares of common stock used in computing diluted net income (loss) per common
share
|
|
10,344,666
|
|
10,194,214
|
|
10,344,666
|
|
30,151,568
|
|
10
Table
of Contents
|
|
Three months ended June 30,
|
|
Six months ended June 30,
|
|
|
|
2008
|
|
2007
|
|
2008
|
|
2007
|
|
|
|
|
|
|
|
|
|
|
|
Calculation of
net income (loss) per common share:
|
|
|
|
|
|
|
|
|
|
Basic:
|
|
|
|
|
|
|
|
|
|
Net income
(loss) applicable to common stockholders
|
|
$
|
(29,916
|
)
|
$
|
(3,486
|
)
|
$
|
(34,676
|
)
|
$
|
49
|
|
|
|
|
|
|
|
|
|
|
|
Weighted average
shares of common stock used in calculating basic net income (loss) per common
share, including 17,844,052 participatory subordinated convertible notes
payable shares
|
|
10,344,666
|
|
10,194,214
|
|
10,344,666
|
|
28,040,266
|
|
Net income
(loss) per common share applicable to common stockholders:
|
|
$
|
(2.89
|
)
|
$
|
(0.34
|
)
|
$
|
(3.35
|
)
|
$
|
0.00
|
|
|
|
|
|
|
|
|
|
|
|
Diluted:
|
|
|
|
|
|
|
|
|
|
Net income
(loss) applicable to common stockholders
|
|
$
|
(29,916
|
)
|
$
|
(3,486
|
)
|
$
|
(34,676
|
)
|
$
|
49
|
|
|
|
|
|
|
|
|
|
|
|
Weighted average
shares of common stock used in calculating diluted net income (loss) per
common share
|
|
10,344,666
|
|
10,194,214
|
|
10,344,666
|
|
30,151,568
|
|
|
|
|
|
|
|
|
|
|
|
Net income
(loss) per common share applicable to common stockholders
|
|
$
|
(2.89
|
)
|
$
|
(0.34
|
)
|
$
|
(3.35
|
)
|
$
|
0.00
|
|
11
Table of Contents
Stock-Based Compensation:
The
Company has adopted Statement of Financial Accounting Standards No. 123
(revised 2004), Share-Based Payment (SFAS No. 123R), a revision to
SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123R requires that the Company
measure the cost of employee services received in exchange for equity awards
based on the grant date fair value of the awards, with the cost to be
recognized as compensation expense in the Companys financial statements over
the vesting period of the awards.
The
Company accounts for stock option and warrant grants issued and vesting to
non-employees in accordance with EITF No. 96-18, Accounting for Equity
Instruments that are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services and EITF 00-18 Accounting
Recognition for Certain Transactions involving Equity Instruments Granted to
Other Than Employees, whereas the value of the stock compensation is based
upon the measurement date as determined at either (a) the date at which a
performance commitment is reached or (b) at the date at which the
necessary performance to earn the equity instruments is complete.
For the past several
years, the Company has consistently utilized the Black-Scholes option-pricing
model to calculate the fair value of stock options and warrants issued as
compensation, primarily to management, employees and directors. The Black-Scholes option-pricing model is a
widely-accepted method of valuation that public companies typically utilize to
calculate the fair value of options and warrants that they issue in such
circumstances.
In calculating the Black-Scholes value of stock
options and warrants issued, the Company uses the full term of the option, an
appropriate risk-free interest rate (generally from 4% to 5%), and a 0%
dividend yield.
The Company utilizes the daily closing stock prices of
its common stock as quoted on the OTC Bulletin Board to calculate the expected
volatility used in the Black-Scholes option-pricing model. Since the Companys business operations and
capital structure changed dramatically on July 28, 2005 as a result of the
acquisition of MediaDefender and the related financing transactions, the
Company has utilized daily closing stock prices from August 1, 2005
through each subsequent quarter end to generate a volatility factor for use in
calculating the fair value of options and warrants issued during each respective
period. By utilizing daily trading data
related to the period of time that reflects the Companys current business
operations, the Company believes that this methodology generates volatility
factors that more accurately reflect, as well as adjust for, normal market
fluctuations in the Companys common stock over an extended period of
time. This methodology has generated
volatility factors ranging from approximately 163% to 100% during 2005, 2006
and 2007. These volatility factors have
generally trended downward during 2006, 2007 and 2008.
Derivative Financial
Instruments:
Statement of Financial
Accounting Standards No. 133, Accounting for Derivative Instruments and
Hedging Activities (SFAS No. 133), requires all derivatives to be
recorded on the balance sheet at fair value. When multiple derivatives
(both assets and liabilities) exist within a financial instrument, they are
bundled together as a single hybrid compound instrument in accordance with SFAS
No. 133 Implementation Issue No. B15, Embedded Derivatives: Separate Accounting for Multiple Derivative
Features Embedded in a Single Hybrid Instrument. The calculation of the fair value of
derivatives utilizes highly subjective and theoretical assumptions that can
materially affect fair values from period to period. The change in the fair value of the
derivatives from period to period is recorded in other income (expense) in the
statement of operations. As a result, the
Companys financial statements are impacted quarterly based on factors such as
the price of the Companys common stock and the principal amount of Sub-Debt
Notes converted into common stock.
Consequently, the Companys results of operations and financial position
may vary from quarter to quarter based on factors other than those directly
associated with the Companys operating revenues and expenses. The recognition of these derivative amounts
does not have any impact on cash flows.
EITF 00-19, Accounting
for Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Companys Own Stock (EITF 00-19), requires freestanding contracts that are
settled in a companys own stock, including common stock warrants, to be
designated as an equity instrument, an asset or a liability. When the
ability to physically or net-share settle a conversion option or the exercise
of freestanding options or warrants is deemed to be not within the control of
the Company, the embedded conversion option or freestanding options or warrants
may be required to be accounted for as a derivative liability. Under the provisions of EITF 00-19, a
contract designated as an asset or a liability must be carried at fair value on
a companys balance sheet, with any changes in fair value recorded in a
companys results of operations.
12
Table of Contents
The Company has accounted
for registration rights penalties in accordance with EITF 00-19-2, Accounting
for Registration Payment Arrangements, which the Company adopted as of December 31,
2006, and Statement of Financial Accounting Standards No. 5, Accounting
for Contingencies.
The Company accounts for
derivatives, including the embedded derivatives associated with the Sub-Debt
Notes and the warrants issued in conjunction with the Senior Financing and the
Sub-Debt Financing, at fair value, adjusted at the end of each reporting period
to reflect any material changes, with any such changes included in other income
(expense) in the statement of operations.
At the date of the
conversion of Sub-Debt Notes into common stock or the principal repayment of
Senior Notes, the pro rata portion of the related unamortized discount on debt
and deferred financing costs is charged to operations and included in other
income (expense). At the date of
exercise of any of the warrants, or the conversion of Sub-Debt Notes into
common stock, the pro rata portion of the fair value of the related warrant
liability and/or embedded derivative liability is transferred to additional
paid-in capital.
Foreign Currency
Transactions:
The Companys reporting
currency and functional currency is the United States dollar. The Company periodically receives payments
for services in Canadian dollars and British pounds, which are translated into
United States dollars using the exchange rate in effect at the date of
payment. Gains or losses resulting from
foreign currency transactions, to the extent material, are included in other
income (expense) in the statement of operations.
Adoption of New
Accounting Policies:
In September 2006,
the FASB issued Statement of Financial Accounting Standards No. 157, Fair
Value Measurements (SFAS No. 157), which establishes a formal
framework for measuring fair value under Generally Accepted Accounting
Principles (GAAP). SFAS No. 157 defines and codifies the many
definitions of fair value included among various other authoritative
literature, clarifies and, in some instances, expands on the guidance for
implementing fair value measurements, and increases the level of disclosure
required for fair value measurements. Although SFAS No. 157 applies
to and amends the provisions of existing FASB and American Institute of
Certified Public Accountants (AICPA) pronouncements, it does not, of itself,
require any new fair value measurements, nor does it establish valuation
standards. SFAS No. 157 applies to all other accounting
pronouncements requiring or permitting fair value measurements, except for:
SFAS No. 123R, share-based payment and related pronouncements, the
practicability exceptions to fair value determinations allowed by various other
authoritative pronouncements, and AICPA Statements of Position 97-2 and 98-9
that deal with software revenue recognition. SFAS No. 157 was effective
January 1, 2008. Additional
disclosure required as a result of the Companys implementation of SFAS No. 157
in 2008 is presented at Note 5.
In February 2007,
the FASB issued Statement of Financial Accounting Standards No. 159, The
Fair Value Option for Financial Assets and Financial Liabilities (SFAS No. 159),
which provides companies with an option to report selected financial assets and
liabilities at fair value. SFAS No. 159s objective is to reduce both
complexity in accounting for financial instruments and the volatility in
earnings caused by measuring related assets and liabilities differently.
Generally accepted accounting principles have required different measurement
attributes for different assets and liabilities that can create artificial
volatility in earnings. SFAS No. 159 helps to mitigate this type of
accounting-induced volatility by enabling companies to report related assets
and liabilities at fair value, which would likely reduce the need for companies
to comply with detailed rules for hedge accounting. SFAS No. 159
also establishes presentation and disclosure requirements designed to
facilitate comparisons between companies that choose different measurement
attributes for similar types of assets and liabilities. SFAS No. 159
requires companies to provide additional information that will help investors
and other users of financial statements to more easily understand the effect of
the companys choice to use fair value on its earnings. SFAS No. 159
also requires companies to display the fair value of those assets and
liabilities for which the company has chosen to use fair value on the face of
the balance sheet. SFAS No. 159 does not eliminate disclosure
requirements included in other accounting standards, including requirements for
disclosures about fair value measurements included in SFAS No. 157
and SFAS No. 107. SFAS No. 159
was effective January 1, 2008, and did not have any impact on the Companys
financial statement presentation or disclosures in 2008.
13
Table of Contents
Recent Accounting
Pronouncements:
In December 2007,
the FASB issued SFAS No. 141(R), Business Combinations (SFAS No. 141(R)),
which requires an acquirer to recognize in its financial statements as of the
acquisition date (i) the identifiable assets acquired, the liabilities
assumed, and any noncontrolling interest in the acquiree, measured at their
fair values on the acquisition date, and (ii) goodwill as the excess of
the consideration transferred plus the fair value of any noncontrolling
interest in the acquiree at the acquisition date over the fair values of the
identifiable net assets acquired. Acquisition-related costs, which are the
costs an acquirer incurs to effect a business combination, will be accounted
for as expenses in the periods in which the costs are incurred and the services
are received, except that costs to issue debt or equity securities will be
recognized in accordance with other applicable GAAP. SFAS No. 141(R) makes
significant amendments to other Statements and other authoritative guidance to
provide additional guidance or to conform the guidance in that literature to
that provided in SFAS No. 141(R). SFAS No. 141(R) also
provides guidance as to what information is to be disclosed to enable users of
financial statements to evaluate the nature and financial effects of a business
combination. SFAS No. 141(R) is effective for financial
statements issued for fiscal years beginning on or after December 15,
2008. Early adoption is prohibited. The adoption of SFAS No. 141(R) will
affect how the Company accounts for a business combination concluded after December 31,
2008.
In December 2007,
the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements an amendment of ARB No. 51 (SFAS No. 160),
which revises the relevance, comparability, and transparency of the financial
information that a reporting entity provides in its consolidated financial
statements by establishing accounting and reporting standards that require (i) the
ownership interests in subsidiaries held by parties other than the parent be
clearly identified, labeled, and presented in the consolidated statement of
financial position within equity, but separate from the parents equity, (ii) the
amount of consolidated net income attributable to the parent and to the
noncontrolling interest be clearly identified and presented on the face of the
consolidated statement of income, (iii) changes in a parents ownership
interest while the parent retains its controlling financial interest in its
subsidiary be accounted for consistently as equity transactions, (iv) when
a subsidiary is deconsolidated, any retained noncontrolling equity investment
in the former subsidiary be initially measured at fair value, with the gain or
loss on the deconsolidation of the subsidiary being measured using the fair
value of any noncontrolling equity investment rather than the carrying amount
of that retained investment, and (v) entities provide sufficient
disclosures that clearly identify and distinguish between the interests of the
parent and the interests of the noncontrolling owners. SFAS No. 160
amends FASB No. 128 to provide that the calculation of earnings per share
amounts in the consolidated financial statements will continue to be based on
the amounts attributable to the parent. SFAS No. 160 is effective for
financial statements issued for fiscal years, and interim periods within those
fiscal years, beginning on or after December 15, 2008. Early adoption is
prohibited. SFAS No. 160 shall be applied prospectively as of the
beginning of the fiscal year in which it is initially applied, except for the
presentation and disclosure requirem, which shall be applied retrospectively
for all periods presented. The Company has not yet determined the effect on its
consolidated financial statements, if any, upon adoption of SFAS No. 160.
In March 2008, the
FASB issued SFAS No. 161, Disclosures about Derivative Instruments and
Hedging Activities an amendment of FASB Statement No. 133 (SFAS No. 161). SFAS No. 161 amends and expands the
disclosure requirements of SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities (SFAS No. 133). The objective of
SFAS No. 161 is to provide users of financial statements with an enhanced
understanding of how and why an entity uses derivative instruments, how
derivative instruments and related hedged items are accounted for under SFAS No. 133
and its related interpretations, and how derivative instruments and related
hedged items affect an entitys financial position, financial performance, and
cash flows. SFAS No. 161 requires
qualitative disclosures about objectives and strategies for using derivatives,
quantitative disclosures about fair value amounts of and gains and losses on
derivative instruments, and disclosures about credit-risk-related contingent
features in derivative agreements. SFAS No. 161
applies to all derivative financial instruments, including bifurcated
derivative instruments (and nonderivative instruments that are designed and
qualify as hedging instruments pursuant to paragraphs 37 and 42 of SFAS No. 133)
and related hedged items accounted for under SFAS No. 133 and its related interpretations. SFAS No. 161 also amends certain
provisions of SFAS No. 131. SFAS No. 161 is effective for financial
statements issued for fiscal years and interim periods beginning after November 15,
2008, with early application encouraged.
SFAS No. 161 encourages, but does not require, comparative
disclosures for earlier periods at initial adoption. The Company has not yet determined the effect
on its consolidated financial statements, if any, upon adoption of SFAS No. 161.
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3. ACQUISITION OF MEDIADEFENDER, INC.
On July 28, 2005,
the Company consummated the acquisition of MediaDefender, Inc., a
privately-held Delaware corporation (MediaDefender), which is a provider of
anti-piracy solutions in the internet-piracy-protection (IPP) industry. The stockholders of MediaDefender received
aggregate consideration of $42,500,000 in cash, subject to certain holdbacks
and adjustments described in the Merger Agreement. In order to fund the acquisition of
MediaDefender, the Company completed a $15,000,000 senior secured debt
transaction and a $30,000,000 convertible subordinated debt transaction, as
described at Note 4.
In accordance with the Merger Agreement, the Company
acknowledged the terms of Employment Agreements entered into on July 28,
2005 by MediaDefender with each of Randy Saaf and Octavio Herrera, confirming
the terms of their employment. Mr. Saaf
and Mr. Herrera each earn a base salary of no less than $350,000 per annum
during the initial term of the agreements, which continue until December 31,
2008, and are also each entitled to receive performance bonuses of up to
$350,000 if MediaDefender achieves a certain level of operating earnings. Mr. Saaf and Mr. Herrera are each
entitled to receive twelve months of severance pay at the rate of 100% of their
monthly salary and the pro rata portion of the performance bonus referenced
above if they are terminated without cause.
In conjunction with the acquisition of MediaDefender,
effective July 28, 2005, the Company granted stock options to each of Mr. Saaf
and Mr. Herrera to purchase 200,000 shares of common stock, exercisable
for a period of five years at $3.00 per share, which was in excess of the fair
value of the common stock issued in the MediaDefender transaction. These options vest quarterly over three and
one-half years. The fair value of each
of these options, calculated pursuant to the Black-Scholes option-pricing
model, was determined to be $546,000, which is being recognized as stock-based
compensation over the vesting period.
The Company also acknowledged the terms of
Non-Competition Agreements entered into on July 28, 2005 by MediaDefender
and Mr. Saaf and Mr. Herrera.
The Non-Competition Agreements prohibit Mr. Saaf and Mr. Herrera
from (i) engaging in certain competitive business activities, (ii) soliciting
customers of MediaDefender or the Company, (iii) soliciting existing
employees of MediaDefender or the Company and (iv) disclosing any
confidential information regarding MediaDefender or the Company. Each agreement has a term of four years
and shall continue to remain in force and effect in the event the
above-referenced Employment Agreements are terminated prior to the end of the
four-year term of the Non-Competition Agreements. In consideration, Mr. Saaf and Mr. Herrera
were each entitled to a cash payment of $525,000 from MediaDefender on December 31,
2006 (which payments were timely made).
As a result of these agreements, effective July 28, 2005, the
Company recorded an asset of $1,050,000 for the non-competition agreements and
a related liability of $1,050,000 for the guaranteed payments to MediaDefender
management. The $1,050,000 allocated to
non-competition agreements is being amortized over the term of the employment
agreements.
Mr. Saaf and Mr. Herrera each invested
$2,250,000 in the convertible subordinated debt transaction entered into to
fund the acquisition of MediaDefender on the same terms and conditions as the
other investors in such financing (see Note 4).
In conjunction
with the acquisition of MediaDefender, effective July 28, 2005, the
Company granted stock options to Jonathan Diamond, its former Chief Executive
Officer, to purchase 2,753,098 shares of common stock, exercisable for a period
of five years at $1.55 per share, which was in excess of the fair value of the
common stock issued in the MediaDefender transaction. Options with respect to 1,045,000 shares were
scheduled to vest over three years and options with respect to 1,708,098 shares
were scheduled to vest based on specified performance milestones. The fair value of the time-vested options,
calculated pursuant to the Black-Scholes option-pricing model, was determined
to be $2,936,450, which was being recognized as stock-based compensation over
the vesting period. The terms of the
time-vesting options were modified effective March 6, 2008 (see Note 9).
In conjunction
with the acquisition of MediaDefender, effective July 28, 2005, the
Company granted stock options to Robert Weingarten, its former Chief Financial
Officer, to purchase 550,000 shares of common stock, exercisable for a period
of five years at $1.55 per share, which was in excess of the fair value of the
common stock issued in the MediaDefender transaction. Options with respect to 275,000 shares were
scheduled to vest over three years and options with respect to 275,000 shares
were scheduled to vest based on specified performance milestones. The fair value of the time-vested options,
calculated pursuant to the Black-Scholes option-pricing model, was determined
to be $772,750, which was being recognized as stock-based compensation over the
vesting period. The terms of the
time-vesting options were modified effective August 31, 2007, upon Mr. Weingartens
resignation as Chief Financial Officer of the Company.
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Upon the closing of the transaction, the Company issued 1,109,032
shares of common stock and a seven-year warrant to purchase 114,985 shares of
common stock with an exercise price of $1.55 per share to WNT07 Holdings, LLC (WNT07). The managers of WNT07 are Eric Pulier and
Teymour Boutros-Ghali, both of whom were at the time of the issuance of the
consideration and currently are members of the Companys Board of
Directors. The shares and warrants were
issued as consideration for services provided by Mr. Pulier and Mr. Boutros-Ghali
as consultants to the Company with respect to the MediaDefender
acquisition. The consideration issued to
WNT07 was approved by the disinterested members of the Companys Board of
Directors. The shares and warrants were
issued in reliance upon exemptions from registration pursuant to Section 4(2) under
the Securities Act and Rule 506 promulgated thereunder. The shares of common stock were valued at
$1,585,916 ($1.43 per share) and the warrants were valued at $83,939, based on
a valuation report prepared by an independent valuation firm. The aggregate value of $1,669,855 was
allocated $333,971 (20%) to a covenant not to compete (as described below) and
$1,335,884 (80%) to the costs that the Company incurred to acquire MediaDefender,
based on managements estimate of the relative values, as confirmed by the
independent valuation firm.
On July 28, 2005,
the Company entered into a Non-Competition Agreement with WNT07, Eric Pulier
and Teymour Boutros-Ghali (collectively, the Advisors). The Non-Competition Agreement prohibits any
of the Advisors (i) from engaging in certain competitive business
activities and (ii) from soliciting existing employees of the Company or
its subsidiaries. The covenants not to
complete or solicit expired on April 1, 2007. The amount allocated to the covenant not to
compete was amortized through April 1, 2007.
4. FINANCING TRANSACTIONS WITH RESPECT TO
MEDIADEFENDER, INC. ACQUISITION
In conjunction with the
acquisition of MediaDefender on July 28, 2005 (see Note 3), the Company
completed a $15,000,000 senior secured debt transaction (the Senior Financing)
and a $30,000,000 convertible subordinated debt transaction (the Sub-Debt
Financing).
The Senior Financing was
completed in accordance with the terms set forth in the Note and Warrant
Purchase Agreement entered into on July 28, 2005 by the Company, each of
the investors indicated on the schedule of buyers attached thereto and
U.S. Bank National Association as Collateral Agent (the Note Purchase
Agreement). Pursuant to the terms of
the Note Purchase Agreement, each investor received a note with a term of three
years and eleven months that bears interest at the rate of 11.25% per
annum (each a Senior Note), payable quarterly, with any unpaid principal and
accrued interest due and payable at maturity.
Termination and payment of the Senior Notes by the Company prior to
maturity does not result in a prepayment fee.
As collateral for the $15,000,000 Senior Financing, the investors
received a first priority security interest in all existing and future assets
of the Company and its subsidiaries, tangible and intangible, including, but
not limited to, cash and cash equivalents, accounts receivable, inventories,
other current assets, furniture, fixtures and equipment and intellectual
property.
In addition, not later
than ninety days after the close of each fiscal year, the Company is obligated
to apply 60% of its excess cash flow, as defined in the Note Purchase Agreement
(the Annual Cash Sweep), to prepay the principal amount of the Senior
Notes. At December 31, 2007, there
was $313,000 payable for the 2007 Annual Cash Sweep, which was paid during the
three months ended March 31, 2008.
The Senior Financing
investors also received five-year warrants to purchase an aggregate of
3,250,000 shares of the Companys common stock at an exercise price of $2.00
per share (collectively, the Senior Warrants). The Senior Warrants were valued at $1,982,500
based on a valuation report prepared by an independent valuation firm utilizing
the Black-Scholes option-pricing model, and were recorded as a discount to the
$15,000,000 of senior secured debt, and are being amortized to interest expense
over the term of the debt.
The Senior Warrants were
subject to certain anti-dilution and price reset provisions, as well certain
registration rights obligations requiring the Company to file and maintain
effective a registration statement with the SEC covering the shares of common
stock underlying such warrants, which, if not complied with, subjects the
Company to a cash penalty of 1.5% of the Senior Financing per thirty-day
period. Accordingly, in accordance with
EITF 00-19, the fair value of the Senior Warrants was recorded as warrant
liability in the Companys balance sheet at July 28, 2005, and is being
adjusted to reflect any material changes in such liability from the date of
issuance to the end of each subsequent reporting period, with any such changes
included in other income (expense) in the statement of operations.
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The Sub-Debt Financing
was completed in accordance with the terms set forth in the Securities Purchase
Agreement entered into on July 28, 2005 by the Company and each of the
investors indicated on the schedule of buyers attached thereto (the Securities
Purchase Agreement). Pursuant to the
terms of the Securities Purchase Agreement, each investor received a convertible
subordinated note with a term of four years that bears interest at the
rate of 4.0% per annum (each a Sub-Debt Note), with any unpaid principal and
accrued interest due and payable at maturity.
The interest rate increases to 12.0% per annum during any period in
which the Company is in default of its obligations under the Sub-Debt
Note. Commencing September 30,
2006, interest was payable quarterly in cash or shares of common stock, at the
option of the Company. Each Sub-Debt
Note had an initial conversion price of $1.55 per share, and was subject to
certain anti-dilution, reset and change-of-control provisions. In addition, each Sub-Debt Note is subject to
mandatory conversion by the Company in the event certain trading price targets
for the Companys common stock are met.
The Sub-Debt Notes
contain specific provisions that expressly prohibit the Company from issuing
shares to a Sub-Debt Note holder if, after the conversion, such Sub-Debt Note
holder would exceed the respective limit called for in their Sub-Debt Note,
either 4.99% or 9.99%, of the Companys outstanding common shares.
Following effectiveness
of a registration statement filed by the Company for the securities issued in
the Sub-Debt Financing, two times within any twelve-month period, the Company
has the right to require the holder of each Sub-Debt Note to convert all or a
portion equal to not less than 25% of the note conversion amount (limited to
50% of the note conversion amount if pursuant to clause (a) below) into
shares of the Companys common stock in the event that (a) the closing
sale price of the Companys common stock equals or exceeds $2.32 per share for
each of any fifteen consecutive trading days, with a minimum trading volume of
200,000 shares of common stock on each such trading day, (b) the closing
sale price of the Companys common stock equals or exceeds $3.10 per share on
each trading day during the fifteen consecutive trading day period, with a
minimum trading volume of 200,000 shares of common stock on each such trading
day, subject in both cases to appropriate adjustments for stock splits, stock
dividends, stock combinations and other similar transactions after the issuance
date, or (c) completion of an equity financing (including the issuance of
securities convertible into equity securities, or long-term debt securities
issued as a unit with equity securities, of the Company) at a price per share
of not less than $2.50 generating aggregate gross proceeds of at least
$20,000,000 from outside third party investors.
The holders of the
Sub-Debt Notes are entitled to receive any dividends paid or distributions made
to the holders of common stock to the same extent as if such holders had
converted their Sub-Debt Notes into common stock (without regard to any
limitations on conversion) and had held such shares of common stock on the
record date for such dividend or distribution, with such payment to be made
concurrently with the payment of the dividend or distribution to the holders of
common stock.
The Sub-Debt Financing
investors also received five-year warrants to purchase an aggregate of
1,596,774 shares of common stock at an exercise price of $1.55 per share,
subject to certain anti-dilution and price reset provisions (collectively, the Sub-Debt
Warrants). The Sub-Debt Warrants were
valued at $1,133,710 based on a valuation report prepared by an independent
valuation firm utilizing the Black-Scholes option-pricing model, and were
recorded as a discount to the $30,000,000 of convertible subordinated debt, and
are being amortized to interest expense over the term of the debt.
In conjunction with the
aforementioned financing transactions, a Subordination Agreement dated July 28,
2005 was entered into between the Company, the Senior Financing investors, and
the Sub-Debt Financing investors pursuant to which the Sub-Debt Financing
investors agreed to subordinate their rights to the investors in the Senior
Financing in the event of a default under the Senior Financing transaction
documents and on certain other terms and conditions described therein.
Legal fees paid or reimbursed by the Company for
services provided by the respective legal counsels for the lenders were
recorded as a charge to deferred financing costs and are being amortized over
the terms of the related debt.
Pursuant to the terms of the Note Purchase Agreement
and the Securities Purchase Agreement, the Company was required to amend its
Certificate of Incorporation to increase the number of authorized shares of
common stock from 15,000,000 shares to 60,000,000 shares. The Company obtained the requisite approvals
of the Board of Directors and stockholders and filed a Certificate of Amendment
to the Certificate of Incorporation with the Delaware Secretary of State on November 7,
2005 to effect the increase in the authorized shares of common stock.
If all of the securities
issued in the Senior Financing and the Sub-Debt Financing are converted or
exercised into shares of the Companys common stock in accordance with their
respective terms, it will result in significant dilution to the Companys
existing stockholders and a possible change in control of the Company. If all of the Companys outstanding
equity-based instruments are converted or exercised into shares of the Companys
common stock in accordance with their respective terms, including those issued
in conjunction with the acquisition of MediaDefender, there would be a total of
approximately 38,000,000 shares of the Companys common stock issued and
outstanding.
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The securities issued by
the Company in the Senior Financing and the Sub-Debt Financing were offered and
sold in reliance upon exemptions from registration pursuant to Section 4(2) under
the Securities Act of 1933, as amended (the Securities Act), and Rule 506
promulgated thereunder. Each of the
investors qualified as an accredited investor, as specified in Rule 501
under the Securities Act.
The Sub-Debt Notes and
the Sub-Debt Warrants were subject to certain registration rights obligations
requiring the Company to file and maintain effective a registration statement
with the SEC covering the shares of common stock underlying such warrants, which,
if not complied with, subjects the Company to a cash penalty of 1.0% of the
Sub-Debt Financing per thirty-day period.
Accordingly, in accordance with EITF 00-19, the fair value of the
Sub-Debt Warrants was recorded as warrant liability in the Companys balance
sheet at July 28, 2005, and is being adjusted to reflect any material
changes in such liability from the date of issuance to the end of each
subsequent reporting period, with any such changes included in other income
(expense) in the statement of operations.
The Sub-Debt Notes
contain reset, anti-dilution and change-in-control provisions that the Company
has determined caused such debt instruments to be classified as non-conventional
debt. Upon evaluation of such debt
instruments under SFAS No. 133, Accounting for Derivative Instruments and
Hedging Activities (SFAS No. 133), and EITF 00-19, Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Companys Own Stock (EITF 00-19), it was determined that the Company was
required to bifurcate and value certain rights embedded in the Sub-Debt Notes
on the date of issuance (including, specifically, the initial $1.55 per share
fixed conversion feature, which was in excess of the $1.43 per share fair
market value of the Companys common stock on the date of issuance) and to
classify such rights as either assets or liabilities. The fair value of these bifurcated
derivatives as of July 28, 2005, as determined by an independent valuation
firm, was calculated in accordance with SFAS No. 133 Implementation Issue No. B15,
Embedded Derivatives: Separate
Accounting for Multiple Derivative Features Embedded in a Single Hybrid
Instrument, using a binomial lattice model utilizing highly subjective and
theoretical assumptions that can materially affect fair values from period to
period. The recognition of these
derivative amounts did not have any impact on the Companys revenues, operating
expenses or cash flows. The Company
recorded an initial embedded derivative liability of $10,534,000, which was
recorded as a discount to the $31,460,500 of convertible subordinated notes,
and is being amortized over the term of the debt. The carrying value of the embedded derivative
liability is being adjusted to reflect any material changes in such liability
from the date of issuance to the end of each subsequent reporting period, with
any such changes included in other income (expense) in the statement of
operations. The Company has accounted for
registration rights penalties in accordance with EITF 00-19-2, Accounting for
Registration Payment Arrangements, which the Company adopted as of December 31,
2006, and SFAS No. 5, Accounting for Contingencies.
The Sub-Debt Notes
contain several embedded derivative features (both assets and liabilities) that
have been accounted for at fair value.
The various embedded derivative features of the Sub-Debt Notes have been
valued at the date of inception of the Sub-Debt Financing and at the end of
each reporting period thereafter. The
material derivative features include: (1) the
standard conversion feature of the debentures, (2) a limitation on the
conversion by the holder, and (3) the Companys right to force
conversion. An independent valuation
firm valued the embedded derivative features and determined that, except for
the above-noted features, the remaining derivative attributes (both assets and
liabilities) were immaterial, both individually and in the aggregate, and
effectively offset each other. The value
of the embedded derivatives was bifurcated from the Sub-Debt Notes and recorded
as derivative liability, with the initial amount recorded as discount on the
related Sub-Debt Notes. This discount is
being amortized to interest expense over the life of the Sub-Debt Notes.
The Company determined
that the warrants issued in conjunction with the Senior Financing and the
Sub-Debt Financing created derivative liabilities in accordance with EITF 00-19
because share settlement of these financial instruments was not within the
control of the Company, since the Company could not conclude that it had
sufficient authorized but unissued common shares available to satisfy its
potential share obligations under the warrant agreements. The Company reached this conclusion
because: (1) the Company has an
obligation to file a registration statement with the SEC to register the common
stock underlying warrants, and to have such registration statement declared
effective, and to maintain effective such registration statement, or to pay
penalties in the form of liquidated damages for each thirty-day period that
such registration statement is not effective, (2) the warrants contained
dilution protection features, with no limit or cap on the number of shares that
could be issued by the Company pursuant to such provisions, and (3) the
warrants contained certain price reset features. Because the warrants contain certain
anti-dilution and price reset provisions, as well as have registration rights,
the fair value of the warrants was accounted for as a derivative and presented
as warrant liability.
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Pursuant to the terms of
a letter agreement, dated July 15, 2005, by and between the Company and
Broadband Capital Management LLC (Broadband), effective July 28, 2005,
the Company issued to Broadband (including its affiliates) a Sub-Debt Note in
the aggregate amount of $1,460,500 (in addition to the $30,000,000 referred to
above) and five-year warrants to purchase 1,516,935 shares of common stock with
an exercise price of $1.55 per share.
The notes and warrants issued to Broadband and its affiliates were
issued on the same terms and conditions granted to the other Sub-Debt Financing
investors. The securities were issued as
partial consideration for Broadbands services as the Companys placement agent
in the Sub-Debt Financing and the Senior Financing. The securities were issued in reliance upon
exemptions from registration pursuant to Section 4(2) under the
Securities Act and Rule 506 promulgated thereunder. The Broadband warrants were valued at
$1,077,024 based on a valuation report prepared by an independent valuation
firm utilizing the Black-Scholes option-pricing model. The aggregate value of the Sub-Debt Note, the
warrants and additional cash payments to Broadband aggregating $299,500 were
charged to deferred financing costs and are being amortized to other expense
over the term of the debt. The
securities issued to Broadband and its affiliates were accounted for in a
manner consistent with the accounting for the Sub-Debt Notes and Sub-Debt
Warrants as described above.
Pursuant to the terms of
a letter agreement, dated June 21, 2005, by and between the Company and
Libra FE, LP (Libra), effective July 28, 2005, the Company issued to
Libra a seven-year warrant to purchase 237,500 shares of its common stock with
an exercise price of $2.00 per share upon the closing of the Senior Financing
(the Libra Warrant). The Libra Warrant
was issued as partial consideration for Libras services as the Companys
placement agent in the Senior Financing described above. The Company entered into a Registration
Rights Agreement with Libra on July 28, 2005 (the Libra Registration
Rights Agreement), pursuant to which the Company will include the shares
underlying the Libra Warrant in the registration statement covering the
securities issued in the Senior Financing and the Sub-Debt Financing described
above. The Libra Warrant was issued in
reliance upon exemptions from registration pursuant to Section 4(2) under
the Securities Act and Rule 506 promulgated thereunder. The Libra Warrant was valued at $175,750
based on a valuation report prepared by an independent valuation firm utilizing
the Black-Scholes option-pricing model.
The aggregate value of the Libra Warrant and additional payments to
Libra of $450,997 were charged to deferred financing costs and are being
amortized to other expense over the term of the debt.
The Libra Warrant was
subject to certain registration rights requiring the Company to file and
maintain effective a registration statement with the SEC covering the shares of
common stock underlying such warrant, which if not complied with could subject
the Company to a cash penalty of $5,000 per thirty-day period. In
accordance with EITF 00-19, the fair value of the Libra Warrant was recorded as
warrant liability at July 28, 2005, and was being adjusted to reflect any
material changes in such liability from the date of issuance to the end of each
subsequent reporting period, with any such changes included in other income
(expense) in the statement of operations.
Effective April 19, 2006, the Libra Warrant was exercised on a
cashless basis at $2.00 per share, resulting in the issuance of 123,864 shares
of common stock.
At the date of exercise
of any of the Senior Warrants, the Sub-Debt Warrants or the Libra Warrant, or
the conversion of Sub-Debt Notes into common stock, the pro rata fair value of
the related warrant liability and/or embedded derivative liability is
transferred to additional paid-in capital.
Pursuant to the Senior
Financing and Sub-Debt Financing documents, the Company is required to comply
on a quarterly basis with certain financial covenants, including minimum
working capital, maximum capital expenditures, minimum leverage ratio, minimum
EBITDA and minimum fixed charge coverage ratio.
These financial covenants are identical in the Senior Financing and the
Sub-Debt Financing documents.
Due to the accounting
classification of the warrants issued in conjunction with the Senior Financing
and the Sub-Debt Financing as a current liability in accordance with SFAS No. 133
and EITF 00-19, the Company was not in compliance with certain of these
financial covenants at December 31, 2005.
On April 7, 2006, the lenders provided waivers with respect
to such past events of default under the Senior Notes and amended their loan
documents such that the warrant liability and any change thereto in future
periods will not affect future covenant and excess cash flow calculations. In consideration thereof, the Company offered
to temporarily reduce the exercise price of the 3,250,000 warrants held by the
investors in the Senior Financing from $2.00 to $1.85 per share through April 30,
2006, and agreed to permanently reduce the exercise price of the 1,596,744
warrants held by the investors in the Sub-Debt Financing from $1.55 to $1.43
per share on certain terms and conditions. Any exercise of the
aforementioned warrants at the reduced exercise price was required to be for
cash only. The conversion price of the Sub-Debt Notes of $1.55 per share
was not affected. The Company also entered into similar agreements, as
applicable, and provided identical temporary and permanent reductions to
warrant exercise prices, with Broadband Capital Management LLC (1,516,935
warrants originally exercisable at $1.55 per share) and Libra FE, LP (237,500
warrants originally exercisable at $2.00 per share). The Company also
agreed to utilize 25% of the net proceeds from the exercise of the warrants
held by the investors in the Senior Financing to reduce the respective
principal balances on the Senior Notes payable held by such exercising
investors, and to pay any related unpaid accrued interest on such principal
payments. The aforementioned waivers did
not extend to the embedded derivative liabilities associated with the Sub-Debt.
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Effective April 27, 2006, certain of the investors in the Senior
Financing exercised their warrants to purchase 2,816,667 shares of common stock
at $1.85 per share, resulting in the issuance of 2,816,667 shares of common
stock in exchange for cash proceeds of $5,212,000, of which $1,303,000 was used
to reduce the respective principal balances on the Senior Notes payable held by
such exercising investors. There was no
conversion of subordinated convertible notes payable during April 2006 in
relation to this transaction.
As a result of the $0.15
warrant exercise price reduction offered to the investors in the Senior
Financing in April 2006, the Company recorded a charge to operations
during the year ended December 31, 2006 for the aggregate fair value of
such exercise price reductions of $423,000 relating to the warrants held and
exercised by the Senior Financing investors in April 2006. The Company provided this consideration
primarily in exchange for a waiver of and amendment to certain of the financial
covenants contained in the loan agreements entered into in conjunction with the
July 2005 acquisition of MediaDefender.
The amount charged to operations was calculated by multiplying the $0.15
reduction, which represented the fair value of the consideration transferred,
by the number of warrants that elected to accept the Companys offer and
exercise, as follows: $0.15 x 2,816,667
= $423,000. This charge to operations
was presented as reduction in exercise price of warrants and was included in
other income (expense) in the statement of operations.
As a result of the $0.12
warrant exercise price reduction provided to the investors in the Sub-Debt
Financing in April 2006, the Company recorded a charge to operations
during the year ended December 31, 2006 for the aggregate fair value of
such exercise price reductions of $218,000 relating to the warrants held by the
investors in the Sub-Debt Financing in April 2006. The Company provided this consideration in
exchange for a waiver of and amendment to certain of the financial covenants
contained in the loan agreements entered into in conjunction with the July 2005
acquisition of MediaDefender. This
amount was calculated by determining the difference between the fair value of
the warrants held by the investors in the Sub-Debt Financing, based on a
comparison of updated Black-Scholes calculations using the original $1.55
exercise price and the reduced $1.43 exercise price. The Company utilized revised Black-Scholes
input metrics to reflect updated changes, in particular to estimated life and
volatility. The result was that the
Black-Scholes value of the Sub-Debt warrants was $3.54, based on the original
$1.55 exercise price, as compared to a Black-Scholes value of $3.61, based on
the reduced exercise price of $1.43. The
amount charged to operations was calculated by multiplying the $0.07 difference
($3.61 - $3.54), which represented the fair value of the consideration
transferred, by the number of warrants affected, as follows: $0.07 x 3,113,709 = $218,000. This charge to operations was presented as
reduction in exercise price of warrants and was included in other income
(expense) in the statement of operations.
On November 7, 2006,
the Company entered into a waiver (the Sub-Debt Waiver) with the holders of
the Sub-Debt Notes. A provision of the Sub-Debt Notes contains a negative
covenant pertaining to the Companys Consolidated Fixed Charge Coverage Ratio
(as such term is defined in the Sub-Debt Notes), which is to be calculated on a
quarterly basis (the Fixed Charge Covenant). The Fixed Charge Covenant
as originally drafted did not contemplate that the first cash payment of
accrued interest was not due and payable to the holders of the Sub-Debt Notes
until September 30, 2006 (the First Interest Payment), an approximate
fourteen-month period from the original issuance date of the Sub-Debt
Notes. As a result of the Company timely making the First Interest
Payment of $1,307,000, the Company was forced to breach the Fixed Charge
Covenant. The holders of the Sub-Debt Notes agreed to waive this event of
default under the Sub-Debt Notes that may have been triggered due to a breach
of the Fixed Charge Covenant resulting from the First Interest Payment.
On November 7, 2006,
the Company also entered into a waiver (the Senior Waiver) with the
purchasers of the Senior Notes originally issued by the Company. The Note
Purchase Agreement contains the same Fixed Charge Covenant that is contained in
the Sub-Debt Notes (the Senior Fixed Charge Covenant). As a result of
the Company timely making the First Interest Payment of $1,307,000, the Company
was forced to breach the Senior Fixed Charge Covenant. The holders of the
Senior Notes agreed to waive the event of default under the Note Purchase Agreement
that may have been triggered due to a breach of the Senior Fixed Charge
Covenant resulting from the First Interest Payment.
The financing documents
governing the terms and conditions of the senior and subordinated indebtedness
required the Company to maintain an effective registration statement covering
the resale of shares of common stock underlying the various securities issued
by the Company to each holder. A resale
registration statement on Form SB-2, as amended, was declared effective by
the SEC on December 9, 2005. The Company subsequently filed
Post-Effective Amendment No. 1 to the registration statement on Form SB-2,
which was declared effective by the SEC on May 1, 2006, Post-Effective Amendment
No. 2 to the registration statement on Form SB-2, which was declared
effective by the SEC on July 6, 2007, and Post-Effective Amendment No. 5
to its registration statement on Form S-1, which was declared effective on
June 6, 2008. As a result of the determination to restate previously
issued financial statements (see Note 1), the Form SB-2 was not available
for use by the holders between December 21, 2006 and July 6, 2007.
20
Table of Contents
The financing documents
specify that an event of default of the senior and subordinated indebtedness is
triggered if a resale registration statement is unavailable for use by the
holders for a period of more than ten consecutive trading days after the
expiration of an allowable ten-day grace period. The Company invoked its
use of the ten-day allowable grace period on December 21, 2006, which
expired on December 31, 2006. The Company delivered notice to
holders of its outstanding senior and subordinated indebtedness that, as of December 20,
2006, an event of default had been triggered under their respective senior and
subordinated financing documents.
As of December 20,
2006, the Form SB-2 remained unavailable for use by the holders, and it
continued to be unavailable for use until July 6, 2007, when Amendment No. 2
to the registration statement on Form SB-2 was declared effective by the
SEC. Accordingly, at December 31, 2006, the registration statement
covering the resale of shares of common stock underlying the various securities
issued by the Company to each holder of the senior and subordinated
indebtedness was not effective. As a
result, an event of default, among others, with respect to the senior and
subordinated indebtedness was triggered by the unavailability of the Form SB-2
to the holders between December 20, 2006 and July 6, 2007. The financing documents provide that while
the Form SB-2 remains unavailable for use, holders of senior indebtedness
are entitled to a cash penalty equal to 1.5% of the original Senior Financing,
on a pro rata basis, and the holders of subordinated indebtedness are entitled
to a cash penalty equal to 1.0% of the original Sub-Debt Financing, on a pro
rata basis. These cash penalties are due and payable by the Company at
the end of each thirty-day period while the Form SB-2 remains
unavailable. The first cash penalty payment was due on January 31,
2007, and monthly thereafter.
In accordance with EITF
00-19-2, which the Company adopted as of December 31, 2006, and SFAS No. 5,
the Company accrued seven months liquidated damages (through mid-August 2007)
under the registration rights agreements aggregating approximately $3,777,000
as a charge to operations at December 31, 2006, which was reduced by $395,000
as a result of the Companys registration statement being declared effective on
July 6, 2007, which was earlier than originally estimated, and by an
aggregate of $1,000,000 of advance payments made to the holders of the Senior
Financing during the year ended December 31, 2007 for liquidated damages
under the registration rights agreement.
Accordingly, liquidated damages payable under registration rights
agreements were $2,382,000 at December 31, 2007. During the six months ended June 30,
2008, the Company made a further payment to the holders of the Senior Financing
with respect to liquidated damages under the registration rights agreement of
$410,000, thus reducing liquidated damages payable to $1,972,000 at June 30,
2008. Liquidated damages payable are
presented as a current liability in the Companys balance sheet. The Company believes that the amount of the
liquidated damages accrued reflects the undiscounted maximum potential amount
of liquidated damages payable to the holders of the Senior Financing and the
Sub-Debt Financing since the underlying shares became generally available for
resale under an effective registration statement on July 6, 2007.
A summary of the
registration penalty accrual at June 30, 2008 and December 31, 2007 is presented below.
|
|
June 30,
2008
|
|
December 31,
2007
|
|
|
|
|
|
|
|
Senior secured
notes payable
|
|
$
|
|
|
$
|
410,000
|
|
Subordinated
convertible notes payable
|
|
1,972,000
|
|
1,972,000
|
|
Total
registration penalty accrual
|
|
$
|
1,972,000
|
|
$
|
2,382,000
|
|
As of June 30, 2008 and
December 31, 2007, approximately $12,994,000 and $13,307,000 principal
amount was outstanding with respect to the Senior Financing, respectively, and
approximately $27,658,000 principal amount was outstanding with respect to the
Sub-Debt Financing. In addition, at June 30, 2008, approximately
$129,000 and $4,992,000 was outstanding with respect to accrued interest
payable to the holders of the Senior Financing and the Sub-Debt Financing,
respectively. At December 31, 2007,
approximately $146,000 and $3,206,000 was outstanding with respect to accrued
interest payable to the holders of the Senior Financing and the Sub-Debt
Financing, respectively. Through June 30,
2008, the Company had made payments with respect to the registration delay
penalties to the holders of the Senior Notes aggregating $1,410,000, of which
$1,000,000 was paid during 2007. Through
June 30, 2008, the Company had not made any payments with respect to the
registration delay penalties to the holders of the Sub-Debt Notes. As a result of the registration failure, the
failure to pay certain of the registration delay penalties, and the various
financial covenant and other breaches of the terms of the Senior Financing and
the Sub-Debt Financing, multiple events of default exist under the Senior
Financing and the Sub-Debt Financing.
The terms of the Subordination Agreement among the Company and the
creditor parties thereto (the Subordination Agreement) prevent the Company
from making any cash payments to the Sub-Debt Note holders until the events of
default under the Senior Financing are either cured or waived. Furthermore, upon the occurrence of an event
of default, holders of at least 25% of the outstanding senior indebtedness may
declare the outstanding principal and accrued interest on all senior notes
immediately due and payable upon written notice to the Company, and each holder
of outstanding subordinated indebtedness may only demand redemption of all or
any portion of their respective notes under certain circumstances as described
in the Subordination Agreement. The Company does not have the capital resources
necessary to cure the existing events of default, or to repay any accelerated
indebtedness or redemption or penalty amounts.
21
Table of Contents
On October 16, 2007,
the Company received an Event of Default Redemption Notice from the holders of
approximately $2,693,000 principal amount of Sub-Debt Notes demanding that the
Company redeem their Sub-Debt Notes. The
Company believes and has advised these Sub-Debt Note holders that redemption
(including the demand for redemption) is not permitted under the terms of the
Subordination Agreement. On November 1,
2007, the Company received a copy of a letter to the Sub-Debt Note holders from
Senior Note holders representing approximately 66% of the Senior Notes. The letter advised the Sub-Debt Note holders
that the Subordination Agreement prohibits the Company from redeeming any
Sub-Debt Notes and prohibits any Sub-Debt Note holder from pursuing any
remedies.
All quarterly interest
payments due on the outstanding senior and subordinated indebtedness were
timely paid by the Company through December 2006. In addition, the quarterly interest payments
due on the outstanding senior indebtedness have been timely paid. Pursuant to the terms of the Subordination
Agreement, interest on the outstanding subordinated convertible notes payable
cannot be paid as a result of the existence of the events of default described
herein.
A summary of accrued
interest payable at June 30, 2008 and December 31, 2007 is presented
below.
|
|
June 30,
2008
|
|
December 31,
2007
|
|
|
|
|
|
|
|
Senior secured
notes payable
|
|
$
|
129,000
|
|
$
|
67,000
|
|
Subordinated
convertible notes payable
|
|
4,689,000
|
|
3,034,000
|
|
Liquidated
damages payable with respect to:
|
|
|
|
|
|
Senior secured
notes payable
|
|
-
|
|
79,000
|
|
Subordinated
convertible notes payable
|
|
303,000
|
|
172,000
|
|
Total accrued
interest payable
|
|
$
|
5,121,000
|
|
$
|
3,352,000
|
|
Pursuant to a series of Forbearance and Consent
Agreements with the investors in the Senior Financing, such investors agreed to
forbear from the exercise of their rights and remedies under the Senior
Financing documents as a result of the events of default with respect to the
unavailability of the Companys registration statement, as well as certain
other events of default that existed or that could come into existence during
the forbearance period, from April 17, 2007 through February 20,
2008, in exchange for aggregate cash payments of $1,000,000 in 2007 (applied
against accrued registration delay penalties) and $494,423 ($410,000 applied
against accrued registration delay penalties and $84,423 applied against
interest on accrued registration delay penalties) in February 2008. The payments made by the Company under the
Forbearance and Consent Agreements were credited against the registration delay
cash penalties and interest on the penalties resulting from the Companys
default under the various agreements between the Company and the Senior
Financing investors. On March 17,
2008, the Company entered into a Forbearance and Consent Agreement with the
investors in the Companys Senior Debt Financing, which was effective as of February 20,
2008, whereby the investors agreed to
forbear from exercising any of their rights and remedies under the Senior
Financing transaction documents through December 31, 2008 in exchange for
an adjustment in the interest rate associated with the Senior Notes from 11.25%
to 15.0%, provided the loan is repaid prior to September 30, 2008 or 16.0%
(retroactive to February 20, 2008), if the loan remains outstanding
subsequent to that date.
On August 3, 2007,
the Company entered into a Waiver and Forbearance Agreement with the holders of
the Sub-Debt Financing pursuant to which the holders agreed to waive their
right to charge the 12.0% default interest rate triggered by the Companys
defaults under the Subordinated Financing transaction documents and instead
charge the 4.0% standard interest rate on the Sub-Debt Notes for the period
from July 16, 2007 through August 31, 2007 (the Forbearance Period). The holders of the Sub-Debt Financing also
agreed to forbear from exercising any of their other rights and remedies under
the Sub-Debt Financing transaction documents during the Forbearance Period,
upon the terms and conditions in the Waiver and Forbearance Agreement. Effective September 1, 2007, the
interest rate returned to the 12.0% default interest rate.
22
Table of Contents
As a result of the
requirement to restate certain previously issued financial statements, which
resulted in the recording of an embedded derivative liability, the
reclassification of the senior and subordinated indebtedness to current
liabilities, and the recording of liquidated damages payable under registration
rights agreements, the Company was not in compliance with certain of its
financial covenants under both the Senior Financing and the Sub-Debt Financing
at December 31, 2006.
Notwithstanding such developments, the Company would have been out of
compliance with certain of its financial covenants at December 31, 2007
and subsequently.
The registration delay
penalties and ongoing default interest charges are continuing to have a
significant and material negative impact on the Companys operations and cash
flows. The Company is exploring various
alternatives to resolve the defaults under its senior and secured debt
obligations, but is unable to predict the outcome of such negotiations. On February 7, 2008, the Company
retained the services of Salem Partners, LLC to serve as a financial advisor to
the Company in connection with the sale, merger, consolidation, reorganization
or other business combination and the restructuring of the material terms of
the Companys senior notes and/or subordinated convertible notes. To the extent that the Company is unable to complete
a sale or merger, or restructure its senior and subordinated debt obligations
in a satisfactory manner and/or the lenders begin to exercise additional
remedies to enforce their rights, the Company will not have sufficient cash
resources to maintain its operations. In
such event, the Company may be required to consider a formal or informal
restructuring or reorganization, including a filing under Chapter 11 of the
United States Bankruptcy Code.
5. DERIVATIVE FINANCIAL INSTRUMENTS
In conjunction with the financing for the acquisition
of MediaDefender on July 28, 2005 (see Notes 3 and 4), the Company
completed a $15,000,000 senior secured debt transaction (the Senior Financing)
and a $30,000,000 convertible subordinated debt transaction (the Sub-Debt
Financing). The Company also issued
various warrants in conjunction with such financings.
The Sub-Debt Notes
contain multiple embedded derivative features (both assets and liabilities)
that have been accounted for at fair value as a compound embedded
derivative. The compound embedded
derivative associated with the Sub-Debt Notes has been valued at the date of
inception of the Sub-Debt Financing and at the end of each reporting period
thereafter. The compound embedded
derivative includes the following material features: (1) the standard conversion feature of
the debentures, (2) a limitation on the conversion by the holder, and (3) the
Companys right to force conversion.
An independent valuation
firm assisted the Company in valuing the various derivative features in the
compound embedded derivative and it was determined that, except for the
above-noted features, the remaining derivative attributes (both assets and
liabilities) were immaterial, both individually and in the aggregate, and they
effectively offset one another. The
value of the compound embedded derivative that includes the above-noted
features was bifurcated from the Sub-Debt Notes and recorded as derivative
liability. This initial amount was
recorded as a discount on the related Sub-Debt Notes. This discount is being amortized to interest
expense over the life of the Sub-Debt Notes.
The Company, with the
assistance of an independent valuation firm, calculated the fair value of the
compound embedded derivative associated with the Sub-Debt Notes in accordance
with SFAS No. 133 Implementation Issue No. B15, Embedded
Derivatives: Separate Accounting for
Multiple Derivative Features Embedded in a Single Hybrid Instrument, which
requires that when multiple derivatives (both assets and liabilities) exist
within a financial instrument, they are bundled together as a single hybrid
compound instrument. The calculation
model utilized a complex, customized, binomial lattice model suitable for the
valuation of path-dependent American options. The model uses the risk neutral binomial
methodology to simulate the scenarios and stock price paths. The model also uses backward dynamic
programming to value the payoffs at each node considering all the embedded
options simultaneously.
23
Table of Contents
The valuation model used
the following assumptions for the original valuation and for each succeeding
quarterly valuation:
|
|
2005
|
|
2006
|
|
2007
|
|
2008
|
|
Embedded derivatives
|
|
7/28
|
|
9/30
|
|
12/31
|
|
3/31
|
|
6/30
|
|
9/30
|
|
12/31
|
|
3/31
|
|
6/30
|
|
9/30
|
|
12/31
|
|
3/31
|
|
6/30
|
|
Initial
fair value of common stock ($)
|
|
1.43
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fair
value of common stock at each subsequent reporting period end
|
|
|
|
2.50
|
|
3.30
|
|
4.50
|
|
3.50
|
|
3.25
|
|
2.35
|
|
1.90
|
|
2.00
|
|
1.80
|
|
0.38
|
|
0.38
|
|
0.27
|
|
Conversion
price ($)
|
|
1.55
|
|
1.55
|
|
1.55
|
|
1.55
|
|
1.55
|
|
1.55
|
|
1.55
|
|
1.55
|
|
1.55
|
|
1.55
|
|
1.55
|
|
1.55
|
|
1.55
|
|
Terminal
time period in months
|
|
48
|
|
46
|
|
43
|
|
40
|
|
37
|
|
34
|
|
31
|
|
28
|
|
25
|
|
22
|
|
19
|
|
16
|
|
13
|
|
Expected
return
|
|
4.04
|
%
|
4.18
|
%
|
4.35
|
%
|
4.82
|
%
|
5.10
|
%
|
4.59
|
%
|
4.69
|
%
|
4.58
|
%
|
4.87
|
%
|
3.97
|
%
|
3.05
|
%
|
1.62
|
%
|
2.35
|
%
|
Initial
volatility factor
|
|
55
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Volatility
factor for each subsequent reporting period
|
|
|
|
54
|
%
|
59
|
%
|
56
|
%
|
63
|
%
|
63
|
%
|
53
|
%
|
60
|
%
|
56
|
%
|
63
|
%
|
73
|
%
|
67
|
%
|
74
|
%
|
Triggering
events to forced conversion:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Event
1 - stock price equal or above ($)
|
|
2.32
|
|
2.32
|
|
2.32
|
|
2.32
|
|
2.32
|
|
2.32
|
|
2.32
|
|
2.32
|
|
2.32
|
|
2.32
|
|
2.32
|
|
2.32
|
|
2.32
|
|
Event
2 - daily share trading volume equal or above (in thousands)
|
|
200
|
|
200
|
|
200
|
|
200
|
|
200
|
|
200
|
|
200
|
|
200
|
|
200
|
|
200
|
|
200
|
|
200
|
|
200
|
|
Lack
of liquidity discount for the limitation on conversion
|
|
20
|
%
|
20
|
%
|
20
|
%
|
20
|
%
|
20
|
%
|
20
|
%
|
20
|
%
|
20
|
%
|
20
|
%
|
20
|
%
|
20
|
%
|
20
|
%
|
20
|
%
|
The Company determined
that the warrants issued in conjunction with the Senior Financing and the
Sub-Debt Financing created derivative liabilities in accordance with EITF 00-19
because share settlement of these financial instruments was not within the
control of the Company, since the Company could not conclude that it had
sufficient authorized but unissued common shares available to satisfy its
potential share obligations under the warrant agreements. The Company reached this conclusion
because: (1) the Company has an
obligation to file a registration statement with the SEC to register the common
stock underlying warrants, and to have such registration statement declared
effective, and to maintain effective such registration statement, or to pay
penalties in the form of liquidated damages for each thirty-day period that
such registration statement is not effective, (2) the warrants contained
dilution protection features, with no limit or cap on the number of shares that
could be issued by the Company pursuant to such provisions, and (3) the
warrants contained certain price reset features. Because the warrants contain certain
anti-dilution and price reset provisions, as well as have registration rights,
the fair value of the warrants was accounted for as a derivative and presented
as warrant liability.
24
Table
of Contents
The Company calculated
the fair value of the various warrants using the Black Scholes option-pricing
model, using the volatility factor determined by the independent valuation
firm. The valuation model used the following
assumptions for the original valuation and for each succeeding quarterly
valuation.
|
|
2005
|
|
2006
|
|
2007
|
|
2008
|
|
Warrant liability
|
|
7/28
|
|
9/30
|
|
12/31
|
|
3/31
|
|
6/30
|
|
9/30
|
|
12/31
|
|
3/31
|
|
6/30
|
|
9/30
|
|
12/31
|
|
3/31
|
|
6/30
|
|
Initial
fair value of common stock ($)
|
|
1.43
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fair
value of common stock at each subsequent reporting period end ($)
|
|
|
|
2.50
|
|
3.30
|
|
4.50
|
|
3.50
|
|
3.25
|
|
2.35
|
|
1.90
|
|
2.00
|
|
1.80
|
|
0.38
|
|
0.38
|
|
0.27
|
|
Exercise
price:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Senior
warrants ($)
|
|
2.00
|
|
2.00
|
|
2.00
|
|
2.00
|
|
2.00
|
|
2.00
|
|
2.00
|
|
2.00
|
|
2.00
|
|
2.00
|
|
2.00
|
|
2.00
|
|
2.00
|
|
Sub-debt
warrants ($)
|
|
1.55
|
|
1.55
|
|
1.55
|
|
1.55
|
|
1.43
|
|
1.43
|
|
1.43
|
|
1.43
|
|
1.43
|
|
1.43
|
|
1.43
|
|
1.43
|
|
1.43
|
|
Libra
warrant ($)
|
|
2.00
|
|
2.00
|
|
2.00
|
|
2.00
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Time
period in months:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Senior
warrants
|
|
60
|
|
58
|
|
55
|
|
52
|
|
49
|
|
46
|
|
43
|
|
40
|
|
37
|
|
34
|
|
31
|
|
28
|
|
25
|
|
Sub-debt
warrants
|
|
60
|
|
58
|
|
55
|
|
52
|
|
49
|
|
46
|
|
43
|
|
40
|
|
37
|
|
34
|
|
31
|
|
28
|
|
25
|
|
Libra
warrant
|
|
84
|
|
82
|
|
79
|
|
76
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Expected
return %
|
|
4.04
|
|
4.18
|
|
4.35
|
|
4.82
|
|
5.10
|
|
4.59
|
|
4.69
|
|
4.58
|
|
4.89
|
|
4.03
|
|
3.45
|
|
1.62
|
|
2.35
|
|
Initial
volatility factor
|
|
55
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Volatility
factor for each subsequent reporting period
|
|
|
|
54
|
%
|
59
|
%
|
56
|
%
|
63
|
%
|
63
|
%
|
53
|
%
|
60
|
%
|
56
|
%
|
63
|
%
|
73
|
%
|
67
|
%
|
74
|
%
|
The Companys
Sub-Debt Notes contain compound embedded derivatives (as described above) that
required that they be bifurcated from the debt host instrument at the date of
issuance and valued. The calculation of
the fair value of the compound embedded derivatives required the use of a more
sophisticated valuation model than a Black-Scholes option-pricing model. Accordingly, the Company retained an
independent valuation firm to calculate the fair value of the compound embedded
derivatives, and the changes in fair value at each subsequent period end. The Company, with the assistance of the
independent valuation firm, calculated the fair value of the compound embedded
derivatives associated with the Sub-Debt Notes in accordance with SFAS No. 133
Implementation Issue No. B15, Embedded Derivatives: Separate Accounting for Multiple Derivative
Features Embedded in a Single Hybrid Instrument, by utilizing a complex,
customized, binomial lattice model suitable in the valuation of path-dependent
American options. This model utilized
subjective and theoretical assumptions that can materially affect fair values
from period to period.
The independent valuation
firm concluded that the Companys historical pattern of stock prices as of July 28,
2005, and for some time thereafter, would not provide a sufficient indication
of the long-term expected volatility of the Companys stock going forward for
purposes of the calculation of the fair value of the compound embedded
derivatives, due to the significant changes in the business operations and
capital structure of the Company on July 28, 2005 as a result of the acquisition
of MediaDefender and the related financing transactions.
Accordingly, the Companys independent valuation firm based its
calculation of the Companys expected stock price volatilities on the
volatility factors of similar public companies.
The independent valuation firm identified four companies that were
similar to the Company in terms of industry, market capitalization, stock price
and profitability: Easylink Services
Corporation; Forgent Networks, Inc.; Inforte Corp.; and Think Partnership, Inc. Using historical stock returns data for a
period of one year, the independent valuation firm calculated the volatilities
of these companies at the various reporting dates. The expected volatilities for the Company as
of the reporting dates were calculated based on the average of the volatilities
of these comparable companies. The
resulting volatilities were then used to calculate the fair value, and the
changes in fair value, of the Companys compound embedded derivative
liabilities at each period end. The
Company also utilized these volatilities to calculate the fair value, and the
changes in fair value, of the Companys warrant derivative liabilities at each
period end.
Paragraph A32 of SFAS No. 123R
lists factors to consider in estimating expected volatility. The independent valuation firm retained by
the Company to value the compound embedded derivatives contained in the
Sub-Debt Notes determined that the appropriate methodology to calculate
volatility with respect to the Companys compound embedded derivatives was to
consider the Company as similar to a newly public company without a trading
history because of the significant transformative changes resulting from the
acquisition and financing of the MediaDefender transaction on July 28,
2005.
25
Table of Contents
With reference to newly
public companies, section (c) of paragraph A32 of SFAS No. 123R
suggests that the expected volatility of similar entities be considered. The independent valuation firm arrived at
this determination due to the Companys acquisition of MediaDefender on July 28,
2005 and the related equity-based financing transactions that provided the capital
to fund the acquisition.
The Company adopted SFAS No. 157
on January 1, 2008, delaying, as permitted, application for non-financial
assets and non-financial liabilities.
SFAS No. 157 establishes a framework for measuring fair value, and
expands disclosures about fair value measurements. SFAS No. 157 establishes a fair value
hierarchy that prioritizes the inputs to valuation techniques used to measure
fair value into three levels as follows:
Level 1: quoted prices (unadjusted) in active markets
for an identical asset or liability that the Company has the ability to access
as of the measurement date. Financial
assets and liabilities utilizing Level 1 inputs include active-exchange traded
securities and exchange-based derivatives.
Level 2: inputs other than quoted prices included
within Level 1 that are directly observable for the asset or liability or
indirectly observable through corroboration with observable market data. Financial assets and liabilities utilizing
Level 2 inputs include fixed income securities, non-exchange based derivatives,
mutual funds, and fair-value hedges.
Level 3: unobservable inputs for the asset or
liability are only used when there is little, if any, market activity for the
asset or liability at the measurement date.
Financial assets and liabilities utilizing Level 3 inputs include
infrequently-traded non-exchange-based derivatives and commingled investment
funds, and are measured using present value pricing models.
In accordance with SFAS No. 157,
the Company determines the level in the fair value hierarchy within which each
fair value measurement falls in its entirety, based on the lowest level input
that is significant to the fair value measurement in its entirety.
The warrant liability and
the derivative liability, as described above, are the only financial
instruments that are measured and recorded at fair value on the Companys
balance sheets on a recurring basis. The
following table presents the warrant liability and the derivative liability at
their level within the fair value hierarchy during the three months and six
months ended June 30, 2008, as well as a reconciliation of the changes to
the beginning and ending balances of such financial instruments during such
period.
|
|
Fair Value
|
|
|
|
Level 1
|
|
Level 2
|
|
Level 3
|
|
Total
|
|
Warrant
liability:
|
|
|
|
|
|
|
|
|
|
Balance,
December 31, 2007
|
|
$
|
|
|
$
|
164,000
|
|
$
|
|
|
$
|
164,000
|
|
Change
in fair value gain
|
|
|
|
(65,000
|
)
|
|
|
(65,000
|
)
|
Balance,
March 31, 2008
|
|
|
|
99,000
|
|
|
|
99,000
|
|
Change
in fair value - gain
|
|
|
|
(35,000
|
)
|
|
|
(35,000
|
)
|
Balance,
June 30, 2008
|
|
$
|
|
|
$
|
64,000
|
|
$
|
|
|
$
|
64,000
|
|
|
|
|
|
|
|
|
|
|
|
Derivative
liability:
|
|
|
|
|
|
|
|
|
|
Balance,
December 31, 2007
|
|
$
|
|
|
$
|
313,000
|
|
$
|
|
|
$
|
313,000
|
|
Change
in fair value gain
|
|
|
|
(171,000
|
)
|
|
|
(171,000
|
)
|
Balance,
March 31, 2008
|
|
|
|
142,000
|
|
|
|
142,000
|
|
Change
in fair value gain
|
|
|
|
(117,000
|
)
|
|
|
(117,000
|
)
|
Balance,
June 30, 2008
|
|
$
|
|
|
$
|
25,000
|
|
|
|
$
|
25,000
|
|
6. GOODWILL
Goodwill at December 31,
2007 and 2006 was $31,085,000, which was recorded in conjunction with the
acquisition of MediaDefender in July 2005 (see Note 3). In
accordance with SFAS No. 142, Goodwill and Other Intangible Assets, an
intangible asset that is not subject to amortization such as goodwill shall be
tested for impairment at least on an annual basis, and more often under certain
circumstances, and written down when impaired. An interim impairment test
is required if an event occurs or conditions change that would more likely than
not reduce the fair value of the reporting unit below its carrying value. The first step of the impairment test
consists of a comparison of the total fair value of each reporting unit to the
reporting units net assets on the date of the test. If the fair value is
in excess of the net assets, there is no indication of impairment and thus no
need to perform the second step of the impairment test.
26
Table of Contents
During the three months
ended September 30, 2007, the Company performed its second annual
impairment test with respect to the goodwill recognized in conjunction with the
acquisition of MediaDefender and determined that there was no indication of
impairment. Due to the reduced sales
activity and lower operating margins in the Companys anti-piracy business for
2007 and internal projections for 2008, the Company reviewed the impairment
calculations at December 31, 2007 and noted that while the test thresholds
were narrower, an impairment adjustment was still not required. The Companys further review of the
impairment calculations at March 31, 2008 was consistent with the Companys
observations and conclusions at December 31, 2007, which allowed for a
further decline in revenues in 2008.
On July 7, 2008, as
a result of developments during the latter part of June 2008 with respect
to the business of MediaDefender, the Company concluded that the current
carrying value of the MediaDefender segment goodwill of $31,085,000 was
substantially and permanently impaired at June 30, 2008.
Management reached this
conclusion based on various factors, including less than anticipated revenues
in 2008 from MediaDefenders new advertising initiatives and a significant
further erosion of demand for MediaDefenders core internet anti-piracy
services by the entertainment industry. In particular, the Company was
advised by one of MediaDefenders larger customers, which represented
approximately 18% of MediaDefenders revenues for the year ended December 31,
2007, that it intends to substantially curtail its use of MediaDefenders
anti-piracy services subsequent to the expiration of its current contract with
MediaDefender on June 30, 2008.
Based on these recent
developments, the Company revised MediaDefenders financial projections for the
remainder of 2008 and beyond, as a result of which the Company recorded a
non-cash charge to operations to reflect the impairment of MediaDefender
goodwill at June 30, 2008 of $25,585,000. The calculation of the goodwill
impairment charge at June 30, 2008 was based on various estimates,
assumptions and pending issues, as a result of which the Company may further
revise its calculation of the impairment of the MediaDefender goodwill at September 30,
2008, December 31, 2008 and subsequently.
Management expects
that MediaDefenders anti-piracy revenues will continue to decline during the
remainder of 2008.
7. RELATED PARTY TRANSACTIONS
On January 12, 2007,
the Company entered into a consulting agreement with Eric Pulier, a director of
the Company, through WNT Consulting Group, a California limited liability
company wholly-owned by Mr. Pulier (WNT). During the term of the
consulting agreement, which commenced January 12, 2007 and continues in effect
until any party provides ten days prior written notice to the other parties of
its intention to terminate, Mr. Pulier will provide non-exclusive
consulting and advisory services to the Company outside of the ordinary course
of his services as a member of the Board of Directors. In consideration, Mr. Pulier
(through WNT) is entitled to receive hourly compensation at the rate of $500
per hour. Any consulting request made by the Company must be approved in
advance by all parties prior to commencement of services. The new
consulting agreement was approved by the Compensation Committee of the Companys
Board of Directors. During the three
months and six months ended June 30, 2008 and 2007, Mr. Pulier
(through WNT) did not earn any fees under the new consulting agreement.
During the three months
ended June 30, 2008 and 2007, the Company incurred legal fees of $13,000
and $4,000, respectively, and during the six months ended June 30, 2008
and 2007, the Company incurred legal fees of $15,000 and $4,000, respectively,
to Davis Shapiro Lewit & Hayes, LLP, a law firm in which Fred Davis, a
director of the Company, is a partner.
For the year ending December 31,
2008, each non-employee member of the Companys Board of Directors will receive
a cash retainer of $15,000 for serving on the Board of Directors, payable in
equal quarterly installments, and each director that serves on a standing
Committee of the Board of Directors will receive, for each committee served, an
additional cash retainer of $10,000, payable in equal quarterly installments.
Effective March 7,
2008, the Board of Directors appointed Dimitri Villard as Interim Chief
Executive Officer of the Company to serve on an at will basis at a monthly
compensation of $25,000.
See Notes 3, 4, 8 and 9
for information with respect to additional related party transactions.
27
Table
of Contents
8. EQUITY-BASED TRANSACTIONS
2006 Equity Incentive Plan:
During the three months
and six months ended June 30, 2008 and 2007, the Company issued shares of
common stock and stock options pursuant to consulting agreements described at
Note 9. The Company also issued stock
options as described below.
Effective February 2,
2007, the Company issued to Rene L. Rousselet, the Companys Corporate
Controller and Chief Accounting Officer, a stock option to purchase 50,000
shares of common stock exercisable through February 2, 2012 at $1.50 per
share, the fair market value on the date of grant. The stock option vested and became
exercisable in equal installments on March 31, 2007, June 30, 2007, September 30,
2007 and December 31, 2007. The
fair value of the stock option, determined pursuant to the Black-Scholes
option-pricing model, was $60,000, of which $15,000 and $30,000 was charged to
operations during the three months and six months ended June 30, 2007.
Effective February 2,
2007, the Company issued to its Vice President of Worldwide Sales, a stock
option to purchase 300,000 shares of common stock exercisable through February 2,
2012 at $1.50 per share, the fair market value on the date of grant. Options with respect to 175,000 shares are
scheduled to vest in seven equal quarterly installments on June 30, 2007, September 30,
2007, December 31, 2007, March 31, 2008, June 30, 2008, September 30,
2008 and December 31, 2008, and options with respect to 125,000 shares
will vest on the achievement of performance targets to be mutually determined
by the parties. The fair value of the
time-vested portion of this stock option, determined pursuant to the
Black-Scholes option-pricing model, was $208,000, of which $30,000 and $22,000
was charged to operations during the three months ended June 30, 2008 and
2007, respectively, and $60,000 and $30,000 was charged to operations during
the six months ended June 30, 2008 and 2007, respectively.
The assumptions used in
the Black-Scholes option-pricing model to calculate the fair value of the
aforementioned options were as follows:
Stock
price on date of grant
|
|
$
|
1.50
|
|
Risk-free
interest rate
|
|
4.88
|
%
|
Volatility
|
|
1.065
|
%
|
Dividend
yield
|
|
0
|
%
|
Weighted
average expected life (years)
|
|
5
|
|
Weighted
average fair value of option
|
|
$
|
1.19
|
|
A summary of stock option
activity under the 2006 Equity Incentive Plan during the six months ended June 30,
2008 is as follows:
|
|
Options Outstanding
|
|
|
|
Number
of Shares
|
|
Weighted
Average
Exercise Price
|
|
|
|
|
|
|
|
Options
outstanding at December 31, 2007
|
|
601,551
|
|
$
|
1.96
|
|
Granted
|
|
|
|
|
|
Exercised
|
|
|
|
|
|
Canceled/Expired
|
|
|
|
|
|
Options
outstanding at June 30, 2008
|
|
601,551
|
|
$
|
1.96
|
|
Options
exercisable at June 30, 2008
|
|
426,551
|
|
$
|
2.15
|
|
The intrinsic value of
exercisable but unexercised in-the-money options at June 30, 2008 was $0.
28
Table of Contents
1999 Employee Stock Option Plan:
A summary of stock option activity under the 1999
Employee Stock Option Plan during the six months ended June 30, 2008 is as
follows:
|
|
Options Outstanding
|
|
|
|
Number of
Shares
|
|
Weighted
Average
Exercise
Price
|
|
|
|
|
|
|
|
Options
outstanding at December 31, 2007
|
|
818,077
|
|
$
|
2.81
|
|
Granted
|
|
|
|
|
|
Exercised
|
|
|
|
|
|
Canceled/Expired
|
|
|
|
|
|
Options
outstanding at June 30, 2008
|
|
818,077
|
|
$
|
2.81
|
|
Options
exercisable at June 30, 2008
|
|
751,410
|
|
$
|
2.79
|
|
The intrinsic value of
exercisable but unexercised in-the-money options at June 30, 2008 was
$0. The intrinsic value of options
exercised during the six months ended June 30, 2007 was $25,000.
During
the three months ended June 30, 2008 and 2007, the Company recorded $0 and
$387,000, respectively, and during the six months ended June 30 2008, the
Company recorded $727,000 and $786,000, respectively, as a charge to operations
to recognize the unvested portion of the grant date fair value of awards issued
prior to the adoption of SFAS No. 123R.
As of June 30, 2008,
unrecognized compensation cost related to all unvested stock options will be
charged to operations as follows (amounts are in thousands):
Years Ending December 31,
|
|
|
|
2008
(six months)
|
|
$
|
216
|
|
2009
|
|
26
|
|
Total
|
|
$
|
242
|
|
9. COMMITMENTS
AND CONTINGENCIES
Employment Agreements:
In connection with the acquisition of MediaDefender
(see Note 3), the Company acknowledged the terms of Employment Agreements
entered into on July 28, 2005 by MediaDefender with each of Randy Saaf,
who serves as Chief Executive Officer of MediaDefender, and Octavio Herrera, who
serves as President of MediaDefender. Mr. Saaf and Mr. Herrera will
each earn a base salary of no less than $350,000 per annum during the initial
term of the agreements, which shall continue until December 31, 2008, and
are also entitled to receive performance bonuses of up to $350,000 if
MediaDefender achieves defined operating earnings in fiscal 2007 and 2008,
respectively. The fiscal 2007 bonus
aggregating $700,000 was accrued ratably during 2007 and was paid in March 2008. During the three months ended March 31,
2008, the Company recorded a charge to general and administrative expense and
an accrued liability of $175,000 with respect to the pro rata portion of the
2008 bonus, which was reversed during the three months ended June 30,
2008.
In addition, the Company
granted stock options to purchase 200,000 shares of common stock to each of Mr. Saaf
and Mr. Herrera, exercisable for a period of five years at $3.00 per share
and vesting quarterly over a period of three and one-half years.
The Company also employs
its Vice President of Worldwide Sales through February 2009 under an
agreement that provides for base annual compensation and performance bonus
payments.
29
Table of Contents
On July 28, 2005,
the Company entered into an Employment Agreement with Jonathan Diamond to serve
as the Companys Chief Executive Officer. During the term of the Employment
Agreement through December 31, 2008, Mr. Diamonds base salary would
be no less than $350,000 per annum, plus certain specified perquisites that
include a monthly car allowance. Mr. Diamond was also eligible to receive
an annual discretionary bonus of up to 100% of base salary, as determined by
the Compensation Committee of the Board of Directors or, if none, the Board of
Directors, and an annual performance bonus of up to 100% of base salary if the
Company achieved defined earnings before interest, taxes, depreciation and
amortization in fiscal 2007 ($12,000,000 - $14,400,000) and fiscal 2008
($15,000,000 - $18,000,000). Mr. Diamond was also entitled to receive
stock options at the discretion of the Companys Board of Directors. In the
event Mr. Diamond was terminated without cause, he would be entitled to
receive 12 months of severance pay at the rate of 100% of his monthly
salary, any performance bonus due for the year in which termination occurs and
all stock options subject to time vesting shall be deemed fully vested and
exercisable.
Pursuant to an Amended
and Restated Services Agreement dated as of March 6, 2008 (the Services
Agreement) between the Company and Mr. Diamond, Mr. Diamonds
employment as Chief Executive Officer was ended and he was elected as the
Companys Chairman of the Board of Directors (the Chairman) effective March 6,
2008. Under the Services Agreement, in consideration of Mr. Diamonds
waiver of his rights contained in the Employment Agreement dated as of July 28,
2005 (the Prior Agreement), the execution by Mr. Diamond of a general
release in favor of the Company and its affiliates, and his agreement to serve
as Chairman, the Company agreed to (a) pay Mr. Diamond a severance
payment of $350,000 payable in semi-monthly installments for a period of six
months, (b) accelerate the vesting of Mr. Diamonds Time Vesting
options, (c) accelerate the vesting of Mr. Diamonds options granted
in 2004 to purchase 259,659 shares (the 2004 Options), (d) extend to February 5,
2011 the exercisability of the Time Vesting Options and to March 29, 2011
for the 2004 Options, and (e) pay Mr. Diamond his accrued base salary
through February 29, 2008 and 40 days of accrued vacation time. The severance payment was recorded as a
charge to operations during the three months ended March 31, 2008 and the
six months ended June 30, 2008. The
Company also recorded stock-based compensation costs of $571,000 during the
three months ended March 31, 2008 and the six months ended June 30,
2008 with respect to this settlement.
Future base payments under these employment agreements
and arrangements as of June 30, 2008 are as follows (amounts are in
thousands):
Years Ending December 31,
|
|
|
|
|
|
|
|
2008
(six months)
|
|
$
|
609
|
|
2009
|
|
33
|
|
|
|
$
|
642
|
|
Consulting Agreements:
On October 1, 2006,
the Company entered into a one-year non-exclusive consulting agreement with an
entity for business development consulting services. The consulting agreement provided for a base
monthly fee of $7,500, certain performance-related bonuses, and stock options
to acquire 5,000 shares of common stock on the last day of each month of the
term of the consulting agreement through September 30, 2007. Accordingly, during the three months and six
months ended June 30, 2007, the Company issued options to acquire 15,000
shares and 30,000 shares of common stock, respectively, pursuant to the Companys
2006 Equity Incentive Plan, exercisable through November 30, 2011, at
prices ranging from $1.55 to $2.20 per share, the market price on the date of
each grant. The options were fully
vested when issued. The aggregate fair
value of the options, calculated pursuant to the Black-Scholes option-pricing
model, for the three months and six months ended June 30, 2007, were
$24,000 and $46,000, respectively, and were charged to operations. The
assumptions used in the Black-Scholes option-pricing model to calculate the
fair value of the options were as follows:
Stock price on date of grant
|
|
$
|
1.55 - $ 2.20
|
|
Risk-free
interest rate
|
|
4.84 4.93
|
%
|
Volatility
|
|
105.8 111.6
|
%
|
Dividend
yield
|
|
0
|
%
|
Weighted
average expected life (years)
|
|
4.65 4.85
|
|
Weighted
average fair value of option
|
|
$
|
1.22 - $1.74
|
|
30
Table
of Contents
On October 9, 2006,
the Company entered into an eighteen-month non-exclusive consulting agreement
with Wood River Ventures, LLC and Jonathan Dolgen for consulting and advisory
services with respect to the business and operations of the Company. The
consulting agreement provided for an aggregate cash fee of $187,500, payable
quarterly in six installments of $31,250, and a stock award valued at $112,500,
consisting of 34,615 shares of common stock based on the Companys closing
stock price on October 10, 2006 of $3.25 per share to be issued under the
Companys 2006 Equity Incentive Plan. The shares vested pro rata over the
eighteen-month period of the consulting agreement, beginning on October 10,
2006 and thereafter monthly on the first day of each month of the term of the
consulting agreement through March 2008.
In accordance with EITF 96-18, Accounting for Equity Instruments That
Are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services, the shares granted under this consulting agreement
were valued each month based on the closing market price on the first day of
each month to determine the amount to be recorded as a charge to operations
over the eighteen-month term of the consulting agreement. Accordingly, during the three months ended June 30,
2007, the Company issued 5,769 shares of common stock under this consulting
agreement with a fair value of $19,000, and during the six months ended June 30,
2008 and 2007, the Company issued 5,769 shares and 11,538 shares of common
stock, respectively, under this consulting agreement, with a fair value of
$19,000 and $38,000, respectively, which were charged to operations.
On February 7, 2008,
the Company entered into an Engagement Letter (Engagement Letter) with Salem
Partners LLC (Salem Partners). Under the terms of the Engagement
Letter, Salem Partners has been engaged as financial advisor to the Company on
an exclusive basis for a period of twelve months (a) in connection with an
M&A transaction involving the Company and (b) to render an opinion, if
requested, in a transaction involving the restructuring of the material terms
of the Companys senior secured notes payable and/or subordinated convertible
notes payable. An M&A transaction, whether effected in one
transaction or a series of transactions, is defined as any sale, merger,
consolidation, reorganization or other business combination pursuant to which
all or any portion of assets owned by the Company are sold or otherwise
transferred to, or combined with, a third party or one or more third parties
formed by or affiliated with such third party, including, without limitation,
any joint venture.
As compensation for its
services rendered pursuant to the Engagement Letter, Salem Partners shall be
paid (a) a retainer fee of $50,000 per month, for the first four months of
service, which fee shall be credited against the M&A transaction fee
payable to Salem Partners pursuant to the engagement, plus a cash fee of the
greater of (x) 2.0% of the portion of the Aggregate Consideration of an
M&A transaction, and (y) $1 million, payable upon the closing of an
M&A transaction, plus (b) a cash fee of $300,000 due upon the
completion and delivery of an opinion regarding the M&A transaction, if
requested by the Board of Directors of the Company, regardless of the
conclusions of the opinion; plus (c) a cash fee of $300,000 in the case of
a restructuring transaction for which Salem Partners delivers an opinion, due
upon the completion and delivery of an opinion, regardless of the conclusions
of the opinion; plus (d) $150,000 in the case of a restructuring
transaction for which Salem Partners does not deliver an opinion. For the purposes of calculating compensation
payable, Aggregate Consideration is defined as: (i) the total
consideration paid or to be paid in cash or cash equivalents or in any form of
equity (valued at fair market value) or debt in a transaction (including
without limitation amounts received by holders of warrants, options or
convertible securities); plus (ii) the principal amount of indebtedness
for borrowed money assumed directly or indirectly by the purchaser.
Sub-Lease Agreement:
On January 30, 2006,
the Company entered into a sub-lease agreement for new office facilities in
Santa Monica, California, effective February 2, 2006 through November 30,
2011, to house the operations of ADI and MediaDefender. In connection with the sub-lease agreement,
the Company provided an irrevocable standby bank letter of credit for $180,000
as security for the Companys obligations under the sub-lease agreement, which
was secured by cash of $180,000, which was classified as restricted cash in the
Companys balance sheet. Pursuant to the
terms of the sub-lease agreement, the letter of credit was reduced to $90,000
during February 2007.
This lease contains
predetermined fixed increases in the minimum rental rate during the initial
lease term. The Company began to
recognize the related rent expense on a straight-line basis on the effective
date of the lease. The Company records
the difference between the amount charged to expense and the rent paid as
deferred rent on the Companys balance sheet.
31
Table
of Contents
Future cash payments
under such operating lease as of June 30, 2008 are as follows (amounts are
in thousands):
Years Ending December 31,
|
|
|
|
2008
(six months)
|
|
$
|
236
|
|
2009
|
|
485
|
|
2010
|
|
499
|
|
2011
|
|
471
|
|
|
|
$
|
1,691
|
|
Legal Matters:
The Company is periodically subject to various pending
and threatened legal actions that arise in the normal course of business. The Companys management believes that the
impact of any such litigation will not have a material adverse impact on the
Companys financial position or results of operations.
As a result of the restatement of the Companys
financial statements and other events described elsewhere in this document and
in the Companys Annual Report on Form 10-KSB, as amended, for the fiscal
year ended December 31, 2007, the Company has triggered various events of
default under its senior debt and subordinated debt financing documents. The Company could be subject to future claims
under such financing documents.
Sufficiency of Authorized
but Unissued Shares:
The Company has concluded, for the reasons described below, that it is
highly probable that the Company
will have sufficient shares available to satisfy its existing option and
warrant obligations to officers, directors, employees, consultants, advisors
and others for the foreseeable future (excluding the warrants issued in
conjunction with the financing of the MediaDefender transaction described at
Note 4, which are accounted for as a derivative liability).
Paragraphs 28 to 35 of SFAS No. 123R describe the
types of equity awards that should be classified as a liability, including an
option (or similar instrument) that could require the employer to pay an
employee cash or other assets, unless cash settlement is based on a contingent
event that is (a) not probable
and (b) outside the control of the employee. The Company has concluded that any cash
settlement obligation represented by its outstanding options and warrants
issued to employees, officers and directors would be triggered only by a
contingent event that is both not
probable and is outside the control of the equity holder.
Most of the Companys outstanding options and warrants
were issued to employees, officers and directors in compensatory transactions
accounted for under SFAS No. 123R.
Of the 3,739,272 options and warrants outstanding at June 30, 2008,
3,321,085 were issued to employees, officers and directors. The Company believes that potential impact
pursuant to EITF 00-19-2 of the remaining 418,187 options and warrants issued
to consultants, advisors and others is not material to the consolidated
financial statements. With respect to
the 418,187 options and warrants, 222,000 are exercisable at $0.50 per share
and the remaining 196,187 are exercisable at prices ranging from $1.00 per
share to $7.50 per share; all such exercise prices are in excess of the current
market value of the Companys common stock.
The Company currently has 60,000,000 shares of common
stock authorized, of which 10,344,666 shares of common stock were issued at June 30,
2008, resulting in 49,655,334 unissued shares at such date. If all of the Companys equity-based
instruments were converted or exercised into shares of common stock in
accordance with their respective original terms, without regard to whether such
instruments have vested or are in-the-money, approximately 28,000,000
additional shares would be issued, resulting in a total of approximately
38,000,000 shares of common stock issued and outstanding. Accordingly, this calculation results in
approximately 22,000,000 shares of common stock available for issuance, in
excess of all equity commitments that the Company currently has outstanding.
The Company has approximately $27,658,000 of Sub-Debt
Notes outstanding at June 30, 2008, which are convertible into common
stock at $1.55 per share and which represent the single largest component of
such potential dilution (approximately 17,850,000 shares). However, the financing agreements contain provisions
that expressly prohibit the Company from issuing shares to a Sub-Debt Note
holder if after the conversion, such Sub-Debt Note holder would exceed the
respective limit called for in their Sub-Debt Note, either 4.99% or 9.99% of
the Companys outstanding common shares, thus the Company believes that it is
very unlikely that all of the 17,850,000 shares issuable to the holders of the
Sub-Debt Notes would be issued at one time or even in a short period of time.
32
Table of Contents
Accordingly, based on the foregoing analysis and the
Companys current capital structure, the Company has concluded that it is
highly probable that the Company
will have sufficient shares available to satisfy its existing option and
warrant obligations for the foreseeable future.
The Company will continue to evaluate this issue and if it becomes
probable that there are insufficient authorized shares, the Company will
consider alternative accounting treatment at that time
10. INCOME TAXES
The Company reported a
provison for income taxes of $2,000 for the three months ended June 30,
2008, and a benefit from income taxes of $8,000 for the six months ended June 30,
2008. As a result of the net loss
reported for the three months ended March 31, 2007, the Company did not
record any provision for income taxes for the three months and six months ended
June 30, 2007.
At December 31, 2007, the Company had net
operating loss carryforwards of approximately $112,000,000 for Federal income
tax purposes expiring beginning in 2019 and California state net operating loss
carryforwards of approximately $118,000,000 expiring beginning in 2009.
In assessing the potential realization of deferred tax
assets, management considers whether it is more likely than not that some
portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax
assets (primarily net operating loss carryforwards) is dependent upon the
Company attaining future taxable income during the periods in which those
temporary differences become deductible.
As of June 30, 2008 and December 31, 2007, management was
unable to determine if it is more likely than not that the Companys deferred
tax assets will be realized, and has therefore recorded an appropriate
valuation allowance against deferred tax assets at such dates.
Due to the restrictions
imposed by Internal Revenue Code Section 382 regarding substantial changes
in the stock ownership of companies with loss carryforwards, the utilization of
the Companys federal net operating loss carryforward was severely limited as a
result of the change in the effective stock ownership of the Company resulting
from the debt financings arranged in conjunction with the acquisition of
MediaDefender.
Effective January 1,
2007, the Company adopted FASB Interpretation No. 48, Accounting for
Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109,
Accounting for Income Taxes (FIN 48).
FIN 48 provides criteria for the recognition, measurement, presentation
and disclosure of uncertain tax positions.
A tax benefit from an uncertain tax position may only be recognized if
it more likely than not that the position will be sustained on examination by
the taxing authorities, based on its technical merits of the position. FIN 48 also provides guidance on
de-recognition, classification, interest and penalties on income taxes,
accounting in interim periods, and requires increased disclosures. As of June 30, 2008 and December 31,
2007, no liability for unrecognized tax benefits was required to be recorded.
As of June 30, 2008,
the Companys 2005 and 2006 U.S. federal income tax returns were undergoing
examination by the Internal Revenue Service.
The Internal Revenue Service has proposed various adjustments to the
Companys 2005 and 2006 taxable income.
Estimated taxes and interest relating to such adjustments have been
accrued as income taxes payable in the Companys financial statements at June 30,
2008 and December 31, 2007. As the
Internal Revenue Service has not completed its examination of the Companys
income tax returns, the Company is currently unable to predict the ultimate
resolution of this matter.
11. CONCENTRATIONS AND SEGMENT INFORMATION
During
the three months and six months ended June 30, 2008 and 2007, the Companys
operations consisted of three reportable segments: e-commerce, media, and anti-piracy and
file-sharing services.
Concentrations:
During the three months and
six months ended June 30, 2008, e-commerce revenues were generated from
individual online sales of CDs and DVDs shipped directly to the consumer from
a third party fulfillment company. During
the three months and six months ended June 30, 2007, approximately 64% and
61%, respectively, of e-commerce revenues were generated from the products
related to a single merchandising entity.
The Company restructured its relationship with this merchandising entity
effective August 31, 2007 to eliminate merchandise sales and focus on music
sales, which, as expected, has had a significant negative impact on e-commerce
revenues, although it has had a limited impact on operating margins.
33
Table
of Contents
During the three months and
six months ended June 30, 2008 and 2007, the Companys media revenues were
generated by two outside sales organizations that represented the Company with
respect to advertising and sponsorship on the Companys website and through
affiliated websites, as well as by in-house sales personnel. During the three months June 30, 2008,
approximately 24% of media revenues were generated from two customers, with one
customer accounting for 14% and a second customer accounting for 10%. During the six months ended June 30,
2008, no customer accounted for 10% or more of media revenues. During the three months and six months ended June 30,
2007, one customer accounted for approximately 20% and 13% of media revenues,
respectively.
During
the three months ended June 30, 2008, approximately 66% of MediaDefenders
net revenues were generated by five customers, with one customer accounting for
42%, a second customer accounting for 27%, a third customer accounting for 21%,
a fourth customer accounting for 10%, and a fifth customer was a negative 34%
as a result of a credit issued to settle disputed charges. During the three months ended June 30,
2007, approximately 66% of MediaDefenders net revenues were generated by four
customers, with one customer accounting for 21%, a second customer accounting
for 17%, a third customer accounting for 15%, and a fourth customer accounting
for 13%.
During
the six months ended June 30, 2008, approximately 62% of MediaDefenders net
revenues were generated by three customers, with one customer accounting for 30%,
a second customer accounting for 20%, and a third customer accounting for 12%. During the six months ended June 30,
2007, approximately 38% of MediaDefenders net revenues were generated by two
customers, with one customer accounting for 21% and a second customer
accounting for 17%.
At
June 30, 2008, the amounts due from these
customers were approximately $821,000, which were included in accounts
receivable.
During
the three months ended June 30, 2008, MediaDefender purchased
approximately 90% of its bandwidth from four suppliers. During the three months ended June 30,
2007, MediaDefender purchased approximately 82% of its bandwidth from four
suppliers.
During
the six months ended June 30, 2008, MediaDefender purchased approximately
89% of its bandwidth from four suppliers.
During the six months ended June 30, 2007, MediaDefender purchased
approximately 75% of its bandwidth from five suppliers.
At
June 30, 2008, amounts payable to these suppliers aggregated approximately
$245,000. Although there are other
suppliers of bandwidth, a change in suppliers could cause delays, which could
adversely affect operations in the short-term.
Segment Information:
Information
with respect to the Companys operating segments for the three months ended March 31,
2008 and 2007 is presented below.
The factors for
determining reportable segments were based on services and products. Each segment is responsible for executing a
unique marketing and business strategy.
The Company evaluates performance based on, among other factors,
earnings or loss before interest, taxes, depreciation and amortization (Adjusted
EBITDA). Adjusted EBITDA also excludes
stock-based compensation, changes in the fair value of warrant liability and
derivative liability, and other non-cash write-offs and charges. Included in Adjusted EBITDA are direct
operating expenses for each segment.
34
Table of Contents
The following table summarizes net revenue and
Adjusted EBITDA by operating segment for the three months and six months ended June 30,
2008 and 2007. Corporate expenses
consist of general operating expenses that are not directly related to the
operations of the segments. A
reconciliation of Net Income (Loss) to Adjusted EBITDA is also provided.
|
|
Three Months Ended June 30,
|
|
Six Months Ended June 30,
|
|
|
|
2008
|
|
2007
|
|
2008
|
|
2007
|
|
|
|
(in thousands)
|
|
(in thousands)
|
|
Net Revenue:
|
|
|
|
|
|
|
|
|
|
E-commerce
|
|
$
|
92
|
|
$
|
509
|
|
$
|
198
|
|
$
|
1,003
|
|
Media
|
|
1,082
|
|
2,054
|
|
2,287
|
|
3,165
|
|
Anti-piracy and
file-sharing marketing services
|
|
1,546
|
|
4,030
|
|
4,436
|
|
7,871
|
|
|
|
$
|
2,720
|
|
$
|
6,593
|
|
$
|
6,921
|
|
$
|
12,039
|
|
Adjusted EBITDA:
|
|
|
|
|
|
|
|
|
|
E-commerce
|
|
$
|
(19
|
)
|
$
|
(53
|
)
|
$
|
(38
|
)
|
$
|
(123
|
)
|
Media
|
|
92
|
|
749
|
|
351
|
|
1,077
|
|
Anti-piracy and
file-sharing marketing services
|
|
(379
|
)
|
1,602
|
|
97
|
|
3,131
|
|
|
|
(306
|
)
|
2,298
|
|
410
|
|
4,085
|
|
Corporate
general and administrative expenses
|
|
(541
|
)
|
(1,478
|
)
|
(2,051
|
)
|
(2,638
|
)
|
Reduction in
liquidated damages payable under registration rights agreements
|
|
|
|
719
|
|
|
|
719
|
|
|
|
$
|
(847
|
)
|
$
|
1,539
|
|
$
|
(1,641
|
)
|
$
|
2,166
|
|
|
|
Three Months Ended June 30,
|
|
Six Months Ended June 30,
|
|
|
|
2008
|
|
2007
|
|
2008
|
|
2007
|
|
|
|
(in thousands)
|
|
(in thousands)
|
|
|
|
|
|
|
|
|
|
|
|
Reconciliation
of Adjusted EBITDA to Net Income (Loss):
|
|
|
|
|
|
|
|
|
|
Adjusted EBITDA
per segments
|
|
$
|
(847
|
)
|
$
|
1,539
|
|
$
|
(1,641
|
)
|
$
|
2,166
|
|
Stock-based
compensation
|
|
(108
|
)
|
(533
|
)
|
(805
|
)
|
(988
|
)
|
Depreciation and
amortization
|
|
(251
|
)
|
(292
|
)
|
(552
|
)
|
(447
|
)
|
Amortization of
intangible assets
|
|
(888
|
)
|
(888
|
)
|
(1,776
|
)
|
(1,826
|
)
|
Amortization of
deferred financing costs
|
|
(209
|
)
|
(210
|
)
|
(419
|
)
|
(417
|
)
|
Write-off of
unamortized discount on debt and deferred financing costs resulting from
principal payments on senior secured notes payable
|
|
|
|
|
|
(26
|
)
|
|
|
Interest income
|
|
12
|
|
45
|
|
42
|
|
101
|
|
Interest
expense, including amortization of discount on debt of $767 and $768 for the
three months ended June 30, 2008 and 2007, and $1,536 and $1,529 for the
six months ended June 30, 2008 and 2007
|
|
(2,190
|
)
|
(2,068
|
)
|
(4,310
|
)
|
(3,928
|
)
|
Change in fair
value of warrant liability
|
|
35
|
|
(95
|
)
|
100
|
|
1,131
|
|
Change in fair
value of derivative liability
|
|
117
|
|
(887
|
)
|
288
|
|
4,354
|
|
Goodwill
impairment
|
|
(25,585
|
)
|
|
|
(25,585
|
)
|
|
|
Write-off of
fixed assets
|
|
|
|
(97
|
)
|
|
|
(97
|
)
|
Provision for
income taxes
|
|
(2
|
)
|
|
|
8
|
|
|
|
Net income
(loss)
|
|
$
|
(29,916
|
)
|
$
|
(3,486
|
)
|
$
|
(34,676
|
)
|
$
|
49
|
|
35
Table of Contents
The following table summarizes assets as of June 30,
2008 and December 31, 2007. Assets
by segment are those assets used in or employed by the operations of each
segment. Corporate assets are
principally made up of cash and cash equivalents, short-term investments,
prepaid expenses, computer equipment, leasehold improvements and other assets.
|
|
June 30,
2008
|
|
December 31,
2007
|
|
|
|
(in thousands)
|
|
Assets:
|
|
|
|
|
|
Corporate
|
|
$
|
2,528
|
|
$
|
3,144
|
|
E-commerce
|
|
229
|
|
248
|
|
Media
|
|
1,611
|
|
2,419
|
|
Anti-piracy and
file-sharing marketing services
|
|
13,220
|
|
44,923
|
|
|
|
$
|
17,588
|
|
$
|
50,734
|
|
36
Table of Contents
ITEM
2. MANAGEMENTS DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview:
The Company, through its wholly-owned subsidiary,
ARTISTdirect Internet Group, Inc., conducts its media and e-commerce
business operations through an online music network appealing to music fans,
artists and marketing partners. The
ARTISTdirect Network consists of the Companys website (www.artistdirect.com)
and a network of related music and entertainment websites offering multi-media
content, music news and information, communities organized around shared music
interests, music-related specialty commerce, and digital music services. The Company sells advertising for its own
website and on behalf of its network affiliates.
The Companys
www.artistdirect.com website was recently redesigned and initially experienced
significantly increased traffic after its relaunch in April 2008. The ARTISTdirect Network continues to be
rated in the top three with AOL music, and Yahoo music by Comscore Media Metrix
in the music entertainment category. In
addition to music-related content, the website now includes movie reviews and
ticketing, and additional new features are planned to be introduced later in
2008. The Company also recently signed lyrics
license agreements with two major music publishers and expects to conclude
additional agreements with the other major music publishers in the near future,
as a result of which the Company will begin to include music lyrics within its
own website.
On July 28, 2005, the Company completed the
acquisition of MediaDefender, Inc., a privately-held Delaware corporation,
(MediaDefender). The stockholders of
MediaDefender received aggregate consideration of $42,500,000 in cash, subject
to certain holdbacks and adjustments described in the Merger Agreement. In order to fund the acquisition of
MediaDefender, the Company completed a $15,000,000 senior secured debt
transaction and a $30,000,000 convertible subordinated debt transaction. The two founders of MediaDefender,
Randy Saaf, who serves as the Chief Executive Officer of MediaDefender,
and Octavio Herrera, who serves as the President of MediaDefender, each
invested $2,250,000 in the convertible subordinated debt transaction entered
into to fund the acquisition of MediaDefender on the same terms and conditions
as the other investors in such financing.
MediaDefender is a provider
of anti-piracy solutions in the internet-piracy-protection (IPP)
industry. Revenues related to
MediaDefenders anti-piracy activities declined in 2007 as compared to 2006,
and continued to decline further in 2008.
The Company believes that the largest source of this decline is due to
reduced spending on the part of the major music labels due to a significant
reduction in their sales and profitability (see Net Revenue below).
During 2008,
MediaDefender has attempted to enhance advertising revenue from the
peer-to-peer networks, where the majority of internet traffic occurs. To date, such direct peer-to-peer initiatives
and downloaded branded content-advertising on the filing-sharing networks has
yet to gain traction as a credible adjunct to traditional page-based internet
banner and display advertising campaigns.
MediaDefenders peer-to-peer advertising programs generated
approximately $225,000 of revenues during the six months ended June 30,
2008, as compared to approximately $170,000 for the six months ended June 30,
2007. Management believes that such
peer-to-peer advertising initiatives could partially augment declining
anti-piracy revenues, particularly with respect to those related to television
programming.
Going Concern:
As a result of communications
with the Staff of the Securities and Exchange Commission in 2006, in particular
regarding the application of accounting rules and interpretations related
to embedded derivatives associated with the Companys subordinated convertible
notes payable issued in July 2005, the Company determined that it was
necessary to restate certain previously issued financial statements.
As a result, in December 2006,
the Company was required to suspend the use of its then effective registration
statement for the holders of its senior and subordinated indebtedness. In addition to this initial default, the
Company has since entered into other events of default which continue to be in
effect as of June 30, 2008. During
2007 and 2008, the Company entered into a series of forbearance agreements with
the investors in the senior notes with respect to these defaults.
As a result of the
requirement to restate certain previously issued financial statements, which
resulted in the recording of an embedded derivative liability, the
reclassification of the senior and subordinated indebtedness to current
liabilities, and the recording of liquidated damages payable under registration
rights agreements, the Company was not in compliance with certain of its
financial covenants under both the Senior Financing and the Sub-Debt Financing
at December 31, 2006.
Notwithstanding such developments, the Company would have been out of
compliance with certain of its financial covenants at December 31, 2007
and subsequently.
37
Table of Contents
Pursuant to a series of Forbearance and Consent
Agreements with the investors in the Senior Financing, such investors agreed to
forbear from the exercise of their rights and remedies under the Senior
Financing documents as a result of the events of default which were then in
existence during the period, from April 17, 2007 through February 20,
2008, in exchange for aggregate cash payments of $1,000,000 in 2007 and
$494,423 in February 2008. The
payments made by the Company under the Forbearance and Consent Agreements were
credited against the registration delay cash penalties and interest on the
penalties resulting from the Companys default under the various agreements
between the Company and the Senior Financing investors. On March 17, 2008, the Company entered
into a Forbearance and Consent Agreement with the investors in the Companys
Senior Debt Financing, which was effective as of February 20, 2008,
whereby the investors agreed to forbear
from exercising any of their rights and remedies under the Senior Financing
transaction documents through December 31, 2008 in exchange for an
adjustment in the interest rate associated with the Senior Notes from 11.25% to
15.0% per annum, provided the loan is repaid prior to September 30, 2008,
or 16.0% per annum (retroactive to February 20, 2008), if the loan remains
outstanding subsequent to that date.
In addition, as a result
of a significant deterioration in MediaDefenders business operations and
prospects during the latter part of June 2008, including less than
anticipated revenues in 2008 from MediaDefenders new advertising initiatives
and a significant further erosion of demand for MediaDefenders core internet
anti-piracy services by the entertainment industry, the Companys operations
and cash flows have been materially and negatively impacted.
The registration delay
penalties and ongoing default interest charges are continuing to have a
significant and material negative impact on the Companys operations and cash
flows. The Company is exploring various
alternatives to resolve the defaults under its senior and secured debt
obligations, but is unable to predict the outcome of such negotiations. On February 7, 2008, the Company
retained the services of Salem Partners, LLC to serve as a financial advisor to
the Company in connection with the sale, merger, consolidation, reorganization
or other business combination and the restructuring of the material terms of
the Companys senior notes and/or subordinated convertible notes. To the extent that the Company is unable to
complete a sale or merger or restructure its senior and subordinated debt
obligations in a satisfactory manner and/or the lenders begin to exercise
additional remedies to enforce their rights, the Company will not have
sufficient cash resources to maintain its operations. In such event, the Company may be required to
consider a formal or informal restructuring or reorganization, including a
filing under Chapter 11 of the United States Bankruptcy Code.
The accompanying
consolidated financial statements have been prepared in conformity with
accounting principles generally accepted in the United States of America, which
contemplate continuation of the Company as a going concern. As a result of the foregoing, the Companys
independent registered public accounting firm, in its report on the Companys
2007 consolidated financial statements, expressed substantial doubt about the
Companys ability to continue as a going concern. The consolidated financial statements do not
include any adjustments relating to the recoverability and classification of
recorded asset amounts or the amounts and classification of liabilities that
could result from the outcome of this uncertainty.
Critical
Accounting Policies:
The
discussion and analysis of the Companys financial condition and results of
operations is based upon the Companys consolidated financial statements, which
have been prepared in accordance with accounting principles generally accepted
in the United States of America. The
preparation of these financial statements requires the Company to make
estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities. On an ongoing basis,
the Company evaluates its estimates with respect to
allowances for bad debts, impairment of long-lived
assets, impairment of fixed assets, stock-based compensation, the valuation
allowance on deferred tax assets, and the change in fair value of the warrant
liability and derivative liability.
The Company
bases its estimates on historical experience and on various other assumptions
that it believes to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results may differ materially from
these estimates under different assumptions or conditions. The Company believes that the following
critical accounting policies affect its more significant judgments and
estimates used in the preparation of its consolidated financial statements: revenue recognition, stock-based
compensation, goodwill, intangible assets and long-lived assets, derivative
instruments, income taxes, and accounts receivable. These accounting policies are discussed in Item
6. Managements Discussion and Analysis or Plan of Operation contained in the
Companys December 31, 2007 Annual Report on Form 10-KSB, as amended,
as well as in the notes to the December 31, 2007 consolidated financial statements. There have not been any significant changes
to these accounting policies since they were previously reported at December 31,
2007.
38
Table of Contents
Recent Accounting
Pronouncements:
In December 2007,
the FASB issued SFAS No. 141(R), Business Combinations (SFAS No. 141(R)),
which requires an acquirer to recognize in its financial statements as of the
acquisition date (i) the identifiable assets acquired, the liabilities
assumed, and any noncontrolling interest in the acquiree, measured at their
fair values on the acquisition date, and (ii) goodwill as the excess of
the consideration transferred plus the fair value of any noncontrolling
interest in the acquiree at the acquisition date over the fair values of the
identifiable net assets acquired. Acquisition-related costs, which are the
costs an acquirer incurs to effect a business combination, will be accounted
for as expenses in the periods in which the costs are incurred and the services
are received, except that costs to issue debt or equity securities will be
recognized in accordance with other applicable GAAP. SFAS No. 141(R) makes
significant amendments to other Statements and other authoritative guidance to
provide additional guidance or to conform the guidance in that literature to
that provided in SFAS No. 141(R). SFAS No. 141(R) also
provides guidance as to what information is to be disclosed to enable users of
financial statements to evaluate the nature and financial effects of a business
combination. SFAS No. 141(R) is effective for financial
statements issued for fiscal years beginning on or after December 15,
2008. Early adoption is prohibited. The adoption of SFAS No. 141(R) will
affect how the Company accounts for a business combination concluded after December 31,
2008.
In December 2007, the FASB issued
SFAS No. 160, Noncontrolling Interests in Consolidated Financial
Statements an amendment of ARB No. 51 (SFAS No. 160),
which revises the relevance, comparability, and transparency of the financial
information that a reporting entity provides in its consolidated financial
statements by establishing accounting and reporting standards that require (i) the
ownership interests in subsidiaries held by parties other than the parent be
clearly identified, labeled, and presented in the consolidated statement of
financial position within equity, but separate from the parents equity, (ii) the
amount of consolidated net income attributable to the parent and to the
noncontrolling interest be clearly identified and presented on the face of the
consolidated statement of income, (iii) changes in a parents ownership
interest while the parent retains its controlling financial interest in its
subsidiary be accounted for consistently as equity transactions, (iv) when
a subsidiary is deconsolidated, any retained noncontrolling equity investment
in the former subsidiary be initially measured at fair value, with the gain or
loss on the deconsolidation of the subsidiary being measured using the fair
value of any noncontrolling equity investment rather than the carrying amount
of that retained investment, and (v) entities provide sufficient
disclosures that clearly identify and distinguish between the interests of the
parent and the interests of the noncontrolling owners. SFAS No. 160
amends FASB No. 128 to provide that the calculation of earnings per share
amounts in the consolidated financial statements will continue to be based on
the amounts attributable to the parent. SFAS No. 160 is effective for
financial statements issued for fiscal years, and interim periods within those
fiscal years, beginning on or after December 15, 2008. Early adoption is
prohibited. SFAS No. 160 shall be applied prospectively as of the
beginning of the fiscal year in which it is initially applied, except for the
presentation and disclosure requirements, which shall be applied
retrospectively for all periods presented. The Company has not yet determined
the affect on its consolidated financial statements, if any, upon adoption of
SFAS No. 160.
In March 2008, the
FASB issued SFAS No. 161, Disclosures about Derivative Instruments and
Hedging Activities an amendment of FASB Statement No. 133 (SFAS No. 161). SFAS No. 161 amends and expands the
disclosure requirements of SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities (SFAS No. 133). The objective of
SFAS No. 161 is to provide users of financial statements with an enhanced
understanding of how and why an entity uses derivative instruments, how
derivative instruments and related hedged items are accounted for under SFAS No. 133
and its related interpretations, and how derivative instruments and related
hedged items affect an entitys financial position, financial performance, and
cash flows. SFAS No. 161 requires
qualitative disclosures about objectives and strategies for using derivatives,
quantitative disclosures about fair value amounts of and gains and losses on
derivative instruments, and disclosures about credit-risk-related contingent
features in derivative agreements. SFAS No. 161
applies to all derivative financial instruments, including bifurcated
derivative instruments (and nonderivative instruments that are designed and
qualify as hedging instruments pursuant to paragraphs 37 and 42 of SFAS No. 133)
and related hedged items accounted for under SFAS No. 133 and its related
interpretations. SFAS No. 161 also
amends certain provisions of SFAS No. 131. SFAS No. 161 is effective
for financial statements issued for fiscal years and interim periods beginning
after November 15, 2008, with early application encouraged. SFAS No. 161 encourages, but does not
require, comparative disclosures for earlier periods at initial adoption. The Company has not yet determined the affect
on its consolidated financial statements, if any, upon adoption of SFAS No. 161.
39
Table of Contents
Results
of Operations Three Months Ended June 30, 2008 and 2007:
The
following table presents information with respect to the Companys condensed
consolidated statements of operations as to actual amounts and as a percentage
of total net revenue for the three months ended June 30, 2008 and 2007.
Condensed
Consolidated Statements of Operations ($000):
|
|
Three Months Ended June 30,
|
|
|
|
2008
|
|
2007
|
|
|
|
$
|
|
%
|
|
$
|
|
%
|
|
Net revenue:
|
|
|
|
|
|
|
|
|
|
E-commerce
|
|
$
|
92
|
|
3.4
|
%
|
$
|
509
|
|
7.7
|
%
|
Media
|
|
1,082
|
|
39.8
|
%
|
2,054
|
|
31.2
|
%
|
Anti-piracy and
file-sharing marketing services
|
|
1,546
|
|
56.8
|
%
|
4,030
|
|
61.1
|
%
|
Total net
revenue
|
|
2,720
|
|
100.0
|
%
|
6,593
|
|
100.0
|
%
|
Cost of revenue:
|
|
|
|
|
|
|
|
|
|
E-commerce
|
|
85
|
|
3.1
|
%
|
515
|
|
7.8
|
%
|
Media
|
|
705
|
|
25.9
|
%
|
993
|
|
15.1
|
%
|
Anti-piracy and
file-sharing marketing services
|
|
2,315
|
|
85.1
|
%
|
2,309
|
|
35.0
|
%
|
Total cost of
revenue
|
|
3,105
|
|
114.1
|
%
|
3,817
|
|
57.9
|
%
|
Gross profit
(loss)
|
|
(385
|
)
|
(14.1
|
)%
|
2,776
|
|
42.1
|
%
|
Operating
expenses:
|
|
|
|
|
|
|
|
|
|
Sales and
marketing
|
|
506
|
|
18.6
|
%
|
508
|
|
7.7
|
%
|
General and
administrative (including stock-based compensation)
|
|
1,311
|
|
48.2
|
%
|
2,947
|
|
44.7
|
%
|
Development and
engineering
|
|
117
|
|
4.3
|
%
|
206
|
|
3.1
|
%
|
Write-off of
fixed assets
|
|
|
|
|
%
|
97
|
|
1.5
|
%
|
Goodwill
impairment
|
|
25,585
|
|
940.6
|
%
|
|
|
|
%
|
Total operating
costs
|
|
27,519
|
|
1,011.7
|
%
|
3,758
|
|
57.0
|
%
|
Loss from
operations
|
|
(27,904
|
)
|
(1,025.9
|
)%
|
(982
|
)
|
(14.9
|
)%
|
Interest income
|
|
12
|
|
0.4
|
%
|
45
|
|
0.7
|
%
|
Interest expense
|
|
(2,190
|
)
|
(80.5
|
)%
|
(2,068
|
)
|
(31.4
|
)%
|
Loss on foreign
currency transactions
|
|
|
|
|
%
|
(8
|
)
|
(0.1
|
)%
|
Other income
|
|
225
|
|
8.3
|
%
|
|
|
|
%
|
Reduction in
liquidated damages payable under registration rights agreements
|
|
|
|
|
%
|
719
|
|
10.9
|
%
|
Change in fair
value of warrant liability
|
|
35
|
|
1.3
|
%
|
(95
|
)
|
(1.4
|
)%
|
Change in fair
value of derivative liability
|
|
117
|
|
4.3
|
%
|
(887
|
)
|
(13.5
|
)%
|
Amortization of
deferred financing costs
|
|
(209
|
)
|
(7.7
|
)%
|
(210
|
)
|
(3.2
|
)%
|
Loss before
income taxes
|
|
(29,914
|
)
|
(1,099.8
|
)%
|
(3,486
|
)
|
(52.9
|
)%
|
Provision for
income taxes
|
|
(2
|
)
|
(0.1
|
)%
|
|
|
|
%
|
Net loss
|
|
$
|
(29,916
|
)
|
(1,099.9
|
)%
|
$
|
(3,486
|
)
|
(52.9
|
)%
|
The Company evaluates performance based on, among other
factors, earnings or loss before interest, taxes, depreciation and amortization
(Adjusted EBITDA), which is a non-GAAP financial measure. Adjusted EBITDA also excludes stock-based
compensation, changes in the fair value of warrant liability and derivative
liability, and other non-cash write-offs and charges. Management excludes these items in assessing
financial performance, primarily due to their non-operational nature or because
they are outside of the Companys normal operations. The Company has provided this information
because management believes that it is useful to investors in understanding the
Companys financial condition and results of operations.
Management believes that Adjusted EBITDA enhances an
overall understanding of the Companys financial performance by investors
because it is frequently used by securities analysts and other interested
parties in evaluating companies in its industry segment. In addition, management believes that
Adjusted EBITDA is useful in evaluating the Companys operating performance
compared to that of other companies in its industry segment because the
calculation of Adjusted EBITDA eliminates the accounting effects of financing
costs, income taxes and capital spending, which items may vary for different
companies for reasons unrelated to overall operating performance.
40
Table of Contents
However, Adjusted EBITDA has certain limitations. Adjusted EBITDA is not a recognized
measurement under GAAP, and when analyzing the Companys operating performance,
investors should use Adjusted EBITDA in addition to, and not as an alternative
for, standard GAAP financial measures such as net income (loss) or cash flow
from operations, or any other measure utilized in determining the Companys
operating performance that is calculated in accordance with GAAP. Because Adjusted EBITDA is not calculated in
accordance with GAAP, it may not be comparable to similarly-titled measures
utilized by other companies. Adjusted
EBITDA eliminates certain substantial recurring items from net income (loss),
such as depreciation, amortization, interest expense and income taxes, among
others. Each of these items has been
incurred in the past, will continue to be incurred in the future, and should be
considered in the overall evaluation of the Companys operating
performance. The Company compensates for
these limitations by providing the relevant disclosure of the items excluded in
the calculation of Adjusted EBITDA, both in the reconciliation to the GAAP
financial measure of net income (loss) and in the consolidated financial
statements and footnotes, all of which should be considered when evaluating the
Companys operating performance.
Furthermore, Adjusted EBITDA is not intended to be a measure of the
Companys free cash flow or liquidity in general, as it does not consider
certain ongoing cash requirements, such as a required debt service payments and
income taxes.
The following table summarizes net revenue and
Adjusted EBITDA by operating segment for the three months ended June 30,
2008 and 2007. Corporate expenses
consist of general operating expenses that are not directly related to the
operations of the segments. A
reconciliation of Net Loss to Adjusted EBITDA is also provided.
|
|
Three Months Ended June 30,
|
|
|
|
2008
|
|
2007
|
|
|
|
(in thousands)
|
|
|
|
|
|
|
|
Net Revenue:
|
|
|
|
|
|
E-commerce
|
|
$
|
92
|
|
$
|
509
|
|
Media
|
|
1,082
|
|
2,054
|
|
Anti-piracy and
file-sharing marketing services
|
|
1,546
|
|
4,030
|
|
|
|
$
|
2,720
|
|
$
|
6,593
|
|
|
|
|
|
|
|
Adjusted EBITDA:
|
|
|
|
|
|
E-commerce
|
|
$
|
(19
|
)
|
$
|
(53
|
)
|
Media
|
|
92
|
|
749
|
|
Anti-piracy and
file-sharing marketing services
|
|
(379
|
)
|
1,602
|
|
|
|
(306
|
)
|
2,298
|
|
Corporate
general and administrative expenses
|
|
(541
|
)
|
(1,478
|
)
|
Reduction in
liquidated damages payable under registration rights agreements
|
|
|
|
719
|
|
|
|
$
|
(847
|
)
|
$
|
1,539
|
|
41
Table
of Contents
|
|
Three Months Ended June 30,
|
|
Reconciliation of Adjusted EBITDA to Net Loss
|
|
2008
|
|
2007
|
|
|
|
(in thousands)
|
|
|
|
|
|
|
|
Adjusted EBITDA
per segments
|
|
$
|
(847
|
)
|
$
|
1,539
|
|
Stock-based
compensation
|
|
(108
|
)
|
(533
|
)
|
Depreciation and
amortization
|
|
(251
|
)
|
(292
|
)
|
Amortization of
intangible assets
|
|
(888
|
)
|
(888
|
)
|
Amortization of
deferred financing costs
|
|
(209
|
)
|
(210
|
)
|
Interest income
|
|
12
|
|
45
|
|
Interest
expense, including amortization of discount on debt of $767 and $768 in 2008
and 2007, respectively
|
|
(2,190
|
)
|
(2,068
|
)
|
Change in fair
value of warrant liability
|
|
35
|
|
(95
|
)
|
Change in fair
value of derivative liability
|
|
117
|
|
(887
|
)
|
Goodwill
impairment
|
|
(25,585
|
)
|
|
|
Write-off of
fixed assets
|
|
|
|
(97
|
)
|
Provision for
income taxes
|
|
(2
|
)
|
|
|
Net loss
|
|
$
|
(29,916
|
)
|
$
|
(3,486
|
)
|
Net
Revenue. The Companys net revenue
decreased by $3,873,000 or 58.7%, to $2,720,000 for the three months ended June 30,
2008, as compared to $6,593,000 for the three months ended June 30, 2007,
primarily as a result of decreases in MediaDefender revenues of $2,484,000,
media revenues of $972,000 and e-commerce revenues of $417,000. MediaDefender revenues accounted for 56.8% of
the Companys total net revenue for the three months ended June 30, 2008,
as compared to 61.1% of the Companys total net revenue for the three months
ended June 30, 2007.
As
previously disclosed, management expected MediaDefenders anti-piracy revenues
to continue to decline in 2008 as compared to 2007. MediaDefenders revenue decreased by
$2,484,000 or 61.6%, to $1,546,000 for the three months ended June 30,
2008, as compared to $4,030,000 for the three months ended June 30,
2007. Revenues decreased in 2008 as
compared to 2007 as a result of reduced spending on the part of major entertainment
conglomerates on IPP services.
Specifically, MediaDefenders anti-piracy revenues have been negatively
impacted by the loss of one customer in November 2007 that accounted for
4% of MediaDefenders 2007 annual revenue, citing cost pressures subsequent to
a change in ownership, and the loss of a second customer in January 2008
that accounted for 12% of MediaDefenders 2007 annual revenues, noting that
they were evaluating the use of alternative methods to deal with piracy.
During
late June 2008, the Company was advised that a third customer that
accounted for 18% of MediaDefenders 2007 annual revenues was substantially
curtailing its use of MediaDefenders anti-piracy services subsequent to the
expiration of its current contract with MediaDefender on June 30, 2008,
citing uncertainty with respect to the effectiveness and cost/benefit of
anti-piracy services. MediaDefender
entered into a settlement agreement with this customer to resolve certain
disputes. Pursuant to the settlement agreement MediaDefender issued
approximately $790,000 of credits for previously invoiced services, which were
recorded as a reduction to revenues, of which approximately $592,000 was
recorded as a reduction to accounts receivable and apoproximately $197,000 was
recorded as deferred revenue, which must be utilized by July 24,
2009. All such amounts were recorded as
of June 30, 2008 and the three months then ended.
As a result of the
aforementioned developments with respect to the business of MediaDefender in
late June 2008, as well as revised MediaDefender financial projections for
the remainder of 2008 and beyond, the Company concluded that the current
carrying value of the MediaDefender segment goodwill of $31,085,000 was
substantially and permanently impaired at June 30, 2008. Accordingly, the Company recorded a non-cash
charge to operations to reflect the impairment of MediaDefender goodwill at June 30,
2008 of $25,585,000. The calculation of
the goodwill impairment charge at June 30, 2008 was based on various
estimates, assumptions and pending issues, as a result of which the Company may
further revise its calculation of the impairment of the MediaDefender goodwill
at September 30, 2008, December 31, 2008 and subsequently.
Management expects that
MediaDefenders anti-piracy revenues will continue to decline during the
remainder of 2008.
42
Table of Contents
During
the three months ended June 30, 2008, approximately 66% of MediaDefenders
net revenues were generated by five customers, with one customer accounting for
42%, a second customer accounting for 27%, and a third customer accounting for
21%, a fourth customer accounting for 10% and a fifth customer was a negative
34% as a result of credit issued to settle disputed charges. During the three
months ended June 30, 2007, approximately 66% of MediaDefenders net revenues
were generated by four customers, with one customer accounting for 21%, a second
customer accounting for 17%, a third customer accounting for 15%, and a fourth
customer accounting for 13%. At June 30,
2008, the amounts due from these customers were approximately $821,000, which
were included in accounts receivable.
Media revenue decreased by
$972,000 or 47.3%, to $1,082,000 for the three months ended June 30, 2008,
as compared to $2,054,000 for the three months ended June 30, 2007. Media revenue decreased in 2008 as compared
to 2007 as a result of a general slow-down in online advertising, in particular
banner and display advertising, and increased competition from new
music-related websites. In addition, in April 2007,
the Company entered into a strategic partnership with T-Mobile with the launch
of a specially designed United Kingdom counterpart to the Companys United
States-based online music destination website.
The United Kingdom version of ARTISTdirect.com (www.ARTISTdirect.com/uk)
included numerous T-Mobile enhancements, including exclusive branded content
provided by T-Mobile. This contract
concluded during June 2008. During the three months ended June 30,
2008 and 2007, approximately $29,000 and $423,000, respectively, of media
revenues were generated by T-Mobile.
The Company markets and
sells advertising on a CPM basis to advertising agencies and directly to
various companies seeking to reach one or more of the distinct demographic
audiences viewing content in the ARTISTdirect Network. The Company also markets and sells sponsorships
for various portions of the ARTISTdirect Network. Customers may purchase advertising space on
the entire ARTISTdirect Network, or they may tailor advertising to specific
areas or sections of the Companys websites.
During the three months
ended June 30, 2008 and 2007, the Companys media revenues were generated
by two outside sales organizations that represented the Company with respect to
advertising and sponsorship on the Companys website and through affiliated websites,
as well as by in-house sales personnel.
During the three months June 30, 2008, approximately 24% of media
revenues were generated from two customers, with one customer accounting for
14% and a second customer accounting for 10%.
During the three months ended June 30, 2007, one customer accounted
for approximately 20% of media revenues.
E-commerce revenue decreased
by $417,000 or 81.9%, to $92,000 for the three months ended June 30, 2008,
as compared to $509,000 for the three months ended June 30, 2007. Due to limited opportunities for revenue
growth and acceptable gross margins, the Company had been de-emphasizing
e-commerce activities over the past few years.
During the three months ended June 30, 2007, approximately 64% of
e-commerce revenues were generated from the products related to a single music
merchandising entity. Effective August 31,
2007, the Company restructured its relationship with this music merchandising
entity to eliminate such merchandise sales and focus on music sales, which has
had a significant negative impact on e-commerce sales since such date. As a result, although e-commerce sales
decreased significantly in 2008 as compared to 2007, such restructuring had
limited impact on e-commerce net operating margins, since such merchandise
sales were generating nominal gross margins and the Company was able to
implement internal cost savings as a result of this restructuring.
Cost
of Revenue. The Companys total cost of
revenue decreased by $712,000 or 18.7%, to $3,105,000 for the three months
ended June 30, 2008, as compared to $3,817,000 for the three months ended June 30,
2007, primarily as a result of a decrease in e-commerce cost of revenue of
$430,000 and media cost of revenues of $288,000. Depreciation of property and equipment is
included in cost of revenue for all business segments.
MediaDefenders cost of revenues increased by $6,000
or 0.3%, to $2,315,000 for the three months ended June 30, 2008, as
compared to $2,309,000 for the three months ended June 30, 2007. As noted above, MediaDefenders revenues for
the three months ended June 30, 2008 were reduced by an adjustment of
approximately $790,000 recorded at June 30, 2008. As a result, MediaDefenders cost of revenue
was 149.7% of its net revenue in 2008, as compared to 57.3% of its net revenue
in 2007. MediaDefender has also
continued to experience increased bandwidth, personnel and occupancy costs,
which have had a continuing negative impact on cost of revenue in 2008 as
compared to 2007. Also included in
MediaDefenders cost of revenue for the three months ended June 30, 2008
and 2007 was the amortization of proprietary technology acquired in the
MediaDefender transaction of $634,000.
Media
cost of revenue decreased by $288,000 or 29.0%, to $705,000 for the three
months ended June 30, 2008, as compared to $993,000 for the three months ended
June 30, 2007. As a result, media
cost of revenue was 65.2% of its net revenue in 2008, as compared to 48.3% of
its net revenue in 2007, which reflected the core non-variable cost of revenues
for such segment.
43
Table of Contents
E-commerce
cost of revenue decreased by $430,000 or 83.5%, to $85,000 for the three months
ended June 30, 2008, as compared to $515,000 for the three months ended June 30,
2007. The decrease in e-commerce cost of
revenue in 2008 as compared to 2007 was a result of the Company restructuring
its relationship with a music merchandising entity to eliminate certain
merchandise sales and focus on music sales, as described above in Net Revenue.
As
a result of the foregoing, gross loss was $385,000 for the three months ended June 30,
2008, as compared to a gross profit of $2,776,000 for the three months ended June 30,
2007, reflecting gross margins of (14.2)% and 42.1%, respectively. A summary of gross profit (loss) and gross
margin by segment is as follows ($000):
|
|
Three Months Ended June 30,
|
|
|
|
2008
|
|
2007
|
|
Segment:
|
|
Gross
Profit
(Loss)
|
|
Gross
Margin
|
|
Gross
Profit
(Loss)
|
|
Gross
Margin
|
|
|
|
|
|
|
|
|
|
|
|
E-commerce
|
|
$
|
7
|
|
7.6
|
%
|
$
|
(6
|
)
|
(1.2
|
)%
|
Media
|
|
377
|
|
34.8
|
%
|
1,061
|
|
51.7
|
%
|
Anti-piracy and
file-sharing marketing services
|
|
(769
|
)
|
(49.7
|
)%
|
1,721
|
|
42.7
|
%
|
Totals
|
|
$
|
(385
|
)
|
(14.2
|
)%
|
$
|
2,776
|
|
42.1
|
%
|
Sales
and Marketing. The Companys sales and
marketing expense decreased by $2,000 or 0.4%, to $506,000 for the three months
ended June 30, 2008, as compared to $508,000 for the three months ended June 30,
2007. Also included in sales and
marketing expense for the three months ended June 30, 2008 and 2007 is the
amortization of customer relationships acquired in the MediaDefender
transaction of $189,000.
General and
Administrative. The Companys general
and administrative expense decreased by $1,646,000 or 55.7%, to $1,311,000 for
the three months ended June 30, 2008, as compared to $2,957,000 for the
three months ended June 30, 2007.
General and administrative expense decreased significantly in 2008 as
compared to 2007 as a result of various factors, including a reduction in bonus
accruals, reduced legal and accounting fees and travel expenses, and reduced
equity-based compensation.
Significant components of general and administrative
expense consists of management compensation (and bonuses, when applicable),
personnel and personnel-related costs, insurance, legal and accounting fees,
board compensation, consulting fees, occupancy costs and the provision for
doubtful accounts. Also in
cluded in
general and administrative expense for the three months ended June 30,
2008 and 2007 are stock-based compensation costs of $108,000 and $533,000,
respectively, and the amortization of non-competition agreements of $65,000 and
$66,000, respectively, resulting from the MediaDefender transaction.
During the three months ended June 30, 2008 and
2007, the Company incurred legal, accounting, consulting and printing fees and
costs of approximately $354,000 and $800,000, respectively, relating to the
preparation and filing of various documents with the SEC, negotiations with
senior and subordinated note holders, review and analysis of various
restructuring alternatives, amendments to financing agreements, and other
ordinary course legal and accounting matters.
As a result of the event of defaults related to the Companys senior and
subordinated debt agreements (see Going Concern above), the Company has
continued to incur significant costs in this regard in 2008.
During the three months ended March 31, 2008 and
2007, the Company recorded a charge to general and administrative expense and
an accrued liability of $175,000 with respect to the accrual of annual
performance bonuses payable to MediaDefenders senior management pursuant to
their respective employment agreements.
During the three months ended June 30, 2008, the Company reversed
the $175,000 bonus accrual recorded during the three months ended March 31,
2008.
Development and
Engineering. Development and engineering
costs were $117,000 for the three months ended June 30, 2008, as compared
to $196,000 for the three months ended June 30, 2007.
Development and engineering costs consist primarily of
third-party development costs and payroll and related expenses for in-house
development costs incurred in the design and production of the Companys
content and services, including revisions to the Companys website, and are
charged to operations as incurred.
44
Table of Contents
Goodwill Impairment.
At June 30, 2008, the Company recorded a non-cash charge to
operations to reflect the impairment of MediaDefender goodwill of $25,585,000,
based on the Companys conclusion that the current carrying value of the
MediaDefender segment goodwill of $31,085,000 was substantially and permanently
impaired at June 30, 2008.
Management reached this
conclusion based on various factors, including less than anticipated revenues
in 2008 from MediaDefenders new advertising initiatives and a significant
further erosion of demand for MediaDefenders core internet anti-piracy services
by the entertainment industry. In particular, the Company was advised by
one of MediaDefenders larger customers, which represented approximately 18% of
MediaDefenders revenues for the year ended December 31, 2007, that it
intends to substantially curtail its use of MediaDefenders anti-piracy
services subsequent to the expiration of its current contract with
MediaDefender on June 30, 2008.
Based on these recent
developments, the Company revised MediaDefenders financial projections for the
remainder of 2008 and beyond, as a result of which the Company recorded a
non-cash charge to operations to reflect the impairment of MediaDefender
goodwill at June 30, 2008 of $25,585,000. The calculation of the goodwill
impairment charge at June 30, 2008 was based on various estimates,
assumptions and pending issues, as a result of which the Company may further
revise its calculation of the impairment of the MediaDefender goodwill at September 30,
2008, December 31, 2008 and subsequently.
Management expects that MediaDefenders anti-piracy revenues will
continue to decline during the remainder of 2008.
Write-off of Fixed
Assets. During the three months ended June 30, 2007, the Company
recorded a charge to operations of $97,000 to write-off the net book value of
obsolete computer equipment that it did not expect to utilize in future
periods.
Loss
from Operations. As a result of the
aforementioned factors, the loss from operations was $27,904,000 for the three
months ended June, 2008, as compared to a loss from operations of $982,000 for
the three months ended June 30, 2007.
Interest
Income. Interest income was $12,000 for
the three months ended June 30, 2008, as compared to $45,000 for the three
months ended June 30, 2007.
Interest
Expense.
Interest expense of $2,190,000 and $2,068,000 for the
three months ended June 30, 2008 and 2007, respectively, relates to the
$15,000,000 of 11.25% secured notes payable issued in the Senior Financing and
the $30,000,000 of 4.0% subordinated convertible notes payable issued in the
Sub-Debt Financing, both of which were issued to finance the acquisition of
MediaDefender in July 2005.
Effective January 1, 2007, the interest rate on the Sub-Debt
Financing increased from 4.0% to 12.0% due to the default on the Companys senior
and subordinated debt agreements in January 2007 (see Going Concern
above). On March 17, 2008, the
Company entered into a Forbearance and Consent Agreement with the investors in
the Senior Financing, which was effective as of February 20, 2008, whereby
the investors agreed to forbear from exercising any of their rights and
remedies under the Senior Financing transaction documents through December 31,
2008 in exchange for an adjustment in the interest rate associated with the
11.25% secured notes payable from 11.25% to 15.0% per annum, provided the loan
is repaid prior to September 30, 2008, or 16.0% per annum (retroactive to February 20,
2008), if the loan remains outstanding subsequent to that date.
Additional consideration in the form of warrants issued
to the lenders was accounted for at fair value and recorded as a reduction to
the carrying amount of the debt, and is being amortized to interest expense
over the term of the debt. Accordingly,
the amortization of this discount on debt included in interest expense for the
three months ended June 30, 2008 and 2007 was $177,000 and $178,000,
respectively.
The Sub-Debt Notes contain several embedded derivative
features that have been accounted for at fair value. The various embedded derivative features of
the Sub-Debt Notes have been valued at the date of inception of the Sub-Debt
Financing and at the end of each reporting period thereafter. The value of the embedded derivatives were
bifurcated from the Sub-Debt Notes and recorded as derivative liability, with
the initial amount recorded as discount on the related Sub-Debt Notes. This discount is being amortized to interest
expense over the life of the Sub-Debt Notes.
Accordingly, the amortization of this discount on debt included in
interest expense for the three months ended June 30, 2008 and 2007 was
$590,000.
Loss on Foreign Currency
Transactions. The loss on foreign currency transactions was $8,000 for
the three months ended June 30, 2007. The Company did not have any
loss on foreign currency transactions for the three months ended June 30,
2008.
Other Income.
Other income was $225,000 for the three months ended June 30, 2008,
primarily reflecting a downward adjustment to certain old accrued liabilities.
45
Table of Contents
Reduction in Liquidated
Damages Payable Under Registration Rights Agreements. In accordance with
EITF 00-19-2, which the Company adopted as of December 31, 2006, and SFAS No. 5,
the Company accrued seven months liquidated damages (through mid-August 2007)
under the registration rights agreements aggregating approximately $3,777,000
as a charge to operations at December 31, 2006. As a result of the
Companys registration statement being declared effective on July 6, 2007,
which was earlier than originally estimated, the Company recorded a reduction
to the original accrual of $719,000 in other income (expense) in the statement
of operations during the three months ended June 30, 2007.
Change in Fair Value of Warrant Liability. In accordance with EITF 00-19, the fair value
of the warrants issued in connection with the financing of the MediaDefender
acquisition in July 2005 was recorded as warrant liability. The carrying value of the warrants is
adjusted quarterly to reflect any changes in the fair value such liability and
is included in the statement of operations as other income (expense). For the three months ended June 30, 2008
and 2007, the Company recorded a gain (loss) of $35,000 and $(95,000),
respectively, to reflect the change in warrant liability during such periods.
Change in Fair Value of Derivative Liability. In accordance with EITF 00-19, the fair value
of the embedded derivatives was bifurcated from the subordinated convertible
notes payable issued in connection with the financing of the MediaDefender
acquisition in July 2005 and recorded as a derivative liability. The carrying value of the derivative
liability is adjusted quarterly to reflect any changes in the fair value of
such liability and is included in the statement of operations as other income
(expense). For the three months ended June 30,
2008 and 2007, the Company recorded a gain (loss) of $117,000 and $(887,000),
respectively, to reflect the change in derivative liability during such
periods.
Amortization of Deferred
Financing Costs.
Amortization of deferred financing costs
was $209,000 and $210,000 for the three months ended June 30, 2008 and
2007, respectively. Deferred financing
costs consist of consideration paid to third parties with respect to the
acquisition and financing of the MediaDefender transaction, including cash
payments, subordinated convertible notes payable and the fair value of warrants
issued for placement agent fees, which were deferred and are being amortized
over the term of the related debt.
Income (Loss) Before Income
Taxes. As a result of the aforementioned
factors, the loss before income taxes was $29,914,000 for the three months
ended June 30, 2008, as compared to a loss before income taxes of
$3,486,000 for the three months ended June 30, 2007.
Provision
for Income Taxes.
The Company reported a provision for
income taxes of $2,000 for the three months ended June 30, 2008. As a result of the net loss reported for the
three months ended June 30, 2007, the Company did not record any provision
for income taxes for such period.
Net Loss. As a result of the aforementioned factors,
the Company had a net loss of $29,916,000 for the three months ended June 30,
2008, as compared to a net loss of $3,486,000 for the three months ended June 30,
2007.
46
Table of Contents
Results
of Operations Six Months Ended June 30, 2008 and 2007:
The
following table presents information with respect to the Companys condensed
consolidated statements of operations as to actual amounts and as a percentage
of total net revenue for the six months ended June 30, 2008 and 2007.
Condensed
Consolidated Statements of Operations ($000):
|
|
Six Months Ended June 30,
|
|
|
|
2008
|
|
2007
|
|
|
|
$
|
|
%
|
|
$
|
|
%
|
|
|
|
|
|
|
|
|
|
|
|
Net revenue:
|
|
|
|
|
|
|
|
|
|
E-commerce
|
|
$
|
198
|
|
2.9
|
%
|
$
|
1,003
|
|
8.3
|
%
|
Media
|
|
2,287
|
|
33.0
|
%
|
3,165
|
|
26.3
|
%
|
Anti-piracy and
file-sharing marketing services
|
|
4,436
|
|
64.1
|
%
|
7,871
|
|
65.4
|
%
|
Total net
revenue
|
|
6,921
|
|
100.0
|
%
|
12,039
|
|
100.0
|
%
|
Cost of revenue:
|
|
|
|
|
|
|
|
|
|
E-commerce
|
|
185
|
|
2.7
|
%
|
1,025
|
|
8.5
|
%
|
Media
|
|
1,384
|
|
20.0
|
%
|
1,593
|
|
13.3
|
%
|
Anti-piracy and
file-sharing marketing services
|
|
4,775
|
|
69.0
|
%
|
4,514
|
|
37.5
|
%
|
Total cost of
revenue
|
|
6,344
|
|
91.7
|
%
|
7,132
|
|
59.3
|
%
|
Gross profit
|
|
577
|
|
8.3
|
%
|
4,907
|
|
40.7
|
%
|
Operating
expenses:
|
|
|
|
|
|
|
|
|
|
Sales and
marketing
|
|
971
|
|
14.0
|
%
|
886
|
|
7.3
|
%
|
General and administrative
(including stock-based compensation)
|
|
4,416
|
|
63.8
|
%
|
5,498
|
|
45.7
|
%
|
Development and
engineering
|
|
234
|
|
3.4
|
%
|
323
|
|
2.7
|
%
|
Write-off of
fixed assets
|
|
|
|
|
%
|
97
|
|
0.8
|
%
|
Goodwill
impairment
|
|
25,585
|
|
369.7
|
%
|
|
|
|
%
|
Total operating
costs
|
|
31,206
|
|
450.9
|
%
|
6,804
|
|
56.5
|
%
|
Loss from
operations
|
|
(30,629
|
)
|
(442.6
|
)%
|
(1,897
|
)
|
(15.8
|
)%
|
Interest income
|
|
42
|
|
0.6
|
%
|
101
|
|
0.8
|
%
|
Interest expense
|
|
(4,310
|
)
|
(62.3
|
)%
|
(3,928
|
)
|
(32.6
|
)%
|
Loss on foreign
currency transactions
|
|
|
|
|
%
|
(14
|
)
|
(0.1
|
)%
|
Other income
|
|
270
|
|
3.9
|
%
|
|
|
|
%
|
Reduction in
liquidated damages payable under registration rights agreements
|
|
|
|
|
%
|
719
|
|
6.0
|
%
|
Change in fair
value of warrant liability
|
|
100
|
|
1.4
|
%
|
1,131
|
|
9.4
|
%
|
Change in fair
value of derivative liability
|
|
288
|
|
4.2
|
%
|
4,354
|
|
36.2
|
%
|
Amortization of
deferred financing costs
|
|
(419
|
)
|
(6.1
|
)%
|
(417
|
)
|
(3.5
|
)%
|
Write-off of
unamortized discount on debt and deferred financing costs resulting from
principal payments on senior secured notes payable
|
|
(26
|
)
|
(0.4
|
)%
|
|
|
|
%
|
Income (loss)
before income taxes
|
|
(34,684
|
)
|
(501.3
|
)%
|
49
|
|
0.4
|
%
|
Benefit from
income taxes
|
|
(8
|
)
|
(0.1
|
)%
|
|
|
|
%
|
Net income
(loss)
|
|
$
|
(34,676
|
)
|
(501.2
|
)%
|
$
|
49
|
|
0.4
|
%
|
The Company evaluates performance based on, among
other factors, earnings or loss before interest, taxes, depreciation and
amortization (Adjusted EBITDA), which is a non-GAAP financial measure. Adjusted EBITDA also excludes stock-based
compensation, changes in the fair value of warrant liability and derivative
liability, and other non-cash write-offs and charges. Management excludes these items in assessing
financial performance, primarily due to their non-operational nature or because
they are outside of the Companys normal operations. The Company has provided this information
because management believes that it is useful to investors in understanding the
Companys financial condition and results of operations.
47
Table of Contents
Management believes that Adjusted EBITDA enhances an
overall understanding of the Companys financial performance by investors
because it is frequently used by securities analysts and other interested
parties in evaluating companies in its industry segment. In addition, management believes that
Adjusted EBITDA is useful in evaluating the Companys operating performance
compared to that of other companies in its industry segment because the
calculation of Adjusted EBITDA eliminates the accounting effects of financing
costs, income taxes and capital spending, which items may vary for different
companies for reasons unrelated to overall operating performance.
However, Adjusted EBITDA has certain limitations. Adjusted EBITDA is not a recognized measurement
under GAAP, and when analyzing the Companys operating performance, investors
should use Adjusted EBITDA in addition to, and not as an alternative for,
standard GAAP financial measures such as net income (loss) or cash flow from
operations, or any other measure utilized in determining the Companys
operating performance that is calculated in accordance with GAAP. Because Adjusted EBITDA is not calculated in
accordance with GAAP, it may not be comparable to similarly-titled measures
utilized by other companies. Adjusted
EBITDA eliminates certain substantial recurring items from net income (loss),
such as depreciation, amortization, interest expense and income taxes, among
others. Each of these items has been
incurred in the past, will continue to be incurred in the future, and should be
considered in the overall evaluation of the Companys operating
performance. The Company compensates for
these limitations by providing the relevant disclosure of the items excluded in
the calculation of Adjusted EBITDA, both in the reconciliation to the GAAP
financial measure of net income (loss) and in the consolidated financial
statements and footnotes, all of which should be considered when evaluating the
Companys operating performance.
Furthermore, Adjusted EBITDA is not intended to be a measure of the
Companys free cash flow or liquidity in general, as it does not consider
certain ongoing cash requirements, such as a required debt service payments and
income taxes.
The following table summarizes net revenue and
Adjusted EBITDA by operating segment for the six months ended June 30,
2008 and 2007. Corporate expenses
consist of general operating expenses that are not directly related to the
operations of the segments. A
reconciliation of Net Income (Loss) to Adjusted EBITDA is also provided.
|
|
Six Months Ended June 30,
|
|
|
|
2008
|
|
2007
|
|
|
|
(in thousands)
|
|
|
|
|
|
|
|
Net Revenue:
|
|
|
|
|
|
E-commerce
|
|
$
|
198
|
|
$
|
1,003
|
|
Media
|
|
2,287
|
|
3,165
|
|
Anti-piracy and
file-sharing marketing services
|
|
4,436
|
|
7,871
|
|
|
|
$
|
6,921
|
|
$
|
12,039
|
|
|
|
|
|
|
|
Adjusted EBITDA:
|
|
|
|
|
|
E-commerce
|
|
$
|
(38
|
)
|
$
|
(123
|
)
|
Media
|
|
351
|
|
1,077
|
|
Anti-piracy and
file-sharing marketing services
|
|
97
|
|
3,131
|
|
|
|
410
|
|
4,085
|
|
Corporate
general and administrative expenses
|
|
(2,051
|
)
|
(2,638
|
)
|
Reduction in
liquidated damages payable under registration rights agreements
|
|
|
|
719
|
|
|
|
$
|
(1,641
|
)
|
$
|
2,166
|
|
48
Table
of Contents
|
|
Six Months Ended June 30,
|
|
Reconciliation of Adjusted EBITDA to Net Income (Loss)
|
|
2008
|
|
2007
|
|
|
|
(in thousands)
|
|
|
|
|
|
Adjusted EBITDA
per segments
|
|
$
|
(1,641
|
)
|
$
|
2,166
|
|
Stock-based
compensation
|
|
(805
|
)
|
(988
|
)
|
Depreciation and
amortization
|
|
(552
|
)
|
(447
|
)
|
Amortization of
intangible assets
|
|
(1,776
|
)
|
(1,826
|
)
|
Amortization of
deferred financing costs
|
|
(419
|
)
|
(417
|
)
|
Write-off of
unamortized discount on debt and deferred financing costs resulting from
principal payments on senior secured notes payable
|
|
(26
|
)
|
|
|
Interest income
|
|
42
|
|
101
|
|
Interest
expense, including amortization of discount on debt of $1,536 and $1,529 in
2008 and 2007, respectively
|
|
(4,310
|
)
|
(3,928
|
)
|
Change in fair
value of warrant liability
|
|
100
|
|
1,131
|
|
Change in fair
value of derivative liability
|
|
288
|
|
4,354
|
|
Goodwill
impairment
|
|
(25,585
|
)
|
|
|
Write-off of
fixed assets
|
|
|
|
(97
|
)
|
Benefit from
income taxes
|
|
8
|
|
|
|
Net income
(loss)
|
|
$
|
(34,676
|
)
|
$
|
49
|
|
Net
Revenue. The Companys net revenue decreased by $5,118,000 or 42.5%, to
$6,921,000 for the six months ended June 30, 2008, as compared to
$12,039,000 for the six months ended June 30, 2007, primarily as a result
of decreases in MediaDefender revenues of $3,435,000, media revenues of
$878,000 and e-commerce revenues of $805,000. MediaDefender revenues accounted
for 64.1% of the Companys total net revenue for the six months ended June 30,
2008, as compared to 65.4% of the Companys total net revenue for the six
months ended June 30, 2007.
As
previously disclosed, management expected MediaDefenders anti-piracy revenues
to continue to decline in 2008 as compared to 2007. MediaDefenders revenue
decreased by $3,435,000 or 43.6%, to $4,436,000 for the six months ended June 30,
2008, as compared to $7,871,000 for the six months ended June 30, 2007. Revenues
decreased in 2008 as compared to 2007 as a result of reduced spending on the
part of major entertainment conglomerates on IPP services. Specifically,
MediaDefenders anti-piracy revenues have been negatively impacted by the loss
of one customer in November 2007 that accounted for 4% of MediaDefenders
2007 annual revenue, citing cost pressures subsequent to a change in ownership,
and the loss of a second customer in January 2008 that accounted for 12%
of MediaDefenders 2007 annual revenues, noting that they were evaluating the
use of alternative methods to deal with piracy.
During
late June 2008, the Company was advised that a third customer that
accounted for 18% of MediaDefenders 2007 annual revenues was substantially
curtailing its use of MediaDefenders anti-piracy services subsequent to the
expiration of its current contract with MediaDefender on June 30, 2008,
citing uncertainty with respect to the effectiveness and cost/benefit of
anti-piracy services. MediaDefender entered into a settlement agreement with
this customer to resolve certain disputes. Pursuant to the settlement agreement
MediaDefender issued approximately $790,000 of credits for previously invoiced
services, which were recorded as a reduction to revenues, of which
approximately $592,000 was recorded as a reduction to accounts receivable and
apoproximately $197,000 was recorded as deferred revenue, which must be
utilized by July 24, 2009. All such amounts were recorded as of June 30,
2008 and for the six months then ended.
As a result of the
aforementioned developments with respect to the business of MediaDefender in
late June 2008, as well as revised MediaDefender financial projections for
the remainder of 2008 and beyond, the Company concluded that the current
carrying value of the MediaDefender segment goodwill of $31,085,000 was
substantially and permanently impaired at June 30, 2008. Accordingly, the
Company recorded a non-cash charge to operations to reflect the impairment of
MediaDefender goodwill at June 30, 2008 of $25,585,000. The calculation of
the goodwill impairment charge at June 30, 2008 was based on various
estimates, assumptions and pending issues, as a result of which the Company may
further revise its calculation of the impairment of the MediaDefender goodwill
at September 30, 2008, December 31, 2008 and subsequently.
Management
expects that MediaDefenders anti-piracy revenues will continue to decline
during the remainder of 2008.
49
Table of Contents
During
the six months ended June 30, 2008, approximately 62% of MediaDefenders net
revenues were generated by three customers, with one customer accounting for 30%,
a second customer accounting for 20% and a third customer accounting for 12%. During
the six months ended June 30, 2007, approximately 38% of MediaDefenders net
revenues were generated by two customers, with one customer accounting for 21%
and a second customer accounting for 17%. At June 30, 2008, the amounts
due from these customers were approximately $821,000, which were included in
accounts receivable.
Media revenue decreased by
$878,000 or 27.7%, to $2,287,000 for the six months ended June 30, 2008,
as compared to $3,165,000 for the six months ended June 30, 2007. Media
revenue decreased in 2008 as compared to 2007 as a result of a general
slow-down in online advertising, in particular banner and display advertising,
and increased competition from new music-related websites. In addition, in April 2007,
the Company entered into a strategic partnership with T-Mobile with the launch
of a specially designed United Kingdom counterpart to the Companys United
States-based online music destination website. The United Kingdom version of
ARTISTdirect.com (www.ARTISTdirect.com/uk) included numerous T-Mobile
enhancements, including exclusive branded content provided by T-Mobile. This
contract concluded during June 2008. During the six months ended June 30,
2008 and 2007, approximately $204,000 and $423,000, respectively, of media
revenues were generated by T-Mobile.
The Company markets and
sells advertising on a CPM basis to advertising agencies and directly to
various companies seeking to reach one or more of the distinct demographic
audiences viewing content in the ARTISTdirect Network. The Company also markets
and sells sponsorships for various portions of the ARTISTdirect Network. Customers
may purchase advertising space on the entire ARTISTdirect Network, or they may
tailor advertising to specific areas or sections of the Companys websites.
During the six months ended June 30,
2008 and 2007, the Companys media revenues were generated by two outside sales
organizations that represented the Company with respect to advertising and
sponsorship on the Companys website and through affiliated websites, as well
as by in-house sales personnel. During the six months June 30, 2008, no
one customer accounted for 10% or more of media revenues. During the six months
ended June 30, 2007, one customer accounted for approximately 13% of media
revenues.
E-commerce revenue decreased
by $805,000 or 80.3%, to $198,000 for the six months ended June 30, 2008,
as compared to $1,003,000 for the six months ended June 30, 2007. Due to
limited opportunities for revenue growth and acceptable gross margins, the
Company had been de-emphasizing e-commerce activities over the past few years. During
the six months ended June 30, 2007, approximately 61% of e-commerce
revenues were generated from the products related to a single music
merchandising entity. Effective August 31, 2007, the Company restructured
its relationship with this music merchandising entity to eliminate such
merchandise sales and focus on music sales, which has had a significant negative
impact on e-commerce sales since such date. As a result, although e-commerce
sales decreased significantly in 2008 as compared to 2007, such restructuring
had limited impact on e-commerce net operating margins, since such merchandise
sales were generating nominal gross margins and the Company was able to
implement internal cost savings as a result of this restructuring.
Cost
of Revenue. The Companys total cost of revenue decreased by $788,000 or 11.0%,
to $6,344,000 for the six months ended June 30, 2008, as compared to
$7,132,000 for the six months ended June 30, 2007, primarily as a result
of a decrease in e-commerce cost of revenue of $840,000 and media cost of
revenues of $209,000, offset by an increase in MediaDefender cost of revenues
of $261,000. Depreciation of property and equipment is included in cost of
revenue for all business segments.
MediaDefenders cost of revenues increased by $261,000
or 5.8%, to $4,775,000 for the six months ended June 30, 2008, as compared
to $4,514,000 for the six months ended June 30, 2007. As noted above,
MediaDefenders revenues for the six months ended June 30, 2008 were
reduced by an adjustment of approximately $790,000 recorded at June 30,
2008. As a result, MediaDefenders cost of revenue was 107.6% of its net
revenue in 2008, as compared to 57.3% of its net revenue in 2007. MediaDefender
has also continued to experience increased bandwidth, personnel and occupancy
costs, which have had a continuing negative impact on cost of revenue in 2008
as compared to 2007. Also included in MediaDefenders cost of revenue for the
six months ended June 30, 2008 and 2007 was the amortization of
proprietary technology acquired in the MediaDefender transaction of $1,267,000.
50
Table of Contents
Media
cost of revenue decreased by $209,000 or 13.1%, to $1,384,000 for the six
months ended June 30, 2008, as compared to $1,593,000 for the six months
ended June 30, 2007. As a result, media cost of revenue was 60.5% of its
net revenue in 2008, as compared to 50.3% of its net revenue in 2007, which
reflected the core non-variable cost of revenues for such segment.
E-commerce
cost of revenue decreased by $840,000 or 82.0%, to $185,000 for the six months
ended June 30, 2008, as compared to $1,003,000 for the six months ended June 30,
2007. The decrease in e-commerce cost of revenue in 2008 as compared to 2007
was a result of the Company restructuring its relationship with a music
merchandising entity to eliminate certain merchandise sales and focus on music
sales, as described above in Net Revenue.
As
a result of the foregoing, gross profit was $577,000 for the six months ended June 30,
2008, as compared to a gross profit of $4,907,000 for the six months ended June 30,
2007, reflecting gross margins of 8.3% and 40.8%, respectively. A summary of
gross profit (loss) and gross margin by segment is as follows ($000):
|
|
Six Months Ended June 30,
|
|
|
|
2008
|
|
2007
|
|
Segment:
|
|
Gross
Profit
(Loss)
|
|
Gross
Margin
|
|
Gross
Profit
(Loss)
|
|
Gross
Margin
|
|
E-commerce
|
|
$
|
13
|
|
6.6
|
%
|
$
|
(22
|
)
|
(2.2
|
)%
|
Media
|
|
903
|
|
39.5
|
%
|
1,572
|
|
49.7
|
%
|
Anti-piracy and
file-sharing marketing services
|
|
(339
|
)
|
(7.6
|
)%
|
3,357
|
|
42.7
|
%
|
Totals
|
|
$
|
577
|
|
8.3
|
%
|
$
|
4,907
|
|
40.8
|
%
|
Sales
and Marketing. The Companys sales and marketing expense increased by $85,000
or 9.6%, to $971,000 for the six months ended June 30, 2008, as compared
to $886,000 for the six months ended June 30, 2007. Also included in sales
and marketing expense for the six months ended June 30, 2008 and 2007 is
the amortization of customer relationships acquired in the MediaDefender
transaction of $378,000 and $377,000, respectively.
General and Administrative. The
Companys general and administrative expense decreased by $1,092,000 or 19.8%,
to $4,416,000 for the six months ended June 30, 2008, as compared to
$5,508,000 for the six months ended June 30, 2007. General and
administrative expense decreased significantly in 2008 as compared to 2007 as a
result of various factors, including a reduction in bonus accruals, reduced
legal and accounting fees and travel expenses, and reduced equity-based
compensation.
Significant components of general and administrative
expense consists of management compensation (and bonuses, when applicable),
personnel and personnel-related costs, insurance, legal and accounting fees,
board compensation, consulting fees, occupancy costs and the provision for
doubtful accounts. Also in
cluded in general and administrative expense
for the six months ended June 30, 2008 and 2007 are stock-based
compensation costs of $805,000 and $988,000, respectively, and the amortization
of non-competition agreements of $131,000 and $181,000, respectively, resulting
from the MediaDefender transaction.
During the six months ended June 30, 2008 and
2007, the Company incurred legal, accounting, consulting and printing fees and
costs of approximately $951,000 and $1,300,000, respectively, relating to the
preparation and filing of various documents with the SEC, negotiations with
senior and subordinated note holders, review and analysis of various
restructuring alternatives, amendments to financing agreements, and other
ordinary course legal and accounting matters. As a result of the event of
defaults related to the Companys senior and subordinated debt agreements (see Going
Concern above), the Company has continued to incur significant costs in this
regard in 2008.
During the six months ended June 30, 2007, the
Company recorded a charge to general and administrative expense and an accrued
liability of $350,000 with respect to the accrual of annual performance bonuses
payable to MediaDefenders senior management pursuant to their respective
employment agreements.
During the six months
ended June 30, 2008, the Company recorded a charge to operations and an
accrued liability of $350,000 to record the severance payment with respect to
the Amended and Restated Services Agreement dated as of March 6, 2008
between the Company and the Companys former Chief Executive Officer. The
Company also recorded stock-based compensation costs of $571,000 during the six
months ended June 30, 2008 with respect to this settlement.
51
Table of Contents
Development and Engineering.
Development and engineering costs were $234,000 for the six months ended June 30,
2008, as compared to $313,000 for the six months ended June 30, 2007.
Development and engineering costs consist
primarily of third-party development costs and payroll and related expenses for
in-house development costs incurred in the design and production of the Companys
content and services, including revisions to the Companys website, and are
charged to operations as incurred.
Goodwill Impairment. At June 30, 2008, the
Company recorded a non-cash charge to operations to reflect the impairment of
MediaDefender goodwill of $25,585,000, based on the Companys conclusion that
the current carrying value of the MediaDefender segment goodwill of $31,085,000
was substantially and permanently impaired at June 30, 2008.
Management reached this
conclusion based on various factors, including less than anticipated revenues
in 2008 from MediaDefenders new advertising initiatives and a significant
further erosion of demand for MediaDefenders core Internet anti-piracy
services by the entertainment industry. In particular, the Company was advised
by one of MediaDefenders larger customers, which represented approximately 18%
of MediaDefenders revenues for the year ended December 31, 2007, that it
intends to substantially curtail its use of MediaDefenders anti-piracy
services subsequent to the expiration of its current contract with
MediaDefender on June 30, 2008.
Based on these recent
developments, the Company revised MediaDefenders financial projections for the
remainder of 2008 and beyond, as a result of which the Company recorded a
non-cash charge to operations to reflect the impairment of MediaDefender
goodwill at June 30, 2008 of $25,585,000. The calculation of the goodwill
impairment charge at June 30, 2008 was based on various estimates,
assumptions and pending issues, as a result of which the Company may further
revise its calculation of the impairment of the MediaDefender goodwill at September 30,
2008.
Management expects that MediaDefenders anti-piracy revenues will
continue to decline during the remainder of 2008.
Write-off of Fixed
Assets. During the six months ended June 30, 2007, the Company recorded a
charge to operations of $97,000 to write-off the net book value of obsolete
computer equipment that it did not expect to utilize in future periods.
Loss
from Operations. As a result of the aforementioned factors, the loss from operations
was $30,629,000 for the six months ended June 30, 2008, as compared to a
loss from operations of $1,897,000 for the six months ended June 30, 2007.
Interest
Income. Interest income was $42,000 for the six months ended June 30,
2008, as compared to $101,000 for the six months ended June 30, 2007.
Interest
Expense.
Interest
expense of $4,310,000 and $3,928,000 for the six months ended June 30,
2008 and 2007, respectively, relates to the $15,000,000 of 11.25% secured notes
payable issued in the Senior Financing and the $30,000,000 of 4.0% subordinated
convertible notes payable issued in the Sub-Debt Financing, both of which were
issued to finance the acquisition of MediaDefender in July 2005. Effective
January 1, 2007, the interest rate on the Sub-Debt Financing increased
from 4.0% to 12.0% due to the default on the Companys senior and subordinated
debt agreements in January 2007 (see Going Concern above). On March 17,
2008, the Company entered into a Forbearance and Consent Agreement with the
investors in the Senior Financing, which was effective as of February 20,
2008, whereby the investors agreed to forbear from exercising any of their
rights and remedies under the Senior Financing transaction documents through December 31,
2008 in exchange for an adjustment in the interest rate associated with the
11.25% secured notes payable from 11.25% to 15.0% per annum, provided the loan
is repaid prior to September 30, 2008, or 16.0% per annum (retroactive to February 20,
2008), if the loan remains outstanding subsequent to that date.
Additional consideration in the form of warrants
issued to the lenders was accounted for at fair value and recorded as a
reduction to the carrying amount of the debt, and is being amortized to
interest expense over the term of the debt. Accordingly, the amortization of
this discount on debt included in interest expense for the six months ended June 30,
2008 and 2007 was $357,000 and $356,000, respectively.
The Sub-Debt Notes contain several embedded derivative
features that have been accounted for at fair value. The various embedded
derivative features of the Sub-Debt Notes have been valued at the date of
inception of the Sub-Debt Financing and at the end of each reporting period
thereafter. The value of the embedded derivatives were bifurcated from the
Sub-Debt Notes and recorded as derivative liability, with the initial amount
recorded as discount on the related Sub-Debt Notes. This discount is being
amortized to interest expense over the life of the Sub-Debt Notes. Accordingly,
the amortization of this discount on debt included in interest expense for the
six months ended June 30, 2008 and 2007 was $1,179,000 and $1,173,000,
respectively.
52
Table of Contents
Loss on Foreign Currency
Transactions. The loss on foreign currency transactions was $14,000 for the six
months ended June 30, 2007. The Company did not have any loss on foreign
currency transactions for the six months ended June 30, 2008.
Other Income. Other income was $270,000 for the six
months ended June 30, 2008, primarily reflecting a downward adjustment to
certain old accrued liabilities.
Reduction in Liquidated
Damages Payable Under Registration Rights Agreements. In accordance with EITF
00-19-2, which the Company adopted as of December 31, 2006, and SFAS No. 5,
the Company accrued seven months liquidated damages (through mid-August 2007)
under the registration rights agreements aggregating approximately $3,777,000
as a charge to operations at December 31, 2006. As a result of the Companys
registration statement being declared effective on July 6, 2007, which was
earlier than originally estimated, the Company recorded a reduction to the
original accrual of $719,000 in other income (expense) in the statement of
operations during the six months ended June 30, 2007.
Change in Fair Value of Warrant Liability. In
accordance with EITF 00-19, the fair value of the warrants issued in connection
with the financing of the MediaDefender acquisition in July 2005 was
recorded as warrant liability. The carrying value of the warrants is adjusted
quarterly to reflect any changes in the fair value such liability and is
included in the statement of operations as other income (expense). For the six
months ended June 30, 2008 and 2007, the Company recorded a gain of
$100,000 and $1,131,000, respectively, to reflect the change in warrant
liability during such periods.
Change in Fair Value of Derivative Liability. In accordance
with EITF 00-19, the fair value of the embedded derivatives was bifurcated from
the subordinated convertible notes payable issued in connection with the
financing of the MediaDefender acquisition in July 2005 and recorded as a
derivative liability. The carrying value of the derivative liability is
adjusted quarterly to reflect any changes in the fair value of such liability
and is included in the statement of operations as other income (expense). For
the six months ended June 30, 2008 and 2007, the Company recorded a gain
of $288,000 and $4,354,000, respectively, to reflect the change in derivative
liability during such periods.
Amortization of Deferred
Financing Costs.
Amortization
of deferred financing costs was $419,000 and $417,000 for the six months ended June 30,
2008 and 2007, respectively. Deferred financing costs consist of consideration
paid to third parties with respect to the acquisition and financing of the
MediaDefender transaction, including cash payments, subordinated convertible notes
payable and the fair value of warrants issued for placement agent fees, which
were deferred and are being amortized over the term of the related debt.
W
rite-Off of Unamortized Discount on Debt and
Deferred Financing Costs Resulting from Principal Payments on Senior Secured
Notes Payable.
Deferred
financing costs and debt discount costs aggregating $26,000 were charged to
operations as a result of principal payments on senior secured notes payable
during the six months ended June 30, 2008. There were no principal
payments on senior secured notes payable during the six months ended June 30,
2007.
Income (Loss) Before Income
Taxes. As a result of the aforementioned factors, the loss before income taxes
was $34,684,000 for the six months ended June 30, 2008, as compared to
income before income taxes of $49,000 for the six months ended June 30,
2007.
Benefit
from Income Taxes.
The
Company reported a benefit from income taxes of $8,000 for the six months ended
June 30, 2008. As a result of the net loss reported for the three months
ended March 31, 2007, the Company did not record any provision for income
taxes for the six months ended June 30, 2007.
Net Loss. As a result of the
aforementioned factors, the Company had a net loss of $34,676,000 for the six
months ended June 30, 2008, as compared to net income of $49,000 for the
six months ended June 30, 2007.
53
Table
of Contents
Liquidity and Capital
Resources June 30, 2008:
As more fully described
above at Going Concern, as a result of communications with the Staff of the
SEC in 2006, in particular regarding the application of accounting rules and
interpretations related to embedded derivatives associated with the Companys
subordinated convertible notes payable issued in July 2005, the Company
determined that it was necessary to restate certain previously issued financial
statements.
As a result, in December 2006,
the Company was required to suspend the use of its then effective registration
statement for the holders of its senior and subordinated indebtedness and thus
incurred an event of default with respect to it registration rights agreements
with the holders of such indebtedness. Accordingly, effective December 20,
2006, the Company began to incur liquidated damages under its registration
rights agreements aggregating approximately $540,000 per month , and the
interest rate on its subordinated convertible notes payable increased from 4.0%
per annum to 12.0% per annum as of January 1, 2007, an increase of
approximately $183,000 per month. On July 6, 2007, the Companys
registration statement was declared effective by the SEC, thus making it
available to the investors in the Senior Financing and the Sub-Debt Financing.
A summary of the
registration penalty accrual at June 30, 2008 and December 31, 2007
is presented below.
|
|
June 30,
2008
|
|
December 31,
2007
|
|
|
|
|
|
|
|
Senior secured
notes payable
|
|
$
|
|
|
$
|
410,000
|
|
Subordinated convertible
notes payable
|
|
1,972,000
|
|
1,972,000
|
|
Total
registration penalty accrual
|
|
$
|
1,972,000
|
|
$
|
2,382,000
|
|
A summary of accrued
interest payable at June 30, 2008 and December 31, 2007 is presented
below.
|
|
June 30,
2008
|
|
December 31,
2007
|
|
|
|
|
|
|
|
Senior secured
notes payable
|
|
$
|
129,000
|
|
$
|
67,000
|
|
Subordinated
convertible notes payable
|
|
4,689,000
|
|
3,034,000
|
|
Liquidated
damages payable with respect to:
|
|
|
|
|
|
Senior secured
notes payable
|
|
|
|
79,000
|
|
Subordinated
convertible notes payable
|
|
303,000
|
|
172,000
|
|
Total accrued
interest payable
|
|
$
|
5,121,000
|
|
$
|
3,352,000
|
|
As a result of the
requirement to restate certain previously issued financial statements, which
resulted in the recording of an embedded derivative liability, the reclassification
of the senior and subordinated indebtedness to current liabilities, and the
recording of liquidated damages payable under registration rights agreements,
the Company was not in compliance with certain of its financial covenants under
both the Senior Financing and the Sub-Debt Financing at December 31, 2006.
Notwithstanding such developments, the Company would have been out of
compliance with certain of its financial covenants at December 31, 2007
and subsequently.
Pursuant to a series of Forbearance and Consent
Agreements with the investors in the Senior Financing, such investors agreed to
forbear from the exercise of their rights and remedies under the Senior
Financing documents as a result of the events of default which were then in
existence during the period, from April 17, 2007 through February 20,
2008, in exchange for aggregate cash payments of $1,000,000 in 2007 and
$494,423 in February 2008. The payments made by the Company under the
Forbearance and Consent Agreements were credited against the registration delay
cash penalties and interest on the penalties resulting from the Companys
default under the various agreements between the Company and the Senior
Financing investors. On March 17, 2008, the Company entered into a
Forbearance and Consent Agreement with the investors in the Companys Senior
Debt Financing, which was effective as of February 20, 2008, whereby the
investors agreed to forbear from exercising any of their rights and remedies
under the Senior Financing transaction documents through December 31, 2008
in exchange for an adjustment in the interest rate associated with the Senior
Notes from 11.25% to 15.0% per annum, provided the loan is repaid prior to September 30,
2008, or 16.0% per annum, if the loan remains outstanding subsequent to that
date.
54
Table of Contents
In addition, as a result
of a significant deterioration in MediaDefenders business operations and
prospects during the latter part of June 2008, including less than
anticipated revenues in 2008 from MediaDefenders new advertising initiatives
and a significant further erosion of demand for MediaDefenders core internet
anti-piracy services by the entertainment industry, the Companys operations
and cash flows have been materially and negatively impacted.
The registration delay
penalties and ongoing default interest charges are continuing to have a
significant and material negative impact on the Companys operations and cash
flows. The Company is exploring various alternatives to resolve the defaults
under its senior and secured debt obligations, but is unable to predict the
outcome of such negotiations. On February 7, 2008, the Company retained
the services of Salem Partners, LLC to serve as a financial advisor to the
Company in connection with the sale, merger, consolidation, reorganization or
other business combination and the restructuring of the material terms of the
Companys senior notes and/or subordinated convertible notes. To the extent
that the Company is unable to complete a sale or merger or restructure its
senior and subordinated debt obligations in a satisfactory manner and/or the
lenders begin to exercise additional remedies to enforce their rights, the
Company will not have sufficient cash resources to maintain its operations. In
such event, the Company may be required to consider a formal or informal
restructuring or reorganization, including a filing under Chapter 11 of the United
States Bankruptcy Code.
The accompanying
consolidated financial statements have been prepared in conformity with
accounting principles generally accepted in the United States of America, which
contemplate continuation of the Company as a going concern. As a result of the
foregoing, the Companys independent registered public accounting firm, in its
report on the Companys 2007 consolidated financial statements, expressed
substantial doubt about the Companys ability to continue as a going concern. The
consolidated financial statements do not include any adjustments relating to
the recoverability and classification of recorded asset amounts or the amounts
and classification of liabilities that could result from the outcome of this
uncertainty
Overview:
Until the acquisition of
MediaDefender effective July 28, 2005, the Company financed its continuing
operations primarily from the sale of its equity securities. Concurrent with
the acquisition of MediaDefender in July 2005, the Company completed a
$15,000,000 Senior Financing and a $30,000,000 Sub-Debt Financing, which
generated approximately $1,000,000 for general working capital purposes. In
addition, MediaDefender had working capital of $2,745,000 at the acquisition
date.
As of June 30, 2008
and December 31, 2007, the Company had $3,445,000 and $4,268,000 of
unrestricted cash and cash equivalents, respectively.
At June 30, 2008,
the Company had a working capital deficiency of $38,060,000, primarily because
of the classification of senior secured notes payable and subordinated
convertible notes payable as current liabilities, the accrual of default
interest on the subordinated convertible notes payable of $4,689,000,
liquidated damages payable under registration rights agreements of $1,972,000,
and warrant liability of $64,000 and derivative liability of $25,000 at such
date. At December 31, 2007, the Company had a working capital deficiency
of $32,273,000, primarily because of the classification of senior secured notes
payable and subordinated convertible notes payable as current liabilities, the
accrual of default interest on subordinated convertible notes payable of
$3,034,000, liquidated damages payable under registration rights agreements of
$2,382,000, and warrant liability of $164,000 and derivative liability of
$313,000 at such date.
The increase in the
working capital deficiency at June 30, 2008 as compared to December 31,
2007 of $5,787,000 is primarily a result of a decrease in accounts receivable
(reflecting the decrease in revenues at MediaDefender) and an increase in
accrued interest payable (reflecting the default interest payable to the
holders of the subordinated convertible notes payable) during the six months
ended June 30, 2008.
Operating. Net cash used
in operating activities for the six months ended June 30, 2008 was
$300,000, as compared to net cash provided by operating activities of $230,000
for the six months ended June 30, 2007. Operating cash flow decreased in
2008 as compared to 2007 primarily as a result of the decrease in MediaDefender
accounts receivable during the six months ended June 30, 2008, and as
result of a decrease in MediaDefender revenues during 2008.
Investing. Net cash used
in investing activities for the six months ended June 30, 2008 and 2007
was $224,000 and $241,000, respectively, for additions to property and
equipment, primarily by MediaDefender.
55
Table of Contents
Financing. Net cash used in financing activities for the
six months ended June 30, 2008 was $299,000, which consisted of principal
payments on senior secured notes payable of $313,000, offset by a decrease in
restricted cash of $14,000. Net cash
provided by financing activities for the six months ended June 30, 2007
was $104,000, consisting of the proceeds from the exercise of stock options of
$17,000 and a decrease in restricted cash of $87,000.
Contractual
Obligations:
As of June 30, 2008,
the Companys principal commitments for the next five fiscal years consisted of
contractual commitments as summarized below.
The summary shown below assumes that the senior secured notes payable
and the subordinated convertible notes payable are outstanding for their full
terms (based on the original terms as contemplated in the senior and
subordinated loan agreements), without any early reduction of the principal
balances based on cash flows.
|
|
|
|
Payments Due by Year (in thousands)
|
|
Contractual cash obligations ($000)
|
|
Total
|
|
2008
|
|
2009
|
|
2010
|
|
2011
|
|
2012
|
|
|
|
|
|
(6 months)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Employment and
consulting contracts and agreements (1)
|
|
$
|
642
|
|
$
|
609
|
|
$
|
33
|
|
$
|
|
|
$
|
|
|
$
|
|
|
Lease
obligations
|
|
3,634
|
|
959
|
|
1,592
|
|
613
|
|
470
|
|
|
|
Liquidated
damages payable under registration rights agreements
|
|
1,972
|
|
|
|
1,972
|
|
|
|
|
|
|
|
Interest on
liquidated damages payable under registration rights agreements
|
|
618
|
|
444
|
|
174
|
|
|
|
|
|
|
|
Senior secured
notes payable
|
|
12,994
|
|
|
|
12,994
|
|
|
|
|
|
|
|
Interest on
senior secured notes payable (2)
|
|
2,091
|
|
1,057
|
|
1,034
|
|
|
|
|
|
|
|
Subordinated
convertible notes payable
|
|
27,658
|
|
|
|
27,658
|
|
|
|
|
|
|
|
Interest on
subordinated convertible notes payable (3)
|
|
8,253
|
|
6,353
|
|
1,900
|
|
|
|
|
|
|
|
Total
contractual cash obligations
|
|
$
|
57,862
|
|
$
|
9,422
|
|
$
|
47,357
|
|
$
|
613
|
|
$
|
470
|
|
$
|
|
|
(1) Base
compensation only; does not include any performance bonuses.
(2) Assumes interest
at 16% from February 20, 2008 through June 2009.
(3) Assumes interest
at 12% default rate through July 2009.
Capital
Expenditures:
The
Company estimates that it will have capital expenditures aggregating
approximately $100,000 for the remainder of the year ending December 31,
2008.
Off-Balance
Sheet Arrangements:
At
June 30, 2008, the Company did not have any transactions, obligations or
relationships that could be considered off-balance sheet arrangements.
56
Table of Contents
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
Not applicable.
ITEM 4. CONTROLS AND PROCEDURES
(a) Evaluation of
Disclosure Controls and Procedures
Disclosure controls and
procedures are controls and other procedures that are designed to ensure that
information required to be disclosed in the reports filed or submitted by the
Company under the Securities Exchange Act of 1934, as amended, is recorded,
processed, summarized and reported, within the time periods specified in the rules and
forms of the Securities and Exchange Commission. Disclosure controls and procedures include,
without limitation, controls and procedures designed to ensure that information
required to be disclosed in the Companys reports filed under the Securities
Exchange Act of 1934, as amended, is accumulated and communicated to the
Companys management, including the Interim Chief Executive Officer and
corporate controller, as appropriate, to allow timely decisions regarding
required disclosure. Management
recognizes that any controls and procedures, no matter how well-designed and
operated, can provide only reasonable assurance of achieving their objectives,
and management necessarily applies its judgment in evaluating the cost-benefit
relationship of possible controls and procedures.
The Company carried out an
evaluation, under the supervision and with the participation of its management,
including its Interim Chief Executive Officer and corporate controller, of the
effectiveness of the Companys disclosure controls and procedures as of the end
of the period covered by this report.
Based upon and as of the date of that evaluation, the Companys Interim
Chief Executive Officer and corporate controller concluded that the Companys
disclosure controls and procedures were effective.
(b) Changes in
Internal Control Over Financial Reporting
There were no changes in the
Companys internal control over financial reporting or in other factors that
materially affected, or are reasonably likely to materially affect, those
controls subsequent to the date of the Companys most recent evaluation.
57
Table
of Contents
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is periodically subject to various pending
and threatened legal actions that arise in the normal course of business. The Companys management believes that the
impact of any such litigation will not have a material adverse impact on the
Companys financial position or results of operations.
As a result of the restatement of the Companys financial
statements and other events described elsewhere in this document and in the
Companys Annual Report on Form 10-KSB, as amended, for the fiscal year
ended December 31, 2007, the Company has triggered various events of
default under its senior debt and subordinated debt financing documents. The Company could be subject to future claims
under such financing documents.
ITEM
1A. RISK FACTORS
Not applicable.
ITEM
2. UNREGISTERED SALES OF EQUITY
SECURITIES AND USE OF PROCEEDS
Not applicable.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
As a result of the determination to restate previously
issued financial statements, the Companys registration statement on Form SB-2
was not available for use by the holders of its senior and subordinated
indebtedness between December 21, 2006 and July 6, 2007.
The financing documents
specify that an event of default of the senior and subordinated indebtedness is
triggered if a resale registration statement is unavailable for use by the
holders for a period of more than ten consecutive trading days after the
expiration of an allowable ten-day grace period. The Company invoked its
use of the ten-day allowable grace period on December 21, 2006, which
expired on December 31, 2006. The Company delivered notice to
holders of its outstanding senior and subordinated indebtedness that, as of December 20,
2006, an event of default had been triggered under their respective senior and
subordinated financing documents (see Note 4 to the Condensed Consolidated
Financial Statements and Item 2. Managements Discussion and Analysis of
Financial Condition and Results of Operations Liquidity and Capital Resources
June 30, 2008).
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY
HOLDERS
Not
applicable.
ITEM
5. OTHER INFORMATION
Not applicable.
ITEM 6. EXHIBITS
A list of exhibits required
to be filed as part of this report is set forth in the Index to Exhibits, which
immediately precedes such exhibits, and is incorporated herein by reference.
58
Table of Contents
SIGNATURES
Pursuant to the requirements
of Section 13 or 15(d) 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.
|
|
ARTISTdirect, Inc.
|
|
|
(Registrant)
|
|
|
|
|
|
|
Date: August 12, 2008
|
By:
|
/s/ DIMITRI S. VILLARD
|
|
|
Dimitri S. Villard
|
|
|
Interim Chief Executive Officer
|
|
|
(Duly Authorized Officer)
|
|
|
|
|
|
|
Date: August 12, 2008
|
By:
|
/s/ RENE L. ROUSSELET
|
|
|
Rene L. Rousselet
|
|
|
Corporate Controller
|
|
|
(Principal Accounting Officer)
|
59
Table of Contents
INDEX
TO EXHIBITS
EXHIBIT
NUMBER
|
|
DESCRIPTION
|
|
|
|
4.01
|
|
Forbearance and Consent
Agreement dated as of January 31, 2008 by and among the Registrant, U.S.
Bank National Association, as Collateral Agent, JMB Capital Partners, L.P.,
JMG Capital Partners, L.P., JMG Triton Offshore Fund, Ltd., and CCM Master
Qualified Fund, Ltd. (incorporated by reference to Exhibit 4.1 to
current report on Form 8-K filed on February 14, 2008).
|
|
|
|
4.02
|
|
Forbearance and Consent
Agreement dated as of February 20, 2008 by and among the Registrant,
U.S. Bank National Association, as Collateral Agent, JMB Capital Partners,
L.P., JMG Capital Partners, L.P., JMG Triton Offshore Fund, Ltd., and CCM
Master Qualified Fund, Ltd. (incorporated by reference to Exhibit 4.1 to
current report on Form 8-K filed on March 20, 2008).
|
|
|
|
10.01
|
|
Engagement Letter,
dated as of February 7, 2008, by and between the Registrant and Salem
Partners LLC (incorporated by reference to Exhibit 10.1 to current
report on Form 8-K filed on February 14, 2008).
|
|
|
|
10.02
|
|
Amended and Restated
Services Agreement dated as of March 6, 2008 between the Registrant and
Jon Diamond (incorporated by reference to Exhibit 10.1 to current report
on Form 8-K filed on March 12, 2008).
|
|
|
|
31.1
|
|
Certifications of the
Interim Chief Executive Officer under Section 302 of the Sarbanes-Oxley
Act. (1)
|
|
|
|
31.2
|
|
Certifications of the
Principal Accounting Officer under Section 302 of the Sarbanes-Oxley
Act. (1)
|
|
|
|
32.1
|
|
Certifications of the
Interim Chief Executive Officer under Section 906 of the Sarbanes-Oxley
Act. (1)
|
|
|
|
32.2
|
|
Certifications of the
Principal Accounting Officer under Section 906 of the Sarbanes-Oxley
Act. (1)
|
(1) Filed herewith.
60
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