Loudeye 10Q 2001 Q3 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)


[X]	Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2001

or


[ ]	Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from _________________ to _________________

Commission File Number:0-29583

Loudeye Technologies, Inc.
(Exact name of registrant as specified in its charter)


Delaware		91-1908833
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)


Times Square Building 414 Olive Way, Suite 500, Seattle, WA		98101
(Address of principal executive offices)		(Zip Code)

206-832-4000
(Registrant’s telephone number, including area code)

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

Yes [X] No [ ]

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.


Common		40,470,486

(Class)		(Outstanding at November 1, 2001)

TABLE OF CONTENTS


PART I — FINANCIAL INFORMATION
	ITEM I — FINANCIAL STATEMENTS
		CONDENSED CONSOLIDATED BALANCE SHEETS
		CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
		NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
	ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
PART II. OTHER INFORMATION
	ITEM 1: LEGAL PROCEEDINGS
	ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS
	ITEM 3: DEFAULTS UPON SENIOR SECURITIES
	ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY SHAREHOLDERS
	ITEM 5: OTHER INFORMATION
	ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURES
EXHIBIT 10.36
EXHIBIT 10.37

Loudeye Technologies, Inc.

Form 10-Q Quarterly Report
For the Quarter Ended September 30, 2001

TABLE OF CONTENTS


		Page
		Number

PART I	FINANCIAL INFORMATION
Item 1	Financial Statements		1

	Condensed Consolidated Balance Sheets as of September 30, 2001 and December 31, 2000		1

	Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2001 and 2000		2

	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2001 and 2000		3

	Notes to Unaudited Condensed Consolidated Financial Statements		4

Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations		12

Item 3	Quantitative and Qualitative Disclosures About Market Risk		29

PART II.	OTHER INFORMATION
Item 1	Legal Proceedings		30
Item 2	Changes in Securities and Use of Proceeds		30
Item 3	Defaults Upon Senior Securities		30
Item 4	Submission of Matters to a Vote of Security Holders		30
Item 5	Other Information		31
Item 6	Exhibits and Reports on Form 8-K		32

SIGNATURES			32

PART I — FINANCIAL INFORMATION

ITEM I — FINANCIAL STATEMENTS

LOUDEYE TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands except share amounts)


			September 30,			December 31,
			2001			2000

			(Unaudited)
ASSETS

Current assets:
	Cash and cash equivalents		$	61,866		$	51,689
	Short-term investments			6,783			43,300
	Accounts receivable, net of allowance of $722 and $709, respectively			2,867			3,241
	Prepaid and other current assets			2,618			1,072

		Total current assets		74,134			99,302
	Property and equipment, net			12,036			15,955
	Goodwill, net			3,080			9,785
	Intangibles and other long-term assets, net			16,633			7,634

		Total assets	$	105,883		$	132,676


LIABILITIES AND STOCKHOLDERS’ EQUITY

Current liabilities:
	Accounts payable		$	1,730		$	1,137
	Accrued compensation and benefits			2,058			1,554
	Other accrued expenses			3,377			1,368
	Deposits and deferred revenues			425			800
	Current portion of long-term debt and capital lease obligations			1,429			4,425

		Total current liabilities		9,019			9,284
Long-term debt and capital lease obligations, net of current portion				15,765			7,324
Accrued acquisition consideration				3,000			—

		Total liabilities		27,784			16,608

Stockholders’ equity (deficit):
	Common stock, additional paid-in capital and warrants, $0.001 par value, 100,000,000 shares authorized; 44,397,788 and 37,072,442 issued and outstanding			194,585			185,609
	Deferred stock compensation			(1,142	)		(3,387	)
	Accumulated deficit			(115,344	)		(66,154	)

		Total stockholders’ equity		78,099			116,068

		Total liabilities and stockholders’ equity	$	105,883		$	132,676

The accompanying notes are an integral part of these balance sheets.

LOUDEYE TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(in thousands, except share and per share amounts)


			Three Months Ended						Nine Months Ended
			September 30,						September 30,

			2001			2000			2001			2000

Revenues:
	Digital media services		$	1,588		$	3,037		$	4,964		$	6,987
	Digital media applications and other			910			381			2,139			632

		Total revenues		2,498			3,418			7,103			7,619
Cost of revenues:
	Digital media services			2,159			3,320			7,251			8,453
	Digital media applications and other			579			76			1,297			160

		Total cost of revenues		2,738			3,396			8,548			8,613
		Gross margin		(240	)		22			(1,445	)		(994	)
Operating expenses:
	Research and development			2,459			1,816			7,868			4,909
	Sales and marketing			2,001			3,920			7,341			10,924
	General and administrative			2,508			2,016			7,710			5,548
	Amortization of intangibles and other assets			2,131			2,051			5,941			5,580
	Stock-based compensation			313			1,035			211			4,402

				9,412			10,838			29,071			31,363
Special charges				2,721			—			20,462			—

Operating loss				(12,373	)		(10,816	)		(50,978	)		(32,357	)
Interest income				631			1,659			2,731			4,075
Interest expense				(267	)		(298	)		(943	)		(574	)

				364			1,361			1,788			3,501

Net loss			$	(12,009	)	$	(9,455	)	$	(49,190	)	$	(28,856	)

Basic and diluted net loss per share			$	(0.27	)	$	(0.27	)	$	(1.19	)	$	(1.05	)

Weighted average shares outstanding used to compute basic and diluted net loss per share				44,280,456			35,570,456			41,361,885			27,565,273

Basic and diluted pro forma net loss per share									$	(1.19	)	$	(0.87	)

Weighted average shares outstanding used to compute basic and diluted pro forma net loss per share										41,361,885			33,338,160

The accompanying notes are an integral part of these statements.

LOUDEYE TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands)


				Nine Months Ended
				September 30,

				2001			2000

Cash flows from operating activities:
	Net loss			$	(49,190	)	$	(28,856	)
	Adjustments to reconcile net loss to net cash used in operating activities:
		Depreciation and amortization			11,396			8,590
		Special charges and other			16,160			24
		Stock-based compensation			211			4,402
	Changes in operating assets and liabilities, net of amounts acquired in purchase of business
		Accounts receivable			2,235			(1,939	)
		Prepaid expenses and other assets			(453	)		(539	)
		Accounts payable			(345	)		(4,332	)
		Accrued compensation, benefits and other expenses			1,808			1,070
		Deposits and deferred revenue			(375	)		—

			Net cash used in operating activities		(18,553	)		(21,580	)
Cash flows from investing activities:
	Purchases of property and equipment, net of amounts acquired				(2,264	)		(14,820	)
	Cash paid for acquisition of business and technology, net				(9,580	)		(1,907	)
	Cash placed into escrow related to acquisitions of business				—			—
	Sales (purchases) of short-term investments, net				36,688			(370	)
	Capitalized software development costs				—			(883	)

			Net cash provided by (used in) investing activities		24,844			(17,980	)
Cash flows from financing activities:
	Proceeds from sale of stock and exercise of stock options, net				137			80,836
	Proceeds from long-term debt and capital lease obligations				15,163			9,279
	Principal payments on long-term debt and capital lease obligations				(11,414	)		(1,333	)

			Net cash provided by financing activities		3,886			88,782

			Net increase in cash and cash equivalents		10,177			49,222
Cash and cash equivalents, beginning of period					51,689			49,273

Cash and cash equivalents, end of period				$	61,866		$	98,495

Supplemental disclosure of cash flow information:
Cash paid for interest				$	718		$	402
Issuance of common stock for acquisition of business and technology					10,756			1,105

The accompanying notes are an integral part of these statements.

LOUDEYE TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2001
(UNAUDITED)

1. ORGANIZATION AND DEVELOPMENT STAGE RISKS

The Company

Loudeye Technologies, Inc. (the Company) provides digital media infrastructure services, live and on-demand enterprise webcasting services, digital media applications and audio and video content restoration services. The Company is headquartered in Seattle, Washington and to-date has conducted business in the United States and Europe in one business segment.

The Company is subject to a number of risks similar to other companies in a comparable stage of development including reliance on key personnel, successful marketing of its services in an emerging market, competition from other companies with greater technical, financial, management and marketing resources, successful development of new services, the enhancement of existing services, and the ability to secure adequate financing to support future operations.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Unaudited Interim Financial Data

The interim condensed consolidated financial statements are unaudited and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. These condensed consolidated financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K as filed with the Securities and Exchange Commission on February 27, 2001. The financial information included herein reflects all adjustments (consisting only of normal recurring adjustments) that are, in the opinion of management, necessary for a fair presentation of the results for interim periods. The results of operations for the quarters ended September 30, 2001 and 2000 are not necessarily indicative of the results to be expected for the full years.

Cash and Cash Equivalents

Cash and cash equivalents consist of demand deposits and money market accounts maintained with financial institutions and certain other investment grade instruments. Recorded amounts approximate fair value. The Company considers all cash deposits and highly liquid investments with an original maturity of three months or less to be cash equivalents.

Short-term Investments

The Company has invested amounts in investment-grade government obligations, institutional money market funds and other obligations with FDIC insured U.S. banks. Concentration is limited to 10% in any one instrument or issuer. The Company’s primary focus is to preserve capital and earn a market rate of return on its investments. The Company does not speculate or invest in publicly traded equity securities and, therefore, does not believe that its capital is subject to significant market risk. The average portfolio maturity must remain under one year in duration.

As described further in Note 8, at least $25 million of short-term investments and cash equivalents are utilized as collateral for the company's credit facility. Additionally, the Company has approximately $670,000 of short-term investments which are utilized as collateral for certain irrevocable standby letters of credit.

Long-Lived Assets

The Company assesses potential impairments to its long-lived assets when there is evidence that events or changes in circumstances have made recovery of the asset’s carrying value unlikely. An impairment loss is recognized when the sum of the expected future undiscounted net cash flows is less than the carrying amount of the asset. As described in Note 4, the Company recorded impairment charges of $2.0 million related to long-lived assets in the quarter ended September 30, 2001.

Software Development Costs

The Company capitalizes internal costs of developing software products upon determination that technological feasibility has been established for the product, if that product is to be sold, leased, or otherwise marketed. Costs incurred prior to the establishment of technological feasibility are charged to research and development expense. When the product is available for general release to customers, capitalization is ceased, and such previously capitalized costs are amortized on a product-by-product basis computed as the greater of (a) the ratio that current gross revenues for the product bear to the total of current and anticipated future gross revenues or (b) the straight-line amortization over the remaining estimated economic useful life of the product. The amortization is recorded as a component of digital media applications cost of revenues.

Software developed for internal use is capitalized once the preliminary project stage has been completed and management has committed to funding the continuation of the development project. Capitalization is ceased when the software project is substantially complete and ready for its intended use.

As of September 30, 2001, the Company has approximately $432,000 of remaining capitalized software development costs, of which approximately $150,000 has been amortized. The Company performs ongoing analysis of these assets and believes them to be fully realizable.

Reclassifications

Certain information reported in previous periods has been reclassified to conform to the current period presentation.

3. REVENUE RECOGNITION

The Company generates revenues primarily from two sources: (1) digital media services and (2) licensing and selling digital media applications.

Digital media services

Encoding Services consist of services to convert audio, and to a lesser extent video, content into Internet media formats. Sales of digital media services are generally under nonrefundable time and materials or per unit contracts. Under these contracts, the Company recognizes revenues as services are rendered and the Company has no continuing involvement in the goods and services delivered, which generally is the date the finished media is shipped to the customer.

Media Restoration and Migration Services consist of services to restore and upgrade old or damaged archives of traditional media. The Company recognizes revenues as services are rendered.

Enterprise webcasting services are provided through the Company’s subsidiary, Activate. Customer arrangements are generally for a quantity of services over a specified time frame (generally one year) or for specific events. Revenues are recognized when collectibility is probable and all services have been provided.

Digital media applications and other

Digital Media Applications and other revenues are generated from our music samples service business and in the prior year from licensing and selling of software and through application service provider arrangements. The Company sells digital media applications in application service provider arrangements. The Company is required to host the applications and the customer does not have the ability to have the application hosted by another entity without penalty to the customer. Billings are made based upon minutes of content streamed, and revenue is recognized as the services are delivered.

4. SPECIAL CHARGES

As described further in Note 7, the Company closed the acquisition of Activate.net, a Seattle-based company which provides live and on-demand enterprise webcasting services. Concurrent with the closing of this acquisition the Company developed a facilities consolidation plan as well as a plan to eliminate redundant personnel and equipment. In addition, the Company continued its previously announced cost-savings initiatives. These combined activities resulted in a special charge of $2.7 million in the third quarter of 2001.

The Company’s Board of Directors formally approved the facilities consolidation plan which, when implemented in the fourth quarter of 2001 and first quarter of 2002, will result in all Seattle-based operations moving to Activate’s facilities in

Seattle. The facility consolidation resulted in an impairment charge of $2.0 million, primarily related to tenant improvement write-offs for facilities to be closed in the fourth quarter and redundant equipment. In addition, other closure costs of approximately $522,000 are expected to be incurred. The remaining portion of the special charge is cash severance charges related to employees terminated in September.

The Company’s special charge accrual activity was as follows for the quarter ended September 30, 2001:


	Balance							Balance
(in thousands)	June 30, 2001		Payments			Accruals		Sept. 30, 2001

Facilities charges	$	661	$	(132	)	$	522	$	1,051
Severance and other		203		(88	)		11		126

	$	864	$	(220	)	$	533	$	1,177

The facilities costs accrual primarily relates to estimated lease termination costs. Cash payments made in 2001 related to restructuring charges and were consistent with the previous estimates.

5. NET LOSS PER SHARE

In accordance with Statement of Financial Accounting Standards (SFAS) No. 128, “Earnings Per Share,” basic earnings per share is computed by dividing net loss by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed by dividing net loss by the weighted average number of common and dilutive common equivalent shares outstanding during the period. Common equivalent shares consist of shares of common stock issuable upon the conversion of the convertible preferred stock (using the if-converted method) and shares issuable upon the exercise of stock options and warrants (using the treasury stock method); common equivalent shares are excluded from the calculation if their effect is antidilutive. Diluted net loss per share for all periods shown does not include the effects of the convertible preferred stock and shares issuable upon the exercise of stock options and warrants as the effect of their inclusion is antidilutive during each period presented.

Basic and diluted pro forma net loss per share is computed based on the weighted average number of shares of common stock outstanding giving effect to the conversion of convertible preferred stock into common stock upon the completion of the Company’s initial public offering on March 15, 2000 (using the if-converted method from the original issue date) as if the conversion and IPO had occurred on January 1, 2000. Diluted pro forma net loss per share excludes the impact of stock options and warrants, as the effect of their inclusion would be antidilutive. As of September 30, 2001, the Company had 8,263,548 options outstanding which have been excluded for calculation of earnings per share as their inclusion would be antidilutive.

At September 30, 2001, the Company had 106,327 stock options that had been exercised but which were subject to repurchase at a weighted average exercise price of $0.30 per share. Accordingly, the impact of these unvested but exercised options has been removed from the calculation of weighted average shares outstanding for purposes of determining net loss per share.

The following table presents shares used to calculate earnings per share:


	For the Three Months Ended Sept. 30,

	2001			2000

Weighted average shares outstanding		44,394,975			36,927,215
Weighting of shares subject to repurchase		(114,519	)		(1,356,759	)

Weighted average shares used to calculate basic and diluted earnings per share		44,280,456			35,570,456


	For the Nine Months Ended Sept. 30,

	2001			2000

	Actual			Actual			Pro Forma

Weighted average shares outstanding		41,565,429			29,093,959			34,866,846
Weighting of shares subject to repurchase		(203,544	)		(1,528,686	)		(1,528,686	)

Weighted average shares used to calculate basic and diluted earnings per share		41,361,885			27,565,273			33,338,160

6. CONCENTRATION OF RISK AND SEGMENT DISCLOSURES

Financial instruments that potentially subject the Company to concentrations of market risk consist of cash and cash equivalents, short-term investments, and long-term obligations. Fair values of cash and cash equivalents and short-term investments approximate cost due to the short period of time to maturity. The fair values of financial instruments that are short-term or that have little or no market risk are considered to have a fair value equal to book value. The Company maintains cash and cash equivalents on deposit at various institutions that at times exceed the insured limits by the Federal Deposit Insurance Corporation. This exposes the Company to potential risk of loss in the event the institutions become insolvent.

The Company is exposed to credit risk since it extends credit to its customers. The Company performs initial and ongoing evaluations of its customers’ financial positions, and generally extends credit on open account, requiring collateral as deemed necessary. As of September 30, 2001, one of the company’s customers accounted for 13% of its outstanding receivables.

During the quarters ended September 30, 2001, and 2000, the Company had sales to certain significant customers, as a percentage of revenues, as follows:


	2001			2000

Customer A		18	%		—
Customer B		13	%		—
Customer C		0	%		35	%

		31	%		35	%

The Company operates in one business segment, digital media services and applications, for which the Company receives revenues from its customers. The Company’s Chief Operating Decision Maker is considered to be the Company’s Executive Team (CET) which is comprised of the Company’s Chief Executive Officer, Chief Operating Officer, Chief Financial Officer, and its other Senior Vice Presidents. The CET reviews financial information presented on a consolidated basis accompanied by disaggregated information about products and services for purposes of making decisions and assessing financial performance. The Company does not have any operating units which exceed the threshold required for separate disclosure and therefore, the Company does not have operating segments required to be separately disclosed by SFAS 131, “Disclosure About Segments of an Enterprise and Related Information”.

7. ACQUISITION OF ACTIVATE.NET

The Company acquired 100% of the voting interests of Activate.net Corporation (“Activate”) on September 25, 2001. Activate is a Seattle-based company which provides live and on-demand webcasting services for a variety of enterprise business communication needs in all major industry standard formats. Activate had been operated as a majority-owned operating company of CMGi, Inc. The acquisition is expected to provide positive gross margin and operating efficiencies after the facilities consolidation is completed. Activate’s historical operations incorporate many of the services the Company has previously provided either internally or through outsourcing, therefore, the Company does not believe that this will result in a segment as defined by SFAS131, rather the results will be presented as digital media services in the statements of operations.

Total purchase consideration was $6.6 million, $1.0 million was paid in cash at closing and the Company assumed $2.4 million of liabilities. The remaining $3.0 million of the purchase price will be paid in cash or stock one year from the initial close of the transaction. The Company may determine the composition of the second closing payment subject to a number of factors, including the market price of Loudeye’s common stock and the ownership level the stock would represent to CMGi. The purchase consideration was as follows:


(in millions)
Purchase consideration

Liabilities assumed	$	2.4
Direct acquisition costs		0.2
Cash at closing		1.0
Accrued acquisition consideration		3.0

	$	6.6

The Company accounted for the acquisition in accordance with SFAS No. 141 “Business Combinations” (“SFAS141”). The primary identified intangibles were related to technology in service which has not yet been patented and purchased contracts with firmly committed customer backlog. No purchase price has been assigned to goodwill or in-process research and development. The preliminary purchase price allocation based upon the Company’s estimates was as follows:


(in millions)
Preliminary Purchase Price Allocation

Current assets assumed	$	2.5
Property and Equipment		2.4
Unpatented Technology		1.6
Acquired Contracts		0.1

	$	6.6

The purchase price allocation set forth above is tentative and preliminary and is subject to change in future periods. Amounts allocated to unpatented technology will be amortized over two years, while the amounts allocated to acquired contracts will be amortized over the life of those contracts, which is generally one year.

As the acquisition was completed on September 25, only four days of operating results are included in the consolidated results for the period ended Sept. 30, 2001. The Company will be filing an Amended Report on Form 8-K (“Form 8-K”) with the Securities and Exchange Commission by December 10, 2001, which should be referred to for greater detail concerning historical results of operations for Activate and for pro forma results of operations as if the transaction had occurred at the beginning of the periods presented. The pro forma information required by SFAS141 will be included in the Form 8-K.

8. LONG-TERM DEBT, COMMITMENTS AND CONTINGENCIES

Long-term Debt

On August 22, 2001, the Company entered into a credit agreement (the “Credit Agreement”) with a bank providing for a revolving credit facility (“Revolving Facility”) and letters of credit aggregating up to $15.0 million to be used for working capital and general corporate needs, and to refinance existing long-term debt. Obligations under the Credit Agreement are collateralized by a security interest in short-term investments and cash equivalents with a value of at least $25.0 million. The Revolving Facility requires monthly payments of interest only until maturity on July 31, 2003. On July 31, 2002, the Company has an option to extend the maturity date to July 31, 2004, provided that the Company is not in default under the Credit Agreement.

Loans under the Revolving Facility bear interest, at the Company’s option, at the bank’s prime rate, or the London Interbank Offered Rate (“LIBOR”) plus 100 basis points. On August 22, 2001, the Company borrowed $15 million against the Revolving Facility with an interest rate election of LIBOR plus 100 basis points, or 4.5125%. The interest rate will be adjusted after the LIBOR term to reflect the LIBOR rate in effect at that time. Approximately $8 million of the proceeds were utilized to pay off an existing line of credit and term loan facility with another bank. In October 2001, the Credit Agreement was amended to increase the principal sum to $19 million and, accordingly the collateral requirement was increased to $30 million.

The Company also has a credit facility that provided advances for the purchase of capital equipment. Advances under the equipment loan are payable in 36 equal monthly installments from inception date and are secured by assets financed under the agreement. As of September 30, 2001, approximately $980,000 was outstanding under this equipment facility. The notes payable bear interest at rates ranging from 8.57% to 9.65%, with various maturity dates through February 2003. A fee equal to 15% of the principal balance is due with the final payment of each advance. That additional fee is accrued on a monthly basis and is included in other accrued expenses and interest expense over the term of the loan.

Capital Lease Obligations

In March 2001, in connection with the acquisition of DiscoverMusic, the Company assumed master lease agreements with two finance companies for the lease of certain property and equipment. Borrowings under the lease agreements have individual

terms of 36 months and bear interest ranging from 9.00% to 9.25% and are collateralized by the assets purchased. As of September 30, 2001, approximately $646,000 was outstanding under the leases.

9. STOCK-BASED COMPENSATION

The Company records deferred stock compensation for the difference between the exercise price of stock options granted and the deemed fair market value or the price of the Company’s common shares as traded on the NASDAQ national market at the date of grant. The deferred compensation is amortized over the vesting period of the related options, which is generally four and one-half years.

During the quarter ended September 30, 2001, the Company amortized approximately $313,000 of deferred stock compensation that is included in stock-based compensation expense in the accompanying statements of operations.

The Company records stock-based compensation charges as a separate component of operating expenses. In July 2001, the Company completed a stock option exchange whereby employees holding options with an exercise price greater than $4.30 were allowed to exchange those options at an exchange ratio of 3 for 4. A total of 1,083,250 options with a weighted average exercise price of $7.50, were exchanged for options to purchase 812,443 shares of common stock priced at $1.21 per share. The new options are being treated as a re-pricing in accordance with FASB Interpretation No. 44, and accordingly, are treated under the variable method of accounting, which requires the company to mark the options to market until the date those options are exercised, are forfeited, or expire unexercised. The new options have a vesting period of three years from the date of issuance. As the company’s stock price at September 30, 2001 was lower than the strike price of the re-granted shares, there was no stock-based compensation recorded in the quarter ended September 30, 2001.

10. LEGAL PROCEEDINGS

In connection with the acquisition of DiscoverMusic, Loudeye assumed certain liabilities and contingencies, including a patent infringement lawsuit filed by InTouch Group, Inc. (“InTouch”) in which DiscoverMusic is one of the defendants. We believe that we have meritorious defenses to InTouch’s claims and we intend to vigorously defend against such claims. However, to the extent that their patent rights are valid and enforceable and cover our activities, we may be required to pay damages, obtain a license to use such patents or use non-infringing methods to accomplish our activities with regard to the acquired interactive music previewing technology. It is possible that a license from InTouch would not be available on commercially acceptable terms, or at all, or that we would be unable to use our interactive music samples technology in a non-infringing manner. If successful, the InTouch claim that we violate their intellectual property rights could seriously harm our business by forcing us to cease using important intellectual property or requiring us to pay monetary damages.

Between July 26, 2001 and August 30, 2001, several substantially similar class action complaints were filed in the United States District Court for the Southern District of New York against us and certain of our present and former officers and directors as well as against certain underwriters who handled our March 15, 2000 initial public offering of common stock. The various complaints were purportedly filed on behalf of a class of persons who purchased our common stock during the time period beginning on March 15, 1999 and ending on December 6, 2000. The complaints together allege violations of the Securities Act of 1933 and the Securities Exchange Act of 1934 primarily based on the allegation that there was undisclosed compensation received by our underwriters in connection with our initial public offering and the allegation that the underwriters entered into undisclosed arrangements with some investors that were designed to distort and/or inflate the market price for our common stock in the aftermarket following the initial public offering. The allegations set forth in these complaints are substantially similar to those made in class actions filed against approximately 180 other companies that issued securities within the past three years. These actions have all been consolidated before the same judge for pretrial purposes.

We believe that the individual defendants and we have meritorious defenses to the claims made in the complaint and we intend to defend the actions vigorously. However, there can be no assurance that we will be successful, and an adverse resolution of the lawsuit could have a material adverse affect on our financial position and results of operation in the period in which the lawsuit is resolved. We are not presently able to reasonably estimate potential losses, if any, related to the lawsuit, although we do not believe it will have a material adverse impact on our financial condition or results of operations.

On May 8, 2001, the company filed an arbitration demand with the American Arbitration Association (“AAA”) against Valley Media, Inc (“Valley”). The Company alleges that Valley is liable for substantial damages for material breaches of a Services Agreement between the companies dated as of December 17, 1999, in which Valley made representations and warranties and agreed to perform certain obligations to facilitate the creation of a venture to create and market an Internet music clip streaming service. The Company provided notice of its intent to terminate that agreement by letter dated February 6, 2001,

and that termination was effective 30 days thereafter. The company has also alleged claims for misrepresentation, fraud, unjust enrichment and promissory estoppel. The date for the arbitration hearing is June 10, 2002. Under AAA rules, arbitration proceedings are confidential and private. Valley has filed an answer in which it denies liability, and asserts counterclaims for breach of contract, conversion, and declaratory relief.

11. SUBSEQUENT EVENTS

In November 2001, the Company announced a permanent reduction in force of approximately 50 employees or approximately 19 percent of the workforce. This reduction is expected to result in an additional special charge related primarily to payments for severance and outplacement totaling approximately $1.0 million, in addition to certain non-cash charges expected to approximate $1.0 million in the fourth quarter of 2001.

On October 26, 2001, the Company entered into an agreement with its founder and largest shareholder, Martin Tobias, and his wife, Alex Tobias. Loudeye purchased 4 million shares of Loudeye common stock from Mr. Tobias for $2.0 million, or $0.50 per share, and also entered into a comprehensive agreement with Mr. Tobias, including the extension of a $2.0 million secured line of credit to Mr. Tobias (“the Loan”). Mr. Tobias had previously entered into a loan agreement with City National Bank to borrow a principal amount of $3.0 million. The Company secured $2.5 million of the principal amount with a letter of credit. The $2.0 million payment due to Mr. Tobias from the Company for the common stock was paid directly to City National Bank to reduce the current outstanding principal balance to $500,000 which the company secured by a letter of credit in the same amount. The new credit line is collateralized by liens on certain real property assets owned by Mr. Tobias, as well as all his remaining 4.6 million Loudeye shares. Under the terms of the agreement, the collateral shares will be restricted from public market sale, without Loudeye’s consent, until the later of January 31, 2003, or the full repayment of the credit facility. The credit line matures June 30, 2003. As part of the agreement, Mr. Tobias granted the Board of Directors of the Company an irrevocable proxy to vote the remaining shares of Common Stock owned by Mr. Tobias at any stockholders’ meeting. The proxy terminates on the later of January 31, 2003 or the repayment of the Loan. In addition, as part of the agreement, Mr. Tobias resigned from the Company’s Board of Directors. The agreement also permits Mr. Tobias to establish a program for sales of his shares consistent with Rule 10b5-1 under the Securities Exchange Act of 1934 and with Rule 144 under the Securities Act of 1933, so long as the minimum per share sales price of the shares under such plan equals or exceeds $1.25. The Company has also agreed to exercise reasonable efforts to identify and to assist Mr. Tobias in identifying a private buyer for some or all of Mr. Tobias’s shares, on terms acceptable to Mr. Tobias.

In addition, if under the Rule 10b5-1 program described above, Mr. Tobias is unable to sell shares of Loudeye common stock so that the proceeds from these sales equal the lesser of (a) $500,000 or (b) the proceed from sales of 150% of the maximum number of shares that could have been sold by Mr. Tobias under Rule 144 during the calendar quarter multiplied by the Discounted Share Price (as defined below) (the “Minimum Liquidity Commitment”), then Mr. Tobias may require the Company to purchase shares from him at the Discounted Share Price so that his total proceeds for the quarter equal the Minimum Liquidity Amount. The Discounted Share Price is the lesser of (x) the average closing bid price of the Company’s common stock for the trailing 30 trading days or (y) 95% of the closing bid price of the Company’s common stock on the last trading day of the quarter. This right expires on the earlier of (i) three business days following June 30, 2003, (ii) repayment in full of the Loan or (iii) such time as Mr. Tobias ceases to be the beneficial or record owner of any shares of the Company’s common stock.

Further details are included in the Report on Form 8-K as filed with the Securities and Exchange Commission on October 26, 2001.

12. RECENT ACCOUNTING PRONOUNCEMENTS

In July 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 141 “Business Combinations” and SFAS No. 142 “Goodwill and Other Intangible Assets.” SFAS No. 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting and broadens the criteria for recording intangible assets separate from goodwill. Recorded goodwill and intangibles will be evaluated against this new criteria and may result in certain intangibles being subsumed into goodwill, or alternatively, amounts initially recorded as goodwill may be separately identified and recognized apart from goodwill. The Company believes that its current practices regarding purchase price allocation are consistent with SFAS141, and accordingly does not believe that its implementation will require reclassification of intangibles with indefinite lives into goodwill or reclassification from goodwill into identified intangibles. SFAS No. 142 requires the use of a nonamortization approach to account for purchased goodwill and certain intangibles. Under a nonamortization approach, goodwill and certain intangibles will not be amortized into results of operations, but instead will be reviewed for impairment and written down and charged to results of operations only in the periods in which the recorded value of goodwill and certain intangibles is more than its estimated fair value. The provisions of each statement which apply to goodwill and intangible assets

acquired prior to June 30, 2001 will be adopted by the Company on January 1, 2002. The adoption of SFAS No. 142 will result in the Company’s discontinuation of amortization of its goodwill; however, the Company will be required to test its goodwill for impairment under the new standard beginning in the first quarter of 2002, which could have an adverse effect on the Company’s future results of operations if an impairment occurs. The Company currently has gross goodwill of approximately $3.9 million, with approximately $851,000 in related accumulated amortization as of September 30, 2001. This goodwill is expected to have related amortization expense of approximately $370,000 through the remainder of 2001, at which point amortization will cease. At implementation, the Company expects to have unamortized goodwill of approximately $2.8 million, which will be treated in accordance with SFAS142; accordingly, the Company expects the impact of implementation of these two standards to have a positive net future impact resulting from the decrease in amortization by approximately $2.8 million in 2002.

In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," effective for the Company on January 1, 2002. This Statement supersedes FASB Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" and other related accounting guidance. The Company is in the process of evaluating the financial statement impact of the adoption of SFAS No. 144.


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

Forward-Looking Statements

The following discussion of our financial condition and results of operations contains forward-looking statements within the meaning of section 27A of the Securities Act of 1993 and Section 21E of the Securities Exchange Act of 1934. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as may, will, should, expect, plan, anticipate, believe, estimate, predict, potential or continue, the negative of terms like these or other comparable terminology. These statements are only predictions. Actual events or results may differ materially. All forward-looking statements included in this document are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. In evaluating these statements, you should specifically consider various factors, including the risks outlined under the caption “Risk Factors” set forth at the end of this Item 2, the Risk Factors set forth in our Annual report on Form 10-K for the year ended December 31, 2000 filed with the Securities and Exchange Commission and those contained from time to time in our other filings with the SEC. We caution investors that our business and financial performance are subject to substantial risks and uncertainties.

Overview

We are a leading provider of authorized digital media solutions that empower today’s top media, entertainment and Fortune 1000 companies to transform traditional media assets into dynamic digital content and enable distribution of content digitally via webcasting services. Our digital media services and applications encompass an end-to-end solution for customers that includes:

	•		media preservation and restoration;

	•		media and metadata capture and digital archive management;

	•		encoding, or the transformation of audio and video content into streaming media or digital download formats;

	•		distribution through a variety of methods;

	•		live and on-demand enterprise webcasting services;

	•		hosted subscription services for music samples; and

	•		online radio.

Our operations are focused on digital music infrastructure and distribution, and enterprise webcasting, because we believe they offer the best market opportunities for us over the next 12 to 24 months. Our solutions simplify and accelerate the process of delivering audio and video content on the Internet and other digital distribution platforms. Our proprietary systems and technology enable scalable and cost effective archival, retrieval and processing of large inventories of digital media. Our services and applications are built upon a robust production and delivery infrastructure. The benefits of our services and applications include:

	•		an end-to-end solution to reduce complexity for customers and cost-effectively enable a wide range of digital media strategies;

	•		significant capacity to process and manage large volume projects in a rapid time frame;

	•		a highly scalable and extensible platform to enable tailored customer solutions;

	•		platform agnostic applications, compatible with MS Windows Media Player, RealPlayer, Apple QuickTime and many others; and

	•		strategic relationships with selected major media companies, content owners and digital media service providers.

In the third quarter of 2001, we served over 150 customers, including AOL, MSN, Napster, Coca Cola, CD Now!, BMG Direct, Universal Music Group, barnesandnoble.com and Amazon.com.

Our objective is to be the leading digital media infrastructure provider of comprehensive digital media solutions. We seek to achieve this objective through the following key strategies:

	•		developing and marketing an end-to-end suite of products and services;

	•		leveraging existing management, production and delivery systems to support new products and services;

	•		establishing relationships and obtaining content licensing agreements from content owners;

	•		expanding into selected international markets; and

•

selectively pursuing strategic acquisitions to strengthen our market position, expand our proprietary technology and accelerate our product strategy.

Despite the serious legal issues raised, the Napster experience in 2000 demonstrated the growing demand for digital music, and we believe that demand for digital music will continue to grow. To address the opportunity in the digital music market, we intend to focus our efforts on developing and marketing an end-to-end suite of digital music services and applications that leverage our advanced digital media infrastructure systems and software applications. This will enable media and music companies to deliver authorized digital music offerings to this growing audience. To support these initiatives, we intend to continue executing our strategy to develop relationships with copyright owners in the music industry, including major music companies, independent record labels, artists and publishers, to enable them, and their authorized licensees, to distribute digital music to their audiences. To this end, in 2000 we announced content licensing agreements with Universal Music Group, Warner Music Group and BMG Entertainment. In 2001 we announced licensing agreements with Sony Music Entertainment, Inc. and EMI Recorded Music.

The large majority of our revenues to date have been generated from digital media services. With the acquisition of DiscoverMusic in March 2001, we began generating recurring digital media applications revenues from Media Subscription Services provided through an applications service provider model, whereby we charge our customers for digital media services on either a time and materials basis or a fixed fee basis that depends on a variety of factors, such as volume and type of content provided and number and type of output formats requested. We recognize digital media services revenues as the service is provided and we have no further involvement. Standard payment terms with customers require payment within 30 days of the invoice date. We intend to integrate the operations of Activate, which we acquired in September, 2001, into our historical operations as our primary digital media services offering. Our ongoing digital media applications strategy consists primarily of the Media Subscription Services applications obtained in the DiscoverMusic acquisition and online radio technology acquired through assets purchased from OnAir Streaming Networks in March 2001, Addition Systems, Inc. in June 2001 and theDial.com in July 2001.

We have sustained losses on a quarterly basis since inception and we expect to sustain losses for the foreseeable future. For the three months ended September 30, 2001, we had a net loss of $12.0 million. As of September 30, 2001, we had an accumulated deficit of $115.3 million. Operating losses resulted from significant costs incurred in the development and sale of our products and services as well as significant non-cash charges related to stock-based compensation and amortization or write-down of intangibles and other assets associated with the corporate restructuring. In addition to normal, recurring charges, we recorded $2.7 million in the third quarter of 2001, and $20.5 million year to date related to a company-wide restructuring and consolidation of operations and integration of acquisitions. These charges related to employee severance, impairments of assets and facilities consolidation. We expect the restructuring of operations to generate significant cost savings once fully implemented.

We anticipate that operating expenses, as well as planned capital expenditures, debt repayments and any acquisitions, will constitute a material use of our cash resources throughout the remainder of 2001 and into 2002. We expect to incur additional losses and continued negative cash flow from operations in the foreseeable future. We cannot assure you that we will achieve or sustain profitability or positive operating cash flow.

Our limited operating history makes the prediction of future operating results difficult. In view of our limited operating history and the early and rapidly evolving nature of our business, we believe that interim and annual period-to-period comparisons of our operating results are not meaningful and should not be relied upon as an indication of future performance. Our business prospects must be considered in light of the risks and uncertainties often encountered by early-stage companies in the Internet-related products and services market. We may not be successful in addressing these risks and uncertainties. We have experienced significant percentage growth in revenues in recent periods; however, we do not believe that prior growth rates or possibly even sequential quarterly growth are sustainable or indicative of future growth rates (see “Forward-Looking Statements”). In some future quarter our operating results may fall below our expectations as well as those of securities analysts and investors. In this event, the trading price of our common stock may fall significantly.

Results of Operations

Three Months Ended September 30, 2001 compared to 2000

Revenues. Revenues totaled $2.5 million and $3.4 million for the three months ended September 30, 2001 and 2000, respectively. The decrease was primarily due to the decrease in demand for large-scale encoding projects, the termination of our consulting services group and the discontinuation of our Loudeye Media Syndicator offering, offset by increases related to the acquisition of DiscoverMusic in March 2001 and the acquisition of VidiPax in June 2000.

Digital Media Services revenues were generated from a large number of projects, including projects with XM Radio, Napster and Coca-Cola as well as the continued performance of our Media Subscription Services. One audio project represented 13% of the Company’s revenues in the three months ended September 2001.

Media Subscription Services revenues totaled $910,000 in the three months ended September 30, 2001. Those revenues are related to the offering of music samples to customers obtained in the DiscoverMusic acquisition during the first quarter of 2001 and are included in digital media applications and other in the statements of operations. We had no subscription services available in the three months ended September 30, 2000, and accordingly had no revenues. We expect the quarterly revenues to remain relatively flat or decrease as the customer base evolves and pricing pressures on the services continues. Our Media Subscription Services strategy for the future is geared towards the music industry. Additional Subscription Services offerings may be available in the future in areas such as online radio, full song lockers and other music-related subscription offerings.

We had no video encoding revenues in 2001 as a direct result of our decision to significantly de-emphasize that line of business. Media restoration revenues, including those from VidiPax increased significantly over the same period in prior year. We expect video-related revenues from VidiPax, to remain relatively flat or achieve a slight increase on a sequential or quarter-over-quarter basis in 2001 as we continue to focus primarily on digital music opportunities.

In the three months ended September 30, 2000 we generated revenues from the sale or license of custom applications totaling $381,000. These revenues related to product offerings that we decided to no longer support in conjunction with our operational restructuring. In the three months ended September 30, 2001 we generated no revenues from sales or license of such technologies.

We expect consolidated revenues to increase approximately 50% sequentially in the fourth quarter primarily as a result of the acquisition of Activate.

Cost of Revenues.Cost of revenues decreased to $2.7 million in the three months ended September 30, 2001 from $3.4 million in the period ended September 30, 2000. Cost of revenues includes the cost of production and consulting, personnel and an allocated portion of facilities and equipment and other supporting functions related to the delivery of digital media services and applications. Stock-based compensation charges of $25,000 and $67,000 for the quarters ended September 30, 2001 and 2000, respectively, are attributable to employees included in cost of revenues and are presented in the separate operating expense line item within the statements of operations. Cost of revenues as a percent of revenues increased from the same period in 2000 primarily due to decreased capacity utilization resulting from the fewer large-scale encoding projects in the quarter. This underutilization was partially offset by lower personnel and facilities costs as a result of our restructuring; decreased depreciation related to equipment taken out of service or otherwise disposed of and the inclusion of higher margin product offerings acquired from DiscoverMusic. We expect margins on digital media applications provided through our Media Subscription Services and media restoration services provided by VidiPax to remain consistent through the fourth quarter. We expect the margins generated by traditional digital media services to be positively impacted as a result of the acquisition of Activate and as the effects of our cost-containment initiatives are realized.

Research and Development Expenses.Research and development expenses totaled $2.5 million and $1.8 million in the three months ended September 30, 2001 and 2000, respectively. Research and development expenses consist of salaries and consulting fees paid to support technology development, costs of technology acquired from third parties to incorporate into applications and other proprietary technology currently under development. The increase over the same period in 2000 is primarily due to the acquisition of on-line radio technology and personnel in 2001. Additionally, in 2000, certain projects met the requirements for capitalization of development costs. We do not currently have any development projects that meet the criteria for capitalization. Costs of developing the automated production system, continued development of online radio technology and other unannounced applications comprised a majority of our research and development expenses. Stock-based compensation charges of $16,000 and $42,000 for the quarters ended September 30, 2001 and 2000, respectively, are attributable to employees included in research and development and are presented in the separate operating expense line item within the statements of operations.

We believe that continued investment in research and development is critical to attaining our strategic objectives. However, due to our operational restructuring and focus on digital audio opportunities and enterprise webcasting services, development headcount was significantly reduced and, as a result, we expect research and development expenses to continue sequentially at lower rates. This decrease is expected to be slightly offset by the development efforts ongoing at Activate.

Sales and Marketing Expenses.Sales and marketing expenses totaled $2.0 million and $3.9 million in the three months ended September 30, 2001 and 2000, respectively. Sales and marketing expenses consist primarily of salaries, commissions, co-

marketing expenses, trade show expenses, product branding costs, advertising and cost of marketing collateral. The significant decrease in sales and marketing expenses was primarily due to the decreased personnel subsequent to our corporate restructuring, a focus on controlling costs in all areas of our business, and to a lesser degree, reduced sales commission on the lower level of sales. Stock-based compensation charges of $41,000 and $110,000 for the quarters ended September 30, 2001 and 2000, respectively, are attributable to employees included in sales and marketing and are presented in the separate operating expense line item within the statements of operations. We expect sales and marketing expenses to increase in the fourth quarter as a direct result of the acquisition of Activate. In addition, sales and marketing expenses are expected to increase as the level of sales grows.

General and Administrative Expenses. General and administrative expenses totaled $2.5 million and $2.0 million in the three months ended September 30, 2001 and 2000, respectively. General and administrative expenses consist primarily of unallocated rent, facilities and information technology charges, salaries and legal and other general corporate expenses associated with being a public company. The increase was primarily due to increased legal expenses related to ongoing corporate initiatives, litigation and rights acquisitions. Stock-based compensation charges of $231,000 and $816,000 for the quarters ended September 30, 2001 and 2000, respectively, are attributable to employees included in general and administrative and are presented in the separate operating expense line item within the statements of operations. We expect general and administrative expenses to increase on a gross basis, but decrease on a percentage of total expense basis as a result of the Activate acquisition.

Amortization of Intangibles and Other Assets.Amortization of intangibles and other assets totaled $2.1 million and $2.1 million in the three months ended September 30, 2001 and 2000, respectively, and includes amortization of the goodwill and identified intangible assets related to past acquisitions and amortization related to the fair value of warrants granted to certain partners. The amortization expense remained flat, however, this was due to increased amortization on intangibles related to acquisitions closed in 2001 offset by lower amortization on intangibles resulting from the Alive.com transaction in 1999, which were written down in the impairment charge in the first quarter of 2001. The closing of the Activate acquisition in September 2001 will increase future amortization. We expect to continue our growth strategy and should additional acquisitions occur, amortization expense would increase accordingly.

Stock-Based Compensation.Stock-based compensation expense totaled $313,000 and $1.0 million in the three months ended September 30, 2001 and 2000, respectively. This decrease was primarily related to lower deferred compensation balances as a result of past reductions in force. We expect the future amortization levels to continue to decrease, although at a slower rate.

In July 2001, we completed a stock option exchange whereby employees holding options with an exercise price greater than $4.30 were allowed to exchange those options at an exchange ratio of 3 for 4. A total of 1,083,250 options with a weighted average exercise price of $7.50, were exchanged for options to purchase 812,443 shares of common stock priced at $1.21 per share. The new options will be treated as a re-pricing in accordance with FASB Interpretation No. 44, and accordingly, will be treated under the variable method of accounting, which requires the company to mark the intrinsic value of the options to market until the date those options are exercised, are forfeited, or expire unexercised. The new options vest ratably three years from the date of issuance. As the company’s stock price at September 30, 2001 was lower than the strike price of the newly issued options, there was no stock-based compensation recorded in the quarter ended September 30, 2001. As a result of this tender offer, we believe that stock-based compensation will fluctuate in future periods as our stock price continues to fluctuate.

Special Charges.We closed the acquisition of Activate, a Seattle-based company which provides live and on-demand enterprise webcasting services. This acquisition led to a facilities integration plan as well as a plan to eliminate redundant personnel and equipment. In addition, we continued our previously announced cost-savings initiative. These combined activities resulted in a special charge of $2.7 million in the third quarter of 2001.

Our Board of Directors formally approved the facilities consolidation plan which, when implemented, will result in all Seattle-based operations moving to Activate’s facility in Seattle. The facility consolidation resulted in an impairment charge of $2.0 million, primarily related to tenant improvement write-offs for facilities expected to be closed by the end of the fourth quarter and redundant equipment. In addition, other closing costs of approximately $522,000 are expected to be incurred. The remaining portion of the special charge is cash severance charges related to employees terminated in September 2001. In November we announced a permanent reduction in force of approximately 19%. This reduction is expected to result in an additional charge totaling approximately $1.0 million. In addition, certain related charges, primarily non-cash tenant improvement write-downs, totaling an additional $1.0 million are expected to be recorded in the fourth quarter of 2001. Included in the property and equipment charges are accrued lease buy-out fees for closed facilities as well as assets related to the reduction in personnel that took place as a result of the announced restructuring.

Interest Income.Interest income representing earnings on our cash, cash equivalents and short-term investments totaled

$631,000 and $1.7 million in the three months ended September 30, 2001 and 2000, respectively. The decreased income was due primarily to our significantly lower average cash and investment balances in 2001 in addition to lower interest rates. We expect that our interest income will decrease in the future as our cash balances decrease to fund our operating, investing and financing activities.

Interest Expense.Interest expense consists of interest expense related to our debt instruments as well as amortization of financing charges related to our debt instruments. This totaled $267,000 and $298,000 in the three months ended September 30, 2001 and 2000, respectively. The decrease was due primarily to the improved terms of our refinanced debt and the lower prevailing interest rates.

Nine Months Ended September 30, 2001 compared to 2000

Revenues. Revenues totaled $7.1 million and $7.6 million for the nine months ended September 30, 2001 and 2000, respectively. The decrease was primarily due to decreases in revenues associated with video encoding projects and consulting services, offset largely by increases related to the acquisition of DiscoverMusic in March 2001 and the acquisition of VidiPax in June 2000.

Media Subscription Services revenues totaled $2.1 million in the nine months ended September 30, 2001. We had no subscription services available in the nine months ended September 30, 2000, and accordingly had no revenues. Video and other related revenues remained relatively flat on a comparative basis. Revenues from video encoding projects and consulting projects decreased significantly in the first three quarters of 2001 as a result of our decision to de-emphasize that portion of our business. Media restoration revenues, which include those from VidiPax, increased due to the inclusion of nine months in our financial results in 2001 and three and one half-months in the same period in 2000, offsetting the decrease in video encoding and consulting revenues. In the nine months ended September 30, 2000 we generated revenues from the sale or license of custom applications totaling $632,000. These revenues related to product offerings, which we decided to no longer support after our operational restructuring. In the nine months ended September 30, 2001 we generated no revenues from sales or license of those technologies.

Cost of Revenues.Cost of revenues decreased to $8.5 million in the nine months ended September 30, 2001 from $8.6 million in the period ended September 30, 2000. A stock-based compensation credit totaling $34,000 was related to stock option cancellations of $138,000 and deferred stock amortization charges of $104,000 for the three quarters ended September 30, 2001 and stock-based compensation charges of $407,000 in 2000, are attributable to employees included in cost of revenues and are presented in the separate operating expense line item within the statements of operations. Cost of revenues as a percent of revenues increased slightly from the same period in 2000 primarily due to the significantly higher personnel levels in the first quarter of 2001, as well as decreased capacity utilization resulting from lower volumes of large-scale encoding projects in 2001. Additional depreciation in 2001 from significant asset acquisitions in 2000 also contributed to the increase. These increases were partially offset by the inclusion of higher margin product offerings acquired from DiscoverMusic and VidiPax. We believe that margins should improve as a result of the consolidation of our production operations from three separate facilities to the one facility acquired in the Activate transaction and the related reduction in personnel requirements. This integration of business units should result in lower overhead costs in one shared facility. We expect margins on traditional service offerings to remain fairly constant through the remainder of 2001 and expect future margins to improve as product mix changes towards Media Subscription Services and offerings based upon our archival platform.

Research and Development Expenses.Research and development expenses totaled $7.9 million and $4.9 million in the nine months ended September 30, 2001 and 2000, respectively. The increase over the same period in 2000 is primarily due to the acquisition of on-line radio technology and personnel in 2001, increased headcount in the first quarter of 2001 over the same period in the prior year and the cessation of capitalization of software development costs on completed projects in 2000. We do not currently have any development projects which meet the criteria for capitalization. Costs of enhancing the automated production system, the development of our archival platform and the continued development of online radio technology and other unannounced applications and service offerings comprised a majority of our research and development expenses in 2001, while 2000 included a number of projects which have since been terminated. A stock-based compensation credit totaling $21,000 was related to stock option cancellations of $85,000 and deferred stock amortization charges of $64,000 for the three quarters ended September 30, 2001. Stock-based compensation charges of $253,000 in 2000, are attributable to employees included in research and development and are presented in the separate operating expense line item within the statements of operations.

development headcount was significantly reduced and, as a result, we expect research and development expenses to continue sequentially at lower rates. This decrease is expected to be slightly offset by the development efforts ongoing at Activate.

Sales and Marketing Expenses.Sales and marketing expenses totaled $7.3 million and $10.9 million in the nine months ended September 30, 2001 and 2000, respectively. Sales and marketing expenses consist primarily of salaries, commissions, co-marketing expenses, trade show expenses, product branding costs, advertising and cost of marketing collateral. The significant decrease in sales and marketing expenses was primarily due to the decreased personnel subsequent to our corporate restructuring and an overall reduction in marketing spending. A stock-based compensation credit totaling $57,000 was related to stock option cancellations of $227,000 and deferred stock amortization charges of $170,000 for the three quarters ended September 30, 2001 and stock-based compensation charges of $668,000 in 2000, are attributable to employees included in sales and marketing and are presented in the separate operating expense line item within the statements of operations.

General and Administrative Expenses. General and administrative expenses totaled $7.7 million and $5.5 million in the nine months ended September 30, 2001 and 2000, respectively. The increase was primarily due to the higher headcount in early 2001 compared to the same period in 2000 as well as higher unallocated facilities charges in 2001. Additional increases were due to contractual bonuses paid to employees acquired in the Vidipax transaction and increased legal expenses related to ongoing corporate initiatives. We believe that general and administrative expenses will decrease slightly or remain flat in future periods as a result of our restructuring efforts and our focus on controlling costs in all areas, although, new initiatives may cause these expenses to actually increase over time. Stock-based compensation charges totaling $323,000 were related to the acceleration of certain options in the first quarter of 2001 of $635,000, deferred stock amortization charges of $947,000, partially offset by stock option cancellations of $1,259,000. Stock-based compensation charges of $3.1 million in 2000, are attributable to employees included in general and administrative. Stock-based compensation charges are presented in the separate operating expense line item within the statements of operations.

Amortization of Intangibles and Other Assets.Amortization of intangibles and other assets totaled $5.9 million and $5.6 million in the nine months ended September 30, 2001 and 2000, respectively, and includes amortization of the goodwill and identified intangible assets related to past acquisitions and amortization related to the fair value of warrants granted to certain partners. The increase was primarily due to increased amortization resulting from the DiscoverMusic, OnAir, Addition Systems, Inc. and theDial transactions closed in 2001 and amortization of intangibles resulting from the VidiPax acquisition in June 2000, partially offset by lower amortization on intangibles resulting from the Alive.com transaction in 1999, which were written down in the impairment charge in the first quarter of 2001. Future amortization will increase as a result of the Activate acquisition. Additionally, we expect to continue our growth strategy and should additional acquisitions occur, amortization expense would increase accordingly.

Stock-Based Compensation.Stock-based compensation totaled $211,000 and $4.4 million in the nine months ended September 30, 2001 and 2000, respectively. Stock-based compensation in 2001 consisted of approximately $1,285,000 in amortization of deferred stock compensation, a charge of $635,000 related to a modification associated with stock options held by a former employee, partially offset by a credit related to option cancellations resulting from employee terminations and cancellation of related stock options which had previously generated amortized deferred stock compensation of approximately $1.7 million. Stock-based compensation in 2000 consisted of $3.7 million in amortization of deferred stock compensation related to stock options granted below deemed fair market value through March 31, 2000, charges of $1.3 million related to marking options granted to consultants to fair market value as of September 30, 2000 and a credit resulting from option cancellations which had previously amortized deferred stock compensation of approximately $574,000.

Special Charges.Throughout 2001, we have implemented an effort to reduce overall levels of operating expenses through a series of operational restructurings and consolidations. As a result of these restructurings, the reduction in personnel, the discontinuation of certain product offerings, facilities consolidations, the impairment of redundant equipment and the impairment of previously recorded intangibles resulting from past acquisitions, we have recorded special charges totaling approximately $20.5 million in 2001. There were no such charges recorded in 2000. Of these special charges, $16.2 million of represents non-cash charges related to the write-down of video-related equipment, intangibles, redundant equipment or leasehold improvements. The remaining charges of $4.0 million are related to facility closure costs and severance-related payments to terminated employees. A breakout of these charges for the nine months ended September 30, 2001 follows:


(in millions)
Intangible impairments	$	12.2
Equipment impairments		2.6
Facility charges and other		3.4
Employee severance		2.3

	$	20.5

We currently anticipate future special charges related to the facilities consolidation into Activate’s facilities and the reduction in force announced in November of approximately $2.0 million. We reevaluate the carrying value of our assets at appropriate times, and future charges may be necessary if conditions require them.

Interest Income.Interest income representing earnings on our cash, cash equivalents and short-term investments totaled $2.7 million and $4.1 million in the nine months ended September 30, 2001 and 2000, respectively. The decreased income was due primarily to our lower average cash and investment balances in 2001 in addition to lower interest rates. We expect that our interest income will decrease in the future as our cash and investment balances decrease to fund our operating, investing and financing activities.

Interest Expense.Interest expense consists of interest expense related to our debt instruments as well as amortization of financing charges related to our debt instruments. This totaled $943,000 and $574,000 in the nine months ended September 30, 2001 and 2000, respectively. The increase was due primarily to increased levels of borrowings incurred to finance fixed asset acquisitions, partially offset by decreased interest rates.

Liquidity and Capital Resources

As of September 30, 2001, we had approximately $68.6 million of cash, cash equivalents and short-term investments.

Net cash used in operating activities was $18.6 million and $21.6 million in the nine months ended September 30, 2001 and 2000, respectively. For 2001, cash used in operating activities resulted primarily from a net loss of $49.2 million; partially offset by non-cash charges totaling $27.8 million related to depreciation and amortization, the non-cash components of the special charges, and stock- based compensation, a decrease of approximately $2.2 million in accounts receivable, an increase in accrued compensation, benefits and other expenses of $1.8 million, partially offset by other uses of $1.2 million. Cash used in operating activities in 2000 was due primarily to a net loss of $28.9 million, a decrease in accounts payable of $4.3 million, an increase in accounts receivable of $1.9 million, partially offset by an increase in accrued compensation, benefits and other expenses of $1.0 million and non-cash stock-based compensation, depreciation and amortization charges totaling $13.0 million.

Net cash provided by investing activities was $24.8 million in the nine months ended September 30, 2001, and net cash used in investing activities was $18.0 million in the nine months ended September 30, 2000. For 2001, cash provided by investing activities was primarily related to the net sales of short-term investments, partially offset by purchases of property and equipment and cash paid for the acquisitions closed in 2001. Cash used in investing activities in 2000 was primarily related to purchases of property and equipment; cash paid for acquisition of businesses and capitalized software costs.

Net cash provided by financing activities was $3.9 million in the nine months ended September 30, 2001 and net cash provided by financing activities was $88.8 million in the nine months ended September 30, 2000. The cash provided by financing activities in 2001 primarily resulted from the funds received from our new credit facility, offset by principal payments of our long-term debt and capital lease obligations. Net cash provided by financing activities in 2000 primarily resulted from the net proceeds of our initial public offering, the concurrent sale of common shares to a strategic investor, and the underwriters’ exercise of their over-allotment option.

As of September 30, 2001, our principal commitments consisted of obligations outstanding under operating leases, as well as notes payable totaling $17.2 million under our credit facilities and capital lease obligations. In addition, we have certain financial commitments under existing agreements that will require significant uses of our cash resources.

Since our inception, our operating expenses have significantly increased in order to support our growth. We currently anticipate that such expenses will continue to be a material use of our cash resources. We expect that capital expenditures, excluding acquisitions, will total approximately $500,000 in the remainder of calendar year 2001 and will relate primarily to the facilities consolidation.

We believe that our existing cash, cash equivalents, and short-term investments will be sufficient to fund our operations and meet our working capital and capital expenditure requirements during 2001 and 2002. Thereafter, if we cannot fund operating and other expenses, working capital and capital expenditure requirements from our operations, we may find it necessary to obtain additional equity or debt financing, sell assets or reduce spending plans. In the event additional equity or debt financing is required, we may not be able to raise it on acceptable terms, or at all.

RISK FACTORS

We have a limited operating history, making it difficult for you to evaluate our business and your investment

The Company was formed as a limited liability company in August 1997 and incorporated in March 1998. We therefore have a very limited operating history upon which an investor may evaluate our operations and future prospects. Because of our limited operating history, we have limited insight into trends that may emerge and affect our business. In addition, the revenue and income potential of our business and market are unproven. Because of the recent emergence of the Internet media infrastructure industry, our executives have limited experience in this industry. As a young company, we face risks and uncertainties relating to our ability to implement our business plan successfully, particularly due to the relatively early stage of the streaming media industry. Our potential for future profitability must be considered in light of the risks, uncertainties, expenses and difficulties frequently encountered by companies in their early stages of development, particularly companies in new and rapidly evolving markets, such as the Internet media infrastructure industry, using new and unproven business models.

Because we expect to continue to incur net losses, we may not be able to implement our business strategy and the price of our stock may decline

We have incurred net losses from operations of $101.2 million during the period August 12, 1997 (inception) through September 30, 2001. Given the level of our planned operating and capital expenditures, we expect to continue to incur losses and negative cash flows for the foreseeable future. To achieve profitability, we must, among other things:

	•		Successfully integrate our recent acquisition of Activate and execute our webcasting services strategy;

	•		Incorporate our online radio technology strategy;

	•		Achieve customer adoption and acceptance of our products and services;

	•		Successfully scale our current operations and integrate our facilities;

	•		Introduce new digital media services and applications;

	•		Implement and execute our business and marketing strategies;

	•		Address media copyright issues without negatively impacting our business;

	•		Develop and enhance our brand;

	•		Respond to competitive developments in the Internet media infrastructure industry;

	•		Continue to attract, integrate, retain and motivate qualified personnel; and

	•		Upgrade and enhance our technologies to accommodate expanded digital media service and application offerings.

We might not be successful in achieving any or all of these objectives. Failure to achieve any or all of these objectives could have a serious adverse impact on our business, results of operations and financial position. Even if we ultimately do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. Our ability to reduce our operating expenses from our corporate cost-savings initiatives implemented throughout 2001 may be adversely affected by expenditures related to expanding our digital media service and application offerings; obtaining, administering, and renewing financially reasonable music content license agreements with the various third parties in the fragmented music recording and publishing industries; growing our customer base; enhancing our brand image; and improving our technology infrastructure.

Our ability to operate our business and implement our business strategy may be hampered by our future negative cash flows, and the value of our stock may decline as a result. Our capital requirements may vary materially from those currently planned if, for example, we have to incur unforeseen capital expenditures, unforeseen operating expenses or make investments to maintain our competitive position. If this is the case, we may have to delay or abandon some or all of our development plans or otherwise forego market opportunities.

Our quarterly financial results are subject to fluctuations that may make it difficult to forecast our future performance and could cause our stock price to decline

Our quarterly operating results have fluctuated in the past, and we expect our revenues and operating results to vary significantly from quarter to quarter due to a number of factors, including:

	•		Variability in demand for our digital media services and applications;

	•		Profitability and viability of existing and emerging businesses focused on distribution of digital media content over the Internet;

	•		Willingness of our customers to enter into digital media and applications services agreements for digital media in light of the economic and legal uncertainties related to their business models;

	•		Ability of our customers to procure necessary intellectual property rights in the digital media content they intend to utilize in their businesses;

	•		Market acceptance of new digital media services and applications offered by us and our competitors;

	•		Introduction or enhancement of digital media services and applications offered by us and our competitors;

	•		The mix of distribution channels through which our products and services are licensed and sold;

	•		Changes in the growth rate of Internet usage and adoption of broadband access;

	•		Variability in average order size or product mix;

	•		Ability of customers to cancel agreements or orders on little or no advance notice;

	•		Changes in our pricing policies or the pricing policies of our competitors;

	•		Technical difficulties with respect to the use of our products and services;

	•		Governmental regulations affecting use of the Internet, including regulations concerning intellectual property rights and security measures;

	•		The amount and timing of operating costs and capital expenditures related to expansion of our business operations and infrastructure;

	•		Competition from companies entering our markets;

	•		General economic conditions such as fluctuating interest rates and inflation; and

	•		Economic conditions specifically related to the Internet such as fluctuations in the costs of Internet access, hardware and software.

Our current and future levels of operating expenses and capital expenditures are to a large extent, fixed in the short term. Thus, we may not be able to adjust spending in a timely manner to compensate for any shortfall in revenues and any significant shortfall in revenues relative to planned expenditures could have an immediate adverse effect on our business and results of operations. If our operating results fall below our expectations as well as those of securities analysts and investors in some future periods, our stock price will likely decline.

Historically, we have priced our digital media services based on the customer’s projected service volumes. We generally offer our digital media services through volume purchase orders with prices determined by customers committing to specific service volumes and schedules and paying nonrefundable deposits. We attempt to secure these commitments from customers to enable us to schedule time in our production facilities, to staff our operations efficiently and to forecast revenues and cost of revenues. If our customers are not willing to do business with us on these terms or if they do not fulfill their commitments under volume purchase orders, our ability to forecast revenues will be adversely affected and could contribute to increased fluctuation in our quarterly results, which could seriously harm our business.

Our common stock price has been volatile and there is a risk we could be delisted from the Nasdaq National Market

Our common stock price has been, and may continue to be, extremely volatile, and there is a risk we could be delisted from the Nasdaq National Market. The market price of our common stock has declined significantly in recent months, and we expect that it will continue to be subject to significant fluctuations as a result of variations in our quarterly operating results and volatility in the financial markets. Our stock currently trades below $1.00 and may continue to do so. If our stock continues to trade below $1.00 per share for 30 consecutive business days after December 31, 2001, we may receive notice from the Nasdaq National Market that we need to comply with the requirements for continued listing on the Nasdaq National Market within 90 calendar days from such notification or be delisted. If our stock is delisted from the Nasdaq National Market, an investor could find it more difficult to dispose of, or to obtain accurate quotations as to the market value of, our common stock. Additionally, our stock may be subject to “penny stock” regulations. If our common stock were subject to “penny stock” regulations, which apply to certain equity securities not traded on the Nasdaq National Market which have a market price of less than $5.00 per share, subject to limited exceptions, additional disclosure would be required by broker-dealers in connection with any trades involving such penny stock.

Substantial sales of our common stock could cause our stock price to decline

Sales of a substantial number of shares of common stock in the public market, or the perception that these sales may occur, could adversely affect the market price of the common stock by potentially introducing a large number of sellers of our common stock into a market in which the common stock price is already volatile, thus driving the common stock price down. In addition, the sale of these shares could impair our ability to raise capital through the sale of additional equity securities.

We depend on the development and rate of adoption of digital media and Internet broadcasting and the delay or failure of this development would seriously harm our business

We depend on the development and rate of adoption of digital media and Internet broadcasting and the delay or failure of this development would seriously harm our business. Our success depends on users having access to the necessary hardware, software and bandwidth, or data transmission capability, to receive high quality digital media over the Internet. Congestion over the Internet and data loss may interrupt audio and video streams, resulting in unsatisfying user experiences. The success of digital media over the Internet depends on the continued rollout of broadband access to consumers on an affordable basis. If the Internet does not develop as an effective medium for the distribution of digital media content to consumers or if businesses predicated on the distribution of digital media content are not profitable or are unable to raise necessary operating capital, then we will not succeed in executing our business plan. Many factors could inhibit the growth of electronic commerce in general and the distribution of digital media content in particular, including concerns about the profitability of Internet-based businesses, uncertainty about intellectual property rights associated with music and other digital media, bandwidth constraints, piracy and privacy. Widespread adoption of digital media technology depends on overcoming these obstacles, identifying viable revenue models for digital media-based business, improving audio and video quality and educating customers and users in the use of digital medial technology. If digital media technology fails to overcome these obstacles, our business could be seriously harmed.

Commercial failure of Internet-based businesses will reduce demand for our digital media services and applications

The substantial proportion of customers for our digital media services and applications have been Internet-based businesses and we expect that in the future, a majority of our customers will be these types of businesses.

Our business prospects and revenues would be harmed by the commercial failure or diminished commercial prospects of these or like customers. In addition, if such customers have difficulty raising additional capital to fund their operations, our business prospects and revenues would be harmed.

We may be liable or alleged to be liable to third parties for the content that we encode, distribute or make available on our site:

We may be liable or alleged to be liable to third parties for the content that we encode, distribute or make available on our site:

	•		If the content or the performance of our services violates third party copyright, trademark, or other intellectual property rights;

	•		If our customers violate the intellectual property rights of others by providing content to us or by having us perform digital media services; or

	•		If content that we encode or otherwise handle for our customers is deemed obscene, indecent, or defamatory.

In addition, we face the risk that our customers might not have all necessary ownership or license rights in the content for us to perform our encoding services. Any alleged liability could harm our business by damaging our reputation, requiring us to incur legal costs in defense, exposing us to awards of damages and costs and diverting management’s attention which could have an adverse effect on our business, results of operations and financial condition. Our customers for encoding services generally agree to hold us harmless from claims arising from their failure to have the right to encode the content given to us for that purpose. However, customers may contest this responsibility or not have sufficient resources to defend claims and we have limited insurance coverage for claims of this nature.

Because we host audio and video content on our Web site and on other Web sites for customers and provide services related to digital media content, we face potential liability or alleged liability for negligence, infringement of copyright, patent, or trademark rights, defamation, indecency and other claims based on the nature and content of the materials we host. Claims of

this nature have been brought, and sometimes successfully pressed, against Internet content distributors. In addition, we could be exposed to liability with respect to the unauthorized duplication of content or unauthorized use of other parties’ proprietary technology. The music industry in particular has recently been the focus of heightened concern with respect to copyright infringement and other misappropriation claims, and the outcome of developing legal standards in that industry is expected to impact music, video and other content being distributed over the Internet. These risks are difficult to quantify in light of the continuously evolving nature of laws and regulations governing the Internet. Any claim relating to proprietary rights, whether meritorious or not, could be time-consuming, result in costly litigation, cause service upgrade delays or require us to enter into royalty or licensing agreements, and we can not assure you that we will have adequate insurance coverage or that royalty or licensing agreements will be available on terms acceptable to us or at all.

We depend on a limited number of customers for a majority of our revenues so the loss of, or delay in payment from, one or a small number of customers could have a significant impact on our revenues and operating results

A limited number of customers have accounted for a majority of our revenues and will continue to do so for the foreseeable future. During the three months ended September 30, 2001, two of our customers accounted for approximately 31% of our revenues; while in the three months ended September 30, 2000, one other customer accounted for approximately 35% of our revenues. We believe that a small number of customers will likely continue to account for a significant percentage of our revenues for the foreseeable future. Due to high revenue concentration among a limited number of customers, the cancellation, reduction or delay of a large customer order or our failure to timely complete or deliver a project during a given quarter is likely to significantly reduce revenues for the quarter. If we were to lose a key customer, our business, financial condition, and operating results could suffer. In addition, if any customer fails to pay amounts it owes us, or does not pay those amounts on time, our revenues and operating results could suffer. If we are unsuccessful in increasing our customer base, our business could be harmed.

We rely on strategic relationships to promote our services and for access to licensed technology and content; if we fail to maintain or enhance these relationships, our ability to serve our customers and develop new services and applications could be harmed

Our ability to provide our services to users of multiple technologies and platforms depends significantly on our ability to develop and maintain our strategic relationships with key streaming media technology companies including, among others, Apple Computer, Inc., Microsoft Corporation, and RealNetworks, Inc. We rely on these relationships for licensed technology to maintain our ability to service RealNetworks RealMedia, Microsoft Windows Media and Apple Quicktime platforms and applications. In addition, we rely on relationships with major recording labels for our music content licensing strategy. Obtaining comprehensive music content licenses is challenging, as doing so may require us to obtain copyright licenses with various third parties in the fragmented music recording and publishing industries. These copyrights often address differing activities related to the delivery of digital media, including reproduction and performance, some of which may require separate licensing arrangements from various rights holders such as publishers, artists and record labels. The effort to obtain the necessary rights by such third parties is often significant, and could disrupt, delay, or prevent us from executing our business plans. Because of the large number of potential parties from which we must obtain licenses, we may never be able to obtain a sufficient number of licenses to allow us to provide services that will meet our customers’ expectations. We cannot be certain that we will be successful in developing new relationships or that our partners will view these relationships as significant to their own business or that they will continue their commitment to us in the future. If we are unable to maintain or enhance these relationships, we may have difficulty strengthening our technology development and increasing the adoption of our brand and services.

Our growth could be limited if we fail to successfully identify and integrate potential acquisitions and investments

We expect to evaluate and acquire businesses, technologies, services, or products that we believe are a strategic fit with our business. Entering into an acquisition entails many risks of any which could materially harm our business, including:

	•		Diversion of management’s attention from other business concerns;

	•		Failure to assimilate the acquired company with our pre-existing business;

	•		Potential loss of key employees from either our pre-existing business or the acquired business;

	•		Dilution of our existing stockholders as a result of issuing equity securities, including the shares potentially issuable as a result of the Activate acquisition; and

	•		Assumption of liabilities of the acquired company.

	•		Complementary products and services may not be available on commercially reasonable terms;

	•		We may be unable to compete for acquisitions of products and services with many of our competitors who have greater financial resources than we do;

	•		Acquired products and services may not meet the needs of our customers;

	•		We may incur difficulties associated with the integration of the personnel and operations of an acquired company with our personnel and operations;

	•		We may incur difficulties in assimilating products, services or technologies, with our existing products, services and technologies we obtained from acquisitions; and

	•		Integration of acquired and existing products and services may result in decreases in revenue from existing products and services.

In particular, transactions of this sort require the process of integrating an acquired business, technology, service, or product and may result in unforeseen operating difficulties and expenditures and may absorb significant management attention that would otherwise be available for ongoing development of our business. Moreover, we cannot assure you that the anticipated benefits of any acquisition will be realized. For example, we may not be able to successfully assimilate the personnel, technology, operations and customers we obtained from acquisitions into our business. In addition, we may fail to achieve the anticipated synergy from these acquisitions, including marketing, product development, distribution and other operational synergies. Acquisitions could also result in material use of cash resources, potentially dilutive issuances of equity securities, the incurrence of debt, contingent liabilities, or amortization expenses related to goodwill and other intangible assets and the incurrence of large and immediate write-offs, any of which could seriously harm our business, results of operations and financial condition.

In addition, the reduced availability of write-offs for in-process research and development costs under the purchase method of accounting in connection with an acquisition could make an acquisition more costly for us. We will incur additional amortization expense in future periods as a result of the excess purchase price associated with our acquisitions of DiscoverMusic, Addition Systems, Inc. and Activate and certain assets and technology from OnAir and theDial.com.

As a result of the Activate acquisition, we will be required to make payments totaling $3.0 million on September 25, 2002. If the common stock issued at that time is the maximum amount as prescribed by the closing agreement, existing stockholders could have their current holdings diluted by approximately 15%.

The United States music industry is extremely litigious; we may become involved in litigation and expenses related to litigation could severely impact our financial condition, and could also result in the discontinuation or interruption of services to our customers

The music industry in the United States is generally regarded as extremely litigious in nature compared to other industries. As a result, in the future we could become engaged in litigation with others in the music industry. Any litigation could subject us to significant liability for damages and could result in us having to discontinue or interrupt services to our customers. In addition, even if we were to prevail, litigation could be time-consuming and expensive to defend and could result in the diversion of management time and attention.

A class action lawsuit has been filed against us which may result in litigation that is costly to defend and the outcome of which is uncertain and may harm our business

We and certain of our current or former officers and directors are named as defendants in a purported class action complaint which has been filed allegedly on behalf of certain persons who purchased our common stock during the time period beginning on March 15, 1999 and ending on December 6, 2000. The complaint alleges violations of the Securities Act of 1933 and the Securities Exchange Act of 1934. Primarily it alleges that there was undisclosed compensation received by our underwriters in connection with our initial public offering.

We can provide no assurance as to the outcome of this matter. Any resolution of this matter in a manner adverse to us would have a material adverse affect on our financial position and results of operation. In addition, the costs to us of defending any litigation or other proceeding, even if resolved in our favor, could be substantial. Such litigation could also substantially divert the attention of our management and our resources in general. Uncertainties resulting from the initiation and continuation of any litigation or other proceedings could harm our ability to compete in the marketplace. In addition, because class action litigation has often been brought against companies following periods of volatility in their stock prices, we could become involved in additional litigation.

If we are ineffective in managing our growth, our business may be harmed

Our current or future infrastructure and systems (such as information technologies and accounting) may prove to be insufficient to indefinitely accommodate our targeted level of future operations. Effectively managing any future growth will

require, among other things, that we successfully upgrade and expand our production processes and systems, expand the breadth of products and services we offer, continue to improve our management reporting capabilities and accounting systems. We also need to retain our highly skilled and motivated executives and other employees. We must also maintain close coordination among our marketing, operations, development, finance and administrative organizations.

Our music content licenses could result in operational complexity that may divert resources or make our business more expensive to conduct

The large number of licenses which we need to maintain in order to expand our services creates operational difficulties in connection with tracking the rights that we have acquired and the complex royalty structures under which we must pay. In addition, our licensing agreements typically allow the third party to audit our royalty tracking and payment mechanisms to ensure that we are accurately reporting and paying the royalties owed. If we are unable to accurately track the numerous parties that we must pay in connection with each delivery of digital music services and deliver the appropriate payment in a timely fashion, we may risk termination of certain licenses.

Technological advances may cause our services and applications to be unnecessary

As more audio and video content is originally created in digital media formats, the need for our encoding services may decrease. In addition, the advancement of features in streaming media software applications from Microsoft, RealNetworks and others may incorporate services and applications we currently offer, or intend to offer, making our services or applications unnecessary or obsolete. This could seriously harm our business.

The failure to retain and attract key technical personnel and other highly qualified employees could harm our business

Because of the complexity of our services, applications and related technologies, we are substantially dependent upon the continued service of our existing product development personnel. In addition, we may hire additional engineers with high levels of experience in designing and developing software and rich media products in time pressured environments. As we continue to introduce additional applications and services, and as our customer base and revenues grow, we will need to hire additional qualified personnel in other areas of operations as well. New personnel will require training and education and take time to reach full productivity. Our failure to attract, train, and retain these key technical personnel could seriously harm our business. Further, our business and operations are substantially dependent on the performance of our executive officers and key employees, all of whom are employed on an at-will basis and have worked together for only a relatively short period of time. We do not maintain “key person” life insurance on any of our executive officers. In addition, we hired or named new employees in 2000 and 2001 in key executive positions, including our Chief Executive Officer, Chief Financial Officer, Senior Vice President of Sales, Senior Vice President of Corporate Development and General Counsel. The loss of several key executives could seriously harm our business. Finally, we added significant numbers of employees in connection with our acquisitions of DiscoverMusic and Activate and the OnAir and theDial transactions. As we complete the integration of those acquisitions and employees, we are reviewing our organizational structure and number of employees. Any reorganization or reduction in the size of our employee base could harm our ability to attract and retain other valuable employees critical to the success of our business.

Competition may decrease our market share, revenues, and gross margins

The market for digital media services and applications is relatively new, and we face competition from in-house encoding services by potential customers, other vendors that provide outsourced digital media services and companies that directly provide digital media applications. If we do not compete effectively or if we experience reduced market share from increased competition, our business will be harmed. In addition, the more successful we are in the emerging market for Internet media services and applications, the more competitors are likely to emerge including turnkey Internet media application and service providers; streaming media platform developers; digital music infrastructure providers; and digital media applications service providers (including for digital music subscription). As we continue to develop media subscription applications, we may also over time begin to compete with some of our historical customers and partners who could also develop and market business-to-business subscription offerings.

In addition, we may not compete successfully against current or future competitors, many of whom have substantially more capital, longer operating histories, greater brand recognition, larger customer bases and significantly greater financial, technical and marketing resources than we do. These competitors may also engage in more extensive development of their technologies, adopt more aggressive pricing policies and establish more comprehensive marketing and advertising campaigns than we can. Our competitors may develop products and service offerings that are more sophisticated than our own. In addition, our competitors may bundle their services with other software or hardware to offer a more complete range of Internet media products and services to meet all of the content distribution needs of our customers. For these and other reasons, our

competitors’ products and services may achieve greater acceptance in the marketplace than our own, limiting our ability to gain market share and customer loyalty and to generate sufficient revenues to achieve a profitable level of operations.

Our industry is experiencing consolidation that may intensify competition

The Internet and media distribution industries have recently experienced substantial consolidation and a proliferation of strategic transactions. We expect this consolidation and strategic partnering to continue. Acquisitions or strategic relationships could harm us in a number of ways. For example:

	•		competitors could acquire or enter into relationships with companies with which we have strategic relationships and discontinue our relationship, resulting in the loss of distribution opportunities for our products and services or the loss of certain enhancements or value-added features to our products and services;

	•		competitors could obtain exclusive access to desirable multimedia content and prevent that content from being available in our formats, thus decreasing the use of our products and services to distribute and experience the content that audiences most desire, and hurting our ability to attract advertisers to our Web sites and product offerings;

	•		suppliers of important or emerging technologies could be acquired by a competitor or other company which could prevent us from being able to utilize such technologies in our offerings, and disadvantage our offerings relative to those of competitors;

	•		a competitor could be acquired by a party with significant resources and experience that could increase the ability of the competitor to compete with our products and services; and

	•		other companies with related interests could combine to form new, formidable competition, which could preclude us from obtaining access to certain markets or content, or which could dramatically change the market for our products and services.

Any of these results could put us at a competitive disadvantage, which could cause us to lose customers, revenue and market share. They could also force us to expend greater resources to meet the competitive threat, which could also harm our operating results.

Our business model is unproven, making it difficult to forecast our revenues and operating results

Our business model is based to a certain degree on the premise that digital media content providers and developers will outsource a large percentage of their encoding services needs and content management needs. Our potential customers may rely on internal resources for these needs. In addition, technological advances may render an outsourced solution unnecessary, particularly as new media content is created in a digital format. Market acceptance of our services may depend in part on reductions in the cost of our services so that we may offer a more cost effective solution than both our competitors and our customers doing the work internally. Our cost reduction efforts may not allow us to keep pace with competitive pricing pressures and may not lead to improved gross margins. In order to remain competitive, we expect to reduce the cost of our services through design and engineering changes. We may not be successful in reducing the costs of providing our services.

Average selling prices of our services may decrease, which may harm our gross margins

The average selling prices of our services may be lower than expected as a result of competitive pricing pressures, promotional programs and customers who negotiate price reductions in exchange for longer term purchase commitments or otherwise. The pricing of services sold to our customers depends on the duration of the agreement, the specific requirements of the order, purchase volumes, the sales and service support and other contractual agreements. We have experienced and expect to continue to experience pricing pressure and anticipate that the average selling prices and gross margins for our products will decrease over product life cycles. We may not be successful in developing and introducing on a timely basis new products with enhanced features that can be sold at higher gross margins.

If we fail to enhance our existing services and applications products or develop and introduce new digital media services, applications and features in a timely manner to meet changing customer requirements and emerging industry standards, our ability to grow our business will suffer

The market for Internet media infrastructure solutions is characterized by rapidly changing technologies and short product life cycles. These market characteristics are heightened by the emerging nature of the Internet and the continuing trend of companies from many industries to offer Internet-based applications and services. The widespread adoption of the new Internet, networking, streaming media, or telecommunications technologies or other technological changes could require us to incur substantial expenditures to modify or adapt our operating practices or infrastructure. Our future success will depend in large part upon our ability to:

	•		Obtain the necessary intellectual property rights from music companies and other content owners to be able to legally provide our services;

	•		Identify and respond to emerging technological trends in the market;

	•		Enhance our products by adding innovative features that differentiate our digital media services and applications from those of our competitors;

	•		Acquire and license leading technologies;

	•		Bring digital media services and applications to market on a timely basis at competitive prices; and

	•		Respond effectively to new technological changes or new product announcements by others.

We will not be competitive unless we continually introduce new services and applications and enhancements to existing services and applications that meet evolving industry standards and customer needs. In the future, we may not be able to address effectively the compatibility and interoperability issues that arise as a result of technological changes and evolving industry standards. The technical innovations required for us to remain competitive are inherently complex, require long development schedules and are dependent in some cases on sole source suppliers. We will be required to continue to invest in research and development in order to attempt to maintain and enhance our existing technologies and products, but we may not have the funds available to do so. Even if we have sufficient funds, these investments may not serve the needs of customers or be compatible with changing technological requirements or standards. Most development expenses must be incurred before the technical feasibility or commercial viability or new or enhanced services and applications can be ascertained. Revenue from future services and applications or enhancements to services and applications may not be sufficient to recover the associated development costs.

We cannot be certain that we will be able to protect our intellectual property, and we may be found to infringe on proprietary rights of others, which could harm our business

Our intellectual property is important to our business, and we seek to protect our intellectual property through copyrights, trademarks, patents, trade secrets, confidentiality provisions in our customer, supplier and strategic relationship agreements, nondisclosure agreements with third parties, and invention assignment agreements with our employees and contractors. We have filed six U.S. patent applications and four international patent applications that claim priority to six previously filed provisional applications. We cannot assure that measures we take to protect our intellectual property will be successful or that third parties will not develop alternative solutions that do not infringe upon our intellectual property.

In connection with the acquisition of DiscoverMusic, the Company assumed certain liabilities, including a patent infringement lawsuit filed by InTouch Group, Inc. (“InTouch”) in which DiscoverMusic is one of the defendants. We believe that we have meritorious defenses to InTouch’s claims and we intend to vigorously defend against such claims. However, to the extent that their patent rights are valid and enforceable and cover our activities, we may be required to pay damages, obtain a license to use such patents or use non-infringing methods to accomplish our activities with regard to our interactive music samples preview technology. It is possible that a license from InTouch would not be available on commercially acceptable terms, or at all, or that we would be unable to use our interactive music samples preview technology in a non- infringing manner. If successful, the InTouch claim that we violate their intellectual property rights could seriously harm our business by forcing us to cease using important intellectual property or requiring us to pay monetary damages. Even if unsuccessful, these claims still can harm our business severely by damaging our reputation, requiring us to incur legal costs, lowering our stock price and public demand for our stock, and diverting management’s attention away from our primary business activities in general.

Our business might be harmed if challenges against Intellectual Property laws by new digital music delivery technologies are successful

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

shared copies are available, legally or illegally, consumers may choose not to pay for downloads from retail and other music delivery sites, which could harm our business.

If standards for the secure, digital delivery of recorded music are not adopted, the piracy concerns of record companies and artists might not be satisfied, and they might not use our platform for digital delivery of their music

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

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

The length of our sales cycle is uncertain and therefore could cause significant variations in our operating results

Our customers typically include large corporations that often require long testing and approval processes before making a purchase decision. Therefore, the length of our sales cycle, the time between an initial customer contact and completing a sale, has been and may continue to be unpredictable. The time between the date of our initial contact with a potential new customer and the execution of a sales contract with that customer ranges from less than two weeks to more than nine months, depending on the size of the customer, the application of our solution and other factors. Our sales cycle is also subject to delays as a result of customer-specific factors over which we have little or no control, including their procurement of appropriate rights from content owners, budgetary constraints and internal acceptance procedures. During the sales cycle, we may expend substantial sales and management resources without generating corresponding revenues. Our expense levels are relatively fixed in the short term and are based in part on our expectation of future revenues. As a result, any delay in our sales cycle could cause significant variations in our operating results, particularly because a relatively small number of customer orders represent a large portion of our revenues.

The technology underlying our services and applications is complex and may contain unknown defects that could harm our reputation, result in product liability or decrease market acceptance of our services and applications.

The technology underlying our digital media services and applications is complex and includes software that is internally developed and software licensed from third parties. These software products may contain errors or defects, particularly when first introduced or when new versions or enhancements are released. We may not discover software defects that affect our current or new services and applications or enhancements until after they are sold. Furthermore, because our digital media services are designed to work in conjunction with various platforms and applications, we are susceptible to errors or defects in third-party applications that can result in a lower quality product for our customers. Because our customers depend on us for digital media management, any interruptions could:

	•		Damage our reputation;

	•		Cause our customers to initiate product liability suits against us;

	•		Increase our product development resources;

	•		Cause us to lose sales; and

	•		Delay market acceptance of our digital media services and applications.

We do not possess product liability insurance, and our errors and omissions coverage is not likely to be sufficient to cover our complete liability exposure.

The concentration of ownership by our affiliated stockholders and provisions in our charter documents and provisions of applicable state law may delay or prevent any merger or takeover of the Company

Certain of our existing stockholders have significant influence over our management and affairs, which they could exercise against your best interests. As of November 1, 2001, our officers and directors, together with entities that may be deemed affiliates of or related to such persons or entities, will beneficially own or have voting control over approximately 32% of our outstanding common stock. Martin Tobias, a former member of the board of directors, has given the board of directors, an irrevocable proxy to vote all of the 4.6 million shares of our Common Stock that he owns. See Note 11 to the Notes to Consolidated Financial Statements and our Report on Form 8-K as filed with the Securities and Exchange Commission on October 30, 2001 for a more complete description of the proxy. As a result, these stockholders, acting together, may be able to influence significantly our management and affairs and matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. Accordingly, this concentration of ownership may have the effect of impeding a merger, consolidation, takeover or other business consolidation involving us, or discouraging a potential acquiror from making a tender offer for our shares. This concentration of ownership could also adversely affect our stock’s market price or lessen any premium over market price that an acquiror might otherwise pay.

Certain provisions of our certificate of incorporation and bylaws and the provisions of Delaware and Washington law could have the effect of delaying, deferring or preventing an acquisition of the Company, even if an acquisition would be beneficial to our stockholders.

We may need to raise additional capital in the future, and if we are unable to secure adequate funds on terms acceptable to us, we may be unable to execute our business plan

We believe that our existing cash, cash equivalents, short-term investments, the amounts available under our modified credit facility will be sufficient to meet our operating expenses working capital, capital expenditure and business expansion requirements through 2001 and 2002. Thereafter, we may need to raise additional funds. We may have to raise funds even sooner in order to fund more rapid expansion, to develop new or enhanced services or products, to respond to competitive pressures, to acquire complementary products, businesses or technologies or otherwise to respond to unanticipated requirements. If additional funds are raised through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced. If we raise capital through debt financing, we may be forced to accept restrictions affecting our liquidity, including restrictions on our ability to incur additional indebtedness or pay dividends. We cannot assure you that additional financing will be available on favorable terms or at all. If adequate funds are not available or are not available on acceptable terms, we may not be able to fund our ongoing operations and planned expansion, take advantage of unanticipated acquisition opportunities, develop or enhance services and applications or respond to competitive pressures. This inability could seriously harm our business, results of operations and financial condition.

Our enterprise webcasting, encoding, data storage and web server systems may stop working or work improperly due to natural disasters, failure of third-party services, power outages, fire and other unexpected problems

Since our primary encoding and data storage facilities and network facilities are located in the state of Washington, a seismic disturbance, or other natural disaster could affect these primary facilities simultaneously. An unexpected event like a power or telecommunications failure, fire, flood, seismic disturbance at or near our encoding and on-site data storage facility or at any of our Internet service providers’ facilities could cause the loss of critical data and prevent us from offering our services to our customers. Our insurance may not adequately compensate us for any losses that may occur.

Our development of an online radio business may be adversely affected by interruptions or failures of Internet related services and technologies, lack of content, and uncertainty involving copyrights and royalty payments

A reduction in the performance, reliability and availability of the Internet, our network infrastructure, or content delivery networks may harm our ability to provide online radio to our users, as well as our reputation and ability to attract and retain users, customers, advertisers and content providers. Our operations will also depend on receipt of timely feeds from our content providers, and any failure or delay in the transmission or receipt of such feeds could disrupt our operations. We will also depend on Web browsers, ISPs and online service providers to provide Internet users access to our online radio. We also intend to provide rebroadcasting solutions and these will be dependent on providing customers with efficient and reliable services to enable such customers to broadcast content to large audiences on an as-needed basis. Our online radio will also be dependent in part upon transmission capacity provided by third-party telecommunications network providers. Any failure of such network providers to provide the capacity we require may result in a reduction in, or interruption of, service to our customers. Our online radio business will also depend on the availability of reasonably priced quality content and our ability to produce quality content.

Our online radio business will likely be subject to the uncertainty related to copyrights and royalty payments discussed above.

Government regulation may require us to change our business

On October 28, 1998, the United States Congress enacted the Digital Millennium Copyright Act (or “DMCA”). The DMCA includes statutory licenses for the performance of sound recordings and for the making of recordings to facilitate transmissions. Under these statutory licenses, depending on our and our customers’ future business activities, we and our customers may be required to pay licensing fees for digital sound recordings streamed or distributed from web sites and through retransmissions of radio broadcasts and/or other audio content. The DMCA does not specify the rate and terms of such licenses, which will be determined either through voluntary inter- industry negotiations or arbitration. Moreover, with respect to digital publishing, sound recording and other music licenses not directly covered by the DMCA, various companies and individuals in the digital music industry plan to engage in a proceeding before a tribunal of the United States Copyright Office along with the Recording Industry Association of America during 2001 to determine what, if any, licensee fees should be paid to various rights holders. Depending on the rates and terms adopted for the statutory licenses, our business could be harmed both by increasing our own cost of doing business, and by increasing the cost of doing business for our customers. In addition, broadcasting of content over the Internet may become subject to more extensive government regulations, similar in scope to those applying to television and radio.

Because of this rapidly evolving and uncertain regulatory environment, both domestically and internationally, we cannot predict how existing or proposed laws and regulations might affect our business. In addition, these uncertainties make it difficult to ensure compliance with the laws and regulations governing digital music. These laws and regulations could harm us by subjecting us to liability or forcing us to change our business.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We provide Internet media infrastructure services and applications. Our financial results could be affected by factors such as changes in interest rates and fluctuations in the stock market. As substantially all sales are currently made in U.S. dollars, a strengthening of the dollar could make our services less competitive in foreign markets. We do not use derivative instruments to hedge our risks. Our interest income and expense is sensitive to changes in the general level of U.S. interest rates, particularly since the majority of our investments are in short-term instruments. Due to the nature of our short-term investments, we anticipate no material market risk exposure. Therefore, no quantitative tabular disclosures are presented.

PART II. OTHER INFORMATION

ITEM 1: LEGAL PROCEEDINGS

Between July 26, 2001 and August 30, 2001, several substantially similar class action complaints were filed in the United States District Court for the Southern District of New York against us and certain of our present or former officers and directors as well as against certain underwriters who handled our March 15, 2000 initial public offering of common stock. The various complaint were purportedly filed on behalf of a class of persons who purchased our common stock during the time period beginning on March 15, 1999 and ending on December 6, 2000. The complaint together allege violations of the Securities Act of 1933 and the Securities Exchange Act of 1934 primarily based on the allegation that there was undisclosed compensation received by our underwriters in connection with our initial public offering and the allegation that the underwriters entered into undisclosed arrangement with some investors that were designed to distort and/or inflate the market price for our common stock in the aftermarket following the initial public offering. The allegations set forth in these complaints are substantially similar to those made in class actions filed against approximately 180 other companies that issued securities within the past three years. These actions have all been consolidated before the same judge for pretrial purposes.

On May 8, 2001, we filed an arbitration demand with the American Arbitration Association (“AAA”) against Valley Media, Inc (“Valley”). We alleged that Valley is liable for substantial damages for material breaches of a Services Agreement between the companies dated as of December 17, 1999, in which Valley made representations and warranties and agreed to perform certain obligations to facilitate the creation of a venture to create and market an Internet music clip streaming service. We provided notice of our intent to terminate that agreement by letter dated February 6, 2001, and that termination was effective 30 days thereafter. We have also alleged claims for misrepresentation, fraud, unjust enrichment and promissory estoppel. The date for the arbitration hearing is June 10, 2002. Under AAA rules, arbitration proceedings are confidential and private. Valley has filed an answer in which it denies liability, and asserts counterclaims for breach of contract, conversion, and declaratory relief.

See Item 1 of Part II of our quarterly report on Form 10-Q for the quarterly periods ended March 31, 2001 and June 30, 2001 for a discussion of legal proceedings as to which there were no material developments in the quarter ended September 30, 2001.

ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS

On July 10, 2001, pursuant to the June 2000 acquisition agreement for VidiPax, Inc., we issued 2,189,111 shares of Loudeye Common Stock to the sole stockholder of VidiPax, Inc. and to two consultants in connection with the transaction. The shares issued pursuant to the acquisition were issued in reliance on the exemption from registration provided by Section 4(2) under the Act. The investors made certain representations to us as to investment intent, their receipt of all information they considered necessary or appropriate in deciding whether to purchase the securities, their knowledge and experience in financial or business matters such that they were capable of evaluating the risks and merits of the investment in the securities, and their ability to bear the economic risk of the investment in the securities, that they possessed a sufficient level of financial sophistication and that they received information about us. The shares issued in the transactions were subject to restrictions on transfer absent registration under the Securities Act, and no offers to sell the securities were made by any form of general solicitation or general advertisement.

ITEM 3: DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY SHAREHOLDERS

None.

ITEM 5: OTHER INFORMATION

None.

ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits.


Exhibit
Number		Description

10.36		Credit Agreement between US Bank National Association and Loudeye Technologies, Inc., dated as of August 22, 2001.
10.37		First Amendment to Credit Agreement between US Bank National Association and Loudeye Technologies, Inc., dated as of October 25, 2001.

(b) Reports on Form 8-K

On September 25, 2001 we filed a Report on Form 8-K that announced that on such date we closed the acquisition of Activate.net Corporation. Our press release announcing the acquisition was filed as an exhibit to the report.

On October 30, 2001, we filed a Report on Form 8-K that announced that on October 26, 2001, we closed the purchase of 4,000,000 shares of Loudeye common stock from Martin Tobias and Alex Tobias. Our press release announcing the purchase as well as the purchase agreement were filed as exhibits to the report.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, on November 13, 2001.


	LOUDEYE TECHNOLOGIES, INC

	By	/s/ BRADLEY A. BERG

		Bradley A. Berg Senior Vice President and Chief Financial Officer Principal Financial Officer


	By	/s/ JEROLD J. GOADE

		Jerold J. Goade Vice President Finance, Controller Principal Accounting Officer

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Loudeye Inactive 10-Q2001 Q3 Quarterly report

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