IPUB IndiePub Entertainment Inc (CE)

ITEM 1. FINANCIAL STATEMENTS.

See accompanying notes to condensed consolidated financial statements.

See accompanying notes to condensed consolidated financial statements.

INDIEPUB ENTERTAINMENT, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

See accompanying notes to condensed consolidated financial statements.

See accompanying notes to condensed consolidated financial statements.

indiePub Entertainment, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

NOTE 1. DESCRIPTION OF ORGANIZATION

indiePub Entertainment, Inc., (formerly Zoo Entertainment, Inc.) (“indiePub” or the “Company”) was incorporated under the laws of the State of Nevada on February 13, 2003, under the name Driftwood Ventures, Inc. On December 3, 2008, Driftwood Ventures, Inc. changed its name to Zoo Entertainment, Inc. On May 17, 2012, Zoo Entertainment, Inc. changed its name to indiePub Entertainment, Inc.

indiePub is a developer, publisher and distributor of interactive entertainment software for digital distribution channels. indiePub’s digital business strategy centers on bringing fresh, innovative content to digital distribution channels and mobile devices. The Company utilizes its indiePub website ( www.indiePub.com ) as an innovative content creation site that is designed to unearth content for future development and eventual publication. The Company intends to release a unique distribution platform that will allow anyone to sell and monetize apps.

The Company is currently developing and/or publishing downloadable games for “connected services,” including Microsoft’s Xbox Live Arcade (XBLA), Sony’s PlayStation Network (PSN), Facebook, PC/Mac, iOS and Android devices.

As of September 30, 2012, the Company operated in one segment in the United States with a focus on developing, publishing and distributing interactive entertainment software in North American and international markets. The Company began phasing out its retail business during 2011 .

Unless the context otherwise indicates, the use of the terms “we,” “our” or “us” refer to the Company and its operating subsidiaries, Zoo Games, Inc., Zoo Publishing, Inc., and indiePub, Inc.

NOTE 2. GOING CONCERN

These condensed consolidated financial statements have been prepared assuming the Company will continue as a going concern. The Company has incurred operating losses since inception, resulting in an accumulated deficit of approximately $82.2 million as of September 30, 2012. In addition, the Company has a history of negative cash flows from operating activities. As of September 30, 2012, the Company’s working capital deficit was approximately $1.6 million. Given the Company’s history of net losses and generating negative cash flows from operating activities, combined with its shift to a new digital sales strategy, there can be no assurance that it will be able to generate positive cash flows from operations, nor can the Company predict whether it will have sufficient cash from operations to meet its financial obligations for the 12-month period beginning October 1, 2012, which raises substantial doubt about the Company’s ability to continue as a going concern.

The Company’s ability to continue as a going concern is dependent on, among other factors, the following significant short-term actions: (i) its ability to generate cash flow from operations sufficient to maintain its daily business activities; (ii) its ability to reduce expenses and overhead; (iii) its ongoing ability to renegotiate certain obligations; and (iv) its ability to raise additional capital or financing. Management’s active efforts in this regard include negotiations with certain vendors to satisfy cash obligations with non-cash assets or equity, reductions of headcount and overhead obligations, and the development of strategies to convert other non-cash assets into cash. There can be no assurance that all or any of these actions will meet with success.

On March 9, 2012, the Company and MMB Holdings LLC (“MMB”) entered into a Loan and Security Agreement (the “Loan Agreement”) pursuant to which MMB agreed to provide the Company with loans totaling $4,381,110. These loans were granted: (i) to repay and satisfy all of indiePub’s obligations to MMB under the Second Amended and Restated Factoring and Security Agreement, dated as of October 28, 2011, as amended through February 29, 2012, and totaling $1,831,110; (ii) for purposes of settling, at a discount, certain obligations to unsecured creditors of the Company (the “Existing Unsecured Claims”); and (iii) for working capital and other purposes permitted under the Loan Agreement. Through June 30, 2012, the Company had borrowed the entire loan facility of $4,381,110. On July 30, 2012, the Company entered into the First Amendment to Loan and Security Agreement (the “First Amendment”) with MMB, pursuant to which the parties agreed to amend that certain Loan and Security Agreement dated as of March 9, 2012, by and between the Company and MMB. Pursuant to the First Amendment, MMB agreed to provide up to $1,600,000 in additional funding to the Company under the Loan and Security Agreement utilizing the same terms and conditions. In addition, MMB notified the Company that it was exercising its right to convert all accrued and unpaid interest outstanding under the Loan and Security Agreement through June 30, 2012, which amount was approximately $114,480, into the outstanding loan balance. As of September 30, 2012, there was approximately $123,000 of available borrowings remaining under the First Amendment. The interest rate under the Loan Agreement is ten percent (10%) per annum, or eighteen percent (18%) per annum upon the occurrence of an event of default. The maturity date of the loans is March 31, 2014. The amounts under the Loan Agreement are secured by a first priority security interest (except to the extent subordinated by the Factoring Agreement) on all of the assets of the Company. Refer to Note 16 – Subsequent Event, for further information.

Utilizing proceeds from the Loan Agreement, the Company entered into agreements providing for the settlement of approximately $10.8 million of liabilities owed to certain of its unsecured creditors for approximately $990,000 in cash, approximately 2.6 million shares of the Company’s common stock, approximately $131,000 of inventory, and warrants to purchase 365,000 shares of the Company’s common stock at an exercise price of $0.50 per share. As of September 30, 2012, approximately $10.4 million of the settlements were finalized for approximately $964,000 cash, the issuance of approximately 2.4 million shares of the Company’s common stock, the reliquinshment of approximately $131,000 in inventory, and the issuance of a warrant to purchase 365,000 shares of the Company’s common stock at an exercise price of $0.50 per share, resulting in a gain of approximately $7.1 million, which amount is included in the category gain on extinguishment of liabilities in the Company’s condensed consolidated statements of operations and comprehensive (loss) income. The Company anticipates it will finalize the remaining agreements during the fourth quarter of 2012, although no assurances can be given in this regard. In addition, the Company utilized proceeds from the Loan Agreement to settle amounts owed under sales and distribution agreements with former master distributors of the Company’s products.

The condensed consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded assets, or the amounts of and classification of liabilities that might be necessary as a result of this uncertainty.

NOTE 3. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation and Interim Financial Information

The accompanying unaudited interim condensed consolidated financial statements were prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and the interim financial statement rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, these statements include all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the condensed consolidated financial statements. The condensed consolidated financial statements should be read in conjunction with the Company’s management discussion and analysis contained elsewhere herein and the consolidated financial statements for the year ended December 31, 2011 filed with the SEC on April 16, 2012. The Company’s results for the three and nine months ended September 30, 2012 might not be indicative of the results for the full year or any future period.

The condensed consolidated financial statements of the Company include the accounts of Zoo Games, Inc. and its wholly-owned subsidiaries, Zoo Publishing, Inc. (and its wholly-owned subsidiary, indiePub, Inc.) and Zoo Entertainment Europe Ltd. All intercompany accounts and transactions are eliminated in consolidation.

Use of Estimates

The preparation of financial statements in conformity with principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the reporting periods. The estimates affecting the condensed consolidated financial statements that are particularly significant include: the recoverability of product development costs; the adequacy of allowances for doubtful accounts, and; the valuation of equity instruments. Estimates are based on historical experience, where applicable, or other assumptions that management believes are reasonable under the circumstances. Due to the inherent uncertainty involved in making estimates, actual results may differ from those estimates under different assumptions or conditions.

Concentration of Credit Risk

The Company maintains cash balances at what it believes are several high-quality financial institutions. While the Company attempts to limit credit exposure with any single institution, balances at times exceed Federal Deposit Insurance Corporation insurable amounts.

If the financial condition and operations of the Company’s customers deteriorate, its risk of collection could increase substantially. On July 12, 2011, the Company entered into a sales and distribution agreement with Alter Ego Games, LLC (“AEG”), which allowed AEG to be an exclusive master distributor of the Company’s catalogue product in the United States, South America and Europe. Also on July 12, 2011, the Company entered into a sub-publishing and distribution agreement with Southpeak Interactive, LLC (“Southpeak”), an affiliate of AEG, which allowed Southpeak to sub-publish, manufacture and distribute the Company’s “ Minute to Win It ” game on the Microsoft platform in the United States and Latin America. Consequently, a significant portion of the Company’s revenues and accounts receivable after July 12, 2011 and through August 17, 2012, the date on which these agreements were terminated, were concentrated in two entities related to each other. Prior to July 12, 2011, a majority of the Company’s trade receivables were derived from sales to major retailers and distributors. As the Company continues to migrate to digital sales, credit risk for collection of accounts receivable will be concentrated amongst a few digital platform operators.

During the three months ended September 30, 2012, the Company derived the majority of its revenue through the recognition of royalties under its sub-publishing and distribution agreement with Southpeak, which agreement was terminated on August 17, 2012. For the three months ended September 30, 2011, the Company derived the majority of its revenue through the recognition of royalties under its sales and distribution agreement with AEG. For the nine months ended September 30, 2012, the Company derived the majority of its revenue through the recognition of royalties under its sales and distribution agreement with AEG and sub-publishing and distribution agreement with Southpeak, which agreements were terminated on August 17, 2012. During the third quarter of 2012, the Company recorded a gain of approximately $528,000 in connection with the termination of these agreements. For the nine months ended September 30, 2011, the Company derived the majority of its revenue from the sale of its catalogue products. During that period the Company’s five largest ultimate customers accounted for approximately 57% (of which the following customers constituted balances greater than 10%: customer A – 13%; customer B – 12%; customer C – 12%; and customer D – 11%) of net revenue. During the nine months ended September 30, 2012 and 2011, the Company sold $0 and approximately $11.9 million, respectively, of receivables to its factors with recourse. The factored receivables were $0 of the Company’s accounts receivable and due from factor, net, as of September 30, 2012 and December 31, 2011, respectively. The Company regularly reviews its outstanding receivables for potential bad debts and has had no history of significant write-offs due to bad debts.

Reclassifications

The accompanying condensed consolidated financial statements for the three and nine months ended September 30, 2011 contain certain reclassifications to conform to the current year presentation.

Inventory

Inventory is stated at the lower of cost or market. Estimated product returns are included in the inventory balances and also recorded at the lower of actual cost or market.

Product Development Costs

The Company utilizes third-party product developers and frequently enters into agreements with these developers that require it to make payments based on agreed-upon milestone deliverable schedules for game design and enhancements. The Company receives the exclusive publishing and distribution rights to the finished game title as well as, in some cases, the underlying intellectual property rights for that game. The Company typically enters into these development agreements after it has completed the design concept for its products. The Company contracts with third-party developers that have proven technology and the experience and ability to build the designed video game as conceived by the Company. As a result, technological feasibility is determined to have been achieved at the time when the Company enters the agreement and it therefore capitalizes such payments as prepaid product development costs. On a product-by-product basis, the Company reduces prepaid product development costs and records amortization using the proportion of current year unit sales and revenues to the total unit sales and revenues expected to be recorded over the life of the title. For its digital products, the Company amortizes prepaid product development costs into expense based upon the estimated downloads over the expected life of the product.

At each balance sheet date, or earlier if an indicator of impairment exists, the Company evaluates the recoverability of capitalized prepaid product development costs, development payments and any other unrecognized minimum commitments that have not been paid, using an undiscounted future cash flow analysis, and charges any amounts that are deemed unrecoverable to cost of goods sold if the product has already been released. If the product development process is discontinued prior to completion, any prepaid unrecoverable amounts are charged to research and development expense.

During the three and nine months ended September 30, 2011, the Company wrote off approximately $0 and $2.3 million, respectively, of expense relating to costs incurred for the development of games that were abandoned during those periods, which amounts were recorded in research and development expense in the condensed consolidated statements of operations and comprehensive (loss) income. There were no write-offs to research and development in the comparable 2012 periods. During the three and nine months ended September 30, 2012, the Company wrote off approximately $16,000 and $419,000, respectively, of product development costs relating to games that were still in development but not yet released, or games that were released but whose development costs were not expected to be recoverable. During the three and nine months ended September 30, 2011, the Company wrote off approximately $0 and $272,000, respectively, of product development costs. The Company determined that amounts incurred to develop the games were not recoverable from future sales of those games and included these amounts in cost of goods sold in the Company’s condensed consolidated statements of operations and comprehensive (loss) income. The Company uses various measures to estimate future revenues for its product titles, including past performance of similar titles and orders for titles prior to their release. For sequels, the performance of predecessor titles is also taken into consideration.

Prior to establishing technological feasibility, the Company expenses research and development costs as incurred.

The Financial Accounting Standards Board (“FASB”) Accounting Standards Update (“ASU”) Topic 808-10-15, “ Accounting for Collaborative Arrangements ” (“ASC 808-10-15”), defines collaborative arrangements and requires collaborators to present the result of activities for which they act as the principal on a gross basis and report any payments received from (made to) the other collaborators based on other applicable authoritative accounting literature, and in the absence of other applicable authoritative literature, a reasonable, rational and consistent accounting policy is to be elected. The Company’s arrangements with third-party developers are not considered collaborative arrangements because the third-party developers do not have significant active participation in the design and development of the video games, nor are they exposed to significant risks and rewards as their compensation is fixed and not contingent upon the revenue that the Company will generate from sales of its product. If the Company enters into any future arrangements with product developers that are considered collaborative arrangements, it will account for them accordingly.

Licenses and Royalties

Licenses consist of payments and guarantees made to holders of intellectual property rights for use of their trademarks, copyrights, technology or other intellectual property rights in the development of the Company’s products. Agreements with holders of intellectual property rights generally provide for guaranteed minimum royalty payments for use of their intellectual property.

Certain licenses extend over multi-year periods and encompass multiple game titles. In addition, certain licenses guarantee minimum license payments to licensors over the term of the license. In addition to guaranteed minimum payments, these licenses frequently contain provisions that could require the Company to pay royalties to the license holder, based on pre-agreed unit sales thresholds.

Certain licensing fees are capitalized on the condensed consolidated balance sheets in prepaid expenses and are amortized as royalties into cost of goods sold, on a title-by-title basis, at a ratio of current period revenues to the total revenues expected to be recorded over the remaining life of the title. Similar to product development costs, the Company reviews its sales projections quarterly to determine the likely recoverability of its capitalized licenses as well as any unpaid minimum obligations. When management determines that the value of a license is unlikely to be recovered by product sales, capitalized licenses are charged to cost of goods sold, based on current and expected revenues, in the period in which such determination is made. Criteria used to evaluate expected product performance and to estimate future sales for a title include: historical performance of comparable titles; orders for titles prior to release; and the estimated performance of a sequel title based on the performance of the title on which the sequel is based. In addition, the Company reviews licenses that contain guaranteed minimum payments and records expense to cost of goods sold for any unearned guaranteed minimum amounts that become payable to licensors.

Fixed Assets

Fixed assets, consisting primarily of office equipment and furniture and fixtures, are stated at cost. Major additions or improvements are capitalized, while repairs and maintenance are charged to expense. Property and equipment are depreciated on a straight-line basis over the estimated useful life of the assets. Office equipment and furniture and fixtures are depreciated over five years, computer equipment and software are generally depreciated over three years, and leasehold improvements are depreciated over the shorter of the related lease term or seven years. When depreciable assets are retired or sold, the cost and related allowances for depreciation are removed from the accounts and any gain or loss is recognized as a component of operating income or loss in the condensed consolidated statements of operations and comprehensive (loss) income.

Revenue Recognition

The Company earns its revenue from the sale of interactive software titles developed by and/or licensed from third party developers or created internally. The Company recognizes such revenue upon the transfer of title and risk of loss to its customers. Accordingly, the Company recognizes revenue for software titles when there is: (i) persuasive evidence that an arrangement with the customer exists, which is generally a customer purchase order or an online order; (ii) the product is delivered; (iii) the selling price is fixed or determinable; (iv) collection of the customer receivable is deemed probable; and (v) the Company does not have any continuing obligations. Historically, the Company’s payment arrangements with customers typically provided net 30- and 60-day terms. Advances received from customers were deferred and reported on the Company’s condensed consolidated balance sheets under the caption accrued expenses and other current liabilities. Under the Company’s previous distribution agreement, payments for cost of goods sold, plus a per-unit tech fee which represented an unearned advance against future royalties, were due to the Company within three to five business days of shipment of the goods. The cost of goods sold portion was recognized as revenue at the time of sale, while the per-unit unearned advance on royalties was deferred until such time that the Company received information from its distributor that allowed it to conclude that all components of the earnings process had been completed . Under the Company’s former sub-publishing and distribution agreement, the Company received payments for per-unit advances based upon the manufacture, sale and sell-through of the Company’s product. These per-unit advances were deferred until such time that the Company received information from its distributor that allowed it to conclude that all components of the earnings process had been completed. Unearned advances were included in the caption accrued expenses and other current liabilities in the Company’s condensed consolidated balance sheets. The Company utilizes digital platform operators, such as Apple and Microsoft, for the sale of certain of its digital games. The Company records revenue as downloads of the Company’s games are reported.

Revenue is presented net of estimated reserves for returns, price concessions and other items. In circumstances when the Company does not have a reliable basis to estimate returns and price concessions or is unable to determine that collection of a receivable is deemed probable, the Company defers the revenue until such time as it can reliably estimate any related returns and allowances and determine that collection of the receivable is deemed probable.

Equity-Based Compensation

The Company issued options to purchase shares of the Company’s common stock to certain members of management, employees and directors during the nine months ended September 30, 2011. Stock option grants vest over periods ranging from immediately to four years and expire within ten years of issuance. Stock options that vest in accordance with service conditions amortize over the applicable vesting period using the straight-line method.

The fair value of the options granted is estimated using the Black-Scholes option-pricing model. This model requires the input of assumptions regarding a number of complex and subjective variables that will usually have a significant impact on the fair value estimate. These variables include, but are not limited to, the volatility of the Company’s stock price and estimated exercise behavior. The Company used the current market price to determine the fair value of the stock price for the March 8, 2011 and August 23, 2011 grants. For the stock option modifications that occurred during the first quarter of 2012 and the second and third quarters of 2011, the Company used the current market price to determine the fair value of the stock price as of the modification date. The following table summarizes the assumptions and variables used by the Company to compute the weighted average fair value of stock option grants and modifications:

For the three months ended March 31, 2011, the Company estimated the implied volatility for publicly traded options on its common shares as the expected volatility assumption required in the Black-Scholes option-pricing model. The selection of the implied volatility approach was based upon the historical volatility of companies with similar businesses and capitalization and the Company’s assessment that implied volatility was more representative of future stock price trends than historical volatility. Commencing with the second quarter of 2011, the Company began using a volatility calculation based upon its own daily stock price, as a more representative sample was available after its July 2010 stock offering and transfer to the NASDAQ stock market, and subsequently to the OTC market.

(Loss) Income Per Share

Basic (loss) income per share (“EPS”) is computed by dividing the net (loss) income applicable to common stockholders for the period by the weighted average number of shares of common stock outstanding during the same period. A 2010 restricted stock grant, of which 27,694 and 94,159 shares were unvested as of September 30, 2012 and 2011, respectively, was excluded from the basic EPS calculation. Diluted EPS is computed by dividing the net income (loss) applicable to common stockholders for the period by the weighted average number of shares of common stock outstanding and common stock equivalents, which includes warrants, options and convertible securities outstanding during the same period, except when the effect would be antidilutive. The number of additional shares is calculated by assuming that outstanding stock options and warrants with an exercise price less than the Company’s average stock price for the period were exercised, and that the proceeds from such exercises were used to acquire shares of common stock at the average market price during the reporting period. For the three months ended September 30, 2012, no stock options and 15,761,979 warrants would have been included in the weighted average shares outstanding calculation for the period if the effect had not been antidilutive. For the nine months ended September 30, 2012, no stock options and 15,761,979 warrants were included in the weighted average shares outstanding calculation for the period. The Company accounts for convertible loans using the “if converted” method. Under this method, the convertible loans are assumed to be converted to shares (weighted for the number of days outstanding in the period) at a conversion price of $0.40 per share, and interest expense, net of taxes, related to the convertible loans is added back to net income. For the three months ended September 30, 2012, an additional 12,470,881 shares would have been included in the weighted average shares outstanding calculation for the period and approximately $383,000 of interest expense would have been added back to net income if the effect had not been antidilutive. For the nine months ended September 30, 2012, this resulted in the inclusion of an additional 7,938,420 shares outstanding for the period and the add back of approximately $652,000 of interest expense to net income. The Company incurred a net loss for the three and nine-month periods ended September 30, 2011, therefore the diluted loss per share is the same as basic loss per share.

Income Taxes

The Company recognizes deferred taxes under the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred income taxes are recognized for differences between the financial statement and tax basis of assets and liabilities at currently enacted statutory tax rates for the years in which the differences are expected to reverse. The effect on deferred taxes of a change in tax rates is recognized as income in the period that includes the enactment date. Valuation allowances are established when the Company determines that it is more likely than not that such deferred tax assets will not be realized.

The Company follows the provisions of FASB Accounting Standards Codification Topic 740 regarding the accounting and recognition for income tax positions taken or expected to be taken in the Company’s income tax returns. As of September 30, 2012, the Company believes it does not have any material unrecognized tax liability from tax positions taken during the current or any prior period. In addition, as of September 30, 2012, tax years 2009 through 2011 remain within the statute of limitations and are subject to examination by tax jurisdictions. The Company’s policy is to recognize any interest and penalties accrued on unrecognized tax benefits as part of income tax expense.

Fair Value Measurement

In accordance with FASB Topic 820 (“Topic 820”), “Fair Value Measurements and Disclosures,” fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). Topic 820 establishes a fair value hierarchy, which prioritizes the inputs used in measuring fair value into three broad levels as follows:

As of September 30, 2012 and December 31, 2011, the carrying value of cash, accounts receivable and due from factor, inventory, prepaid expenses, accounts payable, and accrued expenses were reasonable estimates of the fair values because of their short-term maturity. The carrying value of financing arrangements, loan agreements and notes payable are reasonable estimates of fair value because interest rates closely approximate market rates.

Recently Issued Accounting Pronouncements

In December 2011, the FASB issued ASU No. 2011-11, “ Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities ” (“ASU No. 2011-11”). This ASU requires companies to disclose both net and gross information about assets and liabilities that have been offset, if any, and the related arrangements. The disclosures under this new guidance are required to be provided retrospectively for all comparative periods presented. The Company is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. The Company does not anticipate that adoption of this ASU will have a material impact on its financial condition, results of operations or cash flows.

The Company utilized its remaining catalogue inventory of approximately $131,000 as partial settlement of a vendor obligation in March 2012.

NOTE 5. PREPAID EXPENSES AND OTHER CURRENT ASSETS

Prepaid expenses and other current assets consisted of:

Amortization of product development costs for the three months ended September 30, 2012 and 2011 was approximately $46,000 and $473,000, respectively. Amortization of product development costs for the nine months ended September 30, 2012 and 2011 was approximately $235,000 and $3,000,000, respectively. For the nine months ended September 30, 2012, write-off of product development costs consisted of approximately $419,000 written off to cost of goods sold. For the nine months ended September 30, 2011, write-off of product development costs consisted of approximately $2,300,000 written off to research and development expense, approximately $272,000 written off to cost of goods sold, and approximately $100,000 written off to selling and marketing expense. The Company has classified approximately $1,452,000 of product development costs as current assets and approximately $127,000 as long-term assets as of September 30, 2012.

NOTE 7. CREDIT AND FINANCING ARRANGEMENTS AND LONG-TERM DEBT

The Company used Purchase Order Financing and Receivable Financing through June 2011. In June 2011, the Company terminated those financing arrangements and entered into a Limited Recourse Agreement which remained in effect through the balance of 2011 and into 2012. In March 2012, the Company and MMB entered into a Loan Agreement which replaced a portion of the Limited Recourse Agreement. The Company’s various credit and financing arrangements are described below.

Purchase Order Financing

Zoo Publishing previously utilized purchase order financing with Wells Fargo Bank, National Association (“Wells Fargo”) to fund the manufacture of video game products. Under the terms of the agreement (the “Assignment Agreement”), Zoo Publishing assigned purchase orders received from customers to Wells Fargo, and requested that Wells Fargo purchase the required materials to fulfill such purchase orders. Wells Fargo, which could accept or decline the assignment of specific purchase orders, retained Zoo Publishing to manufacture, process and ship ordered goods, and paid Zoo Publishing for its services upon Wells Fargo’s receipt of payment from the customers for such ordered goods. Upon payment in full of the purchase order invoice by the applicable customer to Wells Fargo, Wells Fargo re-assigned the applicable purchase order to the Company. On June 24, 2011, Zoo Publishing, the Company and Wells Fargo entered into a Termination Agreement.  Pursuant to the Termination Agreement, the Company paid off the balance due of approximately $148,000 and paid $50,000 in full satisfaction of the commitment fee required under the agreement. The commitment fee was included in general and administrative expenses at that date in the consolidated statements of operations and comprehensive (loss) income. Wells Fargo released all security interests that they and their predecessors held in the Company’s assets.

There were no amounts outstanding as of September 30, 2012 and December 31, 2011. The effective interest rate on advances was 5.25% as of the termination date. The charges and interest expense on the advances are included in interest expense in the accompanying condensed consolidated statements of operations and comprehensive (loss) income and were $0 for the three months ended September 30, 2012 and 2011, respectively, and approximately $0 and $65,000 for the nine months ended September 30, 2012 and 2011, respectively.

Receivable Financing

Zoo Publishing previously utilized a factoring agreement, as amended (the “Original Factoring Agreement”) with Working Capital Solutions, Inc. (“WCS”) for the approval of credit and the collection of proceeds from a portion of its sales. Under the terms of the Original Factoring Agreement, Zoo Publishing sold its receivables to WCS, with recourse.  WCS, in its sole discretion, determined whether or not it would accept each receivable based upon the credit risk factor of each individual receivable or account.  Once a receivable was accepted by WCS, WCS provided funding subject to the terms and conditions of the Original Factoring Agreement.  The amount remitted to Zoo Publishing by WCS equaled the invoice amount of the receivable adjusted for any discounts or allowances provided to the account, less a reserve percentage (which amount was 30% at the termination of the agreement) which was deposited into a reserve account established pursuant to the Original Factoring Agreement, less allowances and fees.  The amounts to be paid by Zoo Publishing to WCS for any accepted receivable included a factoring fee for each ten (10) day period the account was open (which fee was 0.56% at the termination of the agreement).  Since WCS acquired the receivables with recourse, the Company recorded the gross receivables including amounts due from its customers to WCS and it recorded a liability to WCS for funds advanced to the Company from WCS. On June 24, 2011, the Company terminated its agreement with WCS (the “WCS Termination Agreement”).

During the nine months ended September 30, 2012 and 2011, the Company sold $0 and approximately $11,600,000, respectively, of receivables to WCS with recourse.  At September 30, 2012 and December 31, 2011, accounts receivable and due from factor were $0 and there were no advances outstanding to the Company as of September 30, 2012 or December 31, 2011.  The interest expense on the advances are included in interest expense in the accompanying condensed consolidated statements of operations and comprehensive (loss) income and were $0 and approximately $1,000 for three months ended September 30, 2012 and 2011, respectively, and were $0 and approximately $575,000 for the nine-month periods ended September 30, 2012 and 2011, respectively.

Limited Recourse Agreement

On June 24, 2011, in connection with the WCS Termination Agreement, WCS agreed to assign all of its rights, title and interest in and to the Original Factoring Agreement and all Collateral to Panta Distribution, LLC (“Panta”) pursuant to a Limited Recourse Agreement, dated as of June 24, 2011 (the “Limited Recourse Agreement”). On June 24, 2011, the Company and Panta also entered into an Amended and Restated Factoring and Security Agreement (the “New Factoring Agreement”), pursuant to which the Company agreed to pay Panta all outstanding indebtedness under the Limited Recourse Agreement and to sell to Panta its accounts receivable with recourse. Under the terms of the agreement and subsequent amendment, total actual borrowings of approximately $2,600,000 and accrued interest due of approximately $1,200,000 were required to be repaid by December 4, 2011. On October 7, 2011, the Company was notified by Panta that it was in default under the terms of the agreements; accordingly, the Company accelerated all amounts owed to Panta at that date to currently due and payable and began accruing interest at the default rate of fifteen percent (15%) per annum.

On October 28, 2011, Zoo Publishing entered into the Second Amended and Restated Factoring and Security Agreement (the “Second New Factoring Agreement”) with Panta and MMB, pursuant to which the parties agreed to amend the New Factoring Agreement, to reflect the assignment by Panta to MMB of documents and accounts, including related collateral security, under the New Factoring Agreement, and to amend certain other terms and conditions of the New Factoring Agreement. In connection with the Second New Factoring Agreement, Panta agreed to assign all of its rights, title and interest in and to the New Factoring Agreement to MMB, as agent for itself and Panta, pursuant to a Limited Recourse Assignment, dated as of October 28, 2011 (the “Limited Recourse Assignment”), for a purchase price of $850,000. Panta retained an interest in the principal amount of approximately $186,000 (together with interest and fees accruing thereon), owed by Zoo Publishing under the New Factoring Agreement.  Under the Second New Factoring Agreement, MMB, as agent for itself and Panta, agreed to temporarily forbear from exercising certain of its rights under default provisions therein until the earlier of November 11, 2011, or the occurrence of an additional default or breach by the Company, unless otherwise waived by MMB. All default interest accrued at the default interest rate of 15% per annum on amounts outstanding to MMB and Panta. Pursuant to the Second New Factoring Agreement, the Company agreed to make scheduled repayments to MMB, as agent for itself and Panta, with respect to obligations owed by it beginning November 4, 2011 and through December 4, 2011 in the cumulative principal amount owed of approximately $1,036,000.  The Second New Factoring Agreement terminates upon the later of: (i) the collection by MMB of all of the Purchased Accounts (as defined in the Second New Factoring Agreement); and (ii) the collection by Panta of approximately $1,036,000 net of all Incurred Expenses (as defined in the Second New Factoring Agreement). Zoo Publishing granted MMB a first priority security interest in certain of its assets as set forth in the Second New Factoring Agreement. MMB is controlled by David E. Smith, a former director of the Company, Jay A. Wolf, Executive Chairman of the Board of Directors of the Company and certain other parties. 

On January 5, 2012, January 30, 2012, February 14, 2012, and February 29, 2012, the Company entered into the First, Second, Third and Fourth, respectively, Amendments to the Second Amended and Restated Factoring and Security Agreement with Panta and MMB, pursuant to which the parties agreed to amend that certain Second Amended and Restated Factoring and Security Agreement dated as of October 28, 2011, by and between Zoo Publishing, Panta and MMB. Pursuant to the amendments, MMB agreed to provide $250,000 (less legal fees of $75,000), $175,000, $232,000, and $200,000, respectively, in additional funding to Zoo Publishing under the Factoring Agreement.  The additional funding bore interest at the lesser of fifteen percent (15%) per annum, or the maximum rate permitted by law.

On March 9, 2012, the amounts due to MMB were repaid utilizing borrowings under the Loan Agreement. Borrowings and accrued interest owed to Panta in the amount of approximately $219,000 remained outstanding as of September 30, 2012.

Loan Agreement

On March 9, 2012, the Company and MMB entered into the Loan Agreement, pursuant to which MMB agreed to provide the Company with loans totaling approximately $4,381,110. These loans were granted: (i) to repay and satisfy all of Zoo’s obligations to MMB under the Second Amended and Restated Factoring and Security Agreement, dated as of October 28, 2011, as amended through February 29, 2012, and totaling approximately $1,831,000; (ii) for purposes of settling, at a discount, certain obligations to unsecured creditors of the Company (the “Existing Unsecured Claims”); and (iii) for working capital and other purposes permitted under the Loan Agreement. Under the Loan Agreement, the Company borrowed the entire $4,381,110 as of June 30, 2012. The interest rate under the Loan Agreement is ten percent (10%) per annum, or eighteen percent (18%) per annum upon the occurrence of an event of default. The maturity date of the loans is March 31, 2014. The amounts under the Loan Agreement are secured by a first priority security interest (except to the extent subordinated by the Factoring Agreement) on all of the assets of the Company. At any time during the term of the Loan Agreement, MMB may convert all of the loan balance into the Company’s common stock at a conversion price of $0.40 per share. In connection with the Loan Agreement, the Company issued MMB immediately exercisable warrants to purchase up to 10,952,775 shares of the Company’s common stock at $0.40 per share, which warrants are exercisable through March 31, 2017. The Company has agreed to provide MMB with certain registration rights with respect to its common stock issued in connection with the Loan Agreement and the warrants. The Loan Agreement contains representations and warranties and affirmative and negative covenants, as negotiated by the parties to the agreement. The fair value of the warrants issued in connection with the Loan Agreement resulted in the Company recording a deferred debt discount, which reduced the face amount of the indebtedness to approximately $1,400,000 at the date of issuance. The deferred debt discount is amortized into interest expense over the term that the borrowings are outstanding utilizing the effective interest method. On July 30, 2012, the Company entered into the First Amendment to Loan and Security Agreement (the “First Amendment”) with MMB, pursuant to which the parties agreed to amend that certain Loan and Security Agreement dated as of March 9, 2012, by and between the Company and MMB. Pursuant to the First Amendment, MMB agreed to provide up to $1,600,000 in additional funding to the Company under the Loan and Security Agreement under the same terms and conditions. In connection with the First Amendment, the Company issued MMB an immediately exercisable warrant to purchase up to 4,000,000 shares of its common stock at $0.40 per share, which warrant is exercisable through July 30, 2017. The fair value of the warrants and the beneficial conversion feature of the convertible loan balance resulted in the Company reducing the face amount of the indebtedness by approximately $757,000, which amount will be amortized into interest expense over the term that the borrowings are outstanding utilizing the effective interest method. In addition, MMB notified the Company that it was exercising its right to convert all accrued and unpaid interest outstanding under the Loan and Security Agreement through June 30, 2012, which amount was approximately $114,000, into the outstanding loan balance. As of September 30, 2012, there were borrowings of approximately $5,859,000 and available borrowings remaining of approximately $123,000 under the Loan Agreement and First Amendment. As of November 9, 2012, all available borrowings had been fully utilized. Refer to Note 16 – Subsequent Event, for further information.

In conjunction with its March 2012 settlements of obligations, the Company entered into agreements to settle approximately $2,677,000 of notes payable that were recorded on the Company’s consolidated balance sheets at December 31, 2011, as well as all accrued interest due as of the date of the settlements, for approximately $300,000 cash and 989,296 shares of the Company’s common stock valued at approximately $917,000, based on the closing price of the Company’s common stock on the date the shares were issued to each creditor.

NOTE 10. INCOME TAXES

The provision for income taxes is based on income recognized for financial statement purposes and includes the effects of temporary differences between such income and that recognized for tax return purposes. For the three months ended September 30, 2012, a federal tax benefit recorded at a 34% rate against the Company’s loss for the period was offset fully by an increase in the valuation allowance against the Company’s deferred tax assets. For the nine months ended September 30, 2012, federal income tax expense recorded at a 34% rate against the Company’s income for the period was offset fully by a decrease in the Company’s valuation allowance against its deferred tax assets. Realization of the Company’s deferred tax assets is dependent upon the generation of future taxable income, the timing and amounts of which, if any, are uncertain. Based on the Company’s history of operating losses and the uncertainty surrounding the Company’s ability to generate future income, the Company was unable to conclude that it is more likely than not that the deferred tax assets will be realized. Accordingly, the Company has recorded a valuation allowance against substantially all of its deferred tax assets at September 30, 2012 and December 31, 2011.

The Company paid approximately $3,000 and $10,000 to various state jurisdictions for income taxes during the nine months ended September 30, 2012 and 2011, respectively.

As of September 30, 2012, the Company had approximately $1,200,000 of available capital loss carryforwards which expire in 2013. A valuation allowance of approximately $416,000 has been recognized to offset the deferred tax assets related to these carryforwards. If the Company is able to utilize the carryforwards in the future, the tax benefit of the carryforwards will be applied to reduce future capital gains of the Company.

As of September 30, 2012, the Company had U.S. federal net operating loss (“NOL”) carryforwards of approximately $25,500,000. This amount included approximately $1,600,000 of acquired NOLs which cannot be immediately utilized as a result of statutory limitations. As a result of such statutory limitations, the Company will only be able to utilize approximately $160,000 of NOL and capital loss carryforwards per year. The federal NOL carryforwards will begin to expire in 2028. The Company has state NOL carryforwards of approximately $24,000,000 which will be available to offset taxable state income during the carryforward period. The state NOL carryforwards will begin to expire in 2031.

NOTE 11. STOCKHOLDERS’ DEFICIT AND STOCK-BASED COMPENSATION ARRANGEMENTS

On May 17, 2012, the Company’s stockholders voted to decrease the number of authorized shares of common stock of the Company from 3,500,000,000 shares of common stock, par value $0.001 per share, to 295,000,000 shares of common stock, par value $0.001 per share. As of September 30, 2012, there were authorized 5,000,000 shares of preferred stock, par value $0.001.

Common Stock

As of September 30, 2012, there were 10,412,528 shares of common stock issued and 10,399,525 shares of common stock outstanding.

In conjunction with the settlement of certain obligations, during the first nine months of 2012, the Company issued 2,388,089 shares of common stock valued at approximately $2.0 million.

On February 11, 2010, the Board of Directors approved the issuance of 281,104 shares of restricted common stock to various members of the Board of Directors. The fair value of the restricted common stock grants was determined to be $397,000, based on the price of the Company’s equity raise in the fourth quarter of 2009 and a marketability discount. The Company expensed approximately $75,000 during each of the nine-month periods ending September 30, 2012 and 2011. The remaining balance as of September 30, 2012 of approximately $37,000 will be expensed throughout the remaining vesting period of the restricted common stock grants until February 2013.

The following table summarizes the activity of non-vested restricted stock:

Preferred Stock

As of September 30, 2012 and December 31, 2011, there were no shares of preferred stock issued or outstanding.

Stock-based Compensation Arrangements

The Zoo Entertainment, Inc. 2007 Employee, Director and Consultant Stock Plan, as amended, (the “2007 Plan”) provides for the issuance of shares of common stock in connection with the issuance of incentive stock options (“ISOs”), non-qualified stock options (“NQSOs”), grants of common stock, or stock-based awards. Under the terms of the 2007 Plan, the options expire no later than ten years from the date of grant in the case of ISOs (five years in the case of ISOs granted to a 10% owner), as set forth in each option agreement in the case of NQSOs, or earlier in either case in the event a participant ceases to be an employee, director or consultant of the Company. The grants vest over periods ranging from immediately to four years. A total of 1,208,409 shares of common stock may be issued under the 2007 Plan.

In March 2012, in conjunction with a separation agreement with the Company’s former Chief Financial Officer, the Company’s Board of Directors agreed to extend the term of all vested stock options of the former Chief Financial Officer until April 15, 2013. Without such modification, the options would have expired 90 days after the date of separation from the Company. The modification to the stock option awards resulted in incremental expense of approximately $13,000, all of which was immediately recognized as a component of general and administrative expense in the Company’s condensed consolidated statements of operations and comprehensive (loss) income at that date, as the options were fully vested and no further service was required from the former employee.

On August 23, 2011, the Company granted options to purchase 113,000 shares of common stock to various employees under the 2007 Plan at an exercise price of $1.56 per share.

In July 2011, the Company’s Chief Operating Officer separated service from the Company. In conjunction with the separation, on August 16, 2011, the Company’s Board of Directors agreed to immediately vest 25% of the original grant shares and extend the term of all vested options through August 16, 2013. Without such modification, the options would have expired 90 days after such separation of service. The modification to the stock option award resulted in incremental expense of approximately $45,000, all of which was immediately recognized as a component of general and administrative expense in the Company’s condensed consolidated statements of operations and comprehensive (loss) income at that date, as the options were fully vested and no further service was required from the former employee.

On March 8, 2011, the Company granted options to purchase 42,138 shares of common stock to a newly-appointed director at an exercise price of $3.86 per share, pursuant to the 2007 Plan.

A summary of the status of the Company’s outstanding stock options as of September 30, 2012 and changes during the period is presented below:

The following table summarizes information about outstanding stock options at September 30, 2012:

The following table summarizes the activity of non-vested outstanding stock options:

As of September 30, 2012, there was approximately $35,000 of unrecognized compensation costs related to non-vested stock option awards, which is expected to be recognized over a remaining weighted-average vesting period of approximately 1.4 years.

At September 30, 2012, there were 1,128,770 shares available for issuance under the 2007 Plan.

The intrinsic value of options outstanding at September 30, 2012 was $0.

Warrants

As of September 30, 2012, there were 16,587,843 warrants outstanding with terms expiring through 2017, all of which are currently exercisable.

On July 30, 2012, in conjunction with an amendment to the MMB Loan Agreement, the Company issued to MMB a warrant to purchase 4,000,000 shares of the Company’s common stock at a price of $0.40 per share. The warrant was immediately exercisable and expires on July 30, 2017. The Company valued the warrant at approximately $698,000 at the date of grant.

On June 15, 2012, in conjunction with the settlement of an outstanding obligation, the Company issued to a former creditor a warrant to purchase 365,000 shares of the Company’s common stock at a price of $0.50 per share. The warrant was immediately exercisable and expires on June 15, 2017. The Company valued the warrant at approximately $202,000 at the date of grant.

On March 9, 2012, in conjunction with the MMB Loan Agreement, the Company issued to MMB a warrant to purchase 10,952,775 shares of the Company’s common stock at a price of $0.40 per share. The warrant was immediately exercisable and expires on March 31, 2017. The Company valued the warrant at approximately $1.6 million at the date of grant.

A summary of the status of the Company’s outstanding warrants as of September 30, 2012 and changes during the period then ended are presented below:

The following table summarizes information about outstanding warrants at September 30, 2012:

NOTE 14. DEFINED BENEFIT PENSION PLAN

The Company maintains a defined benefit pension plan for employees from Zoo Publishing, Inc.’s predecessor, Destination Software, Inc.  Effective December 31, 2007, the plan was frozen and benefits ceased to accrue; therefore, only participants’ service and earnings prior to that date were used by the actuary to determine the expected employee benefits. The Company’s funding policy is to satisfy the minimum funding requirements of the Employee Retirement Income Security Act (“ERISA”). The assets of the Company-sponsored plan are invested in mutual funds, cash, money market accounts and certificates of deposits. In accordance with the recognition and disclosure provisions of ASC 715-30 “Defined Benefit Plans – Pension,” the Company recognizes the funded status of the Company’s retirement plan on the condensed consolidated balance sheets.

The following table sets forth the retirement trust’s approximate benefit obligations, fair value of the plans assets, and funded status for the defined benefit pension plan for the nine months ended September 30, 2012.

The amount unfunded as of December 31, 2011 was approximately $249,000.

Net periodic pension cost for the period January 1, 2012 through September 30, 2012 consists of the following:

Actuarial assumptions are described below:

Amounts recognized in the condensed consolidated balance sheets as of September 30, 2012 and December 31, 2011:

Amounts recognized in accumulated other comprehensive income for the nine months ended September 30, 2012:

The following table sets forth, by level, within the fair value hierarchy, the plan’s assets measured at fair value as of September 30, 2012:

The following table sets forth, by level, within the fair value hierarchy, the plan’s assets measured at fair value as of December 31, 2011:

The estimated net loss that will be amortized from accumulated other comprehensive loss into net periodic benefit cost over the remaining 2012 year is approximately $4,000.

NOTE 15. LITIGATION

On July 22, 2011, Bruce E. Ricker, individually and on behalf of all purchasers of the common stock of the Company from July 7, 2010 through April 15, 2011, filed a putative class action complaint in the United States District Court for the Southern District of Ohio. Mr. Ricker was appointed lead plaintiff on October 19, 2011, and he filed an amended complaint on December 12, 2011. The amended complaint alleges that the Company, Mark Seremet, the Company's Chief Executive Officer, and David Fremed, the Company's former Chief Financial Officer, knowingly or recklessly violated the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated thereunder, by making false material statements in connection with certain financial statements of the Company or by failing to disclose material information in order to make the financial statements not misleading. Specifically, the amended complaint relies upon the Company's April 15, 2011 restatement of its unaudited consolidated financial statements for the three months ended March 31, 2010, the three and six months ended June 30, 2010, and the three and nine months ended September 30, 2010, as the basis for its allegations that the Company's financial statements filed for those periods contained materially false statements. Defendants filed a motion to dismiss the amended complaint, which was then fully briefed and argued to the court on May 10, 2012. On July 30, 2012, the court issued an opinion and order granting the motion to dismiss in its entirety, dismissing all claims and closing the case. On August 2, 2012, the plaintiffs filed a notice of appeal as to the dismissal.

From time to time, the Company is also involved in various legal proceedings and claims incidental to the normal conduct of its business.  Although it is impossible to predict the outcome of any legal proceeding and there can be no assurances, the Company believes that these legal proceedings and claims, individually and in the aggregate, are not likely to have a material adverse effect on its consolidated financial condition, results of operations or cash flows.