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THE ORCHARD ENTERPRISES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
11. Stockholders’ Equity – (continued)
amount determined by the Company’s Board of Directors. As of September 30, 2008, a total of 123,541 shares remained available for grant under the Plan.
12. Related-party Transactions
Operating Lease With Affiliate — In April 2006, the Company began utilizing space subleased by eMusic, an entity controlled by Dimensional, with no formal sublease agreement in place. The Company paid the lessee directly for the space utilized. In August 2007, the sublease to this space was assigned by eMusic to the Company and, accordingly, there is no related party expense for the three and nine months ended September 30, 2008 under this arrangement. The Company incurred $8,291 and $177,516 of expense for the three and nine months ended September 30, 2007 related to this arrangement. The lease expires in January 2009.
Legal Costs — The Company has engaged several outside legal firms to represent its general business interests. One such firm employs a family member of one of the senior executives of Dimensional who also is a member of the Company’s Board of Directors. Amounts included in operating expenses in connection with the services performed by this legal firm were $58,874 and $0 for the three months and $258,889 and $2,263 for the nine months ended September 30, 2008 and 2007, respectively.
Additionally, in July of 2008, the Company engaged an employee of eMusic to perform legal services on behalf of the Company in connection with the acquisition of certain assets from TVT. The amounts paid for these services were $100,000 and $0 for the three months and $100,000 and $0 for the nine months ended September 30, 2008 and 2007, respectively.
Distribution Services With eMusic — eMusic provides digital music distribution services to the Company under a Digital Music Wholesale Agreement, dated January 1, 2004, as amended on March 12, 2007. The agreement grants eMusic worldwide rights, on a non-exclusive basis, to exploit the Company’s master recordings digitally and via the Internet through December 31, 2009. Pursuant to the agreement, the Company is entitled to better royalty terms if eMusic allows any other independent record label such better terms during the term of the agreement (a “Most Favored Nation” clause). Amounts included in revenues in connection with these services were $1,100,784 and $772,441 for the three months and $3,450,972 and $2,089,264 for the nine months September 30, 2008 and 2007, respectively. Amounts included in accounts receivable in connection with these services were $1,112,239 and $1,075,602 at September 30, 2008 and December 31, 2007, respectively.
The Company has distribution agreements with certain labels whereby it has agreed to forego distribution fees to the label or artist for sales by eMusic. For the three months ended September 30, 2008 and 2007, the Company received revenues of $143,403 and $175,185 and for the nine months ended September 30, 2008 and 2007, the Company received revenues of $594,557 and $555,884, respectively, from eMusic relating to such agreements. These amounts were recorded in revenues with an equal amount recorded in cost of revenues.
Revenue Sharing Agreement With CGH Ventures, Inc — During 2003, Orchard Management, Inc., a wholly-owned subsidiary of the Company, entered into a revenue sharing agreement with CGH Ventures, Inc., an entity owned by two of the former stockholders of Orchard NY. Pursuant to this agreement, the Company is obligated to pay CGH Ventures, Inc. 80% of the net revenues earned by Orchard Management, Inc. Orchard Management, Inc. provides management services to a recording group. The Company recorded $1,225 and $16,296 for the three months and $31,933 and $32,274 for the nine months ended September 30, 2008 and 2007, respectively, as commission expense for CGH’s share of the net revenue earned under the management agreement. The commission expense was included in cost of revenues in the accompanying condensed consolidated statements of operations.
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THE ORCHARD ENTERPRISES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
13. Commitments and Contingencies
The Company is a party to litigation matters and claims from time to time in the ordinary course of its operations, including copyright infringement litigation for which it is entitled to indemnification by content providers. While the results of such litigation and claims cannot be predicted with certainty, the Company believes that the final outcome of such matters will not have a material adverse impact on its financial position, cash flows, or results of operations.
On March 11, 2008, the Company initiated suit in federal court in the Eastern District of California against TufAmerica, Inc. The complaint alleges fraud, breach of contract and various other wrongs in connection with a contract dispute with TufAmerica, Inc. concerning the number, nature and technical quality of master recordings the label was required to deliver to our company under the contract. The Company requested various forms of relief from the court, including the return of approximately $2.4 million in fees and advances already paid under the contract. On April 23, 2008, TufAmerica answered the Company’s complaint denying the causes of action asserted against it and asserting its own counterclaims against the Company for breach of contract. Although the claim did not specify an exact amount of damages sought, during the course of the dispute TufAmerica, Inc. had sent a letter to the Company claiming damages in the amount of approximately $1.2 million. The discovery process has begun but, because the litigation is in its early stages, the Company is unable to determine if the outcome of this case will be favorable to it. While the Company believes it has meritorious claims and defenses and intends to pursue them vigorously, litigation is inherently uncertain and the Company can provide no assurance as to the ultimate outcome.
On December 15, 2006, MCS Music America, Inc., on behalf of itself and other publishers, brought an action for copyright infringement against Napster, Inc., one of the Company’s digital music stores. MCS alleged that compositions included in 338 sound recordings made available to Napster as part of its subscription service and free Napster infringed on copyrights owned by MCS. 16 of the 338 sound recordings were licensed to Napster by the Company pursuant to the Content Agreement dated August 26, 2004. On July 10, 2008, MCS and Napster settled the claim.
Under the terms of the Content Agreement, the Company indemnified Napster for damages, including legal fees, incurred by Napster for any copyright infringement related to the content being licensed from the Company. The Company’s liability is estimated to be between $60,000 and $120,000 in settlement of this claim and legal fees. The Company recognized $60,000 of expense related to this matter as of September 30, 2008.
We are involved in legal proceedings from time to time in the ordinary course of our business. To our knowledge, there are no other pending or threatened legal proceedings that could have a material effect on our business, financial condition or results of operations.
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Item 2.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with our unaudited condensed consolidated financial statements and notes thereto included in this Quarterly Report on Form 10-Q, our audited consolidated financial statements and notes thereto for the year ended December 31, 2007, and Management’s Discussion and Analysis of Financial Condition and Results of Operations, included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission, or SEC, on March 31, 2008.
Disclosure Regarding Forward-Looking Statements
This quarterly report on Form 10-Q contains forward-looking statements within the meaning of the federal securities laws. These statements relate to, without limitation, our future financial performance, plans and objectives for future operations and projections of revenue and other financial items and involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from those expressed or implied by the forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “likely,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue” or the negative of these terms or other comparable terminology. These forward-looking statements are subject to a number of risks that could cause them to differ from our expectations. These include, but are not limited to, risks relating to:
| • | Our financial condition and results of operations, including expectations and projections relating to our future performance and ability to achieve profitability; |
| • | Our ability to capitalize on our business strategy, including shifting our revenue to a more diversified revenue mix; |
| • | Our ability to take advantage of opportunities for revenue expansion, including through acquisitions, delivery of video content, organic growth in distribution, and revenue growth from higher margin owned and controlled content; |
| • | Ongoing growth in our industry, particularly gaining market share in the growing digital music and mobile distribution markets, as well as the developing market for digital delivery of video; |
| • | Our ability to continue to acquire digital rights and market our value-added services to content owners; |
| • | Complexities involved in the payment and collection of royalties for digital distribution of copyrighted material and risks associated with availability of indemnities to protect us from liability for copyright infringement; |
| • | Distribution of our music and video content; |
| • | Rapidly evolving and changing competitive and industry conditions in the digital media industry, including potentially significant additional competition for digital distribution; |
| • | The effects of the business combination of The Orchard Enterprises, Inc. (a Delaware corporation formerly known as Digital Music Group, Inc.) and Orchard Enterprises NY, Inc. (a New York corporation formerly known as The Orchard Enterprises Inc.); |
| • | Our ability to integrate the assets acquired from TeeVee Toons, Inc. and/or its affiliates into our ongoing business. |
You should not place undue reliance on these forward looking statements, which are based on our reasonable assumptions at the time made, we can give not assurances that such expectations will be achieved. In evaluating these statements, you should specifically consider various factors, including the foregoing risks and those outlined under “Risk Factors” in our Annual Report on Form 10-K as filed with the SEC on March 31, 2008. Many of these factors are beyond our control. Our forward-looking statements represent estimates and
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assumptions only as of the date of this quarterly report on Form 10-Q. Except as required by law, we undertake no obligation to update any forward-looking statement to reflect events or circumstances occurring after the date of this quarterly report on Form 10-Q.
Business Overview
Background and Basis of Presentation
On November 13, 2007, The Orchard Enterprises, Inc. (formerly known as Digital Music Group, Inc. or “DMGI”) consummated a business combination with Orchard Enterprises NY, Inc. (formerly known as The Orchard Enterprises Inc., which we refer to as “Orchard NY”) through a merger of a subsidiary of DMGI with and into Orchard NY pursuant to the terms of the Second Amended and Restated Merger Agreement dated October 5, 2007, as amended on November 7, 2007 (the “Merger”). Pursuant to the terms of the Merger, all of the outstanding common and preferred stock of Orchard NY was cancelled and the former stockholders of Orchard NY received an aggregate of 2,862,910 shares of DMGI common stock (after giving effect to a one for three reverse stock split of DMGI’s common stock that took effect on November 14, 2007) and 446,918 shares of DMGI Series A convertible preferred stock (the “DMGI Series A Preferred Stock”). In addition, DMGI assumed the obligations of Orchard NY under its outstanding deferred common and preferred stock awards and reserved 157,683 shares of DMGI common stock (on a post-split basis) and 1,915 shares of DMGI Series A Preferred Stock for issuance pursuant to such awards. In connection with the Merger, Orchard NY became our wholly-owned subsidiary, with the former stockholders of Orchard NY collectively owning shares of our common and preferred stock representing approximately 60% of the voting power of our outstanding capital stock. The Orchard Enterprises, Inc. and its subsidiaries are referred to collectively as “we,” “us,” and the “Company.” See Note 4 to our condensed consolidated financial statements appearing elsewhere in this quarterly report for further details on the Merger.
For accounting purposes, the Merger was treated as a reverse acquisition with Orchard NY being the accounting acquirer. Accordingly, the historical financial results prior to the Merger are those of Orchard NY and its consolidated subsidiaries and replace the historical financial results of DMGI as it existed prior to the Merger. The results of operations for DMGI and its pre-Merger consolidated subsidiaries are included in our consolidated financial results beginning on November 13, 2007. The presentation of the Condensed Consolidated Statement of Stockholders’ Equity and Redeemable Preferred Stock reflects the effect of the issuance of shares of DMGI common stock and DMGI Series A Preferred Stock in connection with the Merger and the inclusion of DMGI’s outstanding shares of common stock at the time of the Merger.
Orchard NY was incorporated in New York in September 2000. On April 28, 2003, Dimensional Associates, LLC, or Dimensional, an entity formed by a group of private investors, invested in and acquired operating control of Orchard NY through the purchase of a convertible debt instrument followed by subsequent periodic funding events under similar conditions as the original convertible debt instrument. These debt instruments were redeemed or converted prior to completion of the Merger and are described below in “— Liquidity and Capital Resources — Description of Indebtedness.”
On June 26, 2008, the United States Bankruptcy Court of the Southern District of New York (“the Bankruptcy Court”) entered an order that, among other things, approved the sale of substantially all of the assets of TeeVeeToons, Inc. — debtor in possession (“TVT Records”) to the Company pursuant to the terms and conditions of the form of asset purchase agreement provided to the Bankruptcy Court. On July 3, 2008 the Company and TVT Records entered into a definitive purchase agreement (the “Asset Purchase Agreement”) pursuant to which the Company (i) acquired substantially all of the assets of TVT Records’ record label business operations including, but not limited to, masters, artists’ agreements, certain inventory, accounts receivable and a real property lease and (ii) assumed certain liabilities of TVT Records related to the Assets that the Company elected to acquire. For accounting purposes, the asset purchase was treated as a business combination. The results of operations from the TVT acquisition are included in the Company’s condensed consolidated financial results beginning July 3, 2008.
Business
We are a global leader in digital media services, currently controlling and distributing approximately 1,300,000 music and other audio recordings, or tracks, and over 5,000 hours of video programming through hundreds of digital stores (e.g., iTunes, eMusic, Google, Netflix, V CAST) and mobile carriers (e.g., Verizon
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Wireless, Vodafone, Bell Canada, Moderati, 3) worldwide. We generate income for our label, retailer, brand and agency clients by making these music and audio recordings and videos available for purchase at the online stores and through innovative marketing and promotional campaigns; branded entertainment programs; and film, advertising, gaming and television licensing, among other services.
Significant Customers
Since inception through September 30, 2008, our revenue has been derived primarily from the distribution of digital music content. Two customers, Apple iTunes, or iTunes, and eMusic.com, or eMusic (which is controlled by our majority shareholder), account for a significant portion of our total revenues and related accounts receivable. For the nine months ended September 30, 2008 and 2007, iTunes represented 55% and 54% of total revenues and eMusic represented 8% and 11% of total revenues, respectively. Accounts receivable from iTunes were 25% and 34% of total accounts receivable at September 30, 2008 and December 31, 2007, respectively. Accounts receivable from eMusic were 9% and 14% of total accounts receivable at September 30, 2008 and December 31, 2007, respectively.
Sources of Revenues
Our revenues are derived from the following sources:
| • | Permanent downloads. In aggregate terms, our permanent download revenue is driven by the number of music recordings we have available for downloading at digital music retailers, multiplied by the average number of times our music recordings are downloaded, multiplied by the fee paid to us by each retailer. The download rates for our music recordings are driven primarily by the overall size and growth of the digital music market, the popularity and demand for the recordings we make available, the number and nature of the digital music services through which we make the recordings available to consumers, and our territorial distribution rights. We negotiate the fee we receive per download in advance at the time we enter into an agreement with a digital music retailer. |
| • | Subscription download services on the Internet. We also generate revenues from services that offer consumers the ability to download up to a certain number of recordings each month for a fixed subscription fee. In such models, we typically receive a percentage of the total revenue pool generated by the service, after contractually specified costs and deductions, based on our share of total downloads in the service during the billing period. |
| • | Subscription streaming fees. Some digital music retailers distribute our music recordings via streaming on a subscription basis. Our subscription revenue is a percentage of each retailer’s total subscription revenue (after contractually specified costs and deductions) based on the number of times our music recordings are listened to by subscribers as compared to the total for all music recordings listened to during the relevant time period, although the exact formulations by which our revenue is derived varies between services. Following the termination of their subscription, consumers are not able to play our music recordings. |
| • | Mobile services. Our revenue from mobile services is derived primarily from downloads of full-length music recordings and mastertones. Most mobile services generally make available to consumers a limited selection of ringtones due to the limited space on mobile handset screens and higher per track processing costs related to the many formats that are required for various mobile handset makes and models, although this is changing. |
| • | Other. Our other revenue is comprised mainly from licensing fees also referred to as music services, administrative and consulting fees and other sources such as technology-related servicing fees charged to certain digital music retailers and other non-retail clients. |
Combined revenue from digital downloads and subscription fees comprised approximately 79% and 81% of our total revenues for the nine months ended September 30, 2008 and 2007, respectively. Approximately 11% and 6% of our total revenues for the nine months ended September 30, 2008 and 2007, respectively, was derived from mobile services.
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Cost of Revenues
Our cost of revenues primarily consists of:
| • | revenue sharing payments and recoupment of cash advances to artists, record labels and other content owners; |
| • | royalties to artists and publishers; |
| • | amortization of costs to acquire master recordings, digital rights and digital distribution agreements; |
| • | reserves or write-downs of master recordings, capitalized digital rights, digital distribution agreements or royalty advances that may be deemed necessary from time to time; and |
| • | other direct costs of revenues. |
Our cost of revenues and corresponding gross profit is determined by the revenues earned on our available music and audio content. In our digital distribution agreements with content owners, which usually have terms of two to five years, we typically have an exclusive right to collect revenue directly from the digital entertainment services. We then pay a negotiated revenue sharing percentage to the content owner.
In certain instances, with respect to higher profile labels and/or as an inducement to enter into a longer-term license agreement, we may make a royalty advance against the content owner’s share of future royalties. We capitalize all such advances as a prepaid asset that we amortize as a cost of revenue as the related revenue is earned and the cash advances are recouped. We also include in cost of revenues the fees and direct costs incurred in obtaining content. For long-term distribution agreements, we amortize the legal fees and other direct costs incurred in acquiring the agreement on a straight-line basis over the shorter of the term of the related agreement or ten years. When we acquire digital rights or master recordings, we capitalize the purchase price and the direct ancillary costs and amortize the acquisition costs on a straight-line basis over ten years.
While we are typically not responsible for any third party royalties (such as artists and publishers) in our agreements with content owners, for music content that we own and for content distributed under most of our long-term distribution agreements, we are typically responsible for some or all third-party royalties (such as artists and publishers), the cost of which is included in cost of revenues. Artist royalty obligations for music and audio recordings have historically been between 0% and 15% of the revenue attributable to a specific track or album. The publisher royalties for music and audio recordings are a statutory rate in the United States, which was $.091 for recordings 5 minutes or less, or $.0175 per minute or fraction thereof per copy for songs over 5 minutes in 2007 and 2008.
In connection with the allocation of the purchase price to the assets we were deemed to have acquired from DMGI for accounting purposes, we established an asset called Digital Distribution Agreements, which is a component of “Music and Audio Content,” to reflect the estimated fair market value of DMGI’s license agreements at the Merger date. The Company also acquired Digital Distribution Agreements in conjunction with its acquisition of certain assets of TVT Records, which was added to the existing Music and Audio Content pool. We are amortizing these assets to cost of revenues over the term of the related agreements.
We include in cost of revenues depreciation and amortization associated with equipment and computer software that we use to digitally encode music files. Historically, when we have utilized third parties to digitally encode music files into the specific formats required by digital entertainment services, we also included these costs in cost of revenues. We also charge any other third party costs directly associated with earning other revenue to cost of revenues.
Operating expenses include all costs associated with general and administrative expenses, sales and marketing and product development in order to operate the business.
Seasonality
We are not able to identify definitively seasonality in our business because of the early-stage nature of the entire digital distribution industry and our limited operating history. However, we suspect that the first and
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fourth quarters of the calendar year may have seasonally higher sales, because this is the peak time for sales of music recordings in physical format (generally ascribed to increased consumer spending due to the holidays).
Critical Accounting Policies and Estimates
The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures in the consolidated financial statements. Critical accounting estimates and assumptions are those that may be material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change, and that have a material impact on financial condition or operating performance. We base our estimates and judgments on our experience and on various factors that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies used in the preparation of our consolidated financial statements require significant judgments and estimates. For additional information relating to these and other accounting policies, see Note 3 to our condensed consolidated financial statements appearing elsewhere in this quarterly report. There have been no changes in our critical accounting policies since December 31, 2007.
Revenue Recognition and Assessing the Collectability of Accounts Receivable
We follow the provisions of Staff Accounting Bulletin (“SAB”) 104, Revenue Recognition in Financial Statements (“SAB 104”), Emerging Issues Task Force (“EITF”) 00-21, Revenue Arrangements with Multiple Deliverables and EITF 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent. In general, we recognize revenue when there is persuasive evidence of an arrangement, the fee is fixed or determinable, the product or services have been delivered and collectability of the resulting receivable is reasonably assured.
Our distribution revenue from the sale of music recordings through digital distribution channels is recognized when the products are sold by the digital service providers, which provide us with periodic notification of the sales.
For arrangements with multiple obligations (e.g., deliverable and undelivered music content, music publishing information and other services), we allocate revenues to each component of the contract based on objective evidence of its fair value. We recognize revenues allocated to undelivered products when the criteria for product revenues set forth above are met. If objective and reliable evidence of the fair value of the undelivered obligations is not available, the arrangement consideration allocable to a delivered item is combined with the amount allocable to the undelivered item(s) within the arrangement. Revenues are recognized as the remaining obligations are fulfilled. Revenues from multiple element arrangements were not significant during the three and nine months ended September 30, 2008 and 2007.
In accordance with industry practice and as is customary in many territories, certain physical products (such as CDs and cassettes) are sold to customers with the right to return unsold items. We recognize net distribution revenues from such physical sales when reported to us by the retail distributor for the products that are shipped based on gross sales typically less a provision for future estimated returns determined by distributor based on historical trends. During the three and nine months ended September 30, 2008 and 2007, revenues from physical sales were not significant.
We recognize reimbursements received from our customers for encoding our music content in the appropriate digital format for use by the customer under the proportional performance method as revenue in the period that the encoded content is delivered to the customer. We record cash received in advance of providing the service as deferred revenue.
We record the costs associated with shipping physical products as cost of revenues. Shipping and handling charges billed to customers are included in revenues. The physical products are the property of the recording labels and artists. Revenues and cost from shipping and handling were not significant for the three and nine months ended September 30, 2008 and 2007.
Because we receive payment at approximately the same time as we receive the detailed revenue reports, our accounts receivable generally consists of approximately one month’s revenue for digital entertainment
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services that report on a monthly basis and one quarter’s revenue for digital entertainment services that report on a quarterly basis. In making estimates regarding the collectability of our accounts receivable, our management considers the credit profile of our retailers, current economic trends, contractual terms and conditions, historic payment experience and known or expected events that may impact the retailer’s ability to pay its obligations. Historically, we have incurred minimal losses for bad debts, although this may not be the case in the future. We maintained a bad debt allowance of $630,000 at September 30, 2008 and $427,000 at December 31, 2007.
Recoverability of Royalty Advances
We pay advance royalties to certain record labels and artists and account for these advance royalty payments pursuant to the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 50,Financial Reporting in the Record and Music Industry (“SFAS 50”). Pursuant to SFAS 50, certain advance royalty payments that are believed to be recoverable from future royalties to be earned by the content owner or its distributor are capitalized as assets. The decision to capitalize an advance to a content owner or its distributor as an asset requires significant judgment as to the recoverability of these advances. We assess the recoverability of these assets upon initial commitment of the advance based upon our forecast of anticipated revenues from the sale of future and existing music and publishing-related products. In determining whether these amounts are recoverable, we evaluate the current and past popularity of the artist or songwriter, the initial or expected commercial acceptability of the product, the current and past popularity of the genre of music that the product is designed to appeal to, and other relevant factors. Based upon this information, the portion of such advances that is believed not to be recoverable is expensed. All advances are assessed for recoverability periodically and, at minimum, on a quarterly basis.
Accounting for Income Taxes
Deferred income taxes result primarily from temporary differences between financial and tax reporting. Deferred tax assets and liabilities are determined based on the difference between the financial statement basis and tax basis of assets and liabilities using enacted tax rates. Future tax benefits are subject to a valuation allowance when management is unable to conclude that our deferred tax assets will more likely than not be realized from the results of operations. At each of the financial statement dates presented, we recorded a full valuation allowance against deferred income taxes due to our limited operating history and net losses recorded since inception. Our estimate for the valuation allowance for deferred tax assets requires management to make significant estimates and judgments about projected future operating results. If actual results differ from these projections or if management’s expectations of future results change, it may be necessary to adjust the valuation allowance.
We have generated losses for federal and state income tax reporting since inception. These tax losses are available for carryforward until their expiration. In addition to potential expiration, there are other factors that could limit our ability to use our federal and state tax loss carryforwards. For example, use of prior net operating loss carryforwards can be limited after an ownership change, such as the Merger. Accordingly, it is not certain how much of our existing net operating loss carryforwards will be available for use. In addition, we must generate taxable income in the future in order to use net operating loss carryforwards that have not expired.
Effective January 1, 2007, we began to measure and record uncertain tax positions in accordance with FIN 48Accounting for Uncertainty in Income Taxes (“FIN 48”) an Interpretation of FASB Statement No. 109. FIN 48 prescribes a threshold for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Only tax positions meeting the more-likely-than-not recognition threshold at the effective date may be recognized or continue to be recognized upon adoption of this Interpretation. FIN 48 also provides guidance on accounting for derecognition, interest and penalties, and classification and disclosure of matters related to uncertainty in income taxes. Accounting for uncertainties in income tax positions under FIN 48 involves significant judgments by management.
Share-Based Compensation
We recognize compensation expense, under the provisions of SFAS No. 123 (R)Share-Based Payment. As a result, we recognize compensation expense for share-based awards, such as stock options and restricted stock granted to employees and non-employees based upon the grant date fair value of the award over the
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requisite service period. This estimation of the fair value of each share-based grant or issuance on the date of grant involves numerous assumptions by management. Although we calculate the compensatory element under the Trinomial Lattice Model, which is a standard option pricing model, this model still requires the use of numerous assumptions. Assumptions used in this model include, among others, the expected life (turnover), a risk-free interest rate, dividend yield, and assumptions as to volatility of the underlying equity security. The model and assumptions also attempt to account for changing employee behavior as the stock price changes and capture the observed pattern of increasing rates of exercise as the stock price increases. We based our assumption of the expected volatility of our stock using the comparable industry data because sufficient historical trading data does not yet exist for our stock. The use of different peer group companies and other assumptions by management in the Trinomial Lattice Model could produce substantially different results.
Goodwill
Our goodwill represents the excess of the purchase price over the estimated fair values of the net tangible and intangible assets of DMGI as a result of the Merger and TVT as a result of our TVT acquisition. We will review goodwill for impairment annually and whenever events or changes in circumstances indicate its carrying value may not be recoverable in accordance with SFAS No. 142,Goodwill and Other Intangible Assets. The provisions of SFAS 142 require that a two-step impairment test be performed on goodwill. In the first step, we will compare the fair value to its carrying value. If the fair value exceeds the carrying value, goodwill will not be considered impaired and we will not be required to perform further testing. If the carrying value exceeds the fair value, then we must perform the second step of the impairment test in order to determine the implied fair value of goodwill. If the carrying value of goodwill exceeds its implied fair value, then we would record an impairment loss equal to the difference. Determining the implied fair value involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates, future economic and market conditions and determination of appropriate market comparables. We base our fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates.
Impairment of Intangible Assets
We test our intangible assets (other than goodwill) for impairment annually, and more frequently if there are indications of a loss in value. The most significant intangible assets that we test for impairment are those resulting from the Merger. We test for impairment on the basis of the same objective criteria that were used for the initial valuation. Our initial valuation and ongoing tests are based on the relationship of the value of our projected future cash flows associated with the asset to either the purchase price of the asset (for its initial valuation) or the carrying amount of the asset (for ongoing tests). The determination of the underlying assumptions related to the recoverability of intangible assets is subjective and requires the exercise of considerable judgment by our management. Any changes in key assumptions about our business and prospects, or changes in market conditions, could result in an impairment charge.
Recent Accounting Pronouncements
In September 2006, FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value, and expands required disclosures about fair value measurements. The provisions of SFAS 157 are effective for our company beginning January 1, 2008, except with respect to our non-financial assets for which the effective date is January 1, 2009. The adoption of SFAS 157 with respect to our financial assets and liabilities did not have a material effect on our condensed consolidated financial statements.
In February 2007, FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS 159 is effective for our company as of the beginning of fiscal year 2009. The adoption of SFAS 159 did not have a material effect on our condensed consolidated financial statements.
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In December 2007, FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS 141R”). SFAS 141R establishes principles and requirements for how an acquirer in a business combination: (i) recognizes and measures the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree; (ii) recognizes and measures the goodwill acquired in a business combination or gain from a bargain purchase; and (iii) determines what information to disclose to enable financial statement users to evaluate the nature and financial effects of the business combination. SFAS 141R is applicable prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. After its effective date, SFAS No. 141R would have an impact on the accounting for any business we may acquire in the future.
In December 2007, FASB issued SFAS No. 160, Non-controlling Interests in Consolidated Financial Statements (“SFAS 160”). SFAS 160 establishes accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 is effective for fiscal years beginning after December 15, 2008. Early adoption of SFAS 160 is prohibited. After its effective date, SFAS 160 would have an impact on the presentation and disclosure of the non-controlling interests of any non-wholly-owned businesses we may acquire in the future.
In March 2008, FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS 161”), as an amendment to SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). SFAS 161 requires enhanced disclosures about how and why a company uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS 133 and how they affect an entity’s financial performance. SFAS 161 is effective for our company as of the beginning of fiscal year 2009. Management has determined at this time that this pronouncement does not apply to any of its transactions.
In April 2008, the FASB issued FASB Staff Position SFAS 142-3,Determination of the Useful Life of Intangible Assets (“FSP SFAS 142-3”). FSP SFAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No. 142,Goodwill and Other Intangible Assets. The objective of this FSP is to improve the consistency between the useful life of a recognized intangible asset under Statement 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS 141R,Business Combinations, and other U.S. GAAP principles. FSP SFAS 142-3 is effective for fiscal years beginning after December 15, 2008. The adoption of FSP SFAS 142-3 is effective January 1, 2009 and is not expected to have a material impact on the Company’s condensed consolidated financial statements.
In June 2008, The Emerging Issues Task Force (“EITF”) of FASB issued EITF 07-5, “Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock” (“EITF 07-5”). This EITF is effective for financial statements issued for fiscal years beginning after December 15, 2008 and interim periods within those fiscal years. The Company is evaluating whether this EITF would apply to the Company’s redeemable preferred stock.
In October 2008, the FASB issued FSP 157-3 “Determining Fair Value of a Financial Asset in Market That is Not Active” (“FSP 157-3”). FSP 157-3 clarified the application of SFAS No. 157 in an inactive market. It demonstrated how the fair value of a financial asset is determined when the market for that financial asset is inactive. FSP 157-3 was effective upon issuance, including prior periods for which financial statements had not been issued. Management has determined at this time that this pronouncement does not apply to any of its transactions.
For additional information relating to these and other recent accounting pronouncements, see Note 3 to our condensed consolidated financial statements appearing elsewhere in this quarterly report.
Internal Control over Financial Reporting
In connection with the audit for the year ended December 31, 2007, our independent auditors identified significant deficiencies in our internal controls over financial reporting regarding our lack of formalized written policies and procedures in the financial accounting area, our lack of appropriate resources to both manage the financial close process on a timely basis and handle the accounting for complex equity and other transactions, our lack of sophisticated financial reporting systems to allow the reporting of financial information on a
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timely basis, which is due in part to the small size of our company prior to the Merger, and our lack of a formalized disaster recovery plan in the information technology area. These significant deficiencies together constitute a material weakness in our internal controls over financial reporting. These significant deficiencies, along with the actions taken to remedy the significant deficiencies, are described in Item 4T “Controls and Procedures,” appearing elsewhere in this quarterly report.
Factors Affecting Future Results
We have incurred losses since inception and our ability to achieve profitability in the near term is primarily dependent on increasing revenue while controlling and limiting expenses. Some of the current industry conditions and factors that we expect could have a significant impact on our future results are discussed below:
Factors impacting revenue and download rates for music content. Achieving profitable growth will require continued growth in the overall market for digital retail sales of music, video and other forms of media, and our ability to maintain a competitive suite of digital distribution and service offerings that will be attractive to independent record labels and other owners of digital media content. We expect continued competition from entrenched music distribution companies moving more aggressively into the digital sector (e.g., the distribution companies owned by the four major music companies), other independent distributors, and new entrants to the market. We believe that our revenue and download rates for music content might be affected by a number of macrofactors, including:
| • | Overall growth of the legitimate retail consumer market for digital music, in the context of a still robust so called peer-to-peer (P2P) pirate market; |
| • | Amount of additional digital music and video recordings that are made available to consumers from all sources and the impact on average sales that results from having an increasing amount of music and video content available within the retail channels; |
| • | The speed and efficacy with which new digital entertainment services — either through traditional a la carte downloads or subscription models, or new forms of music retail such as advertising-based or P2P models — enter and grow the market; and |
| • | The speed and efficacy with which digital music retailers invest, on the one hand, in product enhancements that allow them to more dynamically serve music to targeted subgroups (e.g., ethnic nationals living abroad) and, on the other hand, particularly with respect to mobile operators, integrate their sophisticated marketing segmentation and direct marketing capabilities more closely with demographically-based music marketing. |
Gross profit. Our gross profit is directly affected by our ability to negotiate favorable digital distribution agreements with record labels and other content owners. The current and future marketplace will continue to evolve and shape our ability to enter into new distribution agreements with content owners seeking to access the digital marketplace and renew existing agreements as they begin to expire. As more competitors enter this market and seek to sign similar agreements with content owners, this could adversely impact our gross profit.
Operating expenses. Our operating expenses include all costs associated with general and administrative expenses, sales and marketing and product development in order to operate the business. These expenses increased in each of the past three fiscal years and relatively quarter over quarter as we added additional personnel dedicated to expanding our operations and broadening our product and service offerings.
Business development. We plan to continue to build our core music and video businesses by building on our established digital distribution relationships and by adding additional record labels and content owners, showcasing top-tier global artists, and expanding our marketing capabilities. We also plan to continue to develop our broad services platform, including:
| • | Marketing and technology programs to service brands, consumer packaged goods companies and other businesses integrating music with their marketing objectives; |
| • | Placement of master recordings for synchronization use in advertising, film and television programs; |
| • | Mechanical licensing and administration of music publishing for digital sales in the United States; |
| • | Collection of sound performance recording royalties globally, among other offerings. |
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Results of Operations
The following table sets forth items in our Condensed Consolidated Statements of Operations as a percentage of revenue, as well as certain additional revenue and operating data for the periods indicated.
 | | | | | | | | |
| | For the Three Months Ended September 30, |
| | | 2008 | | 2007 |
| | | Amount | | Percentage of Total | | Amount | | Percentage of Total |
Statement of Operations Data:
| | | | | | | | | | | | | | | | |
| Revenue | | $ | 14,624,068 | | | | 100 | % | | $ | 6,705,047 | | | | 100 | % |
| Cost of revenues | | | 9,975,959 | | | | 68 | % | | | 4,901,875 | | | | 73 | % |
| Gross profit | | | 4,648,109 | | | | 32 | % | | | 1,803,172 | | | | 27 | % |
| Operating expenses | | | 4,878,805 | | | | 33 | % | | | 4,771,342 | | | | 71 | % |
| Other income (expense) | | | 171,846 | | | | 1 | % | | | (10,107 | ) | | | 0 | % |
| Net loss | | $ | (58,850 | ) | | | 0 | % | | $ | (2,978,277 | ) | | | (44 | )% |
Key Revenue and Operating Data:
| | | | | | | | | | | | | | | | |
Digital music revenue by source:
| | | | | | | | | | | | | | | | |
| Downloads | | $ | 9,009,749 | | | | 61.6 | % | | $ | 4,049,045 | | | | 60.4 | % |
| Subscriptions(1) | | | 2,129,238 | | | | 14.6 | % | | | 1,232,709 | | | | 18.4 | % |
| Mobile services | | | 1,810,088 | | | | 12.4 | % | | | 775,018 | | | | 11.6 | % |
| Other | | | 1,674,993 | | | | 11.4 | % | | | 648,275 | | | | 9.6 | % |
| Total | | $ | 14,624,068 | | | | 100 | % | | $ | 6,705,047 | | | | 100 | % |
| Average number of music recordings available for downloading during the period | | | 1,219,415 | | | | | | | | 706,123 | | | | | |
| Number of music recordings available for downloading at the end of the period | | | 1,271,650 | | | | | | | | 741,396 | | | | | |
| Number of paid downloads during the period | | | 12,477,149 | | | | | | | | 5,362,281 | | | | | |
| (1) | Includes subscription download and streaming services on the Internet, including revenues from eMusic (which is controlled by our majority stockholder) of $1,100,784 and $772,441 for the three months ended September 30, 2008 and 2007, respectively. |
Comparison of Three Months Ended September 30, 2008 to September 30, 2007
Revenues. Revenues increased to approximately $14.6 million for the three months ended September 30, 2008 from approximately $6.7 million for the three months ended September 30, 2007. Revenues from digital distribution (including permanent downloads and subscription services) increased to approximately $11.1 million for the three months ended September 30, 2008 from approximately $5.3 million for the three months ended September 30, 2007, primarily as a result of the increase in paid downloads, as well as the increase in the number of recordings available for download as a result of the combined operations following the Merger. The increase in paid downloads resulted primarily from a significant increase in the average number of available tracks for sale, which increase resulted from organic growth and the effects of the Merger. The increase in paid downloads is also in part due to a more efficient distribution process, which resulted in part from launch of our proprietary V.E.C.T.O.R.TM system in 2007. Digital revenue in 2008 includes approximately $0.7 million from TVT. Revenue from mobile distribution increased to approximately $1.8 million for the three months ended September 30, 2008 from approximately $0.8 million for the three months ended September 30, 2007, as a result of adding additional mobile stores, increased available content for our mobile channel partners and overall favorable industry trends, as well as the impact of the Merger. Mobile revenue in 2008 includes approximately $0.3 million from TVT. Other revenue from licensing and music services (including placement of master recordings for use in film, television and commercials), physical sales, and other sources such as fees charged to non-retail clients and service fees charged to digital music retailers, increased to approximately $1.7 million for the three months ended September 30, 2008 from approximately
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$0.6 million for the three months ended September 30, 2007, primarily due to greater exploitation of digital assets. Other revenue in 2008 includes approximately $0.2 million from TVT.
Cost of revenues. Our cost of revenues increased to approximately $10.0 million for the three months ended September 30, 2008 from approximately $4.9 million for the three months ended September 30, 2007. Royalty expense from digital distribution (including permanent downloads and subscription services) and mobile services paid to artists, labels and other content owners and other costs increased to approximately $9.6 million for the three months ended September 30, 2008 from approximately $4.7 million for the three months ended September 30, 2007, which increase is primarily related to the increase in overall revenues, which includes the impact of the Merger. During the three months ended September 30, 2008 and 2007, our royalties paid to artists, labels and other content owners and other costs from digital distribution (including permanent downloads and subscription services) and mobile services amounted to approximately 65% and 70% of revenues, respectively. Other costs of revenues increased to approximately $0.4 million for the three months ended September 30, 2008, compared with $0.2 million for the three months ended September 30, 2007. Gross profit margin increased to 31.8% of revenues for the three months ended September 30, 2008 from 26.9% of revenues for the three months ended September 30, 2007, predominately because of the higher percentage of total revenue earned in the three months ended September 2008 from higher profit margin areas such as fees charged to non-retail clients and service fees charged to digital music retailers as well as the higher margins associated with the sale of TVT owned content.
Operating expenses. The following table sets forth the individual components of our operating expenses for the three months ended September 30, 2008 and 2007:
| | | | | | | | |
| | For the Three Months Ended September 30, |
| | | 2008 | | 2007 |
| | | Amount | | Percentage of Total | | Amount | | Percentage of Total |
| Personnel-related expenses | | $ | 2,316,549 | | | | 47 | % | | $ | 3,070,709 | | | | 64 | % |
| Professional fees | | | 1,222,002 | | | | 25 | % | | | 831,514 | | | | 17 | % |
| Office expenses | | | 677,549 | | | | 14 | % | | | 268,460 | | | | 6 | % |
| Travel expenses | | | 224,929 | | | | 5 | % | | | 223,982 | | | | 5 | % |
| Marketing | | | 238,331 | | | | 5 | % | | | 81,306 | | | | 2 | % |
| Other expenses | | | 199,445 | | | | 4 | % | | | 295,371 | | | | 6 | % |
| | | $ | 4,878,805 | | | | 100 | % | | $ | 4,771,342 | | | | 100 | % |
Operating expenses increased approximately $0.1 million to $4.9 million for the three months ended September 30, 2008 from $4.8 million for the three months ended September 30, 2007. Personnel-related expenses decreased due to additional compensation charges incurred in the comparative period of 2007 related to the issuance of common stock to founders as a result of the conversion of the Company’s convertible debt. Professional fees increased in the three months ended September 30, 2008 compared to 2007 as a result of costs associated with being a public company including accounting and legal expenses and directors fees, which costs and fees were not applicable for the three months ended September 30, 2007.
Other income and expense. For the three months ended September 30, 2008, we had interest income of approximately $0.01 million on cash included in the DMGI assets acquired as a result of the Merger. In addition the Company recognized $0.2 million of other income related to the sale of an acquired artist purchased as part of the TVT asset purchase agreement. We had no other income for the same period in 2007. We had no interest expense for the three months ended September 30, 2008, compared with approximately $0.01 million for the three months ended September 30, 2007 attributable to interest payable to Dimensional (our majority stockholder) on outstanding convertible debt, which has since been converted.
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Comparison of Nine Months Ended September 30, 2008 to September 30, 2007
Results of Operations
The following table sets forth items in our Condensed Consolidated Statements of Operations as a percentage of revenue, as well as certain additional revenue and operating data for the periods indicated.
| | | | | | | | |
| | For the Nine Months Ended September 30, |
| | | 2008 | | 2007 |
| | | Amount | | Percentage of Total | | Amount | | Percentage of Total |
Statement of Operations Data:
| | | | | | | | | | | | | | | | |
| Revenue | | $ | 41,182,368 | | | | 100 | % | | $ | 18,692,312 | | | | 100 | % |
| Cost of revenues | | | 29,438,304 | | | | 71 | % | | | 13,515,662 | | | | 72 | % |
| Gross profit | | | 11,744,064 | | | | 29 | % | | | 5,176,650 | | | | 28 | % |
| Operating expenses | | | 14,024,850 | | | | 34 | % | | | 9,930,208 | | | | 53 | % |
| Other income (expense) | | | 332,059 | | | | 1 | % | | | (416,980 | ) | | | (2 | )% |
| Net loss | | $ | (1,948,727 | ) | | | (6 | )% | | $ | (5,170,538 | ) | | | (27 | )% |
Key Revenue and Operating Data:
| | | | | | | | | | | | | | | | |
Digital music revenue by source:
| | | | | | | | | | | | | | | | |
| Downloads | | $ | 26,260,030 | | | | 63.8 | % | | $ | 11,061,402 | | | | 59.2 | % |
| Subscriptions(1) | | | 5,915,132 | | | | 14.4 | % | | | 3,481,776 | | | | 18.6 | % |
| Mobile services | | | 4,599,759 | | | | 11.2 | % | | | 1,758,689 | | | | 9.4 | % |
| Other | | | 4,407,447 | | | | 10.6 | % | | | 2,390,445 | | | | 12.8 | % |
| Total | | $ | 41,182,368 | | | | 100 | % | | $ | 18,692,312 | | | | 100 | % |
| Average number of music recordings available for downloading during the period | | | 1,184,517 | | | | | | | | 628,887 | | | | | |
| Number of music recordings available for downloading at the end of the period | | | 1,271,650 | | | | | | | | 741,396 | | | | | |
| Number of paid downloads during the period | | | 35,892,567 | | | | | | | | 14,787,816 | | | | | |
| (1) | Includes subscription download and streaming services on the Internet, including revenues from eMusic (which is controlled by our majority stockholder) of $3,484,820 and $2,089,264 for the nine months ended September 30, 2008 and 2007, respectively. |
Comparison of Nine Months Ended September 30, 2008 to September 30, 2007
Revenues. Revenues increased to approximately $41.2 million for the nine months ended September 30, 2008 from approximately $18.7 million for the nine months ended September 30, 2007. Revenues from digital distribution (including permanent downloads and subscription services) increased to approximately $32.2 million for the nine months ended September 30, 2008 from approximately $14.5 million for the nine months ended September 30, 2007, primarily as a result of the increase in paid downloads, as well as the increase in the number of recordings available for download as a result of the combined operations following the Merger. The increase in paid downloads resulted primarily from a significant increase in the average number of available tracks for sale, which increase resulted from organic growth and the effects of the Merger. The increase in paid downloads is also in part due to a more efficient distribution process, which resulted in part from launch of our proprietary V.E.C.T.O.R.TM system in 2007. Digital revenue in 2008 includes approximately $0.7 million from TVT. Revenue from mobile distribution increased to approximately $4.6 million for the nine months ended September 30, 2008 from approximately $1.8 million for the nine months ended September 30, 2007, as a result of adding additional mobile stores, increased available content for our mobile channel partners and overall favorable industry trends, as well as the impact of the Merger. Mobile revenue in 2008 includes approximately $0.3 million from TVT. Other revenue from licensing and music services (including placement of master recordings for use in film, television and commercials), physical sales, and other sources such as fees charged to non-retail clients and service fees charged to digital music retailers,
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increased to approximately $4.4 million for the nine months ended September 30, 2008 from approximately $2.4 million for the nine months ended September 30, 2007. This increase was primarily due to a one-time bonus from one of our retail partners received in recognition of our assistance in the success of its business and, due to organic growth and the effects of the Merger. Other revenue in 2008 includes approximately $0.2 million from TVT.
Cost of revenues. Our cost of revenues increased to approximately $29.4 million for the nine months ended September 30, 2008 from approximately $13.5 million for the nine months ended September 30, 2007. Royalty expense from digital distribution (including permanent downloads and subscription services) and mobile services paid to artists, labels and other content owners and other costs increased to approximately $28.4 million for the nine months ended September 30, 2008 from approximately $12.6 million for the nine months ended September 30, 2007, which increase is primarily related to the increase in overall revenues, which includes the impact of the Merger. During the nine months ended September 30, 2008 and 2007, our royalties paid to artists, labels and other content owners from digital distribution (including permanent downloads and subscription services) and mobile services amounted to approximately 69% and 67% of revenues, respectively. Other costs of revenues increased to approximately $1.0 million for the nine months ended September 30, 2008 from $0.9 million the nine months ended September 30, 2007. Gross profit margin increased to 28.5% of revenues for the nine months ended September 30, 2008 from 27.7% of revenues for the nine months ended September 30, 2008, predominantly because of the higher percentage of total revenue earned in the nine months of 2007 from higher profit margin areas such as fees charged to non-retail clients and service fees charged to digital music retailers and the higher margins associated with the sale of TVT owned content.
Operating expenses. The following table sets forth the individual components of our operating expenses for the three months ended September 30, 2008 and 2007:
| | | | | | | | |
| | For the Nine Months Ended September 30, |
| | | 2008 | | 2007 |
| | | Amount | | Percentage of Total | | Amount | | Percentage of Total |
| Personnel-related expenses | | $ | 6,809,041 | | | | 49 | % | | $ | 6,005,700 | | | | 60 | % |
| Professional fees | | | 3,505,717 | | | | 25 | % | | | 1,731,746 | | | | 17 | % |
| Office expenses | | | 1,942,839 | | | | 14 | % | | | 785,598 | | | | 8 | % |
| Travel expenses | | | 780,296 | | | | 6 | % | | | 692,799 | | | | 7 | % |
| Marketing | | | 591,147 | | | | 4 | % | | | 355,843 | | | | 4 | % |
| Other expenses | | | 395,810 | | | | 2 | % | | | 358,522 | | | | 4 | % |
| | | $ | 14,024,850 | | | | 100 | % | | $ | 9,930,208 | | | | 100 | % |
Operating expenses increased to approximately $14.0 million for the nine months ended September 30, 2008, from approximately $9.9 million for the nine months ended September 30, 2007. Personnel-related expenses increased due to selected increases in staffing in order to provide operational, technology and artist and label client services as we continue to grow and also, staff investments in new business areas such as brand entertainment which we do not expect to become material revenue sources until later in 2009 but view strategically as critical and margin-accretive growth areas; as well as corresponding travel and office expenses. In addition to costs associated with salary and benefits, we also incurred share-based compensation in the nine months ended September 30, 2008 that were not applicable for the nine months ended September 30, 2007. Professional fees increased in the nine months ended September 30, 2008 compared to 2007 as a result of costs associated with being a public company including accounting and legal expenses and directors fees, which costs and fees were not applicable for the nine months ended September 30, 2007. Other operating expenses increased for the nine months ended September 30, 2008 compared to 2007 primarily as a result of an increase in reserve for bad debts.
Other income and expense. For the nine months ended September 30, 2008, we had interest income of approximately $0.2 million on cash included in the DMGI assets acquired as a result of the Merger. We had no other income for the same period in 2007. We had no interest expense for the nine months ended September 30, 2008, compared with approximately $0.4 million for the nine months ended September 30, 2007
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attributable to interest payable to Dimensional (our majority stockholder) on outstanding convertible debt, which has since been converted. In addition the Company recognized $0.2 million of other income in 2008 related to the sale of an acquired artist purchased as part of the TVT asset purchase agreement.
Liquidity and Capital Resources
We have incurred net losses of approximately $1.9 million and $5.2 million for the nine months ended September 30, 2008 and 2007, respectively. Prior to the Merger, we received cash advances in the form of convertible debt (later converted to equity) from Dimensional to fund losses and operate the business. However, subsequent to the Merger, no such cash advances have been received from Dimensional, nor are any expected to be made in the future. At September 30, 2008, we had approximately $3.5 million in cash and cash equivalents. Management believes that the Company has sufficient resources from cash balances on hand and cash flow to be generated from operations to fund its net cash requirements for the next 12 months. The Company is also in the process of securing a source of financing in order to fund the Company’s working capital requirements for further growth.
Cash Flows for the Nine Months Ended September 30, 2008 compared to Nine Months Ended September 30, 2007
Net cash provided by operations for the nine months ended September 30, 2008 was approximately $0.3 million. The reconciliation of net loss of approximately $1.9 million to net cash provided by operations for the nine months ended September 30, 2008 included non-cash charges for depreciation and amortization of approximately $1.0 million, bad debt expense of approximately $0.2 million and share-based compensation of approximately $0.7 million. As a result of our increase in revenues, our corresponding accounts receivable increased by approximately $3.7 million whereas our royalty payable increased by $3.0 million for the period ended September 30, 2008. Similarly, deferred revenue increased $1.0 million. Additionally, as a result of our content acquisition strategy, we generated approximately $0.6 million net cash for royalty advances on previously secured music and audio content rights.
Net cash used in operations for the nine months ended September 30, 2007 was approximately $3.2 million. The reconciliation of net loss of approximately $5.2 million to net cash used in operations for the nine months ended September 30, 2007 included non-cash charges for depreciation and amortization of approximately $0.2 million, and an increase in bad debt expense of approximately $0.2 million. These non-cash charges were offset by reduced working capital requirements of approximately $2.4 million, primarily because accounts receivable coupled with costs associated with the DMGI Merger increased at a faster rate than accrued royalties as our business continued to expand in 2007.
Our investing activities resulted in a net cash outflow of approximately $7.5 million for the nine months ended September 30, 2008 as a result of professional fees and other expenditures that increased goodwill associated with the Merger of $0.5 million, expenditures to purchase property and equipment of $0.6 million, the costs associated with the acquisition of certain TVT assets of $6.0 million and the issuance of a loan receivable for $0.4 million. For the nine months ended September 30, 2007, investing activities resulted in a net cash outflow of approximately $0.4 million to purchase property and equipment. The property and equipment additions for both the nine months ended September 30, 2008 and 2007 were primarily due to the increase in headcount as our business continued to grow and for designing, developing and implementing our V.E.C.T.O.RTM direct digital delivery system, which we launched in 2007.
Cash provided from financing activities for the nine months ended September 30, 2008 and 2007 was $0 and approximately $5.0 million, respectively. In 2007, such amount reflects the proceeds from the issuance of additional convertible debt to Dimensional for cash advances received during the first nine months of 2007.
As of September 30, 2008, we had cash and cash equivalents of approximately $3.5 million and working capital deficit of approximately $0.1 million, compared to cash and cash equivalents of approximately $10.6 million and working capital of approximately $7.1 million at December 31, 2007. The decrease in cash and cash equivalents is primarily attributed to the acquisition of TVT. The decrease in working capital is primarily attributed to the acquisition of TVT. In the fourth quarter, we expect to utilize cash and cash equivalents to fund operations, acquire additional digital rights to music catalogs and make additions to property and equipment. We are also in the process of securing a source of financing in order to fund working capital
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requirements for further growth. There can be no assurance that the Company will be able to secure such funding. As discussed above, subsequent to September 30, 2008, we acquired substantially all of the assets of TVT Records.
Description of Indebtedness
As of September 30, 2008, we had no debt. The following discussion relates to debt outstanding in 2007 prior to the Merger.
Convertible Debt Instruments
Since April 2003, Dimensional extended various loans to Orchard NY, which debt was convertible into that number of shares of Orchard NY’s Series A Convertible Preferred Stock, or the Orchard NY Series A Preferred Stock, determined by dividing the principal balance by a conversion price of $1.00 per share of Orchard NY Series A Preferred Stock (i) at any time, at Dimensional’s sole option or (ii) automatically, upon the closing of a sale of 3,000,000 shares of Orchard NY Series A Preferred Stock pursuant to a stock purchase agreement with Dimensional.
In May 2006, Orchard NY issued 7,931,000 shares of its Series A Convertible Preferred Stock and 7,931,000 shares of its Series B Convertible Preferred Stock to Dimensional in exchange for the conversion and cancellation of convertible debt with a principal balance of approximately $7.9 million (the outstanding convertible debt principal balance at December 31, 2005). Accrued interest relating to this debt was not cancelled at this time. At December 31, 2006, the outstanding principal balance of the Dimensional convertible debt was approximately $6.6 million and the outstanding balance of the accrued interest was approximately $1.2 million (which includes interest on the approximately $7.9 million debt cancelled in May 2006). Interest expense on the convertible debt was approximately $0.5 million, for the year ending December 31, 2006.
In 2007 and prior to the Merger, Orchard NY undertook two recapitalizations (a July 2007 recapitalization and a September 2007 recapitalization) whereby Dimensional agreed to convert its then outstanding convertible debt in exchange for shares of preferred stock of Orchard NY and forgave accrued interest. These recapitalizations are described in Note 9 to our consolidated financial statements in our Annual Report on Form 10-K. In November 2007, we amended the September 2007 recapitalization to recharacterize $600,000 of funding as a loan payable instead of a capital contribution. We repaid this $600,000 loan in November 2007.
On November 13, 2007, in conjunction with the Merger, all outstanding shares of Orchard NY’s Series A Convertible Preferred Stock, Series B Convertible Preferred Stock, Series C Convertible Preferred Stock and common stock were cancelled and the former Orchard NY stockholders received 448,833 shares of our Series A Preferred Stock and 3,021,202 shares of our common stock, including 1,915 shares of our Series A Preferred Stock and 157,683 shares of our common stock that are subject to deferred stock awards assumed in connection with the Merger.
At September 30, 2008, we had 448,833 shares of our Series A Preferred Stock outstanding. Our Series A Preferred Stock is not entitled to any dividend or any interest. Each share is convertible into 3.3 shares of our common stock at any time at the sole discretion of the preferred shareholders. The shares are redeemable for $55.70 per share (equivalent to $16.72 per common share) at the sole discretion of our board of directors after November 13, 2012 and only if our common stock is trading above $30.00 per share for more than thirty days in a row.
As of September 30, 2008, we had no outstanding convertible debt owed to Dimensional.
Off-Balance Sheet Arrangements
As of September 30, 2008, we had no off-balance sheet arrangements.
Related Party Transactions
Dimensional is the controlling stockholder of The Orchard Enterprises, Inc., owning approximately 54% of our voting common stock on a fully diluted basis as of September 30, 2008. Dimensional is also the controlling stockholder of eMusic, which provides digital music distribution services to us under a Digital Music
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Wholesale Agreement, dated January 1, 2004, as amended on March 12, 2007. This agreement grants eMusic worldwide rights, on a non-exclusive basis, to exploit our master recordings digitally and via the Internet through December 31, 2009. Pursuant to the agreement, we are entitled to better royalty terms if eMusic allows any other independent record label such better terms during the term of the agreement (a “Most Favored Nation” clause). Amounts included in revenues in connection with these services were $1,100,784 and $772,441 for the three months ended September 30, 2008 and 2007, respectively. Amounts included in accounts receivable in connection with these services were $1,112,239 and $1,075,602 at September 30, 2008 and December 31, 2007, respectively. We also have distribution agreements with certain labels whereby we have agreed to forego distribution fees to the label or artist for sales by eMusic. For the nine months ended September 30, 2008 and 2007, we received revenues of $594,557 and $555,884 respectively, from eMusic relating to such agreements. We recorded these amounts in revenues with an equal amount recorded in cost of revenues.
For information relating to other related party transactions, see Note 12 to our condensed consolidated financial statements appearing elsewhere in this quarterly report.
Item 4T.CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
In evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this quarterly report on Form 10-Q. Due to the existence of a material weakness described below, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are not effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 (1) is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and (2) is accumulated and communicated to management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Notwithstanding the conclusion that our disclosure controls and procedures were not effective as of the end of the period covered by this report, the Chief Executive Officer and the Chief Financial Officer believe that the consolidated financial statements and other information contained in this annual report present fairly, in all material respects, our business, financial condition and results of operations. Such conclusion is based on the additional analyses and other post-closing procedures performed to ensure that our condensed, consolidated financial statements contained in this quarterly report were prepared in accordance with U.S. GAAP and applicable SEC regulations.
In connection with the audit of our 2007 consolidated financial statements, our independent auditors identified certain significant deficiencies that together constitute a material weakness in our internal control over financial reporting. These significant deficiencies primarily relate to our lack of formalized written policies and procedures in the financial accounting area, our lack of appropriate resources to both manage the financial close process on a timely basis and handle the accounting for complex equity and other transactions, our lack of sophisticated financial reporting systems to allow the reporting of financial information on a timely basis, which is due in part to the small size of our company prior to the Merger, and our lack of a formalized disaster recovery plan in the information technology area. These significant deficiencies together constitute a material weakness in our internal control over financial reporting. During 2008, the Company has developed and implemented the following actions to address and remediate these significant deficiencies:
| • | Lack of Formal Written Policies and Procedures in the Financial Accounting Area — We have engaged a reputable CPA firm with extensive experience in Sarbanes-Oxley Section 404 implementation to assist us in the identification and documentation of key controls for each of our key financial reporting processes. In connection with ourSarbanes-Oxley Section 404 Implementation Project, key policies and procedures have been formalized and documented in the form of process narratives; and they have been properly discussed with and disseminated to our accounting staff. |
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| • | Lack of Appropriate Resources to Manage the Financial Close and Handle Accounting for Complex Transactions — We have hired an Assistant Controller with the necessary experience to support the financial reporting process, and have refined the roles and responsibilities of our accounting staff and realigned their work flow to ensure proper monitoring review and supervision. We have also updated the respective skill set of our accounting staff as we solidified the leadership of our finance and accounting department. In connection with ourSarbanes 404 Implementation Project, our accounting staff has been specifically trained to ensure the timely completion of our key control activities. |
| • | Lack of Sophisticated Financial Reporting Systems — We have replaced our accounting system and successfully implemented Great Plains to help strengthen the integrity and timeliness of our financial reporting process. |
| • | Lack of a Formalized Disaster Recovery Plan — We have formalized our strategic plan on Disaster Recovery (DR) and it has been recently approved by our Board of Directors. As developed, the draft DR Plan will be tested for its operating effectiveness during the fourth quarter. |
The Company will continue to implement controls and procedures to remediate its identified deficiencies. Management expects to complete all of its remediation efforts before December 31, 2008.
Changes in Internal Control over Financial Reporting
There was no change in our internal control over financial reporting that occurred during the third quarter of 2008 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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PART II. OTHER INFORMATION
Item 1.LEGAL PROCEEDINGS
We are involved in legal proceedings from time to time in the ordinary course of our business.
On March 11, 2008, we initiated suit in federal court in the Eastern District of California against TufAmerica, Inc. The complaint alleges fraud, breach of contract and various other wrongs in connection with a contract dispute with TufAmerica, Inc. concerning the number, nature and technical quality of master recordings the label was required to deliver to our company under the contract. We requested various forms of relief from the court, including the return of approximately $2.4 million in fees and advances already paid under the contract. On April 23, 2008, TufAmerica answered our complaint denying the causes of action asserted against it and asserting its own counter claims against us for breach of contract. Although the claim did not specify an exact amount of damages sought, during the course of the dispute TufAmerica, Inc. had sent a letter to us claiming damages in the amount of approximately $1.2 million. The discovery process has begun but, because the litigation is in its early stages, we are unable to determine if the outcome of this case will be favorable to us. While we believe we have meritorious claims and defenses and intend to pursue them vigorously, litigation is inherently uncertain and we can provide no assurance as to the ultimate outcome of the matter.
On December 15, 2006, MCS Music America, Inc., on behalf of itself and other publishers, brought an action for copyright infringement against Napster, Inc., one of the Company’s digital music stores. MCS alleged that compositions included in 338 sound recordings made available to Napster as part of its subscription service and free Napster infringed on copyrights owned by MCS. 16 of the 338 sound recordings were licensed to Napster by the Company pursuant to the Content Agreement dated August 26, 2004. On July 10, 2008, MCS and Napster settled the claim.
Under the terms of the Content Agreement, the Company indemnified Napster for damages, including legal fees, incurred by Napster for any copyright infringement related to the content being licensed from the Company. The Company’s liability is estimated to be between $60,000 and $120,000 in settlement of this claim and legal fees.
To our knowledge, there are no other pending or threatened legal proceedings that could have a material effect on our business, financial condition or results of operations.
Item 1A.RISK FACTORS
Not applicable.
Item 2.UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Not applicable.
Item 3.DEFAULTS UPON SENIOR SECURITIES
Not applicable.
Item 4.SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
Item 5.OTHER INFORMATION
Not applicable.
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Item 6.EXHIBITS
| | |
| Exhibit Number | | Exhibit Description |
| 2.1 | | Second Amended and Restated Agreement and Plan of Merger, dated as of October 5, 2007, by and among Digital Music Group, Inc., DMGI New York, Inc. and The Orchard Enterprises Inc.(incorporated by reference to Annex A of the Company’s Proxy Statement on Schedule 14A filed on October 10, 2007) |
| 2.2 | | Amendment No. 1 to Second Amended and Restated Agreement and Plan of Merger dated as of November 7, 2007, by and among Digital Music Group, Inc., DMGI New York, Inc. and The Orchard Enterprises Inc.(incorporated by reference to Exhibit 2.1 of the Company’s Current Report on Form 8-K filed on November 8, 2007) |
| 3.1 | | Amended and Restated Certificate of Incorporation(incorporated by reference to Exhibit 3.2 of the Company’s Registration Statement on Form S-1/A filed on January 27, 2006) |
| 3.2 | | Certificate of Amendment of Certificate of Incorporation dated November 13, 2007(incorporated by reference to Exhibit 3.2 of the Company’s Annual Report on Form 10-K filed on March 31, 2008) |
| 3.3 | | Certificate of Designation of Series A Convertible Preferred Stock(incorporated by reference to Exhibit 3.3 of the Company’s Annual Report on Form 10-K filed on March 31, 2008) |
| 3.4 | | Certificate of Ownership and Merger dated February 4, 2008(incorporated by reference to Exhibit 3.1 of the Company’s Current Report on Form 8-K filed on February 6, 2008) |
| 3.5 | | Second Amended and Restated Bylaws of the Company dated September 4, 2008(incorporated by reference to Exhibit 3.1 of the Company’s Current Report on Form 8-K filed on September 10, 2008) |
| 4.1 | | Form of Company’s Common Stock Certificate(incorporated by reference to Exhibit 4.1 of the Company’s Annual Report on Form 10-K filed on March 31, 2008) |
| 4.2 | | Form of Warrant to Purchase Company’s common stock(incorporated by reference to Exhibit 4.1 of the Company’s Current Report on Form 8-K filed on February 10, 2006) |
| 10.1 | | The Company’s 2008 Stock Plan(incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K filed on September 10, 2008) |
| 10.2 | | Non-Executive Directors Compensation Program(incorporated by reference to Exhibit 10.2 of the Company’s Current Report on Form 8-K filed on September 10, 2008) |
| 10.3 | | Registration Rights Agreement, dated as of November 13, 2007 among the Company and certain stockholders of Orchard Enterprises NY, Inc.(incorporated by reference to Exhibit D of Annex A to the Company’s Definitive Proxy Statement on Schedule 14A filed on October 10, 2007) |
| 10.4 | | Form of Indemnification Agreement by and between Company and each of its directors and officers(incorporated by reference to Exhibit 10.1 of the Company’s Registration Statement on Form S-1/A filed on January 4, 2006) |
| 10.5 | | Second Amended and Restated Stockholders Agreement dated September 8, 2005 by and among Digital Musicworks International, Inc. (now the Company) and certain of its stockholders(incorporated by reference to Exhibit 10.3 of the Company’s Registration Statement on Form S-1 filed on September 29, 2005) |
| 10.6 | | Company’s Management Incentive Bonus Plan for the Year Ending December 31, 2007(incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K filed on May 16, 2007) |
| 10 .7 | | Amended and Restated Employment Agreement dated October 5, 2007 between Greg Scholl and Company(incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K filed on November 16, 2007) |
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| | |
| Exhibit Number | | Exhibit Description |
| 10.8 | | Amended and Restated Employment Agreement dated September 9, 2008 between Nathan Fong and Company(incorporated by reference to Exhibit 10.3 of the Company’s Current Report on Form 8-K filed on September 10, 2008) |
| 10.9 | | Amended and Restated Employment Agreement dated February 28, 2008 between Bradley Navin and Company(incorporated by reference to Exhibit 10.7 of the Company’s Annual Report on Form 10-K filed on March 31, 2008) |
| 10.10 | | Amended and Restated Employment Agreement dated February 28, 2008 between Daniel Pifer and Company(incorporated by reference to Exhibit 10.8 of the Company’s Annual Report on Form 10-K filed on March 31, 2008) |
| 10.11 | | Employment Agreement dated February 1, 2007 between Stanley Schneider and The Orchard Enterprises NY, Inc. (formerly known as The Orchard Enterprises Inc.)(incorporated by reference to Exhibit 10.9 of the Company’s Annual Report on Form 10-K filed on March 31, 2008) |
| 10.12 | | Amended and Restated Digital Music Download Sales Agreement, effective as of October 13, 2007, between Apple Inc. and Company(incorporated by reference to Exhibit 10.10 of the Company’s Annual Report on Form 10-K filed on March 31, 2008)† |
| 10.13 | | Amended and Restated Digital Music Download Sales Agreement, effective as of October 13, 2007, between iTunes S.à.r.l. and Company(incorporated by reference to Exhibit 10.11 of the Company’s Annual Report on Form 10-K filed on March 31, 2008)† |
| 10.14 | | Amended and Restated Digital Music Download Sales Agreement, effective as of October 16, 2007, between Apple Inc. and Company(incorporated by reference to Exhibit 10.12 of the Company’s Annual Report on Form 10-K filed on March 31, 2008)† |
| 10.15 | | Amended and Restated Digital Music Download Sales Agreement, effective as of October 16, 2007, between iTunes S.à.r.l. and Company(incorporated by reference to Exhibit 10.13 of the Company’s Annual Report on Form 10-K filed on March 31, 2008)† |
| 10.16 | | Amended and Restated Digital Music Download Sales Agreement, effective as of October 12, 2007, between Apple Inc. and Orchard Enterprises NY, Inc.(incorporated by reference to Exhibit 10.14 of the Company’s Annual Report on Form 10-K filed on March 31, 2008)† |
| 10.17 | | Amended and Restated Digital Music Download Sales Agreement, effective as of October 14, 2007, between iTunes S.à.r.l. and Orchard Enterprises NY, Inc.(incorporated by reference to Exhibit 10.15 of the Company’s Annual Report on Form 10-K filed on March 31, 2008)† |
| 10.18 | | Amended and Restated Digital Music Download Sales Agreement, effective as of October 13, 2007, between Apple Inc. and Digital Rights Agency, Inc.(incorporated by reference to Exhibit 10.16 of the Company’s Annual Report on Form 10-K filed on March 31, 2008)† |
| 10.19 | | Amended and Restated Digital Music Download Sales Agreement, effective as of October 13, 2007, between iTunes S.à.r.l. and Digital Rights Agency, Inc.(incorporated by reference to Exhibit 10.17 of the Company’s Annual Report on Form 10-K filed on March 31, 2008)† |
| 10.20 | | Asset Purchase Agreement by and among The Orchard Enterprises, Inc., and TeeVee Toons, Inc. d/b/a TVT Records, Debtor and Debtor in Possession dated as of July 3, 2008(incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K filed on July 7, 2008) |
| 10.21 | | Amended and Restated Digital Music Download Sales Agreement effective as of August 6, 2008 by and between Apple Inc. and The Orchard Enterprises, Inc.*† |
| 10.22 | | Amended and Restated Digital Music Download Sales Agreement effective as of August 6, 2008 by and between iTunes S.à.r.l. and The Orchard Enterprises, Inc.*† |
| 31.1 | | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002* |
| 31.2 | | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002* |
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| | |
| Exhibit Number | | Exhibit Description |
| 32.1 | | Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002* |
| † | Confidential treatment granted (or requested) for certain confidential portions of this exhibit. These confidential portions have been omitted from this exhibit and filed separately with the Commission. |
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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.
| | |
| | The Orchard Enterprises, Inc. |
| Date: November 12, 2008 | | /s/ Greg Scholl
Greg Scholl
Chief Executive Officer |
| | | /s/ Nathan Fong
Nathan Fong
Chief Financial Officer |
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EXHIBIT INDEX
| | |
| Exhibit Number | | Exhibit Description |
| 2.1 | | Second Amended and Restated Agreement and Plan of Merger, dated as of October 5, 2007, by and among Digital Music Group, Inc., DMGI New York, Inc. and The Orchard Enterprises Inc.(incorporated by reference to Annex A of the Company’s Proxy Statement on Schedule 14A filed on October 10, 2007) |
| 2.2 | | Amendment No. 1 to Second Amended and Restated Agreement and Plan of Merger dated as of November 7, 2007, by and among Digital Music Group, Inc., DMGI New York, Inc. and The Orchard Enterprises Inc.(incorporated by reference to Exhibit 2.1 of the Company’s Current Report on Form 8-K filed on November 8, 2007) |
| 3.1 | | Amended and Restated Certificate of Incorporation(incorporated by reference to Exhibit 3.2 of the Company’s Registration Statement on Form S-1/A filed on January 27, 2006) |
| 3.2 | | Certificate of Amendment of Certificate of Incorporation dated November 13, 2007(incorporated by reference to Exhibit 3.2 of the Company’s Annual Report on Form 10-K filed on March 31, 2008) |
| 3.3 | | Certificate of Designation of Series A Convertible Preferred Stock(incorporated by reference to Exhibit 3.3 of the Company’s Annual Report on Form 10-K filed on March 31, 2008) |
| 3.4 | | Certificate of Ownership and Merger dated February 4, 2008(incorporated by reference to Exhibit 3.1 of the Company’s Current Report on Form 8-K filed on February 6, 2008) |
| 3.5 | | Second Amended and Restated Bylaws of the Company dated September 4, 2008(incorporated by reference to Exhibit 3.1 of the Company’s Current Report on Form 8-K filed on September 10, 2008) |
| 4.1 | | Form of Company’s Common Stock Certificate(incorporated by reference to Exhibit 4.1 of the Company’s Annual Report on Form 10-K filed on March 31, 2008) |
| 4.2 | | Form of Warrant to Purchase Company’s common stock(incorporated by reference to Exhibit 4.1 of the Company’s Current Report on Form 8-K filed on February 10, 2006) |
| 10.1 | | The Company’s 2008 Stock Plan(incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K filed on September 10, 2008) |
| 10.2 | | Non-Executive Directors Compensation Program(incorporated by reference to Exhibit 10.2 of the Company’s Current Report on Form 8-K filed on September 10, 2008) |
| 10 .3 | | Registration Rights Agreement, dated as of November 13, 2007 among the Company and certain stockholders of Orchard Enterprises NY, Inc.(incorporated by reference to Exhibit D of Annex A to the Company’s Definitive Proxy Statement on Schedule 14A filed on October 10, 2007) |
| 10 .4 | | Form of Indemnification Agreement by and between Company and each of its directors and officers(incorporated by reference to Exhibit 10.1 of the Company’s Registration Statement on Form S-1/A filed on January 4, 2006) |
| 10 .5 | | Second Amended and Restated Stockholders Agreement dated September 8, 2005 by and among Digital Musicworks International, Inc. (now the Company) and certain of its stockholders(incorporated by reference to Exhibit 10.3 of the Company’s Registration Statement on Form S-1 filed on September 29, 2005) |
| 10 .6 | | Company’s Management Incentive Bonus Plan for the Year Ending December 31, 2007(incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K filed on May 16, 2007) |
| 10 .7 | | Amended and Restated Employment Agreement dated October 5, 2007 between Greg Scholl and Company(incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K filed on November 16, 2007) |
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| | |
| Exhibit Number | | Exhibit Description |
| 10.8 | | Amended and Restated Employment Agreement dated September 9, 2008 between Nathan Fong and Company(incorporated by reference to Exhibit 10.3 of the Company’s Current Report on Form 8-K filed on September 10, 2008) |
| 10.9 | | Amended and Restated Employment Agreement dated February 28, 2008 between Bradley Navin and Company(incorporated by reference to Exhibit 10.7 of the Company’s Annual Report on Form 10-K filed on March 31, 2008) |
| 10.10 | | Amended and Restated Employment Agreement dated February 28, 2008 between Daniel Pifer and Company(incorporated by reference to Exhibit 10.8 of the Company’s Annual Report on Form 10-K filed on March 31, 2008) |
| 10.11 | | Employment Agreement dated February 1, 2007 between Stanley Schneider and The Orchard Enterprises NY, Inc. (formerly known as The Orchard Enterprises Inc.)(incorporated by reference to Exhibit 10.9 of the Company’s Annual Report on Form 10-K filed on March 31, 2008) |
| 10.12 | | Amended and Restated Digital Music Download Sales Agreement, effective as of October 13, 2007, between Apple Inc. and Company(incorporated by reference to Exhibit 10.10 of the Company’s Annual Report on Form 10-K filed on March 31, 2008)† |
| 10.13 | | Amended and Restated Digital Music Download Sales Agreement, effective as of October 13, 2007, between iTunes S.à.r.l. and Company(incorporated by reference to Exhibit 10.11 of the Company’s Annual Report on Form 10-K filed on March 31, 2008)† |
| 10.14 | | Amended and Restated Digital Music Download Sales Agreement, effective as of October 16, 2007, between Apple Inc. and Company(incorporated by reference to Exhibit 10.12 of the Company’s Annual Report on Form 10-K filed on March 31, 2008)† |
| 10.15 | | Amended and Restated Digital Music Download Sales Agreement, effective as of October 16, 2007, between iTunes S.à.r.l. and Company(incorporated by reference to Exhibit 10.13 of the Company’s Annual Report on Form 10-K filed on March 31, 2008)† |
| 10.16 | | Amended and Restated Digital Music Download Sales Agreement, effective as of October 12, 2007, between Apple Inc. and Orchard Enterprises NY, Inc.(incorporated by reference to Exhibit 10.14 of the Company’s Annual Report on Form 10-K filed on March 31, 2008)† |
| 10.17 | | Amended and Restated Digital Music Download Sales Agreement, effective as of October 14, 2007, between iTunes S.à.r.l. and Orchard Enterprises NY, Inc.(incorporated by reference to Exhibit 10.15 of the Company’s Annual Report on Form 10-K filed on March 31, 2008)† |
| 10.18 | | Amended and Restated Digital Music Download Sales Agreement, effective as of October 13, 2007, between Apple Inc. and Digital Rights Agency, Inc.(incorporated by reference to Exhibit 10.16 of the Company’s Annual Report on Form 10-K filed on March 31, 2008)† |
| 10.19 | | Amended and Restated Digital Music Download Sales Agreement, effective as of October 13, 2007, between iTunes S.à.r.l. and Digital Rights Agency, Inc.(incorporated by reference to Exhibit 10.17 of the Company’s Annual Report on Form 10-K filed on March 31, 2008)† |
| 10.20 | | Asset Purchase Agreement by and among The Orchard Enterprises, Inc., and TeeVee Toons, Inc. d/b/a TVT Records, Debtor and Debtor in Possession dated as of July 3, 2008(incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K filed on July 7, 2008) |
| 10.21 | | Amended and Restated Digital Music Download Sales Agreement effective as of August 6, 2008 by and between Apple Inc. and The Orchard Enterprises, Inc.*† |
| 10.22 | | Amended and Restated Digital Music Download Sales Agreement effective as of August 6, 2008 by and between iTunes S.à.r.l. and The Orchard Enterprises, Inc.*† |
| 31.1 | | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002* |
| 31.2 | | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002* |
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| | |
| Exhibit Number | | Exhibit Description |
| 32.1 | | Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002* |
| † | Confidential treatment granted (or requested) for certain confidential portions of this exhibit. These confidential portions have been omitted from this exhibit and filed separately with the Commission. |
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