REGISTRATION NO. 333-52367 AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON JULY 24, 1998 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 -------------- AMENDMENT NO. 2 TO FORM S-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 -------------- CDNOW, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN CHARTER) -------------- PENNSYLVANIA 5735 23-2813867 (STATE OR OTHER (PRIMARY STANDARD INDUSTRIAL (I.R.S. EMPLOYER JURISDICTION OF CLASSIFICATION CODE NUMBER) IDENTIFICATION NO.) INCORPORATION OR ORGANIZATION) 610 OLD YORK ROAD SUITE 300 JENKINTOWN, PA 19046 (215) 517-7325 (ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING AREA CODE, OF REGISTRANT'S PRINCIPAL EXECUTIVE OFFICES) -------------- JASON OLIM PRESIDENT, CHIEF EXECUTIVE OFFICER AND CHAIRMAN OF THE BOARD 610 OLD YORK ROAD SUITE 300 JENKINTOWN, PA 19046 (215) 517-7325 (NAME, ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING AREA CODE, OF AGENT FOR SERVICE) COPIES TO: ALAN SINGER, ESQ. ALAN H. LIEBLICH, ESQ. MORGAN, LEWIS & BOCKIUS LLP SCHNADER HARRISON SEGAL & LEWIS LLP 2000 ONE LOGAN SQUARE 1600 MARKET STREET PHILADELPHIA, PA 19103 SUITE 3600 (215) 963-5000 PHILADELPHIA, PA 19103 (215) 751-2000 APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC: As soon as practicable after the effective date of this Registration Statement. -------------- If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box. [_] If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [_] If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [_] If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [_] If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box. [_] -------------- THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(A) OF THE SECURITIES ACT OF 1933, AS AMENDED, OR UNTIL THIS REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SUCH SECTION 8(A), MAY DETERMINE. - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- ++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ +INFORMATION CONTAINED HEREIN IS SUBJECT TO COMPLETION OR AMENDMENT. A + +REGISTRATION STATEMENT RELATING TO THESE SECURITIES HAS BEEN FILED WITH THE + +SECURITIES AND EXCHANGE COMMISSION. THESE SECURITIES MAY NOT BE SOLD NOR MAY + +OFFERS TO BUY BE ACCEPTED PRIOR TO THE TIME THE REGISTRATION STATEMENT + +BECOMES EFFECTIVE. THIS PROSPECTUS SHALL NOT CONSTITUTE AN OFFER TO SELL OR + +THE SOLICITATION OF AN OFFER TO BUY NOR SHALL THERE BE ANY SALE OF THESE + +SECURITIES IN ANY STATE IN WHICH SUCH OFFER, SOLICITATION OR SALE WOULD BE + +UNLAWFUL PRIOR TO REGISTRATION OR QUALIFICATION UNDER THE SECURITIES LAWS OF + +ANY SUCH STATE. + ++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ Subject to Completion July 24, 1998 1,330,000 SHARES LOGO CDNOW COMMON STOCK ----------- Of the shares of Common Stock offered hereby, 1,250,000 shares will be sold by CDnow, Inc. ("CDnow" or the "Company") and 80,000 shares will be sold by a selling shareholder of the Company (the "Selling Shareholder"). The Company's Common Stock is quoted on the Nasdaq National Market under the symbol "CDNW". On July 23, 1998, the last reported sale price of the Common Stock was $22.1875 per share. See "Price Range of Common Stock." ----------- THE COMMON STOCK OFFERED HEREBY INVOLVES A HIGH DEGREE OF RISK. SEE "RISK FACTORS" BEGINNING ON PAGE 7. ----------- THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- PRICE UNDERWRITING PROCEEDS PROCEEDS TO DISCOUNTS AND TO TO PUBLIC COMMISSIONS(1) COMPANY(2) SELLING SHAREHOLDER - ------------------------------------------------------------------------------- Per Share............ $ $ $ $ - ------------------------------------------------------------------------------- Total(3)............. $ $ $ $ - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- (1) See "Underwriting" for information relating to indemnification of the Underwriter. (2) Before deducting expenses for this Offering, payable by the Company, estimated at $500,000. (3) The Company has granted the Underwriter a 30-day option to purchase up to 199,500 additional shares of Common Stock, solely to cover over-allotments, if any. To the extent that the option is exercised, the Underwriter will offer the additional shares at the Price to Public shown above. If the option is exercised in full, the total Price to Public, Underwriting Discounts and Commissions and Proceeds to Company will be $ , $ and $ , respectively. See "Underwriting." ----------- The shares of Common Stock are offered by the Underwriter, subject to prior sale, when, as and if delivered to and accepted by it, and subject to the right of the Underwriter to reject any order in whole or in part. It is expected that delivery of the shares of Common Stock will be made at the offices of BT Alex. Brown Incorporated, Baltimore, Maryland, on or about , 1998. BT ALEX.BROWN THE DATE OF THIS PROSPECTUS IS , 1998 ADDITIONAL INFORMATION The Company has filed with the Commission a Registration Statement on Form S-1 under the Securities Act (the "Registration Statement") with respect to the Common Stock offered hereby. This Prospectus does not contain all of the information set forth in the Registration Statement and the exhibits and schedules thereto. For further information with respect to the Company and the Common Stock offered hereby, reference is hereby made to the Registration Statement and to the exhibits and schedules filed therewith. Statements contained in this Prospectus as to the contents of any agreement or other document are not necessarily complete, and in each instance, reference is made to the copy of such agreement or document filed as an exhibit to the Registration Statement, each such statement being qualified in all respects by such reference. The Registration Statement and any amendments thereto, including exhibits filed or incorporated by reference as a part thereof, are available for inspection and copying at the Commission's offices as described in the following paragraph. The Company is subject to the informational requirements of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and, in accordance therewith, is required to file reports, proxy statements and other information with the Commission. Such reports, proxy statements and other information may be inspected without charge at the Commission's principal office in Washington, D.C. at 450 Fifth Street, N.W., Washington, D.C. 20549, and at the Commissions's Regional Offices at Seven World Trade Center, Suite 1300, New York, New York 10048, and Northwest Atrium Center, 500 West Madison Street, Suite 1400, Chicago, Illinois 60661, and copies may be obtained at prescribed rates from the Public Reference Section of the Commission at 450 Fifth Street, N.W., Washington, D.C. 20549. In addition, the Registration Statement and certain other filings made with the Commission through its Electronic Data Gathering Analysis and Retrieval ("EDGAR") system are publicly available through the Commission's Web site located at http://www.sec.gov. The Registration Statement has been filed with the Commission through EDGAR. ---------------- CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS THAT STABILIZE, MAINTAIN OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK. SPECIFICALLY, THE UNDERWRITER MAY OVER-ALLOT IN CONNECTION WITH THE COMMON STOCK OFFERING AND MAY BID FOR AND PURCHASE SHARES OF THE COMMON STOCK IN THE OPEN MARKET. FOR A DESCRIPTION OF THESE ACTIVITIES, SEE "UNDERWRITING". IN CONNECTION WITH THIS OFFERING, THE UNDERWRITER MAY ENGAGE IN PASSIVE MARKET MAKING TRANSACTIONS IN THE COMMON STOCK ON NASDAQ IN ACCORDANCE WITH RULE 103 OF REGULATION M. SEE "UNDERWRITING." ---------------- "CDNOW" IS A FEDERALLY REGISTERED SERVICE MARK OF THE COMPANY. THE COMPANY HAS ALSO APPLIED FOR FEDERAL REGISTRATION OF THE MARK "COSMIC CREDIT." ALL OTHER TRADEMARKS OR SERVICE MARKS APPEARING IN THE PROSPECTUS ARE TRADEMARKS OR SERVICE MARKS OF THE RESPECTIVE COMPANIES THAT USE THEM. 2 PROSPECTUS SUMMARY The following summary is qualified in its entirety by, and should be read in conjunction with, the more detailed information and consolidated financial statements of the Company and the notes thereto included elsewhere in this Prospectus. Unless otherwise indicated, all information presented in this Prospectus assumes no exercise of the over-allotment option granted by the Company to the Underwriter. Unless the context otherwise requires, each reference to the "Company" or "CDnow" refers to CDnow, Inc. and its subsidiaries and each reference to "CDs" refers collectively to compact discs, cassettes and vinyl records. All share numbers used herein reflect all stock splits that have been effected prior to the date hereof. THE COMPANY CDnow is the leading online retailer of CDs and other music-related products. Its early entry into the online music retailing industry has helped the Company gain a well-recognized brand and a large customer base. The Company strives to combine the advantages of online commerce with superior customer focus in order to be the authoritative source for CDs and other music-related products. The Company's online store, cdnow.com, offers broad selection, informative content, easy-to-use navigation and search capabilities, a high level of customer service, competitive pricing and personalized merchandising and recommendations. With over 300,000 items, the Company believes that it provides a selection of readily-available products that is five to ten times that of a typical music retailer. To assist customers in making music selections, the CDnow store contains approximately 325,000 sound samples and 125,000 product notes, reviews and related articles, including articles from Rolling Stone, MTV/VH1 and CDnow's editorial staff. The CDnow store is open 24 hours a day, seven days a week and offers its customers convenient and timely product fulfillment, including an overnight delivery option. CDnow has grown rapidly since its inception in 1994. Of the 569,000 customers who have made purchases from inception through June 30, 1998, 273,000 made their initial purchases during the six month period ended June 30, 1998. Average daily visits to the CDnow store have grown from approximately 12,000 in January 1996 to approximately 173,000 in June 1998. The Company's net sales grew to $11.6 million in the second quarter of 1998 compared to $10.0 million and $3.0 million in the first quarter of 1998 and the second quarter of 1997, respectively. The Company has also generated significant customer loyalty. Despite the Company's rapid acquisition of new customers, repeat customers accounted for approximately 58% of net sales in the second quarter of 1998. The Company believes that a significant opportunity exists for the retailing of music on the Internet. According to the International Federation of the Phonographic Industry, worldwide sales of pre-recorded music in 1997 were approximately $38.1 billion, of which one-third was in North America. Online music retailers currently account for a small but growing portion of total sales. According to Jupiter Communications, Inc. ("Jupiter"), worldwide sales of pre-recorded music over the Internet are projected to grow from approximately $47 million in 1997 to $1.6 billion in 2002. A number of characteristics of online music retailing make the sale of pre- recorded music via the Internet particularly attractive relative to traditional retail stores. The Internet offers many data management and multimedia features which enable consumers to listen to sound samples, search for music by genre, title or artist and access a wealth of information and events, including reviews, related articles, music history, news and recommendations. Internet- based retailers can also offer consumers significantly broader product selection, the convenience of home shopping and 24-hour-a-day, seven-day-a-week operations. In addition, Internet-based retailers can serve international consumers without significant incremental cost and more effectively target their direct marketing activities as a result of the extensive customer demographic and behavioral data that they are able to obtain. The Company's business strategy is designed to promote the CDnow brand and expand its leadership position by (i) focusing on recorded music retailing, (ii) providing an innovative and easy-to-use retail 3 concept, (iii) acquiring customers on an efficient basis, (iv) maximizing customer retention, (v) enhancing its international capabilities and (vi) expanding its customer base through multiple marketing channels. The Company believes that the use of multiple marketing channels allows it to reduce its reliance on any one source of customers, maximize brand awareness and lower average customer acquisition costs. These marketing channels include: . Strategic Alliances. The Company seeks to enter into strategic alliances with major Internet content and service providers and global music- oriented media companies in order to enhance its new customer acquisition efforts, increase purchases by current customers and expand brand recognition. Since February 1998, the Company has broadened its strategic alliance with Yahoo! to include Yahoo! Mail and Yahoo!'s music chat space. The Company has also entered into new strategic alliances with Lycos and Tripod, Lycos Bertelsmann, JAMtv and Straight Arrow Publishers (the latter two, collectively, "Rolling Stone Network") and MTV Networks, a subsidiary of Viacom International, Inc. ("MTV/VH1"), with respect to MTV and VH1. In addition, CDnow has preexisting alliances with GeoCities and Excite's WebCrawler service. CDnow's alliances generally provide for the Company to be the premier online recorded music retailer on certain of the sites of these providers with the exclusive right to place music banner advertisements and integrated links to the CDnow store on certain music-related or other specified pages. The alliance with Rolling Stone Network also entitles CDnow to use the Rolling Stone brand name in conjunction with the display of cover art and excerpts of feature stories, record reviews, artist biographies and music news from current and past editions of Rolling Stone magazine. Under the MTV/VH1 alliance, the Company is the premier online retailer of recorded music on the MTV and VH1 cable television channels with preferred advertising rights with respect to special events and promotions, including exclusive online sponsorship of the 1998 Video Music Awards. The alliance with MTV/VH1 also entitles CDnow to use the MTV and VH1 brand names in conjunction with the display of MTV and VH1 content, music reviews and music news and provides CDnow with integrated links from the MTV and VH1 Web sites. . Online and Traditional Advertising. The Company promotes its brand through an aggressive marketing campaign using a combination of online and traditional advertising. The Company advertises on the sites of major Internet content and service providers, including AltaVista, Infoseek and Microsoft Network, and targeted music-related sites, such as Billboard. CDnow's traditional advertising efforts have included radio advertising in major markets, such as advertising on the Howard Stern program, and print advertising in music-related publications, including Spin and Variety. In the first quarter of 1998, the Company initiated television advertising, including national advertising during the Grammy Awards and the American Music Awards. The Company intends to increase its use of television advertising, including through its alliance with MTV/VH1, and has purchased advertising on such programs as MTV's 1998 Video Music Awards, VH1's Flashback Week and the 1999 Grammy Awards. . Cosmic Credit Program. Through its Cosmic Credit Program, CDnow has arrangements with over 52,000 small Web sites, typically fan sites devoted to particular musical artists. Approximately 42,000 of these sites have enrolled since December 1997. The Company provides Cosmic Credit sites with embedded hyperlinks through which potential customers can immediately be connected to the CDnow store. . Direct Marketing Techniques. The Company uses direct marketing techniques to target new and existing customers with communications and promotions. The Company sends a personalized e-mail newsletter to its customers that includes purchase recommendations based on demonstrated customer preferences and prior purchases. The Company also targets e- mail campaigns to specific customer and prospect segments based upon their recent activity at the CDnow store. The business of the Company was commenced as a sole proprietorship in February 1994. The Company was incorporated in Pennsylvania in April 1995. Its principal offices are located at 610 Old York Road, Suite 300, Jenkintown, Pennsylvania, 19046 and its telephone number is (215) 517-7325. 4 THE OFFERING Common Stock offered by the Company... 1,250,000 shares Common Stock offered by the Selling Shareholder.. 80,000 shares Common Stock to be outstanding after the Offering.. 17,516,397 shares(1) Use of proceeds....................... For sales and marketing expenses, including payments due under strategic alliances; improvements to the Company's Web site and other capital expenditures; working capital; and other general corporate purposes. Nasdaq National Market symbol......... CDNW - -------------------- (1) As of June 30, 1998 and excludes (i) 905,795 shares of Common Stock issuable upon the exercise of options outstanding as of June 30, 1998 under the Company's 1996 Equity Compensation Plan (the "Equity Compensation Plan") at a weighted average exercise price of $8.78 per share, (ii) 659,892 shares reserved for future grants under the Equity Compensation Plan, (iii) 490,515 shares of Common Stock issuable upon the exercise of warrants outstanding as of June 30, 1998 at a weighted average exercise price of $13.42 per share. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity," "Management-- Equity Compensation Plan" and "Description of Capital Stock." This Prospectus contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward looking statements address, among other things, growth in Internet usage and online commerce; future music retailing opportunities on the Internet; the Company's business strategy, including its sales and marketing plans; expectation of future losses; competitive factors; reliance on online and traditional advertising and strategic alliances; use of proceeds; reliance on certain vendors; projected capital expenditures; liquidity; possible business relationships; possible effects of changes in government regulation; dependence on key personnel; exposure to Year 2000; increased net sales in future periods; increased sales to international customers; and pricing policy. These statements may be found under "Prospectus Summary," "Risk Factors," "Use of Proceeds," "Management's Discussion and Analysis of Financial Condition and Results of Operations," and "Business" as well as in the Prospectus generally. Actual events or results may differ materially from those discussed in forward- looking statements as a result of various factors, including those factors discussed below under "Risk Factors" and set forth in this Prospectus generally. 5 SUMMARY FINANCIAL AND OPERATING DATA PERIOD FROM INCEPTION (FEBRUARY 12, SIX MONTHS ENDED 1994) TO YEAR ENDED DECEMBER 31, JUNE 30, DECEMBER 31, ------------------------------------- ------------------------- 1994(1) 1995(1) 1996 1997 1997 1998 ------------- ---------- ----------- ------------ ----------- ------------ STATEMENT OF OPERATIONS DATA: Net sales....................... $103,116 $2,176,474 $ 6,300,294 $ 17,372,795 $ 5,546,203 $ 21,624,030 Cost of sales................... 92,962 1,844,612 5,217,789 14,316,028 4,412,843 18,154,598 -------- ---------- ----------- ------------ ----------- ------------ Gross profit................... 10,154 331,862 1,082,505 3,056,767 1,133,360 3,469,432 Operating expenses: Operating and development...... 26,946 149,982 669,280 2,541,434 812,284 2,765,714 Sales and marketing............ 12,945 200,972 621,454 9,139,348 1,121,960 17,769,619 General and administrative..... 28,712 180,573 563,593 1,953,078 743,385 1,734,159 Dispute settlement(2).......... -- -- 1,024,030 -- -- -- -------- ---------- ----------- ------------ ----------- ------------ Total operating expenses....... 68,603 531,527 2,878,357 13,633,860 2,677,629 22,269,492 -------- ---------- ----------- ------------ ----------- ------------ Operating loss................. (58,449) (199,665) (1,795,852) (10,577,093) (1,544,269) (18,800,060) Interest income (expense), net.. -- (1,248) (14,556) (170,312) (5,415) 733,137 -------- ---------- ----------- ------------ ----------- ------------ Net loss(3)..................... $(58,449) $ (200,913) $(1,810,408) $(10,747,405) $(1,549,684) $(18,066,923) ======== ========== =========== ============ =========== ============ Net loss per common share(4).... $ (1.42) $ (0.20) $ (1.29) ============ =========== ============ Weighted average number of common shares outstanding(4)... 7,845,684 7,845,684 14,044,939 ============ =========== ============ OPERATING DATA: Customers(5).................... 1,787 26,953 87,859 296,450 143,257 569,034 JUNE 30, 1998 -------------------------- ACTUAL AS ADJUSTED(6) BALANCE SHEET DATA: ----------- -------------- Cash and cash equivalents........................... $47,290,625 $73,068,945 Working capital .................................... 47,426,572 73,204,892 Total assets........................................ 60,760,152 86,538,472 Long-term debt, excluding current portion........... 1,098,935 1,098,935 Total shareholders' equity.......................... 53,900,694 79,679,014 - -------------------- (1) The business of the Company was established as a sole proprietorship in February 1994 and commercial operations were commenced in August 1994. The Company was incorporated in April 1995. (2) In December 1996, in settlement of a dispute, the Company issued 882,606 shares of Common Stock to certain persons. See "Certain Relationships and Related Transactions" and Note 7 to Notes to Consolidated Financial Statements. (3) Before the accretion of the redemption premium on Preferred Stock in 1997 and the first six months of 1998 of $410,103 and $115,542, respectively. (4) See Note 2 to Notes to Consolidated Financial Statements for an explanation of the computation of the net loss per common share amounts. (5) Cumulative number of customers who have purchased products from the Company from inception of its business in August 1994 through the end of period. (6) Represents actual data as adjusted to give effect to the sale of 1,250,000 shares of Common Stock offered by the Company (at an assumed offering price of $22.1875 per share and after deducting underwriting discounts and commissions and estimated offering expenses) and the application of the estimated net proceeds therefrom. See "Capitalization" and "Use of Proceeds." 6 RISK FACTORS The following risk factors, as well as the other information contained in this Prospectus, should be considered carefully before purchasing the Common Stock offered hereby. Limited Operating History; History of Losses and Expectation of Future Losses. The Company was founded in February 1994 and began selling music- related products in August 1994. Accordingly, the Company has only a limited operating history on which to base an evaluation of its business and prospects. The Company's prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in their early stage of development, particularly companies in new and rapidly evolving markets such as online commerce. Such risks include, but are not limited to, possible inability to respond promptly to changes in a rapidly evolving and unpredictable business environment and the risk of inability to manage growth. To address these risks, the Company must, among other things, expand its customer base, successfully implement its business and marketing strategies, continue to develop and upgrade its Web site and transaction-processing systems, provide superior customer service, respond to competitive developments, and attract and retain qualified personnel. If the Company is not successful in addressing such risks, it will be materially adversely affected. Since inception, the Company has incurred significant losses, and as of June 30, 1998 had accumulated losses of $30.9 million. For the six months ended June 30, 1998 and the year ended December 31, 1997, the Company's net loss was $18.1 million and $10.7 million, respectively. The Company intends to invest heavily in marketing and promotion, Web site development and technology, and development of its administrative organization. As a result, the Company believes that it will incur substantial operating losses for the foreseeable future, and that the rate at which such losses will be incurred may increase significantly from current levels. Because the Company has relatively low product gross margins, achieving profitability given planned investment levels depends upon the Company's ability to generate and sustain substantially increased revenue levels. There can be no assurance that the Company will be able to generate sufficient revenues to achieve or sustain profitability in the future. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." Dependence on Continued Growth of Online Commerce. The Company's long-term viability is substantially dependent upon the widespread consumer acceptance and use of the Internet as a medium of commerce. Use of the Internet as a means of effecting retail transactions is at an early stage of development, and demand and market acceptance for recently introduced services and products over the Internet is very uncertain. The Company cannot predict the extent to which consumers will be willing to shift their purchasing habits from traditional retailers to online retailers. The Internet may not become a viable commercial marketplace for a number of reasons, including potentially inadequate development of the necessary network infrastructure, delayed development of enabling technologies and inadequate performance improvements. In addition, the Internet's viability as a commercial marketplace could be adversely affected by delays in the development of services or due to increased government regulation. Changes in or insufficient availability of telecommunications services to support the Internet also could result in slower response times and adversely affect usage of the Internet generally and CDnow in particular. Moreover, adverse publicity and consumer concern about the security of transactions conducted on the Internet and the privacy of users may also inhibit the growth of commerce on the Internet. If the use of the Internet does not continue to grow or grows more slowly than expected, or if the infrastructure for the Internet does not effectively support growth that may occur, the Company would be materially adversely affected. Competition. The online commerce market is new, rapidly evolving and intensely competitive, and the Company expects that competition will further intensify in the future. Barriers to entry are minimal, and current and new competitors can launch new sites at a relatively low cost. According to Jupiter, there were approximately 100 online music retailers as of June 1997. In addition, the broader retail music 7 industry is intensely competitive. The Company currently competes with a variety of companies, including (i) online vendors of music, music videos and other related products, (ii) online vendors of movies, books and other related products, (iii) online service providers which offer music products directly or in cooperation with other retailers, (iv) traditional retailers of music products, including specialty music retailers, (v) other retailers that offer music products, including mass merchandisers, superstores and consumer electronic stores; and (vi) non-store retailers such as music clubs. Many of these traditional retailers also support dedicated Web sites which compete directly with the Company. The Company believes that the principal competitive factors in its online market are brand recognition, selection, price, effectiveness of advertising, strategic alliances and other customer acquisition efforts, variety of value- added services, ease of use, site content, quality of service and technical expertise. Many of the Company's current and potential competitors have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing and other resources than the Company. The Company is aware that certain of its competitors have adopted and may continue to adopt aggressive pricing or inventory availability policies and devote substantially more resources to Web site and systems development than the Company. Increased competition may result in reduced operating margins, loss of market share and diminished brand recognition. There can be no assurance that the Company will be able to compete successfully against current and future competitors. New technologies and the expansion of existing technologies may increase the competitive pressures of the Company. For example, applications that select specific titles from a variety of Web sites based on factors such as price may channel customers to online retailers that compete with the Company. In addition, many companies that allow access to transactions through network access or Web browsers promote the Company's competitors and could charge the Company a substantial fee for inclusion. Increased Reliance Upon Strategic Alliances and Online and Traditional Advertising. The Company increasingly relies on strategic alliances and online and traditional advertising to attract users to its Web site. The Company has entered into strategic alliances with Yahoo! Inc. ("Yahoo!"), Excite, Inc. ("Excite"), GeoCities Inc. ("GeoCities"), Lycos, Inc. and Tripod, Inc. (collectively, "Lycos"), Lycos Bertelsmann GMBH & Co. KG ("Lycos Bertelsmann"), Rolling Stone Network and MTV/VH1. The Company's ability to generate increased revenues largely will depend on increased traffic and purchases through these alliances. There can be no assurance that the Company's strategic alliances will generate a substantial number of new customers or net sales or that the Company's infrastructure will be sufficient to handle the increased traffic that may result therefrom. Moreover, there can also be no assurance that the Company will be able to renew successful advertising programs or maintain its strategic alliances beyond their initial terms or that additional third-party alliances will be available to the Company on acceptable commercial terms or at all. The Company has recently committed substantial resources to promoting its brand name through a campaign that includes online, radio and television advertising. The inability to maintain and further develop its advertising campaign or strategic alliances could have a material adverse effect on the Company. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-- Liquidity and Capital Resources" and "Business--Marketing and Promotion-- Strategic Alliances." Risk of Inability to Manage Potential Growth. The Company has rapidly expanded its operations. This expansion has placed, and is expected to continue to place, a significant strain on the Company's management, operations, systems, and financial resources. From December 31, 1994 to June 30, 1998, the Company has grown from three to 161 employees, and several members of the Company's senior management have only recently joined the Company. CDnow's recently hired employees also include a number of key managerial, technical and operations personnel, and the Company expects to add additional key personnel in the near future. To manage its recent growth and any further growth of its operations and personnel, the Company must improve existing operations and systems and expand and 8 integrate its employee base. If the Company is unable to manage its growth effectively, it will be materially adversely affected. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business--Employees." Possible Need for Additional Funds. The Company anticipates that the net proceeds from this Offering, together with other available resources, will be sufficient to fund the Company's operations for at least the next 12 months. However, the Company's capital requirements depend on several factors, including the rate of market acceptance, the ability to expand the Company's customer base, the level of expenditures for sales and marketing, the cost of Web site upgrades and other factors. If capital requirements vary materially from those currently planned, the Company may require additional financing. There can be no assurance that financing will be available in amounts or on terms acceptable to the Company. If equity securities are issued in connection with a financing, dilution to the Company's shareholders may result, and if additional funds are raised through the incurrence of debt, the Company may become subject to restrictions on its operations and finances. See "Management's Discussion and Analysis of Financial Condition and Results of Operation." Reliance on Certain Vendors. The Company's primary provider of order fulfillment for recorded music titles is Valley Record Distributors, Inc. ("Valley"). For the six months ended June 30, 1998 and year ended December 31, 1997, payments to Valley accounted for approximately 82% and 78%, respectively of the Company's cost of sales. The Company has no fulfillment operation or facility of its own and, accordingly, is dependent upon maintaining its existing relationship with Valley or establishing a new fulfillment relationship with one of the few other fulfillment operations. There can be no assurance that the Company will maintain its relationship with Valley beyond the term of its existing two year agreement with Valley, which expires in June 1999, or that it will be able to find an alternative, comparable vendor capable of providing fulfillment services on terms satisfactory to the Company should its relationship with Valley terminate. An unanticipated termination of the Company's relationship with Valley, particularly during the fourth quarter of the calendar year in which a high percentage of recorded music sales are made, could materially adversely affect the Company's results of operations for the quarter in which such termination occurred even if the Company was able to establish a relationship with an alternative vendor. Valley may terminate its existing agreement with the Company upon 30 days' written notice, in the event that Valley decides to discontinue providing fulfillment services to all of Valley's online service customers. To date, Valley has satisfied the Company's requirements on a timely basis. However, to the extent that Valley does not have sufficient capacity and is unable to satisfy on a timely basis increasing requirements of the Company, the Company would be materially adversely affected. As is the case with Valley, the Company generally relies on a single vendor for order fulfillment with respect to each product line carried by the Company. Therefore, the loss of any one vendor could materially and adversely affect the Company's sales of that product line. While the Company seeks to negotiate multi-year contracts with its vendors to ensure the availability of merchandise, there can be no assurance that the Company's current vendors will continue to sell merchandise to the Company on current terms or that the Company will be able to establish new vendor relationships to ensure acquisition of merchandise in a timely and efficient manner and on acceptable commercial terms. If the Company were unable to develop and maintain relationships with vendors that would allow it to obtain sufficient quantities of merchandise on acceptable commercial terms, it would be materially adversely affected. See "Business--Fulfillment." Risk of System Failure; Absence of Redundant Facilities; Capacity Constraints. The Company's business is dependent on the efficient and uninterrupted operation of its computer and communications hardware systems. The Company's systems and operations are vulnerable to damage or interruption from fire, flood, power loss, telecommunications failure, break-ins, earthquake and similar events. Any system interruptions, including any interruptions in the Company's Internet connections or internal systems problems, that result in the unavailability of the Company's Web site or reduced transaction processing performance would reduce the volume of products sold and the attractiveness of the Company's product 9 and service offerings and could, therefore, materially adversely affect the Company. The Company has, from time to time, experienced periodic systems interruptions, and anticipates that such interruptions will occur in the future. The Company does not presently have fully redundant systems or a formal disaster recovery plan and does not carry sufficient business interruption insurance to compensate it for losses that may occur. Substantially all of the Company's computer and communications hardware is located at a single leased facility in Jenkintown, Pennsylvania. The Company intends to move to a new facility by year -end, and chances of system disruption during the move will increase. Any substantial increase in the volume of traffic on the Company's Web site or the number of orders placed by customers will require the Company to expand and upgrade further its technology, transaction-processing systems and network infrastructure. There can be no assurance that the Company will be able to accurately project the rate or timing of increases, if any, in the use of its Web site or expand and upgrade its systems and infrastructure to accommodate such increases. The failure to appropriately upgrade its systems and infrastructure would have a material adverse effect on the Company. Security Risks. A significant barrier to online commerce is concern regarding the security of transmission of confidential information. The Company relies on encryption and authentication technology licensed from third parties that is designed to facilitate the secure transmission of confidential information, such as customer credit card numbers. Nevertheless, the Company's infrastructure is potentially vulnerable to physical or electronic computer break-ins, viruses and similar disruptive problems. A party who is able to circumvent the Company's security measures could misappropriate proprietary information or cause interruptions in the Company's operations. To the extent that activities of the Company or third-party contractors involve the storage and transmission of proprietary information, such as credit card numbers, security breaches could damage the Company's reputation and expose the Company to a risk of loss or litigation and possible liability. Therefore, the Company may be required to expend significant capital and other resources to protect against such security breaches or to alleviate problems caused by such breaches. There can be no assurance that the Company's security measures will prevent security breaches or that failure to prevent such security breaches will not have a material adverse effect on the Company. See "Business-- Technology." Risk of Reliance on Internally Developed Software. The Company uses internally developed software in its Web site, search engine and substantially all aspects of its transaction processing and order management. The Company's inability to modify this software as necessary to accommodate increased traffic on its Web site or increased volume through its transaction processing and order management systems may cause unanticipated system disruptions, slower response times, impaired quality and speed of order fulfillment, degradation in customer service, and delays in reporting accurate financial information. Any of these events could have a material adverse effect on the Company. Potential Fluctuation in Quarterly Operating Results. The Company expects to experience significant fluctuations in its future quarterly operating results due to a variety of factors, many of which are outside the Company's control. Factors that may affect the Company's quarterly operating results include (i) its ability to retain existing customers, attract new customers and maintain customer satisfaction, (ii) the introduction of new or enhanced Web pages, services, products and strategic alliances by the Company and its competitors, (iii) price competition or higher wholesale prices, (iv) the level of use of the Internet and consumer acceptance of the Internet for the purchase of recorded music, (v) seasonality of recorded music sales, (vi) its ability to upgrade and develop its systems and infrastructure and attract qualified personnel, (vii) technical difficulties, system downtime or Internet brownouts, (viii) the amount and timing of operating costs and capital expenditures relating to expansion of the Company's business, operations and infrastructure, (ix) the timing of Company promotions and sales programs, (x) the level of merchandise returns experienced by the Company, (xi) government regulation and (xii) general economic conditions and economic conditions specific to the Internet and the music industry. 10 The Company expects that it will experience seasonality in its business, reflecting a combination of seasonal fluctuations in Internet usage and traditional retail seasonality patterns affecting sales of recorded music. Sales in the traditional retail music industry are significantly higher in the fourth calendar quarter of each year than in the preceding three quarters. However, to date, the Company's limited operating history and rapid growth make it difficult to ascertain the effects of seasonality on its business. Therefore, the Company believes that period-to-period comparisons of the Company's historical results are not necessarily meaningful and should not be relied upon as an indication of future results. The Company's results of operations in future periods may not meet the expectations of securities analysts and investors, in which case the price of the Common Stock would likely be materially adversely affected. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Quarterly Results and Seasonality." Possible Volatility of Stock Price. The market price of the Common Stock has been, and is likely to remain, highly volatile as is frequently the case with new public companies and Internet companies in particular. Quarterly operating results of the Company, deviations in results of operations from estimates of securities analysts, changes in general conditions in the economy, in Internet commerce and in the music retailing industry, or other developments affecting the Company or its competitors could cause the market price of the Common Stock to fluctuate substantially. The equity markets have, on occasion, experienced significant price and volume fluctuations that have affected the market prices for many companies' securities and that have often been unrelated to the operating performance of these companies. Any such fluctuations that occur following completion of the Offering may adversely affect the market price of the Common Stock. Rapid Technological Change. To remain competitive, the Company must continue to enhance and improve the responsiveness, functionality and features of its site and develop new features to meet customer needs. The Internet is characterized by rapid technological change, changes in user and customer requirements and preferences, frequent new product and service introductions and the emergence of new industry standards and practices that could render the Company's existing Web site, technology and systems obsolete. The Company's success will depend, in part, on its ability to license leading technologies useful in its business, enhance its existing services, develop new services and technology that address the needs of its customers, and respond to technological advances and emerging industry standards and practices on a cost-effective and timely basis. If the Company is unable to use new technologies effectively or adapt its Web site, proprietary technology and transaction-processing systems to customer requirements or emerging industry standards, it would be materially adversely affected. See "Business-- Technology." No Designated Use for Substantial Portion of Net Proceeds. At June 30, 1998, the Company had approximately $47.3 million in cash and cash equivalents. The Company has not designated any specific use for a significant portion of the Company's existing cash and cash equivalents and the net proceeds from the sale by the Company of the Common Stock offered hereby. The net proceeds of the Offering, together with its existing cash and cash equivalents, will be used by the Company to fund its obligations under its strategic alliances, to finance its sales and marketing campaign, to make improvements to and expand the capacity of its Web site, to make certain other capital expenditures and for working capital and other general corporate purposes. However, the Company cannot, with precision, estimate the portion of the net proceeds to be devoted to certain of these uses. From time to time, the Company may evaluate potential acquisitions involving complementary businesses, content, products or technologies. However, the Company has no present agreement with respect to any material acquisition or investment. Accordingly, management will have significant flexibility in applying the net proceeds of this Offering. See "Use of Proceeds." Trademarks and Proprietary Rights; Unlicensed Arrangements and Materials; Risk of Claims Resulting from Lack of License Rights. The Company regards its trademarks, trade secrets and similar 11 intellectual property as valuable to its business, and relies on trademark and copyright law, trade secret protection and confidentiality and/or license agreements with its employees and others to protect its proprietary rights. There can be no assurance that the steps taken by the Company will be adequate to prevent misappropriation or infringement of its proprietary property. The Company has licensed in the past, and expects that it may license in the future, certain of its proprietary rights, such as trademarks or copyrighted material, to third parties. While the Company attempts to ensure that the quality of its brand is maintained by such licensees, there can be no assurance that such licensees will not take actions that might materially adversely affect the value of the Company's proprietary rights or reputation, which could have a material adverse effect on the Company. Through its Cosmic Credit Program, the Company is establishing a network of links with numerous small Web sites, typically fan sites devoted to particular musical artists, that permit customers to connect to the Company's site through an embedded hyperlink. See "Business--Marketing and Promotion. " Many of the sites are not officially sanctioned by the artists to which they relate, nor do they have licenses from the artists for use of any intellectual property of the artists, their licensees or record companies which the sites may display. There can be no assurance that the artists, their licensees or record companies will not assert infringement claims against the Cosmic Credit sites and the Company because of its relationships with these sites. In addition, the Company's primary provider of artist and music-related information, such as reviews, articles, photographs and images, which the Company displays in its online retail store, has represented to the Company that it may not have a license to distribute a portion of such information. There can be no assurance that the owners (or their licensees) of intellectual property rights in such information will not assert infringement claims against the provider and the Company. Moreover, the Company has been subject to claims and expects to be subject to legal proceedings and claims from time to time in the ordinary course of its business, including claims of alleged infringement of the trademarks and other intellectual property rights of third parties by the Company and its licensees. Such claims could result in substantial costs and diversion of resources, even if ultimately decided in favor of the Company, and could have a material adverse effect on the Company, particularly if judgments on such claims are adverse to the Company. If a claim is asserted alleging that the Company has infringed the proprietary rights of a third party, the Company may be required to seek licenses to continue to use such intellectual property. The failure to obtain the necessary licenses or other rights at a reasonable cost could have a material adverse effect on the Company. Government Regulation and Legal Uncertainties. The Company is subject, both directly and indirectly, to various laws and regulations relating to its business, although there are few laws or regulations directly applicable to access to the Internet. However, due to the increasing popularity and use of the Internet, it is possible that a number of laws and regulations may be adopted with respect to the Internet. Such laws and regulations may cover issues such as user privacy, pricing, content, copyrights, distribution and characteristics and quality of products and services. Furthermore, the growth and development of the market for online commerce may prompt calls for more stringent consumer protection laws that may impose additional burdens on those companies conducting business online. The enactment of any additional laws or regulations may impede the growth of the Internet which could, in turn, decrease the demand for the Company's products and services and increase the Company's cost of doing business, or otherwise have an adverse effect on the Company. The applicability to the Internet of existing laws in various jurisdictions governing issues such as property ownership, sales and other taxes, contests and sweepstakes, libel, personal privacy, rights of publicity, language requirements and content restrictions, is uncertain and could expose the Company to substantial liability. The laws of certain foreign countries provide the owner of copyrighted products with the exclusive right to expose, through sound and video samples, copyrighted items for sale to the public and the right to distribute such products. Any new legislation or regulation, or the application of existing laws and regulations to the Internet could have a material adverse effect on the Company. For example, 12 major U.S.-based online services (and personnel) have been challenged by German authorities for making certain content accessible in Germany. If the Company were alleged to violate federal, state or foreign, civil or criminal law, even if the Company could successfully defend such claims, it could have a material, adverse impact on the Company. A foreign distribution affiliate of a major record label has sought to enjoin the sale of music-related products by another Internet retailer in Germany. Moreover, in February and March of 1998 the Company received correspondence from the foreign distribution affiliates of two other labels, demanding that the Company cease the sale of certain titles in Germany and pay damages. The Company has retained counsel and is in discussions with these affiliates, each of which is represented by the same counsel, regarding a possible resolution of this matter. There can be no assurance that this matter will be resolved on a satisfactory basis, if at all, or that this and other distribution affiliates will not seek to enjoin, or otherwise prevent, the sale by the Company of music-related products in Germany and other countries. If successful, these actions could materially adversely affect the Company. The Company believes that its use of third party material on its Web sites is permitted under current provisions of copyright law. However, legal rights to certain aspects of Internet content and commerce are not clearly settled and the Company's ability to rely upon one or more exemptions or defenses under copyright law is uncertain. There can be no assurance that the Company will be able to continue to provide rights to information, including downloadable music samples and artist, record and other information. The failure to be able to offer such information could have a material adverse effect on the Company. In addition, several telecommunications carriers are seeking to have telecommunications over the Internet regulated by the Federal Communications Commission (the "FCC") in the same manner as other telecommunications services. For example, America's Carriers Telecommunications Association has filed a petition with the FCC for this purpose. In addition, because the growing popularity and use of the Internet has burdened the existing telecommunications infrastructure and many areas with high Internet use have begun to experience interruptions in phone service, local telephone carriers, such as Pacific Bell, have petitioned the FCC to regulate Internet service providers and online service providers in a manner similar to long distance telephone carriers and to impose access fees on such providers. If either of these petitions are granted, or the relief sought therein is otherwise granted, the costs of communicating on the Internet could increase substantially, potentially slowing the growth in use of the Internet. Any such new legislation or regulation or application or interpretation of existing laws could have a material adverse effect on the Company's business, results of operations and financial condition. U.S. and foreign laws regulate certain uses of customer information and development and sale of mailing lists. The Company believes that it is in material compliance with such laws, but new restrictions may arise in this area that could have an adverse affect on the Company. The law regarding linking to and framing of third party Web sites without permission is uncertain. The Company believes that its linking and framing activities are lawful, but there is a possibility that it may be asked to pay a license fee or cease linking or framing. Possible Liability for Publishing or Distributing Content over the Internet. Due to the fact that the Company may be considered a publisher or distributor of both its own and third party content, as well as the fact that such material may be downloaded or copied from its Web sites and may be subsequently distributed to others, there is a potential that claims will be made against the Company for defamation, negligence, copyright or trademark infringement, invasion of privacy and publicity, unfair competition or other theories based on the nature and content of such material. Such claims have been brought, and sometimes successfully pressed, against online services in the past. For example, claims could be made against the Company if material deemed inappropriate for viewing by young children could be accessed though the Company Web sites. Although the Company carries general liability insurance, the Company's insurance may not cover potential claims of this type or may not be adequate to cover all costs incurred 13 in defense of potential claims or to indemnify the Company for all liability that may be imposed. Any costs or imposition of liability that is not covered by insurance or is in excess of insurance coverage could have a material adverse effect on the Company. Potential Liability for Sales and Other Taxes. The Company does not currently collect sales or other similar taxes in respect of shipments of goods into states other than Pennsylvania, California and Florida. New state tax regulations may subject the Company to the assessment of sales and income taxes in additional states. Tax authorities in a number of states are currently reviewing the appropriate tax treatment of companies engaged in Internet and catalogue retailing and are currently considering an agreement with certain of these companies regarding the assessment and collection of sales taxes. The Company is not a party to any such discussions. As the Company's service is available over the Internet in multiple states and foreign countries, such jurisdictions may claim that the Company is required to qualify to do business as a foreign corporation in each such state and foreign country. The failure by the Company to qualify as a foreign corporation in a jurisdiction where it is required to do so could subject the Company to taxes and penalties for the failure to qualify. Dependence on Key Personnel; Need for Additional Personnel. The Company's success is substantially dependent on the ability and experience of its senior management and other key personnel, particularly Jason Olim, its President, Chief Executive Officer and Chairman of the Board. Moreover, to accommodate its current size and manage its anticipated growth, the Company must maintain and expand its employee base. Competition for personnel, particularly persons having software development and other technical expertise, is intense, and there can be no assurance that the Company will retain existing personnel or hire additional, qualified personnel. The inability of the Company to retain and attract the necessary personnel or the loss of services of any of its key personnel could have a material adverse effect on the Company. See "Business-- Employees" and "Management." Control of the Company. Immediately upon completion of the Offering, approximately 16.9%, 16.9%, 9.8% and 13.2% of the outstanding Common Stock will be beneficially owned by Jason Olim, the Company's President, Chief Executive Officer and Chairman of the Board; Matthew Olim, the Company's Technical Lead and Jason Olim's brother; Alan Meltzer, a director of the Company; and Grotech Partners, IV, L.P., one of the managing directors of which is Patrick Kerins, a director of the Company. As a result, such persons, acting together, will have the ability to control all matters submitted to shareholders of the Company for approval (including the election and removal of directors and any merger, consolidation or sale of all or substantially all of the Company's assets) and to control the management and affairs of the Company. Such concentration of ownership may have the effect of delaying, deferring or preventing a change in control of the Company, impede a merger, consolidation, takeover or other business combination involving the Company or discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of the Company, which in turn could have an adverse effect on the market price of the Company's Common Stock. See "Principal and Selling Shareholders" and "Certain Relationships and Related Transactions." Risks Associated with the Year 2000. The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. In other words, date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in system failures or miscalculations causing disruptions of operations, including, among others, a temporary inability to process transactions, send invoices, or engage in similar normal business activities. The Company does not believe that it has material exposure to the Year 2000 issue with respect to its own information systems since its existing systems correctly define the year 2000. The Company intends to conduct an analysis in 1998 to determine the extent to which its major suppliers' systems (insofar as they relate to the Company's business) are subject to the Year 2000 issue. The Company is currently unable to predict the extent to which the Year 2000 issue will affect its suppliers, or the extent 14 to which it would be vulnerable to the suppliers' failure to remediate any Year 2000 issues on a timely basis. The failure of a major supplier subject to the Year 2000 to convert its systems on a timely basis or a conversion that is incompatible with the Company's systems could have a material adverse effect on the Company. In addition, most of the purchases from the Company's store are made with credit cards via the Internet, and the Company's operations may be materially adversely affected to the extent its customers are unable to use their credit cards or access the Internet due to the Year 2000 issues that are not rectified by their credit card vendors or by those organizations responsible for maintaining and providing access to the Internet. Risks Associated with International Sales. For the six months ended June 30, 1998 and the year ended December 31, 1997, international sales accounted for approximately 22% and 29%, respectively, of the Company's net sales. While the Company expects that its percentage of net sales from international markets may decrease in future periods due to a substantial increase in domestic marketing and advertising, it expects that international sales will continue to represent a significant portion of its net sales. The Company's international business activities are subject to a variety of potential risks, including the adoption of laws, political and economic conditions and actions by third parties that would restrict or eliminate the Company's ability to do business in certain jurisdictions. See "--Government Regulation and Legal Uncertainties." While the Company currently transacts business in U.S. dollars, to the extent that it determines to transact business in foreign currencies, the Company will become subject to the risks attendant to transacting in foreign currencies, including potential adverse effects of exchange rate fluctuations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." Potential Adverse Market Impact of Shares Eligible for Future Sale. The 1,330,000 shares of Common Stock offered hereby, together with the 4,715,000 shares of Common Stock sold in the Company's February 1998 registered offering, will be freely tradeable immediately following the Offering. All of the 11,471,397 remaining outstanding shares (the "Restricted Shares"), have or will become available for sale in the public market during 1998 subject, in certain instances, to the applicable resale limitations of Rule 144 promulgated under the Securities Act of 1933, as amended (the "Securities Act"). In addition, the Company has filed a Registration Statement on Form S-8 covering up to 1,600,000 shares issuable upon exercise of stock options under the Equity Compensation Plan. Such shares, upon issuance, will be immediately available for resale (in the case of holders that are affiliates of the Company, subject to certain limitations under Rule 144). The Company's officers, directors and certain shareholders, who hold, in the aggregate, approximately 10,484,619 shares of Common Stock, have agreed not to sell any shares of Common Stock (excluding shares of Common Stock offered by this Prospectus or shares purchased in the open market) for a period of 45 days following the consummation of the Offering without the prior written consent of BT Alex. Brown Incorporated. In addition, the Selling Shareholder, who upon completion of the Offering will own 225,172 shares of Common Stock, has agreed not to sell any shares of Common Stock (excluding any shares purchased in the open market) for a period of 45 days following the consummation of the Offering without the prior written consent of BT Alex. Brown Incorporated. Thereafter, these shares may become either freely resalable or eligible for sale pursuant to the applicable resale limitations of Rule 144. In addition, beneficial owners of approximately 5,088,008 shares of Restricted Stock have demand and piggyback registration rights with respect to those shares. Sales of substantial amounts of Common Stock in the public market or the availability of substantial amounts of such stock for sale subsequent to the Offering could adversely affect the prevailing market price of the Common Stock and could impair the Company's ability to raise capital through the sale of its equity securities. Anti-Takeover Provisions; Possible Issuances of Preferred Stock and Classified Board. Certain provisions of Pennsylvania law could make it more difficult for a third party to acquire, or could discourage a third party from attempting to acquire control of the Company. Such provisions could limit the price that certain investors might be willing to pay in the future for shares of the Common Stock. In 15 addition, shares of the Company's Preferred Stock, no par value (the "Preferred Stock"), may be issued by the Board of Directors without shareholder approval on such terms and conditions, and having such rights, privileges and preferences, as the Board of Directors may determine. The rights of the holders of the Common Stock will be subject to, and may be adversely affected by, the rights of the holders of any Preferred Stock that may be issued in the future. In addition, the Company's Amended and Restated Bylaws divide the Board of Directors into three classes, each serving a staggered three-year term. The issuance of Preferred Stock and the existence of a classified board could have the effect of delaying, deterring or preventing a change in control of the Company. The Company has no current plans to issue any shares of Preferred Stock. See "Management" and "Description of Capital Stock--Preferred Stock." Immediate and Substantial Dilution. The purchasers of the shares of Common Stock offered hereby will experience immediate and substantial dilution in the net tangible book value of their shares of Common Stock. See "Dilution." In the event the Company offers additional Common Stock in the future, including shares that may be issued upon exercise of stock options, purchasers of Common Stock in the Offering may experience further dilution in the net tangible book value per share of the Common Stock of the Company. PRICE RANGE OF COMMON STOCK The Company's Common Stock has been quoted on the Nasdaq National Market since February 10, 1998. The following table sets forth, for the periods indicated, the high and low sales prices for Common Stock on the Nasdaq National Market. HIGH LOW ------ ------ 1998 First Quarter (beginning February 10, 1998)................ $27.25 $16.00 Second Quarter............................................. $39.00 $16.00 Third Quarter (through July 23, 1998)...................... $27.50 $18.50 On July 23, 1998, the last reported sale price of the Common Stock on the Nasdaq National Market was $22.1875 per share. As of June 30, 1998, there were 16,266,397 shares of Common Stock outstanding, held by approximately 56 holders of record. This figure does not reflect beneficial ownership of shares held in street or nominee name. 16 USE OF PROCEEDS The net proceeds to the Company from the sale of 1,250,000 shares of Common Stock offered by the Company hereby are estimated to be $25.8 million (approximately $30.0 million if the Underwriters' over-allotment option is exercised in full) assuming an offering price of $22.1875 per share and after deducting underwriting discounts and commissions and estimated offering expenses payable by the Company. The Company will not receive any proceeds from shares of Common Stock sold by the Selling Shareholder. The net proceeds from the Offering, together with the Company's existing cash and cash equivalents, will be used by the Company as follows: an aggregate minimum of approximately $23.6 million expected to be due under the Company's strategic alliance agreements during the next 12 months; approximately $18.5 million on advertising and promotion; approximately $4.5 million to make enhancements to, and expand the capacity of, the Company's Web site and other capital expenditures; and the balance for working capital and other general corporate purposes, which may include additional payments due under the Company's existing strategic alliances, payments due under any new strategic alliances and future advertising and promotion activities. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." The amount actually expended for each purpose, other than the payments due under strategic alliance agreements described above, will be determined at the discretion of the Company. The Company's future capital requirements and the allocation of the net proceeds of the Offering, will depend on many factors, including the entrance into new strategic alliances, increases in advertising and promotions, growth of the Company's customer base and other factors. Accordingly, the actual amount of proceeds devoted to each purpose may vary substantially from the amount set forth above. From time to time the Company may evaluate potential acquisitions involving complementary businesses, content, products or technologies. The Company has no agreement or understanding with respect to any material acquisition. Pending utilization of the net proceeds of the Offering, the Company intends to invest the funds in short-term, interest-bearing, investment-grade obligations. The Company believes that the net proceeds from the Offering, together with its current cash and cash equivalents, will be sufficient to meet its anticipated cash needs for working capital and capital expenditures for at least the next 12 months. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." DIVIDEND POLICY The Company has not paid any cash dividends on its Common Stock and does not anticipate paying any cash dividends in the foreseeable future. The Company currently intends to retain future earnings, if any, to fund the development and growth of its business. Any future determination to pay cash dividends will be at the discretion of the Board of Directors and will be dependent upon the Company's financial condition, operating results, capital requirements, applicable contractual restrictions and such other factors as the Board of Directors deems relevant. 17 CAPITALIZATION The following table sets forth, as of June 30, 1998, (i) the actual capitalization of the Company and (ii) the capitalization, as adjusted to reflect the issuance and sale of the 1,250,000 shares of Common Stock offered by the Company hereby and the application of the estimated net proceeds therefrom. See "Use of Proceeds." The capitalization of the Company will not be affected by the sale of Common Stock offered by the Selling Shareholder. This table should be read in conjunction with the Consolidated Financial Statements and the notes thereto and the other financial information included elsewhere in this Prospectus. JUNE 30, 1998 ------------------------ ACTUAL AS ADJUSTED ----------- ----------- Cash and cash equivalents............................ $47,290,625 $73,068,945 =========== =========== Long-term debt, excluding current portion............ $ 1,098,935 $ 1,098,935 ----------- ----------- Shareholders' equity: Preferred Stock, no par value; 20,000,000 shares authorized; no shares issued and outstanding actual and as adjusted............................ -- -- Common Stock, no par value; 50,000,000 shares authorized; 16,266,397 shares issued and outstanding actual; 17,516,397 shares issued and outstanding as adjusted(1)........................ 79,281,341 105,059,661 Additional paid-in capital......................... 4,325,817 4,325,817 Deferred compensation.............................. (300,959) (300,959) Accumulated deficit................................ (29,405,505) (29,405,505) ----------- ----------- Total shareholders' equity....................... 53,900,694 79,679,014 ----------- ----------- Total capitalization........................... $54,999,089 $80,777,949 =========== =========== - --------------------- (1) Excludes (i) 905,795 shares of Common Stock issuable upon the exercise of options outstanding as of June 30, 1998 under the Company's 1996 Equity Compensation Plan (the "Equity Compensation Plan") at a weighted average exercise price of $8.78 per share, (ii) 659,892 shares of Common Stock reserved for future grants under the Equity Compensation Plan, (iii) 490,515 shares of Common Stock issuable upon the exercise of warrants outstanding as of June 30, 1998 at a weighted average exercise price of $13.42 per share. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity," "Management--Equity Compensation Plan" and "Description of Capital Stock." DILUTION At June 30, 1998, the net tangible book value of the Company was approximately $53.9 million or $3.31 per share of Common Stock. Net tangible book value per share is equal to the Company's total tangible assets less its total liabilities, divided by the total number of shares of Common Stock outstanding for the period immediately prior to the Offering. After giving effect to the sale by the Company of 1,250,000 shares of Common Stock offered hereby of at assumed offering price of $22.1875 per share and after deducting underwriting discounts and commissions and estimated offering expenses, the pro forma net tangible book value of the Company at June 30, 1998 would have been $79.7 million or approximately $4.55 per share. This represents an immediate increase in the net tangible book value of $4.55 per share of existing shareholders and immediate dilution of $17.64 per share to new investors purchasing shares of Common Stock in the Offering. The following table illustrates this per share dilution: Assumed Offering price per share.............................. $22.19 Net tangible book value per share as of June 30, 1998....... $3.31 Increase in net tangible book value per share attributable to new investors........................................... 1.24 ----- Pro forma net tangible book value per share after the Offering..................................................... 4.55 ------ Dilution per share to new investors........................... $17.64 ====== 18 SELECTED FINANCIAL AND OPERATING DATA The financial data set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and notes thereto appearing elsewhere in this Prospectus. The statement of operations data for the years ended December 31, 1995, 1996 and 1997 and the balance sheet data as of December 31, 1996 and 1997 have been derived from the Consolidated Financial Statements, which have been audited by Arthur Andersen LLP, independent public accountants, and are included elsewhere in this Prospectus. The statement of operations data for the period from inception (February 12, 1994) to December 31, 1994 and the selected balance sheet data as of December 31, 1994 and 1995 have been derived from consolidated financial statements audited by Arthur Andersen LLP, independent public accountants, not included in this Prospectus. The statement of operations data for the six months ended June 30, 1997 and 1998 and the balance sheet data as of June 30, 1998 have been derived from unaudited consolidated financial statements of the Company that, in the opinion of the Company, include all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the results of operations for the period in accordance with generally accepted accounting principles. The results of operations for the six months ended June 30, 1998 are not necessarily indicative of the results that may be expected for any interim period or for the full year. PERIOD FROM INCEPTION (FEBRUARY 12, SIX MONTHS ENDED JUNE 1994) TO YEAR ENDED DECEMBER 31, 30, DECEMBER 31, ------------------------------------- ------------------------- 1994(1) 1995(1) 1996 1997 1997 1998 ------------- ---------- ----------- ------------ ----------- ------------ STATEMENT OF OPERATIONS DATA: Net sales............... $103,116 $2,176,474 $ 6,300,294 $ 17,372,795 $ 5,546,203 $ 21,624,030 Cost of sales........... 92,962 1,844,612 5,217,789 14,316,028 4,412,843 18,154,598 -------- ---------- ----------- ------------ ----------- ------------ Gross profit............ 10,154 331,862 1,082,505 3,056,767 1,133,360 3,469,432 Operating expenses: Operating and develop- ment................... 26,946 149,982 669,280 2,541,434 812,284 2,765,714 Sales and marketing..... 12,945 200,972 621,454 9,139,348 1,121,960 17,769,619 General and administra- tive................... 28,712 180,573 563,593 1,953,078 743,385 1,734,159 Dispute settlement(2)... -- -- 1,024,030 -- -- -- -------- ---------- ----------- ------------ ----------- ------------ Total operating ex- penses................. 68,603 531,527 2,878,357 13,633,860 2,677,629 22,269,492 -------- ---------- ----------- ------------ ----------- ------------ Operating loss.......... (58,449) (199,665) (1,795,852) (10,577,093) (1,544,269) (18,800,060) Interest expense, net... -- (1,248) (14,556) (170,312) (5,415) 733,137 -------- ---------- ----------- ------------ ----------- ------------ Net loss................ (58,449) (200,913) (1,810,408) (10,747,405) (1,549,684) (18,066,923) Accretion of preferred stock to redemption value.................. -- -- -- (410,103) -- (115,542) -------- ---------- ----------- ------------ ----------- ------------ Net loss applicable to common shareholders.... $(58,449) $ (200,913) $(1,810,408) $(11,157,508) $(1,549,684) $(18,182,465) ======== ========== =========== ============ =========== ============ Net loss per common share(3)............... $ (1.42) $ (0.20) $ (1.29) ============ =========== ============ Weighted average number of common shares outstanding(3)......... 7,845,684 7,845,684 14,044,939 ============ =========== ============ OPERATING DATA: Customers(4)............ 1,787 26,953 87,859 296,450 143,257 569,034 DECEMBER 31, ------------------------------------------- JUNE 30, 1994 1995 1996 1997 1998 -------- --------- ---------- ----------- ----------- BALANCE SHEET DATA: Cash and cash equivalents........... $ 2,008 $ 43,812 $ 775,865 $10,686,001 $47,290,625 Working capital (deficit)............. (42,206) (235,478) 231,455 (1,218,005) 47,426,572 Total assets........... 25,765 268,468 1,575,459 16,448,425 60,760,152 Long-term debt, excluding current portion............... -- 9,519 91,133 962,144 1,098,935 Redeemable convertible preferred stock....... -- -- -- 9,492,594 -- Total shareholders' equity (deficit)...... (18,449) (99,362) 514,017 (9,752,450) 53,900,694 - --------------------- (1) The business of the Company was established as a sole proprietorship in February 1994 and commercial operations were commenced in August 1994. The Company was incorporated in April 1995. (2) In December 1996, in settlement of a dispute, the Company issued 882,606 shares of Common Stock to certain persons. See "Certain Relationships and Related Transactions" and Note 7 to Notes to Consolidated Financial Statements. (3) See Note 2 to Notes to Consolidated Financial Statements for an explanation of the computation of the net loss per common share amounts. (4) Cumulative number of customers who have purchased products from the Company from inception of its business in August 1994 through the end of period. 19 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Prospectus contains certain statements of a forward-looking nature relative to future events or the financial performance of the Company. Actual events or results may differ materially from those indicated by such forward- looking statements for a variety of reasons, including the matters set forth under the caption "Risk Factors." CDnow is the leading online retailer of CDs and other music-related products. Its early entrance into the online music retailing industry has helped the Company gain a well-recognized brand and a large customer base. The Company strives to combine the advantages of online commerce with superior customer focus in order to be the authoritative source for CDs and other music-related products. CDnow offers broad selection, informative content, easy-to-use navigation and search capabilities, a high level of customer service, competitive pricing and personalized merchandising and recommendations. Due to the Company's dedicated retail focus, revenues are almost entirely derived from the sale of pre-recorded music and related products, drawing from its comprehensive selection of over 300,000 items. CDnow has grown rapidly since its inception in 1994. Of the 569,000 customers who have made purchases since inception through June 30, 1998, 273,000 made their initial purchases during the six month period ended June 30, 1998. Average daily visits to the CDnow store have grown from approximately 12,000 in January 1996 to approximately 173,000 in June 1998. The Company's net sales grew to $11.6 million in the second quarter of 1998 compared to $10.0 million and $3.0 million in the first quarter of 1998 and second quarter of 1997, respectively. The Company has also generated significant customer loyalty. Despite the Company's rapid acquisition of new customers, repeat customers accounted for approximately 58% of net sales in the second quarter of 1998. The Company believes that the key factors affecting its long-term financial success include its ability to obtain new customers at reasonable costs, retain customers and encourage repeat purchases. The Company seeks to expand its customer base through multiple marketing channels which include (i) pursuing an aggressive marketing campaign using a combination of online and traditional marketing, (ii) establishing strategic alliances with major Internet content and service providers, (iii) entering into linking arrangements with other Web sites as part of its Cosmic Credit Program, and (iv) using direct marketing techniques to target new and existing customers with personalized communications. The Company entered into strategic alliances with Yahoo!, Excite and GeoCities in August 1997, September 1997 and January 1998, respectively, and has accelerated its marketing campaign since the Company's initial public offering in February 1998 by expanding its relationship with Yahoo! and entering into additional alliances with Lycos, Lycos Bertelsmann, Rolling Stone Network and MTV/VH1. Since its inception, the Company has incurred significant net losses and, as of June 30, 1998, had accumulated losses of $30.9 million. As it seeks to expand aggressively, the Company believes that its operating expenses will significantly increase as a result of the financial commitments related to the development of marketing channels, future strategic relationships, and improvements to its Web site and other capital expenditures. The Company expects that it will continue to incur losses and generate negative cash flow from operations for the foreseeable future as it continues to develop its business. Since the Company has relatively low product gross margins, the ability of the Company to generate and enhance profitability depends upon its ability to substantially increase its net sales. To the extent that significantly higher net sales do not result from the Company's marketing efforts, the Company will be materially adversely affected. There can be no assurance that the Company will be able to generate sufficient revenues from the sale of CDs and other music-related products to achieve or maintain profitability on a quarterly or annual basis. For the six months ended June 30, 1998 and year ended December 31, 1997, international sales accounted for approximately 22% and 29%, respectively, of net sales. While the Company expects that net sales from international markets will continue to represent a significant portion of net sales, the 20 Company believes that the percentage of its net sales from international markets may decrease in future periods due to the substantial increase in the Company's domestic marketing and advertising expenditures. The Company's business started as a sole proprietorship in February 1994. The Company, which was incorporated in April 1995, was taxed as an S- corporation until December 6, 1996 and has been taxed as a C-corporation since such date. RESULTS OF OPERATIONS The following table sets forth statement of operations data as a percentage of net sales for the periods indicated: SIX MONTHS YEAR ENDED ENDED DECEMBER 31, JUNE 30, --------------------- ------------- 1995 1996 1997 1997 1998 ----- ----- ----- ----- ----- Net sales........................... 100.0% 100.0% 100.0% 100.0% 100.0% Cost of sales....................... 84.8 82.8 82.4 79.6 84.0 ----- ----- ----- ----- ----- Gross profit...................... 15.2 17.2 17.6 20.4 16.0 Operating Expenses: Operating and development......... 6.9 10.6 14.6 14.6 12.8 Sales and marketing............... 9.2 9.9 52.6 20.2 82.2 General and administrative........ 8.3 8.9 11.3 13.4 7.9 Dispute settlement................ -- 16.3 -- -- -- ----- ----- ----- ----- ----- Total operating expenses.......... 24.4 45.7 78.5 48.2 102.9 ----- ----- ----- ----- ----- Operating loss.................... (9.2) (28.5) (60.9) (27.8) (86.9) Interest income (expense), net...... -- (0.2) (1.0) (0.1) 3.3 ----- ----- ----- ----- ----- Net loss............................ (9.2)% (28.7)% (61.9)% (27.9)% (83.6)% ===== ===== ===== ===== ===== Beginning in 1998, the Company determined to include royalties paid on CD sales in return for licensing of ratings, reviews and other information ("Information Royalties") in operating and development expenses rather than in cost of sales, as was previously the case. This change was made based on management's determination that including Information Royalties in operating and development expense was more consistent with the treatment of such expenses by retailers generally. The financial information in this Prospectus related to the Company's results of operations for periods prior to 1998 has been restated to reflect this change. Information Royalties were $146,200, $225,737, $97,562, and $137,119 during the years ended December 31, 1996 and 1997 and the six months ended June 30, 1997 and 1998, respectively. There were no Information Royalties paid in 1995. If Information Royalties were included in cost of sales, gross profit margins would have been 14.9%, 16.3%, 18.7%, and 15.4% during the years ended December 31, 1996 and 1997 and the six months ended June 30, 1997 and 1998, respectively. SIX MONTHS ENDED JUNE 30, 1998 COMPARED TO THE SIX MONTHS ENDED JUNE 30, 1997 Net Sales. Net Sales primarily reflect the sales of CDs and related merchandise, net of estimated returns, and include outbound shipping and handling charges. Net sales increased by $16.1 million, or 290%, to $21.6 million for the six months ended June 30, 1998 compared to $5.5 million for the six months ended June 30, 1997. Net sales were $11.8 million in the six months ended December 31, 1997. The increase is attributable to continued growth of the Company's customer base and repeat purchases from existing customers. Net sales were favorably affected by increased advertising and promotional activities, including the Company's Grammy Awards promotion and March 1998 storewide sale, as well as the continued implementation of its strategic alliances. In the six months ended June 30, 1998, the Company added approximately 273,000 new customers, bringing the total number of customers since 21 inception to 569,000 from 296,000 at December 31, 1997. International sales represented 22% and 35% of net sales for the six months ended June 30, 1998 and June 30, 1997, respectively. The Company believes that the decrease in international sales as a percentage of net sales is due to a proportionally larger increase in domestic sales resulting from the substantial increase in domestic marketing and advertising expenditures. Nevertheless, international sales increased to $4.7 million for the six months ended June 30, 1998 from $1.9 million in the six months ended June 30, 1997. Cost of Sales. Cost of sales consists primarily of the cost of merchandise sold to customers, including product fulfillment and outbound shipping and handling. Cost of sales also includes fees charged by credit card processors. Cost of sales increased by $13.8 million, or 311%, to $18.2 million for the six months ended June 30, 1998 compared to $4.4 million for the six months ended June 30, 1997. Cost of sales was $9.9 million for the six months ended December 31, 1997. The Company's gross profit margin decreased to 16.0% for the six months ended June 30, 1998 compared to 16.3% and 20.4% for the six months ended December 31, 1997 and June 30, 1997, respectively. The decline in gross margin was attributable to more aggressive pricing of recent releases and popular titles, as well as increased sales discounts offered by the Company in connection with its Grammy Awards promotion and March 1998 storewide sale. Gross margin for the quarter ended June 30, 1998 was 17.3% compared to 14.6% for the quarter ended March 31, 1998; this increase was attributable to selective price increases, reductions in internal shipping costs and higher margin revenue from the sale of strategic sponsorships. Operating and Development Expense. Operating and development expense consists primarily of payroll and related expenses for store management, design, development and network operations personnel, systems and telecommunications infrastructure, and royalties paid by the Company on CD sales in return for licensing of ratings, reviews, sound samples and other information. Store development costs are charged to expense as incurred. Operating and development expense increased by $2.0 million, or 240%, to $2.8 million for the six months ended June 30, 1998 compared to $812,000 for the six months ended June 30, 1997. The increase is attributable to increased staffing and associated costs related to enhancing the features and functionality of the Company's Web site and transaction-processing systems, as well as increased investment in store content, systems and telecommunications infrastructure. As a percentage of net sales, operating and development expense decreased to 12.8% for the six months ended June 30, 1998 compared to 14.6% for the six months ended June 30, 1997 as operating and development expenses were spread over a larger revenue base. Sales Marketing Expense. Sales and marketing expense consists primarily of payments related to advertising, promotion and strategic alliances as well as payroll and related expenses for personnel engaged in marketing, selling and customer service activities. Sales and marketing expense increased by $16.7 million to $17.8 million for the six months ended June 30, 1998 compared to $1.1 million for the six months ended June 30, 1997. As a percentage of net sales, sales and marketing expense grew to 82.2% for the six months ended June 30, 1998 compared to 20.2% for the six months ended June 30, 1997. The increase in both absolute dollars and as a percentage of net sales was primarily attributable to increased online and traditional advertising, including advertising costs incurred in connection with the Company's Grammy Awards and American Music Awards promotions, costs associated with the Company's strategic alliances, and promotional and public relations expenditures. The Company increased its advertising expense to $14.0 million for the six months ended June 30, 1998 compared to $490,000 for the six months ended June 30, 1997. In addition, the Company incurred increased staffing and related costs in connection with the implementation of its marketing strategy and customer service activities necessary to support its increased customer base. The Company expects the dollar amount of sales and marketing expense generally, and advertising expense in particular, to continue to increase significantly in future periods. While the Company is hopeful that its net sales will also increase in future periods so that its sales and marketing expense will not continue to represent an increasing percentage of net sales, the Company is not able to predict whether its net sales will increase by a sufficient amount for this to occur. No assurance can be given that the Company will achieve increased net sales or that sales and marketing expense will not increase as a percentage of net sales. 22 General and Administrative Expense. General and administrative expense consists of payroll and related expenses for executive, accounting and administrative personnel, insurance, professional fees and other general and corporate expenses. General and administrative expense increased by $1.0 million, or 133%, to $1.7 million for the six months ended June 30, 1998 compared to $743,000 for the six months ended June 30, 1997. The increase in general and administrative expense was primarily due to the hiring of additional personnel and increases in professional fees, as well as the costs associated with becoming a public company. As a percentage of net sales, general and administrative expense decreased to 7.9% for the six months ended June 30, 1998 from 13.4% for the six months ended June 30, 1997, as the Company's fixed costs were spread over a larger revenue base. Net Loss. The Company's net loss was $18.1 million for the six months ended June 30, 1998, an increase of $16.6 million, compared to $1.5 million for the six months ended June 30, 1997. YEAR ENDED DECEMBER 31, 1997 COMPARED TO THE YEAR ENDED DECEMBER 31, 1996 Net Sales. Net sales increased by $11.1 million, or 176%, to $17.4 million for the year ended December 31, 1997 from $6.3 million for the year ended December 31, 1996. This increase is primarily attributable to the significant growth of the Company's customer base and repeat purchases from the Company's existing customers, who have typically purchased more units per order than new customers. International sales represented approximately 29% and 40% of net sales for the years ended December 31, 1997 and December 31, 1996, respectively. The Company believes that this decrease in international sales as a percentage of net sales is due to the substantial increase in the Company's domestic marketing and advertising expenditures. At December 31, 1997, the Company had approximately 296,000 customer accounts compared to approximately 88,000 customer accounts at December 31, 1996. Cost of Sales. Cost of sales increased by $9.1 million, or 174%, to $14.3 million for the year ended December 31, 1997 from $5.2 million for the year ended December 31, 1996. This increase is primarily attributable to the Company's increased sales volume. The Company's gross profit margin was 17.6% for the year ended December 31, 1997 compared to 17.2% for the year ended December 31, 1996. The increase in gross margin as a percentage of net sales was primarily due to price reductions from the Company's suppliers and a change to a lower-price supplier for imported music and music-related products. The Company's gross profit margin declined in the fourth quarter of 1997 due to increased sales promotions during the holiday season. Operating and Development Expense. Operating and development expense increased by $1.9 million to $2.5 million for the year ended December 31, 1997 from $669,000 for the year ended December 31, 1996. As a percentage of net sales, these expenses were 14.6% for the year ended December 31, 1997 and 10.6% for the year ended December 31, 1996. This increase was due to increased staffing and associated costs related to enhancing the features, content and functionality of the Company's Web site and transaction-processing systems, as well as increased investment in systems and telecommunications infrastructure. Sales and Marketing Expense. Sales and marketing expense increased by $8.5 million to $9.1 million for the year ended December 31, 1997 from $621,000 for the year ended December 31, 1996, with $5.8 million of this expense incurred in the fourth quarter. As a percentage of net sales, these expenses increased to 52.6% for the year ended December 31, 1997 from 9.9% for the year ended December 31, 1996. This increase was due to the significant expansion of the Company's advertising expenditures, costs associated with the strategic alliances with Yahoo! and Excite and to the increased staffing and associated costs related to implementing the Company's marketing strategy and supporting the Company's increased customer base. The Company increased its advertising expense to $6.8 million for the year ended December 31, 1997 compared to $61,000 for the year ended December 31, 1996. General and Administrative Expense. General and administrative expense increased by $1.4 million to $2.0 million for the year ended December 31, 1997 from $564,000 for the year ended December 31, 1996. As a percentage of net sales, these expenses increased to 11.3% for the year ended December 23 31, 1997 compared to 8.9% for the year ended December 31, 1996. This increase was primarily due to the recruitment and hiring of additional personnel and increases in professional fees and travel expenses. Net Loss. The Company's net loss increased by $8.9 million to a loss of $10.7 million for the year ended December 31, 1997 from a net loss of $1.8 million for the year ended December 31, 1996. YEAR ENDED DECEMBER 31, 1996 COMPARED TO THE YEAR ENDED DECEMBER 31, 1995 Net Sales. Net sales increased 189% to $6.3 million for the year ended December 31, 1996 from $2.2 million for the year ended December 31, 1995 as a result of the significant growth of the Company's customer base and repeat purchases from existing customers. International sales represented approximately 40% and 22% of net sales for the year ended December 31, 1996 and the year ended December 31, 1995, respectively. At December 31, 1996, the Company had approximately 88,000 customer accounts compared to approximately 27,000 customer accounts at December 31, 1995. Cost of Sales. Cost of sales increased 183% to $5.2 million for the year ended December 31, 1996 from $1.8 million for the year ended December 31, 1995, reflecting the Company's increased sales volume. The Company's gross profit margin increased to 17.2% for the year ended December 31, 1996 from 15.2% for the year ended December 31, 1995. Operating and Development Expense. Operating and development expense increased to $669,000 for the year ended December 31, 1996 from $150,000 for the year ended December 31, 1995. As a percentage of net sales, operating and development expense grew to 10.6% for the year ended December 31, 1996 from 6.9% for the year ended December 31, 1995. This increase in both absolute dollars and as a percentage of net sales was primarily attributable to increased staffing and associated costs related to enhancing the features, content and functionality of the Company's Web site and transaction-processing systems, as well as increased investment in systems and telecommunications infrastructure. Sales and Marketing Expense. Sales and marketing expense increased to $621,000 for the year ended December 31, 1996 from $201,000 for the year ended December 31, 1995. As a percentage of net sales, sales and marketing expense grew to 9.9% for the year ended December 31, 1996 from 9.2% for the year ended December 31, 1995. This increase in both absolute dollars and as a percentage of net sales was primarily attributable to increased staffing and associated costs related to implementing the Company's marketing strategy and supporting the Company's increased customer base, as well as to expansion of the Company's online advertising, promotional and public relations expenditures. General and Administrative Expense. General and administrative expense increased to $564,000 for the year ended December 31, 1996 from $181,000 for the year ended December 31, 1995. As a percentage of net sales, general and administrative expense grew to 8.9% for the year ended December 31, 1996 from 8.3% for the year ended December 31, 1995. This increase in both absolute dollars and as a percentage of net sales was primarily due to the hiring of additional personnel and increases in professional fees and travel expenses. Dispute Settlement. In December 1996, in settlement of a dispute related to certain business arrangements and discussions among the Company and certain persons who are now shareholders of the Company, the Company issued Common Stock valued at approximately $1.0 million to the three shareholders of MBL Entertainment Inc. See "Certain Relationships and Related Transactions--Stock Purchase and Shareholders' Agreement" and Note 7 to Notes to Financial Statements. Net Loss. The Company's net loss increased by $1.6 million to a loss of $1.8 million for the year ended December 31, 1996 from a net loss of $201,000 for the year ended December 31, 1995. 24 QUARTERLY RESULTS OF OPERATIONS AND SEASONALITY The following table sets forth certain unaudited quarterly statement of operations data for the ten quarters ended June 30, 1998. This unaudited quarterly information has been derived from unaudited consolidated financial statements of the Company and, in the opinion of management, include all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the information for the periods covered. The quarterly data should be read in conjunction with the Financial Statements and the notes thereto. The operating results for any quarter are not necessarily indicative of the operating results for any future period. THREE MONTHS ENDED ---------------------------------------------------------------------------------------------- MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, 1996 1996 1996 1996 1997 1997 1997 1997 1998 -------- -------- --------- -------- -------- -------- --------- -------- -------- (IN THOUSANDS) Net sales............... $1,128 $1,352 $1,629 $ 2,191 $2,582 $ 2,964 $ 3,907 $ 7,920 $10,014 Cost of sales........... 944 1,137 1,373 1,764 2,050 2,363 3,167 6,736 8,555 ------ ------ ------ ------- ------ ------- ------- ------- ------- Gross profit............ 184 215 256 427 532 601 740 1,184 1,459 Operating expenses: Operating and development........... 101 138 185 246 322 489 632 1,099 1,081 Sales and marketing..... 91 127 174 229 417 707 2,234 5,781 8,786 General and administrative........ 81 115 157 210 339 404 523 687 850 Dispute settlement...... -- -- -- 1,024 -- -- -- -- -- ------ ------ ------ ------- ------ ------- ------- ------- ------- Total operating expenses............... 273 380 516 1,709 1,078 1,600 3,389 7,567 10,717 ------ ------ ------ ------- ------ ------- ------- ------- ------- Operating loss.......... (89) (165) (260) (1,282) (546) (999) (2,649) (6,383) (9,258) Interest income (expense), net........ (2) (3) (6) (3) 2 (6) 69 (235) 60 ------ ------ ------ ------- ------ ------- ------- ------- ------- Net loss................ $ (91) $ (168) $ (266) $(1,285) $ (544) $(1,005) $(2,580) $(6,618) $(9,198) ====== ====== ====== ======= ====== ======= ======= ======= ======= AS A PERCENTAGE OF NET SALES ---------------------------------------------------------------------------------------------- MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, 1996 1996 1996 1996 1997 1997 1997 1997 1998 -------- -------- --------- -------- -------- -------- --------- -------- -------- Net sales............... 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% Cost of sales........... 83.7 84.1 84.3 80.5 79.4 79.7 81.1 85.1 85.4 ------ ------ ------ ------- ------ ------- ------- ------- ------- Gross profit............ 16.3 15.9 15.7 19.5 20.6 20.3 18.9 14.9 14.6 Operating expenses: Operating and development............ 9.0 10.2 11.4 11.2 12.4 16.5 16.2 13.9 10.8 Sales and marketing..... 8.1 9.4 10.7 10.5 16.2 23.9 57.2 73.0 87.7 General and administrative......... 7.1 8.5 9.6 9.6 13.1 13.6 13.3 8.6 8.6 Dispute settlement...... -- -- -- 46.7 -- -- -- -- -- ------ ------ ------ ------- ------ ------- ------- ------- ------- Total operating expenses..... 24.2 28.1 31.7 78.0 41.7 54.0 86.7 95.5 107.1 ------ ------ ------ ------- ------ ------- ------- ------- ------- Operating loss.......... (7.9) (12.2) (16.0) (58.5) (21.1) (33.7) (67.8) (80.6) (92.5) Interest income (expense), net......... (0.2) (0.2) (0.3) (0.1) -- (0.2) 1.8 (3.0) 0.6 ------ ------ ------ ------- ------ ------- ------- ------- ------- Net loss................ (8.1)% (12.4)% (16.3)% (58.6)% (21.1)% (33.9)% (66.0)% (83.6)% (91.9)% ====== ====== ====== ======= ====== ======= ======= ======= ======= JUNE 30, 1998 ---------- Net sales............... $11,610 Cost of sales........... 9,600 ---------- Gross profit............ 2,010 Operating expenses: Operating and development........... 1,684 Sales and marketing..... 8,984 General and administrative........ 884 Dispute settlement...... -- ---------- Total operating expenses............... 11,552 ---------- Operating loss.......... (9,542) Interest income (expense), net........ 673 ---------- Net loss................ $(8,869) ========== JUNE 30, 1998 ---------- Net sales............... 100.0% Cost of sales........... 82.7 ---------- Gross profit............ 17.3 Operating expenses: Operating and development............ 14.5 Sales and marketing..... 77.4 General and administrative......... 7.6 Dispute settlement...... -- ---------- Total operating expenses..... 99.5 ---------- Operating loss.......... (82.2) Interest income (expense), net......... 5.8 ---------- Net loss................ (76.4)% ========== The Company expects to experience significant fluctuations in its future quarterly operating results due to a variety of factors, many of which are outside the Company's control. Factors that may affect the Company's quarterly operating results include (i) its ability to retain existing customers, attract new customers and maintain customer satisfaction, (ii) the introduction of new or enhanced Web pages, services, products and strategic alliances by the Company and its competitors, (iii) price competition or higher wholesale prices, (iv) the level of use of the Internet and consumer acceptance of the Internet for 25 the purchase of recorded music, (v) seasonality of recorded music sales, (vi) its ability to upgrade and develop its systems and infrastructure and attract qualified personnel, (vii) technical difficulties, system downtime or Internet brownouts, (viii) the amount and timing of operating costs and capital expenditures relating to expansion of the Company's business, operations and infrastructure, (ix) the timing of Company promotions and sales programs, (x) the level of merchandise returns experienced by the Company, (xi) government regulation and (xii) general economic conditions and economic conditions specific to the Internet and the music industry. The Company expects that it will experience seasonality in its business, reflecting a combination of seasonal fluctuations in Internet usage and traditional retail seasonality patterns affecting sales of recorded music. Sales in the traditional retail music industry are significantly higher in the fourth calendar quarter of each year than in the preceding three quarters. However, to date, the Company's limited operating history and rapid growth make it difficult to ascertain the effects of seasonality on its business. The Company believes that period-to-period comparisons of the Company's historical results are not necessarily meaningful and should not be relied upon as an indication of future results. LIQUIDITY AND CAPITAL RESOURCES At June 30, 1998 the Company's cash and cash equivalents were $47.3 million, compared to $269,000 at June 30, 1997. In February 1998, the Company consummated its initial public offering, selling an aggregate of 4,561,250 shares of Common Stock and raising net proceeds of approximately $67.1 million. Prior to February 1998, the Company primarily financed its operations through private sales of capital stock (which, through December 31, 1997, totaled $10.5 million, including $9.3 million raised in July and August of 1997), the private sale of $5.8 million of the Series A Notes in November 1997, internally-generated cash flow, advances from related parties and certain other short-term loans. Net cash used in operating activities of $23.6 million for the six months ended June 30, 1998 was primarily attributable to a net loss of $18.1 million, a decrease of $5.5 million in accounts payable and an increase of $1.6 million in prepaid expenses partially offset by a $903,000 increase in accrued expenses and depreciation and amortization of $751,000. For the six months ended June 30, 1997, cash used in operating activities of $522,000 resulted primarily from a net loss of $1.5 million largely offset by increases in accounts payable and other accrued expenses. Net cash used in investing activities was $1.1 million for the six months ended June 30, 1998, and consisted of purchases of equipment of $1.6 million and $424,000 of cash for the purchase of superSonic Boom, Inc. partially offset by the sale of short-term investments of $1.0 million. Net cash used in investing activities of $87,000 for the six months ended June 30, 1997 was attributable to purchases of equipment of $333,000 partially offset by sales and maturities of short-term investments of $246,000. Net cash provided by financing activities of $61.2 million for the six months ended June 30, 1998 was primarily attributable to the net proceeds of approximately $67.1 million from the Company's initial public offering partially offset by the retirement of $5.8 million of the Company's Series A Notes. Net cash used in operating activities was $3.2 million and $116,000 for the years ended December 31, 1997 and 1996, respectively, while net cash provided by operating activities was $41,000 in the year ended December 31, 1995. For the year ended December 31, 1997, cash used in operating activities was attributable to a $10.7 million net loss and increases in prepaid expenses of $2.4 million, partially offset by an $8.5 million increase in accounts payable and $1.1 million of depreciation and amortization expense (including amortization of deferred compensation, deferred financing costs and debt discount). Net cash used in operating activities for the year ended December 31, 1996 was attributable to a net loss of $1.8 million (however, $1.0 million of the net loss was attributable to the issuance of common stock in settlement of a dispute, which had no cash effect on the Company) and increases in accounts receivable and prepaid expenses, partially offset by increases in certain current liabilities and non-cash items, including $118,000 representing the deemed fair value of services contributed by the Company's founders (one of whom served as President and the other developed the Company's systems architecture and transactions systems). 26 Net cash used in investing activities totaled $1.7 million, $445,000 and $136,000 for the years ended December 31, 1997, 1996 and 1995, respectively. The increases were attributable to purchases of short-term marketable securities and increased purchases of property and equipment. Net cash provided by financing activities was $14.8 million, $1.3 million, and $136,000 for the years ended December 31, 1997, 1996 and 1995, respectively. Cash flows from financing activities in 1997 increased compared to 1996 primarily as the result of $10.0 million in proceeds received from the sale of Series A Preferred Stock and Series B Preferred Stock, net of issuance costs of approximately $700,000; $5.8 million in proceeds from the sale of Series A Notes, net of issuance costs of approximately $175,000; and the proceeds from term loans payable of $219,000. The Company also repaid $200,000 of short-term loans from private investors that were outstanding as of December 31, 1996. Cash flows from financing activities in 1996 increased compared to 1995 principally as the result of $1.2 million in proceeds from the sale of Common Stock in December 1996 to Alan Meltzer, a director of the Company. See "Certain Relationships and Related Transactions." On July 15, 1997, the Company sold 254,582 shares of Series A Preferred Stock to Keystone Ventures IV, L.P. ("Keystone Ventures") for an aggregate price of $1.3 million. The outstanding shares of Series A Preferred Stock automatically converted in February 1998 into an aggregate of 381,873 shares of Common Stock. On August 5, 1997, the Company sold 1,543,505 shares of Series B Preferred Stock to Grotech Partners IV, LP ("Grotech") and 62,000 shares of Series B Preferred Stock to ABS Employees' Venture Fund Limited Partnership ("ABS") for an aggregate price of $8.7 million. The outstanding shares of Series B Preferred Stock automatically converted in February 1998 into an aggregate of 2,408,258 shares of Common Stock. See "Certain Relationships and Related Transactions." On August 21, 1997, the Company entered into an Advertising and Promotion Agreement with Yahoo! Inc. (the "Yahoo! Agreement") which extends until October 1999. The Company is required to pay Yahoo! minimum fees of $3.9 million during the first year of the Agreement, of which an aggregate of $2.8 million was paid through June 30, 1998, and $1.1 million is due in periodic installments through October 1998. The Company will be required to pay Yahoo! certain additional fees during the second year of the term based on the number of users that access the CDnow Web site through the links with Yahoo! during the last two months of the initial term, provided that such fees may not be less than $4.5 million in the aggregate. In addition, during the term of the Yahoo! Agreement, the Company is required to pay Yahoo! an additional variable fee based on the number of users that access the CDnow Web site through the links with Yahoo! in excess of certain stated minimums. On September 30, 1997, the Company and Excite entered into a two-year Linking Agreement (the "Excite Agreement") with respect to Excite's Webcrawler Service. The Company is required to pay Excite $2.0 million and $2.5 million in fees during the first and second years, respectively, of the Excite Agreement. As of June 30, 1998, the Company had paid Excite $2.0 million. The Company is required to pay Excite additional variable fees based on the number of users which access the CDnow site through links with the WebCrawler service in excess of certain minimums. The Company has the right to terminate the Excite Agreement and eliminate any obligation to pay Excite any of the fees scheduled to be paid during the second year of the term if a certain minimum level of links and advertising banners have not been delivered by the WebCrawler service within 30 days after the first anniversary of such Agreement. In November 1997, the Company issued $5.8 million aggregate principal amount of Series A Notes to a group of investors, including Grotech. These Notes, which bore interest at 12% per annum, were retired in February 1998. The Company issued warrants to these investors to purchase an aggregate of 48,550 shares of Common Stock at an exercise price of $11.90 per share. On March 26, 1998, the Company entered into a three-year Linking Agreement with Lycos (the "Lycos Agreement"). The Company is required to pay Lycos $4.5 million, $5.5 million and $6.5 million in 27 fixed fees during the first, second and third years, respectively, of the Lycos Agreement. As of June 30, 1998, the Company had paid Lycos $1.5 million. The Company is also required to pay Lycos certain variable fees based on the number of new customers that access, and new Cosmic Credit sites that are enrolled, through links with the Lycos and Tripod Web sites. In addition, the Company issued 61,665 shares of Common Stock to Lycos. On April 2, 1998, the Company entered into a three-year linking agreement with Lycos Bertelsmann (the "Lycos Bertelsmann Agreement"). The Company is required to pay Lycos Bertelsmann $1.4 million, $1.9 million and $2.2 million in fixed fees during the first, second and third years, respectively, of the Lycos Bertelsmann Agreement. As of June 30, 1998, the Company had paid Lycos Bertelsmann $880,000. The Company is also required to pay Lycos Bertelsmann certain variable fees based on the number of new customers acquired, and new Cosmic Credit sites enrolled, through links with the Lycos Bertelsmann Web sites. On May 18, 1998, the Company entered into a binding memorandum of terms with MTV/VH1 (the "MTV/VH1 Agreement"). Under the MTV/VH1 Agreement, the Company is required to pay MTV/VH1 $5.2 million, $6.8 million, $7.3 million and $121,000 in fixed fees during the remaining six months of 1998 and the years ending December 31, 1999, 2000 and 2001, respectively. As additional consideration, the Company has agreed to issue MTV/VH1 a warrant to purchase 226,892 shares of Common Stock at an exercise price of $23.28 per share. The Company is required to pay aggregate minimum fixed fees of $3.1 million, $2.9 million, $2.4 million and $766,000 during the remaining six months of 1998 and the years ending December 31, 1999, 2000 and 2001, respectively, under the Company's other strategic alliances. The Company expects to fund its future payment obligations under its strategic alliances from its cash and cash equivalents, including a portion of the net proceeds from the Offering. See "Use of Proceeds" and "Business-- Marketing and Promotion." As of June 30, 1998, the Company had $47.3 million of cash and cash equivalents. As of that date, the Company's principal commitments consisted of obligations under its strategic alliances as well as obligations outstanding under capital and operating leases. Although the Company has no material commitments for capital expenditures, it anticipates substantial increases in its capital expenditures and lease commitments consistent with anticipated growth in operations, infrastructure and personnel. The Company believes that the net proceeds from this Offering, together with its current cash and cash equivalents, will be sufficient to meet its anticipated cash needs for working capital and capital expenditures for at least the next 12 months. However, the Company's capital requirements depend on several factors, including the rate of market acceptance, the ability to expand the Company's customer base, the cost of Web site upgrades, the level of expenditures for sales and marketing, and other factors. The timing and amount of such capital requirements cannot accurately be predicted. If capital requirements vary materially from those currently planned, the Company may require additional financing sooner than anticipated. The Company has no commitments for any additional financing, and there can be no assurance that any such commitments can be obtained on favorable terms, if at all. Any additional equity financing may be dilutive to the Company's shareholders, and debt financing, if available, may involve restrictive covenants with respect to dividends, raising future capital and other financial and operational matters which could restrict its operations or finances. If the Company is unable to obtain additional financing as needed, the Company may be required to reduce the scope of its operations or its anticipated expansion, which could have a material adverse effect on the Company. At December 31, 1997, the Company had a net operating loss ("NOL") carryforward of approximately $9.7 million, which begins to expire in 2011. The utilization of the NOL carryforward will be limited pursuant to the Tax Reform Act of 1986, due to cumulative changes in ownership in excess of 50%. See Note 5 to Notes to Consolidated Financial Statements. See Note 2 to Notes to Consolidated Financial Statements for information regarding recently issued accounting standards. 28 Risks Associated with the Year 2000. The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. In other words, date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in system failures or miscalculations causing disruptions of operations, including, among others, a temporary inability to process transactions, send invoices, or engage in similar normal business activities. The Company does not believe that it has material exposure to the Year 2000 issue with respect to its own information systems since its existing systems correctly define the year 2000. The Company intends to conduct an analysis in 1998 to determine the extent to which its major suppliers' systems (insofar as they relate to the Company's business) are subject to the Year 2000 issue. The Company is currently unable to predict the extent to which the Year 2000 issue will affect its suppliers, or the extent to which it would be vulnerable to the suppliers' failure to remediate any Year 2000 issues on a timely basis. The failure of a major supplier subject to the Year 2000 to convert its systems on a timely basis or a conversion that is incompatible with the Company's systems could have a material adverse effect on the Company. In addition, most of the purchases from the Company's store are made with credit cards via the Internet, and the Company's operations may be materially adversely affected to the extent its customers are unable to use their credit cards or access the Internet due to the Year 2000 issues that are not rectified by their credit card vendors or by those organizations responsible for maintaining and providing access to the Internet. 29 BUSINESS INTRODUCTION CDnow is the leading online retailer of CDs and other music-related products. Its early entry into the online music retailing industry has helped the Company gain a well-recognized brand and a large customer base. The Company strives to combine the advantages of online commerce with superior customer focus in order to be the authoritative source for CDs and other music-related products. The Company's online store, cdnow.com, offers broad selection, informative content, easy-to-use navigation and search capabilities, a high level of customer service, competitive pricing and personalized merchandising and communication. With over 300,000 items, the Company believes that it provides a selection of readily-available products that is five to ten times that of a typical music retailer. To assist customers in making music selections, the CDnow store contains approximately 325,000 sound samples and 125,000 product notes, reviews and related articles, including articles from Rolling Stone, MTV/VH1 and CDnow's editorial staff. The CDnow store is open 24 hours a day, seven days a week and offers its customers convenient and timely product fulfillment, including an overnight delivery option. CDnow has grown rapidly since its inception in 1994. Of the 569,000 customers who have made purchases from inception through June 30, 1998, 273,000 made their initial purchases during the six month period ended June 30, 1998. Average daily visits to the CDnow store have grown from approximately 12,000 in January 1996 to approximately 173,000 in June 1998 . The Company's net sales grew to $11.6 million for the second quarter of 1998 compared to $10.0 million and $3.0 million for the first quarter of 1998 and the second quarter of 1997, respectively. The Company has also generated significant customer loyalty. Despite the Company's rapid acquisition of new customers, repeat customers accounted for approximately 58% of net sales in the second quarter of 1998. INDUSTRY OVERVIEW The Internet is an increasingly significant global medium for communications, information and commerce. International Data Corporation ("IDC") estimates that the number of Web users grew to approximately 69 million by the end of 1997 and will grow to approximately 320 million by 2002. The Company believes that the growth in Internet usage has resulted from a number of factors, including the large and growing installed base of PCs in the workplace and home, advances in the performance and speed of PCs and modems, improvements in network infrastructure, easier and cheaper access to the Internet and increased awareness of the Internet among businesses and consumers. Jupiter estimates that the number of online households (households using e-mail, the Internet or a consumer online service) making purchases will grow from an estimated 15.2 million households in 1996 to 57.0 million households, representing over 50% of U.S. households, by the year 2002. IDC estimates that the total value of services and products purchased over the Web grew from $296 million in 1995 to approximately $12.4 billion in 1997, and will increase to approximately $426 billion by 2002. The Company believes that a significant opportunity exists for the retailing of music on the Internet. According to the International Federation of the Phonographic Industry, worldwide sales of pre-recorded music and music videos in 1997 were approximately $38.1 billion, of which one-third was in North America. Online music retailers currently account for a small but growing portion of total sales. According to Jupiter, sales of pre-recorded music over the Internet are projected to grow on a worldwide basis from approximately $47 million in 1997 to $1.6 billion in 2002. A number of characteristics of online music retailing make the sale of pre- recorded music via the Internet particularly attractive relative to traditional retail stores. The Internet offers many data management and multimedia features which enable consumers to listen to sound samples, search for music by genre, title or artist and access a wealth of information and events, including reviews, related articles, music history, news and recommendations. Internet retailers can more easily obtain extensive 30 demographic and behavioral data about their customers, providing them with greater direct marketing opportunities and the ability to offer a more personalized shopping experience. In addition, Internet retailers can also offer consumers significantly broader product selection, the convenience of home shopping and 24-hour-a-day, seven-day-a-week operations, available to any location, foreign or domestic, that has access to the Internet. While physical store-based music retailers must make significant investments in inventory, real estate and personnel for each store location, online retailers incur a fraction of these costs, generally use centralized distribution, and have virtually unlimited merchandising space. Traditional retailers are compelled to limit the amount of inventory they carry at each store and focus on a smaller selection of faster-selling hit releases. As a result, the Company believes that a typical music store may carry up to 12,000 SKUs and a megastore may carry up to 50,000 SKUs, compared to the more than 300,000 SKUs carried by the CDnow store. According to Jupiter, approximately 80% of unit sales at traditional retail stores come from approximately 20% of the available titles. Online retailers can offer consumers a broader range of titles and information and can also offer products from a wider range of music labels, including smaller independent labels which account for an increasing percentage of new titles. According to Soundscan, independent labels accounted for 21% of the total music market in 1996 versus 12% in 1992. While independent labels released 66% of new titles in 1996, traditional music stores often lack the capacity to stock or promote the vast majority of these titles. The Company also believes that online retailers will benefit from the changing demographic profile of music consumers. According to the Recording Industry Association of America, domestic purchases of recorded music by persons age 30 and over have increased from approximately 34% of total U.S. sales in 1986 to approximately 48% of sales, or approximately $5.9 billion, in 1997. The Company believes that the Internet represents a particularly attractive medium for retailing to customers in this age group as they are typically less "hits-driven" than younger age groups and are more likely to purchase a wide variety of titles. These customers generally can afford to buy more titles at one time, have access to computers and use the Internet, and have credit cards with which to make electronic payments. STRATEGY The Company focuses on promoting its brand and extending its leadership position through the following key strategies: Focus on Recorded Music Retailing. CDnow is dedicated to online music retailing. By focusing on its core competency, the Company is able to offer a high quality, customer-oriented online music store and build a clearly delineated brand, which the Company believes will make CDnow the site of choice for recorded music customers. The Company believes that this focus enables it to better direct its sales and marketing campaigns, form effective relationships with Internet content and service providers, and minimize potential conflicts of interest with alternate distribution channels or recorded music labels. Provide Innovative and Easy-to-Use Retail Concept. The Company strives to make its customer experience informative, efficient and intuitive by constantly updating and improving its store format and features. The CDnow store incorporates "point and click" options, supported by technical enhancements including easy-to-use search capabilities (by artist, album title, song title or record label), personalized music suggestions, order tracking and confirmation. The CDnow store promotes music learning and discovery by enabling visitors to access information on titles, music reviews, ratings, articles on music topics and approximately 325,000 sound samples. These features are designed to make shopping at the store entertaining and informative and encourage purchases and repeat visits. The Company is dedicated to providing its customers with a comprehensive selection of both popular and hard-to-find CDs and offers over 300,000 items. The Company continually evaluates the feasibility and marketability of new products and services. With its acquisition of superSonic Boom, Inc., the Company has begun to offer custom compilation discs which contain individual songs selected online by the customer. 31 Expand Customer Base Through Multiple Marketing Channels. The Company seeks to expand its customer base through multiple marketing channels. The Company believes that this strategy enables it to reduce reliance on any one source of customers, maximize brand awareness and lower average customer acquisition cost. . Strategic Alliances. The Company believes it can enhance its new customer acquisition efforts, increase purchases by current customers and expand brand recognition through strategic alliances with major Internet content and service providers and global music-oriented media companies. Since February 1998, the Company has broadened its strategic alliance with Yahoo! to include Yahoo! Mail and Yahoo!'s music chat space. The Company has also entered into new strategic alliances with Lycos and Tripod, Lycos Bertelsmann, Rolling Stone Network and MTV/VH1. In addition, CDnow has preexisting alliances with GeoCities and Excite's WebCrawler service. CDnow's alliances generally provide for the Company to be the premier online recorded music retailer on certain of the sites of these providers with the exclusive right to place music banner advertisements and integrated links to the CDnow store on certain music- related or other specified pages. These pages will prominently feature the CDnow branded link that allows users to click through to the CDnow site. The alliance with Rolling Stone Network also entitles CDnow to use the Rolling Stone brand name in conjunction with the display of cover art and excerpts of feature stories, record reviews, artist biographies and music news from current and past editions of Rolling Stone magazine. Under the MTV/VH1 alliance, the Company is the premier online retailer of recorded music on the MTV and VH1 cable television channels with preferred advertising rights with respect to special events and promotions, including exclusive online sponsorship of the 1998 Video Music Awards. The alliance with MTV/VH1 also entitles CDnow to use the MTV and VH1 brand names in conjunction with the display of MTV and VH1 content, music reviews and music news and provides CDnow with integrated links from the MTV and VH1 Web sites. . Online and Traditional Advertising. The Company promotes its brand through an aggressive marketing campaign using a combination of online and traditional advertising. The Company advertises on the sites of major Internet content and service providers, including AltaVista, Infoseek and Microsoft Network, and targeted music-related sites, such as Billboard. As part of these arrangements, the Company typically purchases the right to display its banners and hyperlinks, often in conjunction with specified search keywords such as "music store". CDnow's traditional advertising efforts have included radio advertising in major markets, such as advertising on the Howard Stern program, and print advertising in music-related publications, including Spin and Variety. In the first quarter of 1998, the Company initiated television advertising, including national advertising during the Grammy Awards and the American Music Awards. The Company intends to increase its use of television advertising, including through its alliance with MTV/VH1, and has purchased advertising on such programs as MTV's 1998 Video Music Awards, VH1's Flashback Week and the 1999 Grammy Awards. . Cosmic Credit Program. Through its Cosmic Credit program, CDnow has arrangements with over 52,000 small Web sites, typically fan sites devoted to particular musical artists. Approximately 42,000 of these sites have enrolled since December 31, 1997. The Company provides Cosmic Credit sites with embedded hyperlinks through which potential customers can immediately be connected to the CDnow site. These highly-focused, music-oriented sites are a significant source of traffic and new customers for the Company. . Direct Marketing Techniques. The Company uses direct marketing techniques to target new and existing customers with communications and promotions. The Company sends a personalized e-mail newsletter to its customers that includes purchase recommendations based on demonstrated customer preferences and prior purchases, as well as more general information concerning new releases and Company promotions. The Company also targets e-mail campaigns to specific customer and prospect segments based upon their recent activity at the CDnow store. The 32 Internet allows rapid and effective experimentation and analysis, instant user feedback and efficient personalization of the store for each customer, all of which CDnow seeks to incorporate in its merchandising. Acquire Customers Efficiently. The Company seeks to target its marketing expenditures towards sources that most efficiently attract new customers. The Company utilizes its three years of online retailing experience and its database of approximately 569,000 customers to better evaluate and predict the effectiveness of potential advertising opportunities and strategic relationships. To enhance the possibility that its banners and other links will be effective, the Company works closely with Internet content and service providers with respect to the placement of banners and other links as well as the surrounding content. As a result, the Company believes that it can acquire new customers and retain existing customers on a more cost-effective basis. Maximize Customer Retention. The Company seeks to maximize customer retention through its emphasis on customer service and personalized communications. The success of this strategy is evidenced by CDnow's high level of repeat customers, who accounted for approximately 58% of net sales during the quarter ended June 30, 1998. The Company strives to accommodate its customers by providing 24-hour-a-day, seven-day-a-week operations and rapid order fullfillment. Products are typically shipped within one business day after an order is placed and confirmation is provided within minutes via e- mail. Customers can make separate inquiries through e-mail or telephone access during extended business hours. The Company strives to respond to customer inquiries within 24 hours of receipt. The Company also maintains ongoing customer contact through its customized e-mail newsletter, The CDnow Update. Enhance International Capabilities. The Company believes that there is a substantial opportunity to increase its sales to international customers. International music sales in 1997 were estimated to be approximately twice that of the U.S. and many products offered by CDnow are not available in these markets. In April 1998, the Company entered into a strategic alliance with Lycos Bertelsmann, a European Internet content and service provider, under which the Company has been designated as the exclusive music retailer for Lycos Bertelsmann's Web services in various European countries. The Company has also entered into a letter of intent with MSI of Miami, Inc. ("MSI") under which MSI would provide an additional 150,000 international titles and create a fulfillment center in the Netherlands to serve European markets commencing in mid-1998. The Company has nine foreign language versions of its Web site that contain translations of account registration and ordering instructions. CDnow supports its international sales efforts with customer service representatives fluent in these languages. THE CDNOW ONLINE RETAIL STORE The Company strives to make the CDnow store informative and authoritative, allowing customers to easily learn about, discover and purchase CDs and other music-related products. The store is designed to be intuitive and easy to use and to enable the ordering process to be completed with a minimum of customer effort. Customers enter the CDnow store through its Web site, cdnow.com, and in addition to ordering music products, can conduct targeted searches, browse among top sellers and other featured titles, read reviews, listen to music samples, register for personalized communications, participate in promotions and check order status. New users may access a page specifically designed to provide a quick understanding of the site and its many features. Merchandising. CDnow believes that its ability to offer a substantially larger selection than traditional retail stores is a significant competitive advantage. The Company currently offers over 250,000 CDs, 40,000 movies and 10,000 music videos as well as t-shirts, music books, DVDs and CD-ROMs. On June 2, 1998, the Company acquired superSonic Boom, Inc. (www.supersonicboom.com), which offers customized CDs on the Internet. To encourage purchases, the Company features various promotions on a rotating basis throughout the store. The Company also launched its Album Advisor in January 1998, an online recommendation service utilizing artificial intelligence technology. The Company adjusts pricing 33 strategies and tactics as necessary to maintain competitiveness and generally prices all recent releases and popular titles aggressively. The Company seeks to encourage the purchase of multiple titles by providing more favorable shipping terms for larger orders. Searching. Through the Company's "FastFind" search engine, customers can quickly and easily navigate the store to find CDs or other products of interest. Customers can search for products based on artist, album title, song title, record label, musical genre or release date for new releases. CDnow recently upgraded its search engine using Verity, Inc.'s K2 search technology to allow for successful searches even with incomplete or misspelled artists' names. By clicking on the album title, a visitor can browse among CDnow's database of reviews, cover art, sound samples and album notes. Through the Company's "Lexicon" feature, customers can browse alphabetical lists based on artists, types of products, record labels and album cover art. Content and Music Discovery. The Company believes that effective use of content encourages purchases by customers who may be browsing the site without a specific title in mind. The Company's Web site contains approximately 325,000 sound samples, extensive information with regard to titles, reviews, ratings, articles on music topics and other information. To help customers browse and discover CDs, CDnow recently launched six music spaces organized by genre: Rock/Pop, Jazz/Blues, Urban/Electronic, Country/Folk, World/New Age and Classical. The main page of each space features links to genre-specific lists, articles, reviews and contests. Within each space, customers can browse sale items, new releases, advance orders and charts, read exclusive CDnow reviews, listen to sound samples and purchase CDs recommended by the Company. Since February 1998, the Company has entered into agreements with MTV/VH1, Rolling Stone Network, College Media, Inc. ("CMJ"), publisher of the CMJ New Music Report and CMJ New Music Monthly, and Billboard magazine to enhance the content available in the CDnow store. The alliance with MTV/VH1 entitles CDnow to use the MTV and VH1 brand names in conjunction with the display of MTV and VH1 content, music reviews and music news. The agreement with Rolling Stone Network entitles CDnow to use Rolling Stone's brand name in conjunction with the display of cover art and excerpts of feature stories, record reviews, artist biographies and music news from current and past editions of Rolling Stone magazine. The agreement with CMJ provides the Company with access to more than 25,000 reviews from this publication. Purchasing. Once a CD has been selected, customers simply click on the price to add products (including advance orders of yet-to-be released products) to their virtual shopping carts. Customers can add and remove products from their shopping carts as they browse, prior to making a final purchase. The shopping cart page displays each item that has been placed in the cart, including title, price and any applicable discount. To execute orders, customers click on the "Place Order" button and are prompted to select shipping and payment methods online or by e-mail, facsimile or telephone. Customers can also add products which they may wish to purchase on future visits to their "lunch box," a special section of the shopping cart where items may be stored over multiple visits. Payment. In paying for orders, customers may use credit cards, personal checks or money orders. For convenience, the Company enables customers to store credit card information on the Company's secure server, thereby avoiding the need to re-enter this information when making future purchases. Customers are offered a variety of shipping options, including overnight delivery. The Company automatically confirms each order by e-mail within minutes after the order is placed and subsequently confirms shipment of each order by e-mail. The Company offers a money back returns policy. Distribution and Fulfillment. The Company's inventory is owned and held by outside vendors and shipped directly from these vendors to customers. The breadth of the inventory maintained by these vendors provides CDnow with the ability to maintain high order fill rates. CDnow updates its site daily with inventory information received from its vendors, which enables customers to check the availability of products before ordering. The Company electronically transmits orders to its outside vendors at least once daily. Orders are shipped by these vendors using a CDnow label and invoice, in most cases within a day after an order is placed with the Company. A customer's credit card is charged once an order is shipped. 34 Multilingual Capabilities. Approximately 22% of the Company's sales for the quarter ended June 30, 1998 were generated from international markets. The Company offers Spanish, French, German, Italian, Portuguese, Japanese, Dutch, Norwegian and Korean language versions of its Web site that contain translation of account registration and ordering instructions and supports its international sales efforts with customer service representatives fluent in these languages. The Company may introduce additional foreign language versions in the future. MARKETING AND PROMOTION CDnow's marketing and promotion strategy is designed to broaden awareness of the CDnow brand, increase customer traffic to the Company's Web site and encourage new and repeat purchases. The Company utilizes multiple channels to market and promote its brand, including strategic alliances, online and traditional advertising, the Company's Cosmic Credit Program, and direct marketing. The Company believes that the use of multiple marketing channels reduces reliance on any one source of customers, maximizes brand awareness and lowers average customer acquisition cost. Strategic Alliances The Company believes that strategic alliances with major Internet service and content providers and global music-oriented media companies can be a source of a significant number of new customers. The Company has entered into the following agreements and arrangements, which are listed in chronological order. Yahoo! The Company and Yahoo! have entered into the Yahoo! Agreement, under which CDnow has been granted exclusivity on music-related pages on the main Yahoo! site, including the Yahoo! Metro Sites and My Yahoo! (collectively, the "Yahoo! Service"). In particular, Yahoo! has agreed to place integrated links to the CDnow store and banner advertisements on certain pages generated from the Yahoo! Service. The Yahoo! Agreement requires Yahoo! to deliver a minimum number of page views during each quarter of the term of the Agreement and limits the ability of other music retailers to place links or advertise on these pages. In addition, CDnow was granted a right- of-first-refusal regarding any promotional opportunity developed by Yahoo! that is similar in scope and nature to that provided by the Yahoo! Agreement. The term of the Yahoo! Agreement expires in October 1999. The Company and Yahoo! recently amended the Yahoo! Agreement to include Yahoo!'s e-mail service, Yahoo! Mail, and music chat space for a period ending in December 1998. WebCrawler. The Company and Excite have entered into the Excite Agreement, under which the Company has been designated as the exclusive online music retailer within Excite's WebCrawler service and has been granted the exclusive right to sponsor targeted links, advertising banners and specific keywords for online retail music purchases within WebCrawler. The Excite Agreement also requires Excite to deliver a minimum number of links and banners on the WebCrawler service during each year of the Agreement and limits the ability of Excite to include advertising for other music retailers on the WebCrawler service. GeoCities. The Company and GeoCities, Inc. have entered into the GeoCities Agreement, under which the Company has been designated as the exclusive retailer of music and video products and one of the four key commerce partners that will occupy a premier position on certain portions of the GeoCities Web site. The GeoCities Agreement requires GeoCities to deliver a minimum number of impressions per month, with each impression consisting of a user's viewing of a page on the GeoCities site containing a link to the Company's Web site. The initial term of the GeoCities Agreement expires in February 1999, subject to the Company's option to renew the GeoCities agreement for a 12 month renewal term. Lycos. The Company and Lycos have entered into the Lycos Agreement, under which the Company has been designated as the exclusive music retailer for the Lycos and Tripod Web sites, and has been 35 granted the exclusive right to sponsor targeted links, relevant content and promotions throughout the Lycos and Tripod Web sites. In addition, the Company was granted a right-of-first-refusal regarding any music retail opportunities on the Lycos and Tripod Web sites. The Lycos Agreement requires Lycos and Tripod to deliver a minimum number of CDnow-branded page views during each year of the term, and precludes Lycos and Tripod from entering into new agreements regarding advertising for other music retailers throughout the Lycos and Tripod Web sites. The Lycos Agreement expires in July 2001. Lycos Bertelsmann. The Company and Lycos Bertelsmann have entered into the Lycos Bertelsmann Agreement under which the Company has been designated as the exclusive music retailer for Lycos Bertelsmann's Web services in various European countries and has been granted the exclusive right to sponsor targeted links, advertising banners, specific keywords, and relevant content on the Lycos Bertelsmann sites. In addition, the Company was granted a right-of-first-refusal regarding any opportunities which Lycos Bertelsmann offers to any other entity which principally sells music products. The Lycos Bertelsmann Agreement requires Lycos Bertelsmann to deliver a minimum number of page views during each year of the term. The term of the Lycos Bertelsmann Agreement expires in April 2001. Rolling Stone Network. The Company and Rolling Stone Network have entered into an agreement under which the Company has been designated the exclusive World Wide Web-based music retailer that may use the Rolling Stone brand name in conjunction with the display of cover art and excerpts of feature stories, record reviews, artist biographies and music news from current and past editions of Rolling Stone magazine. In addition, the Company will be the exclusive online music retailer on the JAMtv and Rolling Stone Network Web sites with the exclusive right to sponsor targeted links, relevant content and promotions. The Rolling Stone Agreement also requires the delivery of a minimum number of page views on the JAMtv and Rolling Stone Network Web sites during each year of the agreement. The Company has also agreed to purchase targeted print, radio broadcast and other promotional advertising from JAMtv and Straight Arrow, the publisher of Rolling Stone magazine. MTV/VH1. Under the MTV/VH1 alliance, the Company is the premier online retailer of recorded music on the MTV and VH1 cable television channels with preferred advertising rights with respect to special events and promotions, including exclusive online sponsorship of the 1998 Video Music Awards. The alliance with MTV/VH1 entitles CDnow to use the MTV and VH1 brand names in conjunction with the display of MTV and VH1 content, music reviews and music news and provides CDnow with integrated links from the MTV and VH1 Web sites. The Company has also been granted certain rights of first refusal to be the exclusive online music retailer of the 1999 and 2000 Video Music Awards with a portion of its minimum annual payments applicable, at the Company's option, to such sponsorship. Other Alliances. The Company has established relationships with other major Internet content and service providers, including America Online ("AOL") with respect to its Love@AOL service, ABC News Starwave Partners, USA TODAY Information Network ("USA TODAY") and CBS Broadcasting, Inc. ("CBS"), designed to attract additional users to, and increase brand awareness of, the Company's Web site. The Company and AOL are parties to an agreement whereby CDnow is the exclusive music retailer on the Love@AOL service. The Company and ABC News Starwave Partners are parties to an agreement under which ABC News Starwave Partners has created links to the Company's Web site from certain music-related pages of its Mr. Showbiz, CelebSite and Wall of Sound Web sites and is required to provide the Company with a minimum number of banner advertisements per month on these Web sites. The Company and USA TODAY are parties to an agreement under which USA TODAY places links to the Company's Web site from the Market Place segment of its Web site and shares in a portion of the revenues realized by the Company as a result of these links. The Company and CBS are parties to an agreement under which, in addition to purchasing commercial advertising time during the 1998 and 1999 Grammy Awards, the Company has been designated as the exclusive online music retailer on the CBS Web site. 36 Online and Traditional Advertising The Company promotes its brand through an aggressive marketing campaign using a combination of online and traditional advertising. The Company advertises on the sites of major Internet content and service providers, including AltaVista, Infoseek and Microsoft Network, and targeted music- related sites, such as Billboard. As part of these arrangements, the Company typically purchases banner advertisements, often in conjunction with specified search keywords or on contextually appropriate pages, that allow consumers to immediately click through to the CDnow site. The significant flexibility of online advertising allows the Company to quickly adjust its advertising plans in response to seasonal and promotional activities. CDnow believes that traditional advertising is a key ingredient in building brand recognition and promoting the benefits of online retail shopping. Traditional advertising can be an effective means of promoting widespread brand awareness and attracting traditional retail consumers to the Company's Web site, including consumers with little or no history of online purchases. CDnow's traditional advertising efforts have included radio advertising in major markets, such as advertising on the Howard Stern program, and print advertising in music-related publications, including Spin and Variety. In the first quarter of 1998, the Company initiated television advertising, including national advertising during the Grammy Awards and the American Music Awards. The Company intends to increase its use of television advertising, including through its alliance with MTV/VH1, and has purchased advertising on such programs as MTV's 1998 Video Music Awards, VH1's Flashback Week and the 1999 Grammy Awards. Cosmic Credit Program Through its Cosmic Credit Program, CDnow has entered into arrangements with over 52,000 small Web sites, typically fan sites devoted to particular music artists. Approximately 42,000 of these sites have enrolled since December 31, 1997. The Company provides Cosmic Credit sites with embedded hyperlinks through which potential customers can immediately be connected to the CDnow site. The Company pays Cosmic Credit participants commissions in store credit or cash based upon the dollar amount of purchases made by persons using the link. These highly focused, music-oriented sites are a significant source of traffic and new customers for the Company. Cosmic Credit participants sign up online at a special Web page, cdnow.com/credit, and are listed inside the CDnow store to assist the Company's customers in finding these sites. The Company rewards the best Cosmic Credit sites with special incentives. Direct Marketing The Company uses direct marketing techniques to target new and existing customers with communications and promotions. The Company sends a personalized e-mail newsletter to its customers, The CDnow Update, that includes purchase recommendations based on demonstrated customer preferences and prior purchases. The newsletter also includes more general information concerning new releases and Company promotions. In addition, the Company targets e-mail communications to persons who have registered at the CDnow store but who have not actually purchased, to new customers and to customers who have not made purchases in recent periods. Through these customized programs, the Company hopes to further stimulate demand, increase repeat purchases, build customer loyalty, and better understand customer preferences. The Internet allows rapid and effective experimentation analysis and instant user feedback and efficient personalization of the store for each customer, all of which CDnow seeks to incorporate in its marketing and merchandising activities. CUSTOMER SERVICE The Company believes that a high level of customer service and support is critical to retaining and expanding its user base. CDnow customer service representatives are available 24 hours a day on 37 weekdays and 10:00 AM to 6:00 PM Eastern Time on weekends to provide assistance via e-mail, phone or fax. The Company strives to answer all inquiries within 24 hours. The Company currently has approximately 45 customer service representatives, including representatives fluent in nine foreign languages. These customer service representatives handle questions about orders, assist customers in finding CDs and other music-related products, and register customer's credit card information over the telephone. The customer service representatives are a valuable source of feedback regarding user satisfaction. CDnow uses BizRate, an online market research company, to compile customer comments on their experiences. BizRate provides monthly reports that enable CDnow to make improvements in response to its customers' comments. The CDnow store also contains a customer service page that outlines store policies and provides answers to frequently asked questions. DISTRIBUTION AND FULFILLMENT The Company does not carry any inventory and relies exclusively on third party vendors for distribution and fulfillment. The Company believes that this distribution strategy allows it to offer extensive selection while avoiding the high fixed costs and capital requirements associated with owning and warehousing product inventory and the significant operational effort associated with same-day shipment. CDnow has experienced a return rate of approximately one percent of all merchandise sold. Since August 1994, the Company has primarily used Valley Record Distributors to fulfill orders for CDs, cassettes and vinyl records produced in the U.S. CDnow transmits data to Valley through a secure network to ensure customer security and data integrity. Valley picks, packs and ships customer orders and charges CDnow for merchandise, shipping and handling. In most cases, products are shipped within two business days after an order is placed with the Company. Customer billing is performed by CDnow through a third-party credit card processor. To date, Valley has satisfied the Company's requirements on a timely basis. For the quarter ended June 30, 1998 and the year ended December 31, 1997, payments to Valley accounted for approximately 82% and 78%, respectively of the Company's cost of sales. The Company's agreement with Valley expires in June 1999, although Valley may terminate its existing agreement with the Company upon 30 days' written notice, if Valley discontinues providing fulfillment services to all of its online service customers. Since May 1997, the Company has used MSI to fulfill orders for CDs produced by non-U.S. labels. The Company has also entered into a letter of intent for MSI to provide an additional 150,000 international titles and create a fulfillment center in the Netherlands to serve European markets commencing in mid-1998. TECHNOLOGY CDnow has developed technologies and implemented systems to support distributed, reliable and scalable online retailing in a secure and easy-to- use format. Using a combination of proprietary solutions and commercially available, licensed technologies, the Company has deployed systems for online content dissemination, online transaction processing, customer service, market analysis and electronic data interchange. Multimedia and User Database. CDnow has developed a database management system to index, retrieve and manipulate product information, content, product catalog, orders and transactions, and customer information. This system allows for rapid searching, sorting, viewing and distribution of a large volume of content including audio samples, music reviews, track lists, cover art and photos. The Company uses Oracle 7.3 as the technology for database management. In December 1997, the Company deployed a data warehouse that enables it to access detailed transaction and customer interaction data and perform sophisticated market analysis and predictive modeling. Store Architecture. The Company's hardware and software systems are based upon a distributed transaction processing model that allows applications to be distributed among multiple parallel servers. 38 Many of the software components, and the pages of the Web site, are developed using a proprietary technology that extends HTML with product, transaction, retail, and advanced programming constructs. This technology results in the separation of the page look and feel from the individual data elements and their associated database lookups thus reducing software updates for Web site changes and minimizing the engineering required to maintain a growing amount of items and content. CDnow's technology also enables Web sites with different formats to integrate CDnow store elements such as search, discography (artist) and product (album) pages. Interfaces. CDnow has developed technologies and tools for managing interfaces with Internet service and content providers. A switchboard system and linking interface are made available to businesses with which the Company has developed strategic alliances and to Cosmic Credit sites. These allow the linking of external Web sites, banners, and promotions to items and functions contained in the CDnow store. Proprietary tools are used by the Company's Online Marketing group to manage the strategic alliances and Cosmic Credit relationships in an efficient and scalable manner. Similar systems and tools have been developed by CDnow for its Customer Service department. The ability to manage customer accounts and orders enables CDnow's Customer Service department to scale effectively and communicate efficiently, thereby responding to most inquiries within 24 hours. These systems automate many routine communications and allow customers to better manage their accounts and orders. Fault Tolerance and Scalability. CDnow's hardware servers, storage systems, Internet connections and networks allow its online systems to operate continuously and enable it to maintain a 24-hour-a-day, seven-day-a-week retail store. The Company runs its Oracle databases and Web servers on a series of Sun Enterprise 4000 servers with fault tolerant characteristics including "hot-swappable" components. The Company maintains dedicated DS-3 connections to the Internet lines provided by multiple Internet service providers. This technology, combined with the architecture of the systems, allows the Company to scale by adding new components or servers while maintaining performance and cost effectiveness. Both proprietary and commercially available tools are used to monitor and manage these systems with minimal operator participation. Security. The Company employs both commercial and proprietary firewalls integrated into the architecture of its system to keep its Internet connections secure. The Company uses the Netscape SSL Commerce Server for secure electronic transactions over the Internet and uses proprietary EDI interfaces and private networks to ensure the security of customer order information and credit card transactions shared with its vendors and credit card processor. Advanced Technologies. The Company continually evaluates emerging technologies and new developments in many areas including electronic commerce, database management, and networking. The Company is currently evaluating technologies that allow for the digital distribution of music recordings. Since April 1997, the Company has been using collaborative filtering to make personal music recommendations in its customer newsletter, The CDnow Update. Online recommendation technology is made available to all CDnow shoppers through the Album Advisor feature, introduced in January 1998. COMPETITION The online commerce market is new, rapidly evolving and intensely competitive, and the Company expects that competition will further intensify in the future. Barriers to entry are minimal, and current and new competitors can launch new sites at a relatively low cost. According to Jupiter, there were approximately 100 online music retailers as of June 1997. In addition, the broader retail music industry is intensely competitive. The Company currently competes with a variety of companies, including (i) online vendors of music, music videos and other related products, (ii) online vendors of movies, books and other related products, (iii) online service providers which offer music products directly or in cooperation with other retailers, (iv) traditional retailers of music products, including specialty music retailers, (v) other 39 retailers that offer music products, including mass merchandisers, superstores and consumer electronic stores; and (vi) non-store retailers such as music clubs. Many of these traditional retailers also support dedicated Web sites which compete directly with the Company. The Company believes that the principal competitive factors in its online market are brand recognition, selection, price, effectiveness of advertising and other customer acquisition efforts, variety of value-added services, ease of use, site content, quality of service and technical expertise. Many of the Company's current and potential competitors have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing and other resources than the Company. The Company is aware that certain of its competitors have adopted and may continue to adopt aggressive pricing or inventory availability policies and devote substantially more resources to Web site and systems development than the Company. Increased competition may result in reduced operating margins, loss of market share and a diminished brand franchise. There can be no assurance that the Company will be able to compete successfully against current and future competitors. New technologies and the expansion of existing technologies may increase the competitive pressures of the Company. For example, applications that select specific titles from a variety of Web sites based on factors such as price may channel customers to online retailers that compete with the Company. In addition, many companies that allow access to transactions through network access or Web browsers promote the Company's competitors and could charge the Company a substantial fee for inclusion. INTELLECTUAL PROPERTY The Company regards its trademarks, trade secrets and similar intellectual property as valuable to its business, and relies on trademark and copyright law, trade secret protection and confidentiality and/or license agreements with its employees, partners and others to protect its proprietary rights. There can be no assurance that the steps taken by the Company will be adequate to prevent misappropriation or infringement of its intellectual property. The Company has licensed in the past, and expects that it may license in the future, certain of its proprietary rights, such as trademarks or copyrighted material, to third parties. While the Company attempts to ensure that the quality of its brand is maintained by such licensees, there can be no assurance that such licensees will not take actions that might materially adversely affect the value of the Company's proprietary rights or reputation, which could have a material adverse effect on the Company. See "Risk Factors-- Trademarks and Proprietary Rights; Unlicensed Arrangements; Risk of Claims Resulting from Lack of License Rights." EMPLOYEES As of June 30, 1998, the Company had 151 full-time and 10 part-time employees. The Company also employs independent contractors and other temporary employees in its editorial, operations and administrative functions. None of the Company's employees is represented by a labor union, and the Company considers its employee relations to be good. Competition for qualified personnel in the Company's industry is intense, particularly among software development and other technical staff. The Company believes that its future success will depend in part on its continued ability to attract, hire and retain qualified personnel. See "Risk Factors--Risk of Inability to Manage Potential Growth" and "--Dependence on Key Personnel; Need for Additional Personnel." FACILITIES The Company's executive offices are located in, and substantially all of its operating activities are conducted from, leased office space located in Jenkintown, Pennsylvania. The Company has leased this facility, which contains approximately 17,000 square feet under a lease that expires in September 2002 and approximately 8,000 square feet under an amendment to such lease that expires in January 1999. 40 The Company has signed a lease for a nearby facility, which contains approximately 60,000 square feet, that expires in 2006. The Company intends to move its offices to this nearby facility in late 1998 and sublease the space in Jenkintown. The Company believes that additional space may be required as its business expands and believes that it will be able to obtain suitable space as needed. The Company does not own any real estate. LEGAL PROCEEDINGS From time-to-time, the Company may be involved in litigation relating to claims arising out of its ordinary course of business. The Company is not currently engaged in litigation. See "Risk Factors--Government Regulation and Legal Uncertainties" for information regarding a demand by certain foreign distributors that the Company cease the sale of certain titles in Germany. 41 MANAGEMENT OFFICERS AND DIRECTORS The executive officers and directors of the Company are as follows: NAME AGE POSITION ---- --- -------- Jason Olim.............. 29 President, Chief Executive Officer and Chairman of the Board of Directors Matthew Olim............ 29 Technical Lead, Secretary, Treasurer and Director Rod Parker.............. 55 Senior Vice President of Product Management and Marketing Joel Sussman............ 49 Vice President and Chief Financial Officer Michael Krupit.......... 34 Vice President of Technology Robert Saltzman......... 46 Vice President of Strategic Business Development David Capozzi........... 42 Vice President and General Counsel Steve Dong.............. 39 Vice President of Operations Alan Meltzer(2)......... 53 Director Patrick Kerins(1)(2).... 43 Director John Regan(1)(2)........ 39 Director - --------------------- (1) Member of the Audit Committee of the Company's Board of Directors. (2) Member of the Compensation Committee of the Company's Board of Directors. Jason Olim co-founded the Company in February 1994 and has been its President since the Company's inception and its Chief Executive Officer since November 1997. Previously, Mr. Olim was employed in the Professional Services group of Soft-Switch, Inc. where he designed and built software systems for routing mail and documents for domestic and international clients. Mr. Olim has a Bachelor of Arts degree in Computer Science from Brown University. Matthew Olim co-founded the Company in February 1994 and has been responsible for the development of the Company's system architecture and transactions systems. Mr. Olim has a Bachelor of Arts degree in Astrophysics from Columbia University. Rod Parker has been the Senior Vice President of Product Management and Marketing since June 1997. Mr. Parker served as the Vice President of Interactive Merchandising at Time Warner Cable Programming from September 1995 to June 1997; General Manager of Catalog I, a joint venture between Time Warner and Spiegel, Inc., from October 1993 to September 1995; and in various other positions with Spiegel, Inc. (including Vice President, New Media and Vice President, Creative Division) from April 1987 to September 1995. Mr. Parker spent more than twenty years in the advertising industry, including service as a Senior Vice President in account management with Ogilvy and Mather. Joel Sussman has been a Vice President and Chief Financial Officer since September 1997. From June 1995 to September 1997, Mr. Sussman was an independent financial management consultant and served as Interim Chief Financial Officer of a number of companies, including CDnow. From July 1994 to June 1995, Mr. Sussman was Vice President, Finance and Administration, and Chief Financial Officer of Personnel Data Systems, Inc. From January 1991 to December 1994, Mr. Sussman was Vice President of Finance and Chief Financial Officer of The Devereux Foundation. Prior to January 1991, Mr. Sussman served for 10 years as Treasurer of Decision Data, Inc. and six years in commercial banking and leasing. Mr. Sussman is a Certified Public Accountant and Certified Management Accountant and holds a Masters degree in Business Administration from the Wharton School of the University of Pennsylvania. Michael Krupit has been the Vice President of Technology since October 1997 and was the Director of Technology from April 1997 to October 1997. Mr. Krupit was the Director of Technology and Product Development at Infonautics, Inc., a provider of searching, viewing, and retrieval applications for the Internet, from February 1994 to March 1997. Mr. Krupit was the Development Manager at Verity, Inc., a provider of online information and archive services, from October 1989 to November 1993. 42 Robert Saltzman has been the Vice President of Strategic Business Development since December 1997. Mr. Saltzman served as the Director of Business Development at Bell Atlantic Network Integration from November 1995 to December 1997. From 1987 to 1995, Mr. Saltzman held various sales and marketing positions with Unisys Corporation. David Capozzi has been a Vice President and General Counsel since April 1998. From February 1996 to April 1998, Mr. Capozzi was an attorney with the law firm of Morgan, Lewis & Bockius LLP. Mr Capozzi also has over 14 years of experience in varying capacities in software design and development, including seven years with Marriott Corporation. Mr. Capozzi holds a Juris Doctorate from The American University, Washington College of Law, a Masters in Business Administration from the Katz Graduate School of Business of the University of Pittsburgh and a Bachelor of Science in Computer Science from the University of Pittsburgh. Steve Dong has been the Vice President of Operations since May 1998. Mr. Dong served as the Director of Operations at Egghead Computer from July 1995 to May 1998. From January 1994 to July 1995, Mr. Dong was Chief Operating Officer of Mac's Place, a wholly owned subsidiary of Egghead Computer. From 1987 to 1994, Mr. Dong held various management positions with Egghead Software including Director of Distribution and Transportation. Alan Meltzer has been a director since December 1996. Mr. Meltzer has been the Chairman and Chief Executive Officer of Wind-up Entertainment, Inc., a New York based record label distributed through Bertelsman Music Group. Mr. Meltzer was the founder of CD One Stop, Inc., a distributor of CDs, and was its Chief Executive Officer from April 1986 to August 1993 and was the President of Alliance Entertainment, a distributor and the successor to CD One Stop, Inc., from September 1993 to September 1994. Mr. Meltzer was elected to the Board of Directors in December 1996 pursuant to an agreement among certain shareholders of the Company that terminated in February 1998. Patrick Kerins has been a director since August 1997. Mr. Kerins is a Managing Director of Grotech Capital Group IV, LLC ("Grotech Capital"). From 1987 to March 1997, he served in the Investment Banking Division of Alex. Brown & Sons Incorporated, most recently as a Managing Director beginning in January 1994. John Regan has been a director since July 1997. Since February 1995, Mr. Regan has been a Vice President of Keystone Venture IV Management Company, L.P. which is the general partner of Keystone Venture IV, L.P. From 1989 to February 1995, he was an associate and then general partner of Apex Management Partnership, a venture capital partnership. The Company's Amended and Restated Bylaws divide the Board of Directors into three classes, and each director will serve for a staggered three year term. Messrs. Kerins and Regan will initially serve as the Class I directors until the annual meeting of shareholders held in 1998, or until their respective successors have been elected and qualified. Matthew Olim will initially serve as the Class II director until the annual meeting of shareholders held in 1999, or until his successor has been elected and qualified. Alan Meltzer and Jason Olim will initially serve as the Class III directors until the annual meeting of shareholders held in 2000, or until their respective successors have been elected and qualified. At each meeting of shareholders, a class of directors will be elected for a three-year term to succeed the directors of the same class whose terms are then expiring. To the extent there is an increase in the number of directors, additional directorships resulting therefrom will be distributed among the three classes so that, as nearly as possible, each class will consist of an equal number of directors. Executive officers of the Company are elected by, and serve at the pleasure of, the Board of Directors. Jason Olim and Matthew Olim are brothers. DIRECTOR COMPENSATION The Company will reimburse its directors for out-of-pocket expenses incurred in connection with their rendering of services as directors. The Company currently does not intend to pay cash fees to 43 directors for attendance at meetings. Directors who are not currently receiving compensation as officers or employees of the Company will be eligible to receive options under the 1996 Equity Compensation Plan. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION Since August 1997, recommendations concerning the aggregate compensation of the Company's employees were made to the Compensation Committee by the Company's President. The Compensation Committee was formed in August 1997. The members of the Compensation Committee are Alan Meltzer, Patrick Kerins and John Regan. Mr. Kerins is a Managing Director of Grotech Capital, the general partner of Grotech Capital Partners IV, L.P., a significant shareholder of the Company. See "Certain Relationships and Related Transactions." Prior to August 1997, decisions concerning the compensation of the Company's employees, including its executive officers, were made by the Company's Board of Directors, which included Jason Olim and Matthew Olim. EXECUTIVE COMPENSATION The following table provides information concerning compensation paid or accrued in the year ended December 31, 1997 with respect to the Company's President and Chief Executive Officer and the two other most highly compensated executive officers of the Company. SUMMARY COMPENSATION TABLE LONG-TERM COMPENSATION ---------------- ANNUAL COMPENSATION SHARES OF COMMON NAME AND --------------------- STOCK UNDERLYING PRNCIPAL POSITIONI YEAR SALARY($) BONUS($) OPTIONS(#) - ------------------ ---- ---------- --------- ---------------- Jason Olim.......................... 1997 $ 95,630 $ -- -- President, Chief Executive Officer and Chairman of the Board of Directors Matthew Olim........................ 1997 95,630 -- -- Technical Lead, Secretary and Treasurer Rod Parker.......................... 1997 122,098 55,000 120,000 Senior Vice President of Product Management and Marketing The following table sets forth certain information regarding stock options granted by the Company during 1997 to Rod Parker. Neither Jason Olim nor Matthew Olim have been granted any options by the Company. OPTION GRANTS IN LAST FISCAL YEAR INDIVIDUAL GRANTS -------------------------------------------- POTENTIAL REALIZABLE VALUE AT ASSUMED PERCENT OF ANNUAL RATES OF NUMBER OF TOTAL STOCK PRICE SHARES OPTIONS APPRECIATION FOR UNDERLYING GRANTED TO EXERCISE OPTION TERM(1) OPTIONS EMPLOYEES IN PRICE PER EXPIRATION --------------------- NAME GRANTED FISCAL YEAR SHARE DATE 5% 10% - ---- ---------- ------------ --------- ---------- ---------- ---------- Rod Parker.. 120,000 16.6% $1.33 5/29/2007 $2,968,000 $4,820,000 - --------------------- (1) Based on the Company's initial public offering price of $16.00 on February 9, 1998. 44 The following table sets forth information regarding stock options held as of December 31, 1997 by Rod Parker. Mr. Parker did not exercise any stock options in 1997. FISCAL YEAR END OPTION VALUES VALUE OF UNEXERCISED IN- NUMBER OF SECURITIES UNDERLYING THE- UNEXERCISED OPTIONS AT MONEY OPTIONS AT DECEMBER 31, 1997 DECEMBER 31, 1997(1) ----------------------------------- ------------------------- NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE - ---- -------------- ----------------- ----------- ------------- Rod Parker.... -- 120,000 -- $1,760,400 - --------------------- (1) There was no public trading market for the Common Stock as of December 31, 1997. These values have been calculated based on the difference between the Company's initial public offering price of $16.00 on February 9, 1998 and the applicable exercise price. EQUITY COMPENSATION PLAN The Company has adopted the Equity Compensation Plan pursuant to which it has awarded and expects to award in the future stock options to its employees, officers, non-employee directors and certain independent contractors and consultants. The Equity Compensation Plan provides for the issuance to employees, non- employee directors and eligible independent contractors and consultants of up to 1,600,000 shares of Common Stock pursuant to the grant of incentive stock options ("ISOs"), non-qualified stock options ("NQSOs"), Stock Appreciation Rights ("SARs") and restricted stock. The Equity Compensation Plan is administered by a Committee of directors appointed by the Board of Directors (the "Committee") that currently consists of Messrs. Meltzer, Kerins and Regan. Upon the completion of this Offering, the Committee will consist of two directors that are not employees of the Company. Subject to the provisions of the Equity Compensation Plan, the Committee has the authority to determine to whom stock options will be granted and the terms of any such grant, including the number of shares subject to, the exercise price and the vesting provisions of, the award. Subject to the terms of the Equity Compensation Plan, the Committee may also amend the terms of any outstanding award. As of June 30, 1998, options to purchase a total of 905,795 shares of Common Stock at a weighted average exercise price per share of $8.78 were outstanding. Of these options, options to purchase 115,991 shares of Common Stock were fully vested and exercisable as of June 30, 1998. As of June 30, 1998, the Company had an additional 659,892 shares of Common Stock available for future grants under the Equity Compensation Plan. The option price per share of Common Stock under the Equity Compensation Plan is determined by the Committee at the time of each grant, provided, however, that the option price per share for any ISO may not be less than the fair market value of the Common Stock at the time of the grant. In addition, if a person who owns 10 percent or more of the Company's Common Stock (a "10% Shareholder") is granted an ISO, the exercise price for such ISO may not be less than 110% of the fair market value on the date of grant. The term of each stock option may not exceed ten years; in the case of a 10% shareholder, the term may not exceed five years. Payment for the exercise of an option may be made by cash, check or other instrument as the Committee may accept, including, in the discretion of the Committee, unrestricted Common Stock of the Company. The Committee may also allow an option holder to surrender all or a portion of a stock option and receive a number of shares of Common Stock with a value equal to the excess of the fair market value over the option price of the surrendered stock option or portion of the stock option. 45 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS SERIES A PREFERRED STOCK Pursuant to the terms of the Stock Purchase Agreement dated July 15, 1997 by and among the Company, Keystone Ventures, Jason Olim and Matthew Olim (the "Stock Purchase Agreement"), Keystone Ventures purchased 254,582 shares of Series A Convertible Preferred Stock, no par value (the "Series A Preferred Stock"), of the Company for an aggregate purchase price of $1.3 million. The outstanding shares of Series A Preferred Stock converted into an aggregate of 381,873 shares of Common Stock in February 1998. John Regan is a Vice President of the general partner of Keystone Ventures and was elected to the Company's Board of Directors pursuant to an agreement among certain shareholders of the Company that was terminated in February 1998. Keystone Ventures received certain registration rights in connection with this transaction. SERIES B PREFERRED STOCK Pursuant to the terms of the Stock Purchase Agreement, as amended by the Amendment No. 1 to the Stock Purchase Agreement dated as of August 5, 1997 by and among the Company, Keystone Ventures, Jason Olim, Matthew Olim, Grotech and ABS, (i) Grotech purchased 1,543,505 shares of Series B Convertible Preferred Stock, no par value (the "Series B Preferred Stock"), of the Company for an aggregate purchase price of $8.4 million, (ii) ABS purchased 62,000 shares of Series B Preferred Stock for an aggregate purchase price of $338,000, (iii) the Company issued to Grotech Capital a warrant to purchase up to 27,524 shares of Common Stock at an exercise price of $3.63 per share, and (iv) the Company issued to Alex. Brown & Sons Incorporated, a predecessor-in- interest to BT Alex. Brown Incorporated ("BT Alex. Brown"), a warrant to purchase up to 154,817 shares of Common Stock at an exercise price of $3.63 per share in partial consideration of its services as the placement agent for the offering of the Series A and Series B Preferred Stock. The outstanding shares of Series B Preferred Stock converted into an aggregate of 2,408,258 shares of Common Stock in February 1998. Patrick Kerins is a Managing Director of Grotech Capital, the general partner of Grotech IV, and was elected to the Company's Board of Directors pursuant to an agreement among certain shareholders of the Company that was terminated in February 1998. Grotech IV, Grotech Capital, ABS and BT Alex. Brown received certain registration rights in connection with this transaction. STOCK PURCHASE AND SHAREHOLDERS' AGREEMENT In May 1995, Milo Productions, Inc. ("Milo"), a corporation owned by Jason and Matthew Olim, entered into a general partnership with MBL Entertainment, Inc. ("MBL") to form a partnership company known as "Music Now." In December 1995, MBL, Alan Meltzer and Jason and Matthew Olim entered into non-binding discussions for the purpose of creating a new company ("NewCo") which would merge with Music Now. These discussions contemplated, among other things, that Alan Meltzer would make a significant cash investment in, and Jason and Matthew Olim would contribute all of the outstanding capital stock of both Milo and CDnow to, NewCo. The parties abandoned these discussions and, in August 1996, MBL and Alan Meltzer instituted a legal action against CDnow, Milo and Jason and Matthew Olim (the "Legal Action"). On December 6, 1996, the Company entered into a Stock Purchase and Shareholders' Agreement (the "Stock Purchase and Shareholders Agreement") with Milo, Jason Olim, Matthew Olim, Alan Meltzer, Jeffrey McClusky, Anthony Lucenti, William Brennan and MBL pursuant to which (i) Mr. Meltzer purchased, for an aggregate purchase price of $1,200,000, 921,834 shares of Common Stock and a warrant exercisable for 871,710 shares of Common Stock, and (ii) an aggregate of 882,606 shares of Common Stock were issued to Messrs. McClusky, Lucenti and Brennan, the sole shareholders of MBL, in exchange for substantially all of the assets and business of MBL. Mr. Meltzer effected a cashless exercise of this warrant in February 1998 and received 809,237 shares. A primary inducement for these transactions was the mutual release by all parties to the Stock Purchase Agreement relating to (i) the Legal Action and 46 (ii) all other prior agreements and relationships among such parties. At the time of the settlement, MBL and Music Now were inactive and had no assets or liabilities. In addition, pursuant to the terms of the Stock Purchase and Shareholders Agreement, each of Jason and Matthew Olim is generally restricted from competing with the Company's business for a three-year period ending on the termination of his relationship (either as an employee, director or consultant) with the Company. SHAREHOLDER ADVANCES The Company had indebtedness due to Dave Olim, the father of Jason and Matthew Olim, in the amount of $74,740, at December 31, 1995. During 1996, Dave Olim advanced additional funds to the Company and on August 16, 1996, in consideration of the cancellation of the $81,923 balance of this debt, the Company issued 41,244 shares of the Company's Common Stock to Dave Olim. The exchange ratio used to convert the debt into shares of Common Stock was negotiated among Jason and Matthew Olim and their father, Dave Olim, and therefore cannot be considered an arms-length transaction. NOTES PAYABLE On December 31, 1995, the Company issued a note for $100,000 to Alan Meltzer, a director of the Company. The proceeds from this loan were used for working capital purposes. All remaining amounts due under the note, which bore interest at the rate of 10%, were repaid on December 31, 1996. From November 16, 1996 through January 31, 1997, the Company received short- term loans aggregating $190,000 from Saltzman Music Partners and Nathan Schwartz and $60,000 from Robert Saltzman, an Executive Officer of the Company and a partner in Saltzman Music Partners. The proceeds from these loans, which bore interest at the rate of 6%, were used for working capital purposes. On May 15, 1997, the Company repaid $110,000 of the principal amount due under these loans. The remaining principal balance was repaid on July 16, 1997. As additional consideration for these loans, these private investors received warrants to purchase an aggregate of 136,362 shares of Common Stock (32,727 with respect to Robert Saltzman) at a price of $1.83 per share, which warrants were exercised on or about May 16, 1998. In 1997, the Company obtained three term loans at rates ranging from 8 to 9% from a bank for an aggregate amount of $219,000. The proceeds from these loans were used to purchase equipment and are secured by a lien on such equipment. These loans are guaranteed by Jason Olim and Matthew Olim. In November 1997, the Company issued $5.8 million aggregate principal amount of Series A Notes to a group of investors, including $1.0 million to Grotech and $127,500 to the ABS Employees' Venture Fund Limited Partnership ("ABS"). The Series A Notes, which were repaid in February 1998, bore interest at the rate of 12% per annum. In addition, the Company issued warrants to these investors to purchase an aggregate of 48,550 shares of Common Stock at an exercise price of $11.90 per share, including warrants issued to Grotech and ABS exercisable for 8,403 and 1,071 shares of Common Stock, respectively. The warrants issued to ABS have an exercise price equal to $16.00 per share. See "Underwriting." 47 PRINCIPAL AND SELLING SHAREHOLDERS The following table sets forth certain information regarding beneficial ownership of the Common Stock as of the date of this Prospectus and as adjusted to reflect the sale of the shares offered hereby by (i) each person known by the Company to own beneficially more than 5% of the outstanding shares of Common Stock, (ii) each director of the Company, (iii) each executive officer of the Company, (iv) all directors and executive officers of the Company as a group and (v) the Selling Shareholder. Unless otherwise indicated below, to the knowledge of the Company, all persons listed below have sole voting and investment power with respect to their shares of Common Stock, except to the extent authority is shared by spouses under applicable law. BENEFICIAL OWNERSHIP BENEFICIAL OWNERSHIP PRIOR TO OFFERING SHARES AFTER OFFERING# ----------------------- OFFERED ----------------------- NAME OF BENEFICIAL OWNER SHARES PERCENT HEREBY SHARES PERCENT - ------------------------ ------------ ---------- ------- ------------ ---------- EXECUTIVE OFFICERS AND DIRECTORS Jason Olim(1)........... 2,960,025 18.2% -- 2,960,025 16.9% Matthew Olim(1)......... 2,960,025 18.2 -- 2,960,025 16.9 Alan Meltzer(2)......... 1,712,621 10.5 -- 1,712,621 9.8 Robert Saltzman(3)...... 42,102 * -- 42,102 * Joel Sussman(4)......... 33,000 * -- 33,000 * Rod Parker(4)........... 30,000 * -- 30,000 * Michael Krupit(4)....... 4,500 * -- 4,500 * Patrick Kerins(5)....... 1,569 * -- 1,569 * John Regan(6)........... -- -- -- -- -- All executive officers and directors as a group (9 persons)(7)... 7,743,842 47.3 -- 7,743,842 43.9 FIVE PERCENT HOLDERS Grotech Partners IV, L.P.(8)................ 2,315,258 14.2 -- 2,315,258 13.2 SELLING SHAREHOLDER Jeffrey McCluskey....... 305,172 1.9 80,000 225,172 1.3 - --------------------- # Assumes no exercise of the Underwriter's over-allotment option. * Less than one percent. (1) Excludes 41,244 shares owned by Dave Olim, the father of Jason and Matthew Olim. Jason and Matthew Olim each disclaim beneficial ownership of these shares. The address of Jason and Matthew Olim is 610 Old York Road, Suite 300, Jenkintown, Pennsylvania 19046. (2) The address of Mr. Meltzer is 944 Park Avenue, New York, New York 10028. (3) Represents 32,727 shares of Common Stock obtainable upon conversion of a presently exercisable warrant held by a trust of which Mr. Saltzman is the beneficiary and 9,375 shares of Common Stock obtainable upon the exercise of a stock option granted under the Equity Compensation Plan. (4) Represents shares of Common Stock presently obtainable, or obtainable within the next 60 days, upon the exercise of a stock option granted under the Equity Compensation Plan. (5) Represents 1,569 shares of Common Stock obtainable upon the conversion of a presently exercisable warrant held by Patrick Kerins. Excludes 2,315,258 shares of Common Stock held by Grotech Partners IV, L.P. Patrick Kerins is a managing director of Grotech Partners IV, L.P. Mr. Kerins disclaims beneficial ownership of any shares owned by Grotech Partners IV L.P. (6) Excludes 381,873 shares of Common Stock held by Keystone Ventures IV, L.P. ("Keystone"). John Regan is a Vice President of the general partner of Keystone and disclaims beneficial ownership of any shares owned by Keystone. (7) Includes an aggregate of 111,171 shares of Common Stock obtainable upon the exercise of presently exercisable options and warrants. (8) The address of Grotech Partners IV, L.P. is 9690 Deereco Road, Timonium, Maryland 21093. Grotech Partners IV, L.P. disclaims beneficial ownership of any shares beneficially owned by Patrick Kerins. 48 DESCRIPTION OF CAPITAL STOCK The authorized capital stock of the Company consists of 50,000,000 shares of Common Stock, no par value (the "Common Stock"), and 20,000,000 shares of Preferred Stock, no par value (the "Preferred Stock"). Immediately after the sale of the 1,330,000 shares of Common Stock offered hereby, there will be 17,516,397 shares of Common Stock outstanding and no shares of Preferred Stock outstanding. The following summary is qualified in its entirety by reference to the Company's Amended and Restated Articles of Incorporation (the "Articles of Incorporation"), which is included as an exhibit to the Registration Statement of which this Prospectus is a part. COMMON STOCK Holders of Common Stock are entitled to one vote for each share held of record on all matters submitted to a vote of shareholders and do not have cumulative voting rights. The election of directors is determined by a plurality of the votes cast and, except as otherwise required by law, all other matters are determined by a majority of the votes cast. The holders of Common Stock are entitled to receive ratably such dividends, if any, as may be declared by the Board of Directors out of funds legally available therefor, subject to any preferential dividend rights of outstanding Preferred Stock. Upon the liquidation, dissolution or winding up of the Company, subject to any preferential liquidation rights of any outstanding shares of Preferred Stock, the holders of Common Stock are entitled to receive ratably the net assets of the Company available after the payment of all debts and other liabilities. The holders of Common Stock have no preemptive, subscription, redemption, sinking fund or conversion rights. The rights and preferences of holders of Common Stock will be subject to the rights of any series of Preferred Stock which the Company may issue in the future. PREFERRED STOCK The Company, by resolution of the Board of Directors and without any further vote or action by the shareholders, has the authority, subject to certain limitations prescribed by law, to issue from time to time up to an aggregate of 20,000,000 shares of Preferred Stock in one or more classes or series and to determine the designation and the number of shares of any class or series as well as the voting rights, preferences, limitations and special rights, if any, of the shares of any such class or series, including the dividend rights, conversion rights, voting rights, redemption rights, and liquidation preferences. The issuance of Preferred Stock may have the effect of delaying, deferring or preventing a change of control of the Company. PENNSYLVANIA ANTI-TAKEOVER LAWS The Pennsylvania Business Corporation Law of 1988, as amended (the "BCL"), contains provisions applicable to publicly held Pennsylvania corporations that may be deemed to have an anti-takeover effect. The Company has specifically opted out of all but one of these provisions. The following is a description of the provision of the BCL that remains applicable to the Company. Under Section 1715 of the BCL, directors of the corporation are not required to regard the interests of the shareholders as being dominant or controlling in considering the best interests of the corporation. The directors may consider, to the extent they deem appropriate, such factors as the effects of any action upon any group affected by such action (including shareholders, employees, suppliers, customers and creditors of the corporation and upon communities in which offices or other establishments of the corporation are located); the short term and long term interests of the corporation (including benefits that may accrue to the corporation from its long term plans and the possibility that these interests may be best served by the continued independence of the corporation); the resources, intent and conduct of any person seeking to acquire control of the corporation; and all other pertinent factors. Section 1715 of the BCL further provides that any act of the board of directors, a committee of the board or an individual 49 director relating to or affecting an acquisition or potential or proposed acquisition of control to which a majority of disinterested directors have assented will be presumed to satisfy the standard of care set forth in the BCL, unless it is proven by clear and convincing evidence that the disinterested directors did not consent to such act in good faith after reasonable investigation. As a result of this and the other provisions of Section 1715 of the BCL, directors are provided with broad discretion with respect to actions that may be taken in response to acquisitions or proposed acquisitions of corporate control. Section 1715 of the BCL may discourage open market purchases of Common Stock or a non-negotiated tender or exchange offer for the Common Stock and, accordingly, may be considered disadvantageous by a shareholder who would desire to participate in any such transaction. In addition, Section 1715 of the BCL may have a depressive effect on the price of the Common Stock. TRANSFER AGENT AND REGISTRAR The Transfer Agent and Registrar with respect to the Common Stock is StockTrans, Inc., Ardmore, Pennsylvania. 50 UNDERWRITING Subject to the terms and conditions set forth in the underwriting agreement (the "Underwriting Agreement"), the Company has agreed to sell to BT Alex. Brown Incorporated (the "Underwriter"), and the Underwriter has agreed to purchase from the Company and the Selling Shareholder an aggregate of 1,330,000 shares of Common Stock at the public offering price less the underwriting discounts and commissions set forth on the cover page of this Prospectus. In the Underwriting Agreement, the Underwriter has agreed, subject to the terms and conditions set forth therein, to purchase all of the shares of Common Stock offered by this Prospectus (other than those subject to the over- allotment option described below) if any such shares are purchased. The Company has granted to the Underwriter an option, exercisable during the 30-day period after the date of this Prospectus, to purchase up to 199,500 shares of Common Stock at the same price per share as the initial shares of Common Stock to be purchased by the Underwriter. The Underwriter may exercise such option only to cover over-allotments in the sale of shares of Common Stock. To the extent that the Underwriter exercises such option, the Underwriter will have a firm commitment, subject to certain conditions, to purchase such additional shares of Common Stock. The Company and its officers, directors and certain shareholders (including the Selling Shareholder) have agreed that, except for shares offered by this Prospectus, the underlying shares sold by the Company upon the exercise of options or warrants or shares purchased in the open market, they will not offer, sell, contract to sell, or otherwise dispose of, directly or indirectly, any shares of Common Stock, or any interests therein, or any securities convertible into, or exchangeable for, shares of Common Stock, or rights to acquire the same, for a period of 45 days from the date of this Prospectus without the prior written consent of the Underwriter. Such consent may be given without any public notice. The Company and the Selling Shareholder have agreed to indemnify the Underwriter against certain liabilities, including liabilities under the Securities Act, or to contribute to payments that the Underwriter may be required to make in respect thereof. To facilitate the offering of the Common Stock, the Underwriter may engage in transactions that stabilize, maintain or otherwise affect the market price of the Common Stock. Specifically, the Underwriter may over-allot shares of the Common Stock in connection with this Offering, thereby creating a short position in the Underwriter's syndicate account. Additionally, to cover such over-allotments or to stabilize the market price of the Common Stock, the Underwriter may bid for, and purchase, shares of the Common Stock at a level above that which might otherwise prevail in the open market. The Underwriter is not required to engage in these activities, and, if commenced, any such activities may be discontinued at any time. In connection with this Offering, the Underwriter, who is a qualified registered market maker on the Nasdaq Stock Market, may engage in passive market making on Nasdaq in accordance with Rule 103 of Regulation M under the Exchange Act during the one business day period before the commencement of the offers or sales of the Common Stock. The passive market making transactions must comply with applicable volume and price limits and be identified as such. In general, a passive market maker may display its bid at a price not in excess of the highest independent bid for such security; if all independent bids are lowered before the passive market maker's bid, however, such bid must then be lowered when certain purchase limits are exceeded. Passive market making may stabilize the market price of the Common Stock at a level above that which might otherwise prevail and, if commenced, may be discontinued at any time. 51 The Underwriter has informed the Company that it does not intend to confirm sales of Common Stock offered hereby for accounts over which it exercises discretionary authority. On August 5, 1997 the Company issued to a predecessor-in-interest to BT Alex. Brown a warrant (the "Warrant") to purchase 154,817 shares of Common Stock at an exercise price of $3.63 per share in partial consideration of its services as the placement agent for the offering by the Company of the Series A Preferred Stock and Series B Preferred Stock. On the same date the ABS Employees' Venture Fund Limited Partnership ("ABS") purchased 62,000 shares of Series B Preferred Stock (the "ABS Shares") for an aggregate purchase price of $338,000. Pursuant to the terms of an Investor Rights Agreement dated July 15, 1997 among BT Alex. Brown, ABS, Grotech, Keystone Ventures and certain holders of Common Stock, the shares of Common Stock owned by ABS and the Warrant and the shares of Common Stock receivable by BT Alex. Brown through exercise of the Warrant may not be sold or otherwise transferred prior to August 9, 1998. On November 26, 1997, ABS was issued $127,500 of the Series A Notes with associated warrants ("Associated Warrants") to purchase 1,071 shares of Common Stock at an exercise price of $11.90 per share. Pursuant to the rules and regulations of the National Association of Securities Dealers, Inc., the Associated Warrants beneficially held by current BT Alex. Brown employees have been deemed compensation of BT Alex. Brown in connection with the Company's February 1998 initial public offering. Pursuant to such rules and regulations, the Associated Warrants have an exercise price equal to $16.00 per share, the initial public offering price in the Company's initial public offering, and the Associated Warrants and the Common Stock receivable by ABS upon exercise of the Associated Warrants may not be sold or otherwise transferred, assigned, pledged or hypothecated until February 9, 1999. LEGAL MATTERS The validity of the Common Stock offered hereby will be passed upon for the Company by Morgan, Lewis & Bockius LLP, Philadelphia, Pennsylvania. Certain legal matters in connection with the Offering are being passed upon for the Underwriter by Schnader Harrison Segal & Lewis LLP, Philadelphia, Pennsylvania. EXPERTS The financial statements of the Company, as of December 31, 1996 and 1997 and for the years ended December 31, 1995, 1996 and 1997, included in this Prospectus have been audited by Arthur Andersen LLP, independent public accountants, as indicated in their report with respect thereto, and are included herein in reliance upon the authority of such firm as experts in giving said report. 52 CDNOW, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Public Accountants.................................. F-2 Consolidated Balance Sheets............................................... F-3 Consolidated Statements of Operations..................................... F-4 Consolidated Statements of Redeemable Convertible Preferred Stock and Shareholders' Equity (Deficit)........................................... F-5 Consolidated Statements of Cash Flows..................................... F-6 Notes to Consolidated Financial Statements................................ F-7 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To CDnow, Inc.: We have audited the accompanying consolidated balance sheets of CDnow, Inc. (a Pennsylvania Corporation) and Subsidiaries as of December 31, 1996 and 1997, and the related consolidated statements of operations, redeemable convertible preferred stock and shareholders' equity (deficit) and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of CDnow, Inc. and Subsidiaries as of December 31, 1996 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. Arthur Andersen llp Philadelphia, Pa., January 14, 1998 (except for the stock split discussed in Note 2, as to which the date is February 3, 1998) F-2 CDNOW, INC. CONSOLIDATED BALANCE SHEETS DECEMBER 31, ----------------------- JUNE 30, 1996 1997 1998 ---------- ----------- ----------- (UNAUDITED) ASSETS CURRENT ASSETS: Cash and cash equivalents............... $ 775,865 $10,686,001 $47,290,625 Short-term investments.................. 245,641 1,003,045 -- Accounts receivable, net of reserve of $12,000, $77,000 and $140,846.......... 130,437 324,411 326,830 Prepaid expenses and other.............. 49,821 2,457,958 5,423,757 ---------- ----------- ----------- Total current assets................... 1,201,764 14,471,415 53,041,212 PROPERTY AND EQUIPMENT, net.............. 362,035 1,884,296 3,855,871 OTHER ASSETS............................. 11,660 92,714 3,863,069 ---------- ----------- ----------- $1,575,459 $16,448,425 $60,760,152 ========== =========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT) CURRENT LIABILITIES: Notes payable........................... $ 200,000 $ 5,575,288 $ -- Current portion of term loans payable... -- 54,091 60,315 Current portion of capitalized lease obligations............................ 35,942 307,471 478,810 Accounts payable........................ 435,682 8,981,430 3,510,308 Accrued expenses........................ 129,317 579,413 1,482,007 Deferred revenues....................... 166,107 188,466 83,200 Advances due to related parties......... 3,261 3,261 -- ---------- ----------- ----------- Total current liabilities.............. 970,309 15,689,420 5,614,640 ---------- ----------- ----------- TERM LOANS PAYABLE....................... -- 136,293 104,930 ---------- ----------- ----------- CAPITALIZED LEASE OBLIGATIONS............ 91,133 825,851 994,005 ---------- ----------- ----------- DEFERRED RENT LIABILITY.................. -- 56,717 145,883 ---------- ----------- ----------- REDEEMABLE SERIES A AND B CONVERTIBLE PREFERRED STOCK......................... -- 9,492,594 -- ---------- ----------- ----------- COMMITMENTS AND CONTINGENCIES (Note 10) SHAREHOLDERS' EQUITY (DEFICIT): Preferred stock, no par value, 20,000,000 shares authorized, 254,582 Redeemable Series A Convertible shares and 1,605,505 Redeemable Series B Convertible shares issued and outstanding at December 31, 1997....... -- -- -- Common stock, no par value, 50,000,000 shares authorized, 7,845,684, 7,845,684, and 16,266,397 shares issued and outstanding at December 31, 1996, 1997 and June 30, 1998................. 579,549 579,549 79,281,341 Additional paid-in capital.............. -- 1,325,817 4,325,817 Deferred compensation................... -- (434,776) (300,959) Accumulated deficit..................... (65,532) (11,223,040) (29,405,505) ---------- ----------- ----------- Total shareholders' equity (deficit)... 514,017 (9,752,450) 53,900,694 ---------- ----------- ----------- $1,575,459 $16,448,425 $60,760,152 ========== =========== =========== The accompanying notes are an integral part of these statements. F-3 CDNOW, INC. CONSOLIDATED STATEMENTS OF OPERATIONS SIX MONTHS ENDED YEAR ENDED DECEMBER 31, JUNE 30, ------------------------------------- ------------------------- 1995 1996 1997 1997 1998 ---------- ----------- ------------ ----------- ------------ (UNAUDITED) NET SALES............... $2,176,474 $ 6,300,294 $ 17,372,795 $ 5,546,203 $ 21,624,030 COST OF SALES........... 1,844,612 5,217,789 14,316,028 4,412,843 18,154,598 ---------- ----------- ------------ ----------- ------------ Gross profit.......... 331,862 1,082,505 3,056,767 1,133,360 3,469,432 ---------- ----------- ------------ ----------- ------------ OPERATING EXPENSES: Operating and development........... 149,982 669,280 2,541,434 812,284 2,765,714 Sales and marketing.... 200,972 621,454 9,139,348 1,121,960 17,769,619 General and administrative........ 180,573 563,593 1,953,078 743,385 1,734,159 Dispute settlement (Note 7).............. -- 1,024,030 -- -- -- ---------- ----------- ------------ ----------- ------------ 531,527 2,878,357 13,633,860 2,677,629 22,269,492 ---------- ----------- ------------ ----------- ------------ Operating loss........ (199,665) (1,795,852) (10,577,093) (1,544,269) (18,800,060) INTEREST INCOME......... -- -- 201,650 1,390 1,228,051 INTEREST EXPENSE........ (1,248) (14,556) (371,962) (6,805) (494,914) ---------- ----------- ------------ ----------- ------------ NET LOSS................ (200,913) (1,810,408) (10,747,405) (1,549,684) (18,066,923) ACCRETION OF PREFERRED STOCK TO REDEMPTION VALUE.................. -- -- (410,103) -- (115,542) ---------- ----------- ------------ ----------- ------------ NET LOSS APPLICABLE TO COMMON SHAREHOLDERS.... $ (200,913) $(1,810,408) $(11,157,508) $(1,549,684) $(18,182,465) ========== =========== ============ =========== ============ NET LOSS PER COMMON SHARE.................. $ (1.42) $ (.20) $ (1.29) ============ =========== ============ WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING............ 7,845,684 7,845,684 14,044,939 ============ =========== ============ The accompanying notes are an integral part of these statements. F-4 CDNOW, INC. CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY (DEFICIT) SHAREHOLDERS' EQUITY (DEFICIT) --------------------------------------------------------------------------- REDEEMABLE CONVERTIBLE COMMON STOCK ADDITIONAL PREFERRED ---------------------- PAID-IN DEFERRED ACCUMULATED STOCK SHARES AMOUNT CAPITAL COMPENSATION DEFICIT TOTAL ----------- ---------- ----------- ---------- ------------ ------------ ------------ BALANCE, DECEMBER 31, 1995................... $ -- 6,000,000 $ -- $ 160,000 $ -- $ (259,362) $ (99,362) Sale of common stock and warrants.......... -- 921,834 1,069,250 130,750 -- -- 1,200,000 Issuance of common stock in settlement of a dispute (Note 7).... -- 882,606 1,024,030 -- -- -- 1,024,030 Issuance of common stock to repay advances due to a related party......... -- 41,244 81,923 -- -- -- 81,923 Services contributed by the founders (Note 9).................... -- -- -- 117,834 -- -- 117,834 Termination of S Corporation status.... -- -- (1,595,654) (408,584) -- 2,004,238 -- Net loss............... -- -- -- -- -- (1,810,408) (1,810,408) ----------- ---------- ----------- ---------- --------- ------------ ------------ BALANCE, DECEMBER 31, 1996................... -- 7,845,684 579,549 -- -- (65,532) 514,017 Sale of Redeemable Series A and B Convertible Preferred Stock, net of expenses and value of warrants issued................ 9,082,491 -- -- 170,000 -- -- 170,000 Value of warrants issued with Series A Convertible Notes..... -- -- -- 404,425 -- -- 404,425 Grant of common stock options below deemed fair value for accounting purposes... -- -- -- 751,392 (751,392) -- -- Amortization of deferred compensation.......... -- -- -- -- 316,616 -- 316,616 Accretion of preferred stock to redemption value................. 410,103 -- -- -- -- (410,103) (410,103) Net loss............... -- -- -- -- -- (10,747,405) (10,747,405) ----------- ---------- ----------- ---------- --------- ------------ ------------ BALANCE, DECEMBER 31, 1997................... 9,492,594 7,845,684 579,549 1,325,817 (434,776) (11,223,040) (9,752,450) Mandatory conversion of Redeemable Series A Convertible Preferred Stock to Common Stock (unaudited)........... (9,608,136) 2,790,131 9,608,136 -- -- -- 9,608,136 Issuance of common stock from consummation of IPO, net of offering costs (unaudited)........... -- 4,561,250 67,077,862 -- -- -- 67,077,862 Issuance of common stock (unaudited)..... -- 96,296 2,134,198 -- -- -- 2,134,198 Issuance of warrants (unaudited)........... -- -- -- 3,000,000 -- -- 3,000,000 Cashless exercise of warrants (unaudited).. -- 905,996 -- -- -- -- -- Exercise of warrants (unaudited)........... -- 32,727 59,890 -- -- -- 59,890 Exercise of options (unaudited)........... -- 34,313 80,706 -- -- -- 80,706 Remeasurement of value of shares issued to Lycos (Note 10) (unaudited)........... -- -- (259,000) -- -- -- (259,000) Amortization of Deferred Compensation (unaudited)........... -- -- -- -- 133,817 -- 133,817 Accretion of preferred stock to redemption value (unaudited)..... 115,542 -- -- -- -- (115,542) (115,542) Net Loss (unaudited)... -- -- -- -- -- (18,066,923) (18,066,923) ----------- ---------- ----------- ---------- --------- ------------ ------------ BALANCE, JUNE 30, 1998 (unaudited)........... $ -- 16,266,397 $79,281,341 $4,325,817 $(300,959) $(29,405,505) $ 53,900,694 =========== ========== =========== ========== ========= ============ ============ The accompanying notes are an integral part of these statements. F-5 CDNOW, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS YEAR ENDED DECEMBER 31, SIX MONTHS ENDED JUNE 30, ------------------------------------ -------------------------- 1995 1996 1997 1997 1998 --------- ----------- ------------ ------------ ------------ (UNAUDITED) OPERATING ACTIVITIES: Net loss................. $(200,913) $(1,810,408) $(10,747,405) $(1,549,684) $(18,066,923) Adjustments to reconcile net loss to net cash provided by (used in) operating activities-- Depreciation and amortization........... 32,999 105,439 1,066,815 129,000 750,610 Provision for returns and doubtful accounts.. -- 12,000 65,000 -- 142,846 Common stock issued in settlement of a dispute................ -- 1,024,030 -- -- -- Services contributed by the founders........... 120,000 117,834 -- -- -- Increase in operating assets and liabilities-- Accounts receivable.... (56,127) (86,310) (258,974) 5,266 (140,185) Prepaid expenses and other................. (26,994) (34,487) (2,401,794) (160,648) (1,597,421) Accounts payable....... 109,386 326,296 8,545,748 722,118 (5,549,024) Accrued expenses....... 58,124 68,139 450,096 339,604 902,594 Deferred revenue....... 4,952 161,155 22,359 (7,442) (105,266) Deferred rent liability............. -- -- 56,717 -- 89,166 --------- ----------- ------------ ------------ ------------ Net cash provided by (used in) operating activities.. 41,427 (116,312) (3,201,438) (521,781) (23,573,603) --------- ----------- ------------ ------------ ------------ INVESTING ACTIVITIES: Purchases of short-term investments............. -- (245,641) (1,005,501) -- -- Sales and maturities of short-term investments.. -- -- 248,097 245,641 1,003,045 Purchases of property and equipment............... (135,777) (198,985) (912,560) (332,965) (1,637,206) Acquisition of a business................ -- -- -- -- (423,694) --------- ----------- ------------ ------------ ------------ Net cash used in investing activities........... (135,777) (444,626) (1,669,964) (87,324) (1,057,855) --------- ----------- ------------ ------------ ------------ FINANCING ACTIVITIES: Borrowings on term loans payable................. -- -- 218,563 190,170 -- Payments on term loans payable................. -- -- (28,179) (6,478) (25,139) Borrowings on notes payable................. 100,000 200,000 -- 50,000 -- Payments on notes payable................. -- (100,000) (200,000) (110,000) -- Proceeds from sale of common stock and warrants................ -- 1,200,000 -- -- -- Proceeds from issuance (repayment of) of Series A Notes and warrants.... -- -- 5,602,706 -- (5,777,500) Proceeds from sale of preferred stock......... -- -- 9,252,491 -- -- Proceeds from (repayment of) advances due to related parties......... 37,683 6,341 -- -- (3,261) Payments on capitalized lease obligations....... (1,529) (13,350) (64,043) (21,012) (176,476) Proceeds from issuance of common stock, net....... -- -- -- -- 67,077,862 Proceeds from warrants exercised............... -- -- -- -- 59,890 Proceeds from options exercised............... -- -- -- -- 80,706 --------- ----------- ------------ ------------ ------------ Net cash provided by financing activities........... 136,154 1,292,991 14,781,538 102,680 61,236,082 --------- ----------- ------------ ------------ ------------ INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS......... 41,804 732,053 9,910,136 (506,425) 36,604,624 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD...... 2,008 43,812 775,865 775,865 10,686,001 --------- ----------- ------------ ------------ ------------ CASH AND CASH EQUIVALENTS, END OF PERIOD............ $ 43,812 $ 775,865 $ 10,686,001 $ 269,440 $ 47,290,625 ========= =========== ============ ============ ============ The accompanying notes are an integral part of these statements. F-6 CDNOW, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (INFORMATION AS OF JUNE 30, 1998 AND FOR THE SIX MONTHS ENDED JUNE 30, 1997 AND 1998 IS UNAUDITED) 1. THE COMPANY: CDnow, Inc. and Subsidiaries (the "Company") is an online retailer of compact discs ("CDs") and other music-related products. The Company strives to combine the advantages of online commerce with superior customer focus in order to be the authoritative source for CDs and other music-related products. The Company contracts with outside warehouses for fulfillment services to deliver products to customers and, therefore, the Company maintains no inventories. Since inception (February 12, 1994), the Company has incurred significant losses, and as of June 30 , 1998 had accumulated losses of $30.9 million. For the year ended December 31, 1997, and the six months ended June 30, 1998 the Company's net loss was $10.7 million and $18.1 million, respectively. The Company intends to invest heavily in marketing and promotion, strategic alliances, Web site development and technology, and development of its administration organization. As a result, the Company believes that it will incur substantial operating losses for the foreseeable future, and that the rate at which such losses will be incurred will increase significantly from current levels. Because the Company has relatively low product gross margins, achieving profitability given planned investment levels depends upon the Company's ability to generate and sustain substantially increased revenue levels. There can be no assurance that the Company will be able to generate sufficient revenues to achieve or sustain profitability in the future. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Prospectus. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Principles of Consolidation The consolidated financial statements include the accounts of CDnow, Inc. and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. Interim Financial Statements The consolidated financial statements for the six month periods ended June 30, 1997 and 1998 are unaudited and, in the opinion of management, include all adjustments (consisting only of normal and recurring adjustments) necessary for a fair presentation of results for these interim periods. The results of operations for the six month ended June 30, 1998 are not necessarily indicative of the results expected for the entire year. Management's Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Net Loss Per Common Share The Company has presented net loss per common share for 1997 and for the six months ended June 30, 1997 and 1998 pursuant to Statement of Financial Accounting Standards (SFAS) No. 128 "Earnings per Share" and the Securities and Exchange Commission Staff Accounting Bulletin No. 98. Net loss per common share has not been presented for any period prior to 1997, since such amounts are not considered meaningful as a result of the Company's S Corporation status during those periods. F-7 CDNOW, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED) Basic loss per common share was computed by dividing net loss applicable to common shareholders by the weighted average number of shares of Common Stock outstanding during 1997 and the six months ended June 30, 1997 and 1998. Diluted loss per common share has not been presented, since the impact on loss per share using the treasury stock method is anti-dilutive due to the Company's losses. Cash and Cash Equivalents Cash equivalents are carried at cost plus accrued interest, which approximates fair value. The Company considers all highly liquid investments with an original maturity date of three months or less to be cash equivalents. Cash equivalents of $742,784, $10,005,132, and $47,290,625 at December 31, 1996 and 1997 and June 30, 1998, respectively, included money market funds, government mortgage-backed bonds and highly rated corporate securities. Short-Term Investments At December 31, 1996 and 1997, short-term investments represented government mortgage-backed bonds maturing in less than a year and each was classified as available-for-sale. Pursuant to SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," available-for-sale securities are carried at fair value, based on quoted market prices, with unrealized gains and losses, net of tax, reported as a separate component of shareholders' equity. At December 31, 1996 and 1997, amortized cost approximated fair value and unrealized gains and losses were immaterial. Gross unrealized holding gains and losses were immaterial in 1995, 1996 and 1997. The gross proceeds from sales and maturities of short-term investments were $248,097 in 1997. No short-term investments were sold or matured prior to 1997. Gross realized gains and losses were immaterial. For the purpose of determining gross realized gains and losses, the cost of the securities sold is based upon specific identification. Prepaid Expenses At December 31, 1997 prepaid expenses included $87,397 of net deferred financing costs related to the Series A Notes. Amortization of deferred financing costs was $87,397 in 1997 and $87,397 in the six month period ended June 30, 1998 and is included in interest expense. Prepaid expenses included $2,000,000 and $3,615,000 at December 31, 1997 and June 30, 1998, respectively, related to linking agreements and strategic alliances (see Note 10). At June 30, 1998, Other Assets included $2,731,000 related to linking agreements and strategic alliances. Property and Equipment Property and equipment are stated at cost. Depreciation and amortization are provided using the straight-line basis over the estimated useful lives of the assets or the lease term, whichever is shorter. Internally Developed Systems and Software The costs to develop internal systems and software, primarily payroll and related expenses for development and design of software, are charged to expense as incurred. Revenue Recognition Net sales, which consist primarily of recorded music sold via the Internet, include outbound shipping and handling charges and are recognized when the products are shipped. The Company records a reserve for estimated returns, which is based on historical return rates. F-8 CDNOW, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED) Operating and Development Operating and development expenses consist principally of payroll and related expenses for development, editorial, and network operations personnel and consultants and expenses for systems and telecommunications infrastructure. Sales and Marketing Advertising costs are included in sales and marketing expenses and are charged to expense as incurred. Such costs were $40,523, $61,432, $6,834,000, $490,486, and $13,992,087 for the years ended December 31, 1995, 1996, 1997 and for the six months ended June 30, 1997 and 1998 respectively. The Company gives merchandise credit to the providers of various small Web sites through its Cosmic Credit Program. Expenses related to this program are included in sales and marketing expenses and, to date, have been immaterial. The Company estimates the amount of unused credits and includes this amount in accrued expenses. Gift Certificates and Coupons Gift certificates are included in deferred revenues in the accompanying balance sheets and are recognized as net sales when they are redeemed. The Company estimates the amount of outstanding coupons which will be redeemed and includes that amount in accrued expenses. This accrual is immaterial for all periods presented. Coupon expense is included in sales and marketing expenses. Supplemental Cash Flow Information For the years ended December 31, 1995, 1996 and 1997, and the six months ended June 30, 1997 and 1998, the Company paid interest of $2,329, $19,467, $284,565, $13,100, and $397,618 respectively. In addition, the Company incurred $15,000, $126,954, $1,070,290, $43,284 and $515,969 in capitalized lease obligations for the years ended December 31, 1995, 1996 and 1997, and the six months ended June 30, 1997 and 1998, respectively. In 1996 the Company issued 41,244 shares of common stock to retire $81,923 of advances due to a related party (see Note 9). Recapitalization In April 1996, the Company amended its Articles of Incorporation to effect a 10,000-for-1 split of its common shares and to change the number of authorized common shares to 5,000,000. In July 1997, the Company amended its Articles of Incorporation to effect a 4-for-1 split of its common shares, to change the number of authorized common shares to 50,000,000, and to authorize 20,000,000 shares of preferred stock. In January 1998, the Company amended its Articles of Incorporation to effect a 1.5-for-1 split of its common shares. All references in the consolidated financial statements to the number of shares and to per share amounts have been retroactively restated to reflect all of these changes. Comprehensive Income In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income" ("SFAS 130"). This statement requires companies to classify items of other comprehensive income by their nature in a financial statement and display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position. SFAS 130 is effective for financial statements issued for fiscal years beginning after December 15, 1997. The Company has adopted SFAS 130 in the first quarter of 1998. The Company has had no other comprehensive income items to report. F-9 CDNOW, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED) Initial Public Offering On February 13, 1998 the Company consummated an initial public offering of its Common Stock (the "Initial Public Offering"). The company sold 4,561,250 shares of its common stock, no par value, at an initial public offering price of $16.00 per share. After deducting the underwriters' discount and other offering expenses, the net proceeds to the company were approximately $67,077,862. Recently Issued Accounting Pronouncements In June 1997, the FASB issued SFAS No. 131, "Disclosure About Segments of an Enterprise and Related Information" ("SFAS 131"). This statement establishes additional standards for segment reporting in the financial statements and is effective for fiscal years beginning after December 15, 1997. Management believes that SFAS 131 will not have an effect on the Company's consolidated financial statements. Reclassification The statement of operations for 1996 and 1997 and the six months ended June 30, 1997 have been reclassified to conform with the presentation of June 30, 1998. Beginning in 1998, the Company determined to include royalties paid on CD sales in return for licensing of ratings, reviews, sound samples and other information ("Information Royalties") in operating and development expenses rather than in cost of sales, as was previously the case. This change was made based on Management's determination that including Information Royalties in operating and development expense was more consistent with the treatment of such expenses by retailers generally. The financial information for periods prior to 1998 has been restated to reflect this change. Information Royalties were $146,200, $225,737, $97,562, and $137,119 during the years ended December 31, 1996 and 1997 and the six months ended June 30, 1997 and 1998, respectively. There were no Information Royalties paid in 1995. 3. RISKS AND UNCERTAINTIES: The Company's future results of operations involve a number of risks and uncertainties. Factors that could affect the Company's future operating results and cause actual results to vary materially from expectations include, but are not limited to, dependence on key personnel, uncertain growth of online commerce, reliance on suppliers of entertainment products, government regulation, online commerce security risks, substantial competition, reliance on certain vendors, risk of system failure, absence of redundant facilities, risks associated with the Year 2000, and capacity constraints. See "Risk Factors" in the Prospectus. Dependence on Suppliers The Company's primary provider of order fulfillment for recorded music titles is Valley Record Distributors ("Valley"). The Company has no fulfillment operation or facility of its own and, accordingly, is dependent upon maintaining its existing relationship with Valley or establishing a new fulfillment relationship with one of the few other fulfillment operations. There can be no assurance that the Company will maintain its relationship with Valley beyond the term of its existing two year agreement, which expires in June 1999, or that it will be able to find an alternative, comparable vendor capable of providing fulfillment services on terms satisfactory to the Company should its relationship with Valley terminate. Valley accounted for 70%, 74%, 78%, 74% and 82% of the cost of sales for the years ended 1995, 1996 and 1997 and the six months ended June 30, 1997 and 1998 respectively. Additionally, the Company F-10 CDNOW, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 3 RISKS AND UNCERTAINTIES: (CONTINUED) purchased all of its import music titles from another vendor. This vendor accounted for 21%, 14% and 11% of the cost of sales in 1995, 1996 and the six months ended June 30, 1997, respectively. The Company replaced this vendor during the year ended December 31, 1997 and neither the current nor the former vendor accounted for more than 10% of cost of sales in the year ended December 31, 1997 and the six months ended June 30, 1998. International Sales The Company derived 22%, 40%, 29%, 35% and 22% of revenues for the years ended 1995, 1996 and 1997, and for the six months ended June 30, 1997 and 1998, respectively, from customers outside the United States. All international sales are paid in U.S. dollars. 4. PROPERTY AND EQUIPMENT: DECEMBER 31, USEFUL LIFE/ --------------------- JUNE 30, LEASE TERM 1996 1997 1998 ------------ --------- ---------- ----------- (UNAUDITED) Computers and equipment.... 3 years $ 387,348 $2,090,144 $4,196,975 Office furniture and equipment................. 5 years 117,876 397,930 779,876 --------- ---------- ---------- 505,224 2,488,074 4,976,851 Less--Accumulated depreciation and amortization.............. (143,189) (603,778) (1,120,980) --------- ---------- ---------- $ 362,035 $1,884,296 $3,855,871 ========= ========== ========== Depreciation and amortization expense for the years ended 1995, 1996 and 1997 and the six months ended June 30, 1997 and 1998 was $32,999, $105,439, $460,589, $129,000 and $544,404, respectively. Total property and equipment under capital leases was $141,954, $1,217,130 and $1,733,099 less accumulated amortization of $25,659, $252,988, and $498,841, at December 31, 1996 and 1997 and at June 30, 1998. 5. INCOME TAXES: The Company records income taxes using the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. From inception (February 12, 1994) until April 25, 1995, the Company operated as an unincorporated entity. From April 25, 1995 until December 5, 1996, the Company was incorporated and elected to be taxed under Subchapter S of the Internal Revenue Code. As a result, the Company was not subject to federal or state income taxes, and the taxable loss of the Company was included in the shareholders' individual tax returns. On December 6, 1996, the Company terminated its status as an S corporation and is now subject to federal and state income taxes. At December 31, 1997, the Company had a net operating loss carryforward for federal income tax purposes of approximately $9,700,000. The net operating loss carryforward will begin to expire in 2011. F-11 CDNOW, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 5. INCOME TAXES: (CONTINUED) The Company's utilization of its loss carryforward will be limited pursuant to the Tax Reform Act of 1986, due to cumulative changes in ownership in excess of 50%. The approximate income tax effect of each type of temporary difference and the loss carryforward is as follows: DECEMBER 31, ---------------------- 1996 1997 --------- ----------- Accruals and reserves not currently deductible.......... $ 6,275 $ 38,590 Benefit of net operating loss carryforward.............. 1,592 3,240,322 Development expenses not currently deductible........... 160,062 476,736 Depreciation methods.................................... 12,134 37,634 Deferred revenues....................................... 42,500 64,078 --------- ----------- 222,563 3,857,360 Valuation allowance..................................... (222,563) (3,857,360) --------- ----------- $ -- $ -- ========= =========== Due to the Company's history of operating losses the realization of the deferred tax asset is uncertain. The Company has, therefore, provided a full valuation allowance against the deferred tax asset. 6. DEBT: On December 31, 1995, the Company issued a note for $100,000 to a private investor who is also a member of the Company's Board of Directors. The note plus accrued interest of 10% was repaid on December 31, 1996. From November 16, 1996 through January 31, 1997, the Company received short- term loans of $250,000 from certain unrelated investors. The investors received warrants as part of the consideration for the loans (see Note 8). These loans bore interest at 6% per year. On May 15, 1997, the Company repaid $110,000 of the loans and, on July 16, 1997, the remaining unpaid balance plus accrued interest was paid. In 1997, the Company obtained three term loans from a bank for an aggregate of $218,563. The proceeds from the loans were used to purchase equipment, which equipment collateralizes the loans. The two founders of the Company have personally guaranteed the loans. The loans bear interest at rates ranging from 8.0% to 9.0% and are repayable in installments over 36 to 48 months. Annual principal repayments are $57,351 in 1998, $62,300 in 1999, $45,676 in 2000 and $25,061 in 2001. In November 1997, the Company sold $5,777,500 of Series A Convertible Notes (Series A Notes) to certain investors, including $1,000,000 to an existing shareholder. The notes bear interest at an annual rate of 12% and are due upon consummation of the Offering. In connection with the sale of the Series A Notes, the Company issued warrants to these investors. The warrants allow the investors to purchase 48,550 shares of common stock at an exercise price of $11.90 per share. The warrants were valued using the Black-Scholes model, and the Series A Notes were recorded net of the value of $404,425 assigned to the warrants. The notes were amortized to their face amount over their estimated term, with $202,213 of amortization included in interest expense for the year ended December 31, 1997 and $202,212 in the six months ended June 30, 1998. The notes were repaid in February 1998. F-12 CDNOW, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 7. DISPUTE SETTLEMENT: In May 1995, MILO Productions, Inc. ("MILO"), which was owned by the Company's then shareholders, entered into a partnership with MBL Entertainment, Inc. ("MBL") called Music Now. In December 1995, MBL, an investor and the Company's then shareholders entered into nonbinding discussions for the purpose of creating a new company ("NewCo") which would merge with Music Now. These discussions contemplated, among other things, that the private investor would make a significant cash investment in, and the Company's then shareholders would contribute all of the outstanding capital stock of both MILO and the Company, to NewCo. The parties abandoned these discussions in August 1996, and MBL and the private investor subsequently instituted a legal action against the Company, MILO and the Company's then shareholders. On December 6, 1996, the Company and all parties involved in this dispute negotiated a settlement pursuant to which (i) the private investor made an investment in the Company (see Note 8) and (ii) the shareholders of MBL were issued an aggregate of 882,606 shares of common stock. The shares issued to the shareholders of MBL were valued at $1,024,030 based on the sale of common stock to the investor, which valued the common stock at $1.16 per share (see Note 8), with the related charge recorded as an expense in the accompanying statement of operations for the year ended December 31, 1996. At the time of the settlement, MBL and Music Now were inactive and had no assets or liabilities. 8. REDEEMABLE CONVERTIBLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY: Common Stock In December 1996, the Company sold to an investor 921,834 shares of common stock and a warrant to purchase an additional 871,710 common shares at $1.15 per share, for aggregate consideration of $1,200,000. Using the Black-Scholes model, the warrants were valued at $130,750. The remaining amount of the proceeds of $1,069,250 was allocated to common stock, resulting in a value per share of $1.16. The investor received the right to appoint two members of the Company's Board of Directors, each having one-half vote. This right terminated upon the consummation of the Company's Initial Public Offering. The investor, who is a director of the Company, exercised the warrant upon consummation of the Initial Public Offering, by tendering to the Company 62,473 shares received upon exercise to satisfy the $999,561 exercise price. This cashless exercise resulted in 809,237 net shares of common stock being received by the investor. Preferred Stock As of December 31, 1997, the Company had 20,000,000 shares of preferred stock authorized, of which 254,582 were designated, issued and outstanding as no par value Redeemable Series A Convertible Preferred Stock ("Series A Preferred") and 1,605,505 were designated, issued and outstanding as no par value Redeemable Series B Convertible Preferred Stock ("Series B Preferred"). The Series A Preferred was sold to an investor in July 1997 for $4.91 per share, resulting in proceeds to the Company of $1,152,186, net of expenses. The Series B Preferred was sold to investors in August 1997 for $5.45 per share, resulting in proceeds to the Company of $8,100,305, net of expenses. Each share of Series A and B Preferred converted into shares of the Company's common stock upon the consummation of the Initial Public Offering in February 1998, on a 1.5-for-1 basis. F-13 CDNOW, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 8. REDEEMABLE CONVERTIBLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY: (CONTINUED) Beginning January 1, 2003, the Series A and B Preferred would have been redeemable at the option of a majority of the holders at $4.91 per share and $5.45 per share, respectively, plus accrued but unpaid dividends, if any. The Series A and B Preferred were being accreted to their redemption values for accounting purposes. The holders of Series A and B Preferred were entitled to receive cumulative dividends of 8% per share per year, when and if declared by the Company; no dividends could have been declared or paid on common stock unless all cumulative dividends were declared and paid on the preferred stock. The Series A and Series B Preferred had liquidation preferences equal to $4.91 per share and $5.45 per share, respectively, plus any accrued and unpaid dividends. Equity Compensation Plan On June 1, 1996, the Company adopted the Equity Compensation Plan (the "Plan"). Under the Plan, incentive and nonqualified stock options, restricted stock and stock appreciation rights may be granted to employees, officers, employee directors and independent contractors and consultants. An aggregate of 1,600,000 shares of common stock have been reserved for issuance under the Plan. No stock options, restricted stock or stock appreciation rights were granted in 1996. Information relative to the Plan is as follows: WEIGHTED AVERAGE RANGE OF AGGREGATE EXERCISE SHARES EXERCISE PRICES EXERCISE PRICE PRICE ------- --------------- -------------- -------- Outstanding January 1, 1997..................... -- -- -- -- Granted................... 721,914 $ 1.33-$10.00 $2,157,680 $ 2.99 ------- ------------- ---------- ------ Outstanding December 31, 1997..................... 721,914 $ 1.33-$10.00 2,157,680 $ 2.99 Granted................... 229,499 $14.00-$35.50 5,909,108 $25.75 Exercised................. (34,313) $ 1.33-$ 3.00 (80,706) $ 2.35 Cancelled................. (11,305) $ 1.33-$10.00 (35,930) $ 3.18 ------- ------------- ---------- ------ Outstanding June 30, 1998..................... 905,795 $ 1.33-$35.50 $7,950,152 $ 8.78 ======= ============= ========== ====== As of June 30, 1998, there were options to purchase 115,991 shares of common stock exercisable with a weighted average exercise price of $1.33 per share. In addition, as of June 30, 1998, there were options to purchase and 659,892 shares of common stock available for grant under the Plan. The Company accounts for its option grants under APB Opinion No. 25 and related interpretations. Accordingly, compensation has been recorded for the Plan based on the intrinsic value of the stock option at the date of grant (i.e., the difference between the exercise price and the fair value of the Company's stock). Compensation, if any, is deferred and recorded as expense over the vesting period. For the year ended December 31, 1997, deferred compensation of $751,392 was recorded for options granted, of which $316,616 and $133,817 was charged to compensation expense for the year ended December 31, 1997 and the six months ended June 30, 1998 respectively. In 1995, the FASB issued SFAS No. 123 "Accounting for Stock Based Compensation" (SFAS 123). SFAS 123 establishes a fair value based method of accounting for stock-based compensation plans. This statement also applies to transactions in which an entity issues its equity instruments to acquire goods or services from non-employees. SFAS 123 requires that an employer's financial statements include certain disclosures about stock-based employee compensation arrangements regardless of the method F-14 CDNOW, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 8. REDEEMABLE CONVERTIBLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY: (CONTINUED) used to account for the plan. Had the Company recognized compensation cost for its stock option plan consistent with the provisions of SFAS 123, the Company's pro forma net loss and net loss per common share for the year ended December 31, 1997 would have been as follows: YEAR ENDED DECEMBER 31, 1997 ------------ Net loss applicable to common shareholders: As reported................................................. $(11,157,508) ============ Pro forma................................................... $(11,265,003) ============ Net loss per common share: As reported................................................. $ (1.42) ============ Pro forma................................................... $ (1.45) ============ The weighted average fair value of the stock options granted during the year ended December 31, 1997 was $2.63. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model, with the following weighted average assumptions: risk free interest rates ranging from 6.4% to 6.8% based on the rates in effect on the date of grant, a volatility of 60% for options granted subsequent to the filing date of the Company's registration statement, no expected dividend yield, and an expected life of eight years for the options. Warrants In August 1997, the Company issued warrants to purchase 121,560 shares of Series B Preferred at an exercise price of $5.45 per share in connection with the Series B Preferred financing. The warrants were issued to one of the investors in the Series B Preferred and to the agent who represented the Company in that financing. These warrants expire in August 2002. Upon the closing of the Initial Public Offering, the warrants converted to warrants to purchase 182,341 shares of common stock at $3.63 per share. Using the Black- Scholes model, the warrants were valued at $170,000. This amount was recorded as a reduction in the carrying value of the preferred stock and was amortized and included in the accretion to the redemption value of the preferred stock recorded in each period. As consideration for certain loans, the lenders received warrants to purchase 59,997 and 76,365 shares of common stock at a price of $1.83 per share until May 16, 1998 and July 16, 1998, respectively (see Note 6). Based on the warrants' 18-month term and exercise price, the Black-Scholes model calculated a minimal value for the warrants. 9. RELATED-PARTY TRANSACTIONS: Additional paid-in capital represents the deemed fair value of services contributed to the Company by the founders in 1994, 1995 and 1996. During this period, one of the founders served as President and the other was responsible for the development of the Company's system architecture and transactions systems. In 1994 and 1995, the founders were paid no compensation and in 1996 the founders' compensation was below market. The fair value of services contributed by the founders was determined by the Company's Board of Directors. In determining the value, the Board considered the founders' level of experience, position in the Company, the compensation level of other employees, the Company's financial resources and the status of the Company's development. F-15 CDNOW, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 9. RELATED-PARTY TRANSACTIONS: (CONTINUED) The Company had a $3,261 advance due to a founder at December 31, 1996 and 1997. This advance was repaid in the six months ended June 30, 1998. At December 31, 1995 the Company had advances due to a founder and his father of $4,103 and $74,740, respectively. During 1996, the father advanced additional funds to the Company and, on August 16, 1996, in consideration of the cancellation of $81,923 debt due to the father, the Company issued 41,244 shares of the Company's common stock. The exchange ratio used to convert the debt into shares of common stock was negotiated between the founders and their father and cannot be considered arms-length. 10. COMMITMENTS AND CONTINGENCIES: Yahoo Agreement In August 1997, the Company entered into an agreement with Yahoo! Inc. (the "Yahoo Agreement"), pursuant to which the Company was granted exclusivity on music-related pages on the www.yahoo.com Web site. The term began in October 1997 and will expire on October 5, 1999. During the first year of the term, the Company is required to pay Yahoo $3,900,000 (of which $900,000 was paid in 1997) in exchange for a specified number of page views. During the second year of the term, the Company will be required to pay Yahoo an amount, not to be less than $4,500,000, calculated using the number of impressions delivered during August and September of 1998. The Company expects to amortize the costs associated with the Yahoo Agreement over the contract term, with the amortization method primarily based on the rate of delivery of a guaranteed number of impressions to be received during the contract term. In connection with the Yahoo Agreement, the Company paid Yahoo an additional $600,000 for advertising in August and September 1997, which amount was charged to expense. Excite Agreement On September 30, 1997, the Company entered into a two-year agreement with Excite, Inc. (the "Excite Agreement"), pursuant to which the Company became the exclusive retail music store sponsor of the Webcrawler.com Web site. The Excite Agreement requires the Company to pay Excite a set-up fee, an annual exclusivity fee and an annual sponsorship fee for ongoing programming, links, placements, advertisements and promotions. The Company has agreed to pay Excite a minimum of $4,500,000 over the contract term, of which $500,000 was paid by December 31, 1997, $2,125,000 will be paid in 1998 and $1,875,000 will be paid in 1999. The Company expects to amortize the costs associated with Excite agreement over the contract term, with the amortization method primarily based on the rate of the delivery of a guaranteed number of impressions to be received during the contract term. Lycos Agreement On March 26, 1998, the Company entered into an agreement with Lycos, Inc. (the "Lycos Agreement"), pursuant to which the Company became the exclusive retail music store sponsor of the www.Lycos.com and www.Tripod.com Web sites. The Lycos Agreement has a term of three years which will commence on the launch date, as defined. The Company has agreed to pay Lycos $4,500,000, $5,500,000 and $6,500,000 during the first, second and third years, respectively of the contract term in exchange for a specified number of page views. In addition, the Company has issued 61,665 shares (the "Lycos Shares") of common stock to Lycos. The Lycos Shares vest as Lycos delivers certain required minimum page views, as defined. The Company has the right to repurchase any of the Lycos shares that do not become vested at a price of $0.01 per share. The Company will measure the stock granted as it F-16 CDNOW, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 10. COMMITMENTS AND CONTINGENCIES: (CONTINUED) vests. If Lycos is unable to deliver a number of guaranteed minimum impressions the Company will not be required to make all of the minimum payments and all of the Lycos shares may not vest. The Company expects to amortize the costs associated with the Lycos Agreement over the contract term, with the amortization method primarily based on the rate of delivery of a guaranteed number of impressions to be received during the contract term. Lycos Bertelsmann Agreement On April 2, 1998, the Company entered into an agreement with Lycos Bertelsmann GMBH & Co. KG (the "Lycos Bertelsmann Agreement), pursuant to which the Company became the exclusive music retailer on certain Lycos branded Web services, as defined, in Europe. The Lycos Bertelsmann Agreement has a three year term which will commence on the launch date, as defined. The Company has agreed to pay Lycos Bertelsmann $1,420,000, $1,880,000 and $2,200,000 during the first, second and third years of the contract term. The Company expects to amortize the costs associated with the Lycos Bertelsmann Agreement over the contract term, with the amortization method primarily based on the rate of delivery of a guaranteed number of impressions to be received during the contract term. MTV Agreement On May 18, 1998, the Company entered into a binding memorandum of terms for a three year advertising and promotion agreement with MTV Networks, a subsidiary of Viacom International, Inc., pursuant to which the Company committed to purchase advertising on certain MTV and VH1 programming and obtained the right to use certain MTV and VH1 content. The Company has agreed to pay MTV Networks $5,200,000, $6,789,000, $7,336,000 and $121,000 during the remainder of 1998 and during the years ending December 31, 1999, 2000, and 2001, respectively. In addition, the Company has granted MTV Networks a warrant to purchase 226,892 shares of the Company's common stock at an exercise price of $23.28 per share. The warrant will vest annually over the three years of the contract term. The warrant was valued at $3,000,000 using the Black-Scholes model, and will be charged to expense ratably over the term of the agreement. Other Agreements On January 5, 1998 the Company entered into a strategic alliance with GeoCities pursuant to which the Company has been designated as the exclusive music retailer as well as one of four key commerce partners that will occupy a premier position on certain pages of the GeoCities Web site. The Company has committed to make payments under advertising and linking agreements with Rolling Stone Network, America Online with respect to the Love@AOL service, and with certain other parties and has expanded its agreement with Yahoo. The Company's aggregate commitment under these arrangements is approximately $3,088,000, $2,927,000, $2,435,000 and $766,000 in the remaining six months of 1998, and in the years ending December 31, 1999, 2000 and 2001, respectively. Many of the Company's agreements including the Yahoo, Excite, Lycos and Lycos Bertelsmann Agreements contain provisions which may require additional payments to be made by the Company based on factors such as click-throughs and new customers generated. No such payments have been incurred to date. Such payments will be expensed as incurred. The Company will continue to evaluate the realizability of assets recorded, if any, related to the Yahoo, Excite, Lycos, Lycos Bertelsmann and other agreements, and, if necessary, write down the assets to realizable value. F-17 CDNOW, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 10. COMMITMENTS AND CONTINGENCIES: (CONTINUED) Leases The Company has entered into various noncancelable operating and capital leases for office space, telephones and other equipment. Future minimum lease payments under operating and capital leases as of December 31, 1997 are as follows: OPERATING CAPITAL ---------- ---------- 1998.................... $ 291,033 $ 464,103 1999.................... 302,044 453,629 2000.................... 343,784 388,761 2001.................... 316,775 146,407 2002.................... 226,037 -- ---------- ---------- Total minimum lease payments............... $1,479,673 1,452,900 ========== Less--Amount representing interest.. (319,578) ---------- Present value of minimum capitalized lease payments............... $1,133,322 ========== Rent expense under operating leases was $51,836, $16,905, $207,724, $49,457 and $253,900 for the years ended 1995, 1996 and 1997 and for the six months ended June 30, 1997 and 1998, respectively. Legal Actions From time-to-time, the Company may be involved in litigation relating to claims arising out of its ordinary course of business. The Company believes that there are no claims or actions pending or threatened against the Company, the ultimate disposition of which, would have a materially adverse effect on the Company. F-18 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NO DEALER, SALESPERSON OR ANY OTHER PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY REPRESENTATIONS NOT CONTAINED IN THIS PROSPECTUS, AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED BY THE COMPANY OR ANY OF THE UNDERWRITERS. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER OF ANY SECURITIES OTHER THAN THOSE TO WHICH IT RELATES OR AN OFFER TO SELL, OR A SOLICITATION OF AN OFFER TO BUY, TO ANY PERSON IN ANY JURISDICTION WHERE SUCH AN OFFER OR SOLICITATION WOULD BE UN- LAWFUL. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE ANY IMPLICATION THAT THE INFORMATION CONTAINED HEREIN IS CORRECT AS OF ANY TIME SUBSEQUENT TO THE DATE HEREOF. ----------------- TABLE OF CONTENTS PAGE ---- Additional Information................................................... 2 Prospectus Summary....................................................... 3 Risk Factors............................................................. 7 Price Range of Common Stock.............................................. 16 Use of Proceeds.......................................................... 17 Dividend Policy.......................................................... 17 Capitalization........................................................... 18 Dilution................................................................. 18 Selected Financial and Operating Data.................................... 19 Management's Discussion and Analysis of Financial Condition and Results of Operations............................................................ 20 Business................................................................. 30 Management............................................................... 42 Certain Relationships and Related Transactions........................... 46 Principal and Selling Shareholders....................................... 48 Description of Capital Stock............................................. 49 Underwriting............................................................. 51 Legal Matters............................................................ 52 Experts.................................................................. 52 Index to Financial Statements............................................ F-1 ----------------- UNTIL , 1998 (25 DAYS AFTER THE DATE OF THIS PROSPECTUS), ALL DEALERS EFFECTING TRANSACTIONS IN THE COMMON STOCK, WHETHER OR NOT PARTICIPATING IN THIS DISTRIBUTION, MAY BE REQUIRED TO DELIVER A PROSPECTUS. THIS IS IN ADDITION TO THE OBLIGATIONS OF DEALERS TO DELIVER A PROSPECTUS WHEN ACTING AS UNDERWRITERS AND WITH RESPECT TO THEIR UNSOLD ALLOTMENTS OR SUBSCRIPTIONS. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 1,330,000 Shares LOGO Common Stock ----------------- PROSPECTUS ----------------- BT ALEX. BROWN , 1998 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- PART II INFORMATION NOT REQUIRED IN PROSPECTUS ITEM 13. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION. The following table sets forth the estimated expenses, other than underwriting discounts and commissions, in connection with the issuance and distribution of the shares of Common Stock being registered, all of which are being borne by the Company: Registration fee................................................... $ 22,374 NASD filing fee.................................................... 8,084 Transfer agent and registrar fees.................................. 5,000 Printing and engraving............................................. 100,000 Legal fees......................................................... 100,000 Blue Sky fees and expenses......................................... 5,000 Nasdaq National Market listing fee................................. 17,500 Accounting fees.................................................... 100,000 Miscellaneous...................................................... 142,042 Total.............................................................. $500,000 ======== ITEM 14. INDEMNIFICATION OF DIRECTORS AND OFFICERS. Chapter 17, Subchapter D of the Pennsylvania Business Corporation Law of 1988, as amended (the "PBCL") contains provisions permitting indemnification of officer and directors of a business corporation in Pennsylvania. Sections 1741 and 1742 of the PBCL provide that a business corporation may indemnify directors and officers against liabilities and expenses they may incur as such in connection with any threatened, pending or completed civil, administrative or investigative proceeding, provided that the particular person acted in good faith and in a manner he or she reasonably believed to be in, or not opposed to, the best interests of the corporation, and, with respect to any criminal proceeding, had no reasonable cause to believe his or her conduct was unlawful. In general, the power to indemnify under these sections does not exist in the case of actions against a director or officer by or in the right of the corporation if the person otherwise entitled to indemnification shall have been adjudged to be liable to the corporation unless it is judicially determined that, despite the adjudication of liability but in view of all the circumstances of the case, the person is fairly and reasonably entitled to indemnification for specified expenses. Section 1743 of the PBCL provides that the corporation is required to indemnify directors and officers against expenses they may incur in defending actions against them in such capacities if they are successful on the merits or otherwise in the defense of such actions. Section 1746 of the PBCL grants a corporation broad authority to indemnify its directors and officers for liabilities and expenses incurred in such capacity, except in circumstances where the act or failure to act giving rise to the claim for indemnification is determined by a court to have constituted willful misconduct or recklessness. Section 1747 of the PBCL permits a corporation to purchase and maintain insurance on behalf of any person who is or was a director or officer of the corporation, or is or was serving at the request of the corporation as a representative of another corporation or other enterprise, against any liability asserted against such person and incurred by him or her in any such capacity, or arising out of his or her status as such, whether or not the corporation would have the power to indemnify the person against such liability under Chapter 17, Subchapter D of the PBCL. II-1 Section 8.01 of the Bylaws provides that the Registrant will indemnify any director or officer of the Registrant or any other person designated by the Board of Directors of the Registrant (which may, but need not, include any person serving at the request of the Registrant as a director or officer, employee, agent, fiduciary or trustee of another corporation, partnership, joint venture, trust, employee benefit plan or other entity or enterprise) against any damage, judgment, amount paid in settlement, fine, penalty, punitive damages, excise tax assessed with respect to an employee benefit plan, or cost or expense of any nature (including, without limitation, attorneys' fees and disbursements) incurred in connection with any proceeding in which such person may be involved as a party or otherwise by reason of the fact that such person is or was serving in such capacity, including, without limitation, liabilities resulting from any actual or alleged breach of duty, error, misstatement or misleading statement, negligent, gross negligence or act giving rise to strict or products liability. Notwithstanding the foregoing, the Registrant shall not indemnify any person for any act or failure to act which is (i) prohibited by applicable law or (ii) finally determined to have constituted willful misconduct or recklessness or to be based upon or attributable to the receipt by such person of a personal benefit to which such person is not legally entitled. Section 8.03 of the Bylaws provides for the advancement of expenses to an indemnified party upon receipt of an undertaking by the party to repay those amounts if it is ultimately determined that the indemnified party is not entitled to indemnification. Section 8.04 of the Bylaws authorizes the Registrant to use any mechanism or arrangement, as determined by the Board of Directors, to further effect, satisfy or secure its indemnification obligations, including purchasing and maintaining insurance, obtaining a letter of credit, creating a reserve, trust, escrow or other fund or account, entering into indemnification agreements or granting security interests. Section 8.08 of the Bylaws mandates indemnification against expenses (including attorney's fees and disbursements) actually and reasonably incurred by any authorized representative of the Registrant who has been successful on the merits or otherwise in defense of any action, suit or proceeding referred to in Sections 1741 or 1742 of the PBCL. Section 8.09 of the Bylaws provides that the rights of indemnification under the Bylaws will be deemed a contract between the Registrant and each person entitled to indemnification. Section 8.10 of the Bylaws states that the indemnification authorized by the Bylaws will not be exclusive of any other rights to which persons seeking indemnification or advancement of expenses may be entitled. The Registrant maintains, on behalf of its directors and officers, insurance protection against certain liabilities arising out of the discharge of their duties. ITEM 15. RECENT SALES OF UNREGISTERED SECURITIES Since the Company's incorporation in April 1995, the Company has issued and sold the following unregistered securities: 1. On August 16, 1996, the Company issued 41,244 shares to an accredited investor in exchange for the cancellation of $81,923 of debt owed by the Company to this investor. 2. On December 6, 1996, the Company issued 921,834 shares of Common Stock to an accredited investor for $1,200,000 and an aggregate of 882,606 shares of Common Stock to three investors in exchange for substantially all of the business and assets of an organization owned by these investors. 3. On July 15, 1997, the Company issued 254,582 shares of Series A Preferred Stock to an accredited investor for $1,250,000. 4. On August 5, 1997, the Company issued 1,605,605 shares of Common Stock to two accredited investors for an aggregate of $8,750,000. 5. On November 26, 1997, the Company issued $5,777,500 in aggregate principal amount of its Series A Convertible Notes and associated warrants exercisable for capital stock of the Company. 6. On March 26, 1998, the Company issued 61,665 shares of Common Stock to an accredited investor as a partial inducement to enter into an agreement with the Company. II-2 7. On May 18, 1998, the Company issued a warrant exercisable for 226,892 shares of Common Stock to an accredited investor as a partial inducement to enter into a strategic alliance with the Company. The Company believes that the transactions described above were exempt from registration under Section 4(2) of the Act because the subject securities were sold to a limited group of persons, each of whom was believed to have been either an accredited investor or a sophisticated investor or had a pre- existing business or personal relationship with the Company or its management and was purchasing for investment without a view to further distribution. Restrictive legends were placed on stock certificates evidencing the shares and/or agreements relating to the right to purchase such shares described above. ITEM 16. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES. (a) Exhibits: The following is a list of exhibits filed as part of this Registration Statement. EXHIBIT NUMBER DESCRIPTION ------- ----------- 1.1 Form of Underwriting Agreement.* 3.1 Amended and Restated Articles of Incorporation of the Company.# 3.2 Amended and Restated Bylaws of the Registrant.# 3.3 Amendment No. 1 to Amended and Restated Bylaws of the Registrant.# 5.1 Opinion of Morgan, Lewis & Bockius LLP regarding legality of the shares of Common Stock being registered.* 10.1 Stock Purchase Agreement dated as of July 15, 1997 by the Registrant and certain shareholders of the Registrant.# 10.2 Amendment No. 1 to Stock Purchase Agreement dated as of August 5, 1997 by the Registrant and certain shareholders of the Registrant.# 10.3 Investors' Rights Agreement dated as of July 15, 1997 by the Registrant and certain shareholders of the Registrant.# 10.4 CDnow, Inc. 1996 Equity Compensation Plan.# 10.5 Amendment 1997-1 to the CDnow, Inc. 1996 Equity Compensation Plan.# 10.6 Warrant dated August 5, 1997 issued by the Registrant to Alex. Brown & Sons Incorporated.# 10.7 Warrant dated August 5, 1997 issued by the Registrant to Grotech Capital Group IV, L.L.P.# 10.8+ Linking Agreement dated September 30, 1997 by and between the Registrant and Excite, Inc.# 10.9+ Advertising and Promotion Agreement dated as of August 21, 1997 by and between the Registrant and Yahoo! Inc.# 10.10 Stock Purchase and Shareholders' Agreement dated December 6, 1996 among Registrant and others.# 10.11+ Order Fulfillment Agreement dated as of June 24, 1997 between Registrant and Sound Delivery.# 10.12 Amendment 1998-1 to the CDNow, Inc. 1996 Equity Compensation Plan.# 10.13+ Linking Agreement dated March 26, 1998 between the Registrant and Lycos, Inc.** 11.1 Statement re: Computation of Per Share Earnings.@ 23.1 Consent of Arthur Andersen LLP.* 23.2 Consent of Morgan, Lewis & Bockius LLP (included in its opinion filed as Exhibit 5.1 hereto).* 24.1 Power of Attorney (included on signature page to this Registration Statement).@ 27.1 Financial Data Schedule.* - --------------------- *Filed herewith. **Incorporated by reference to Exhibit 10.13 to the Registrant's Form 10-Q/A for the three months ended March 31, 1998 filed with the Commission on June 4, 1998. #Incorporated by reference to the Registrant's Registration Statement on Form S-1 (File No. 333-41241). @Previously filed. +Portions of this Exhibit were omitted and filed separately with the Secretary of the Commission pursuant to an application for confidential treatment filed with the Commission pursuant to Rule 406 under the Securities Act. II-3 ITEM 17. UNDERTAKINGS. (i) The undersigned Registrant hereby undertakes to provide to the Underwriters at the closing specified in the Underwriting Agreement certificates in such denominations and registered in such names as required by the Underwriters to permit prompt delivery to each purchaser. (ii) Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers and controlling persons of the Registrant pursuant to the foregoing provisions, or otherwise, the Registrant has been advised that in the opinion of the Commission such indemnification is against public policy as expressed in the Securities Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer or controlling person of the Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act and will be governed by the final adjudication of such issue. (iii) The undersigned Registrant hereby undertakes that: (1) For purposes of determining any liability under the Securities Act, the information omitted from the form of prospectus filed as part of this Registration Statement in reliance upon Rule 430A and contained in a form of prospectus filed by the Registrant pursuant to Rule 424(b)(1) or (4) or 497(h) under the Securities Act shall be deemed to be part of this Registration Statement as of the time it was declared effective. (2) For the purpose of determining any liability under the Securities Act, each post-effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. II-4 SIGNATURES PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1933, AS AMENDED, THE REGISTRANT HAS DULY CAUSED THIS REGISTRATION STATEMENT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, IN JENKINTOWN, PENNSYLVANIA ON JULY 24, 1998. CDnow, Inc. /s/ Jason Olim By: _________________________________ JASON OLIM, PRESIDENT, CHIEF EXECUTIVE OFFICER AND CHAIRMAN OF THE BOARD PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1933, AS AMENDED, THIS REGISTRATION STATEMENT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS IN THE CAPACITIES AND ON THE DATES NAME CAPACITY DATE /s/ Jason Olim President, Chief - ------------------------------------- Executive Officer July 24, 1998 JASON OLIM and Chairman of the Board (principal executive officer) /s/ Joel Sussman Vice President and - ------------------------------------- Chief Financial July 24, 1998 JOEL SUSSMAN Officer (principal financial and accounting officer) * Director - ------------------------------------- July 24, 1998 MATTHEW OLIM * Director - ------------------------------------- July 24, 1998 ALAN MELTZER * Director - ------------------------------------- July 24, 1998 PATRICK KERINS * Director - ------------------------------------- July 24, 1998 JOHN REGAN /s/ Joel Sussman *By:_________________________________ JOEL SUSSMAN, Attorney-in-Fact II-5 EXHIBIT INDEX EXHIBIT NUMBER DESCRIPTION ------- ----------- 1.1 Form of Underwriting Agreement.* 3.1 Amended and Restated Articles of Incorporation of the Company.# 3.2 Amended and Restated Bylaws of the Registrant.# 3.3 Amendment No. 1 to Amended and Restated Bylaws of the Registrant# 5.1 Opinion of Morgan, Lewis & Bockius LLP regarding legality of the shares of Common Stock being registered.* 10.1 Stock Purchase Agreement dated as of July 15, 1997 by the Registrant and certain shareholders of the Registrant.# 10.2 Amendment No. 1 to Stock Purchase Agreement dated as of August 5, 1997 by the Registrant and certain shareholders of the Registrant.# 10.3 Investors' Rights Agreement dated as of July 15, 1997 by the Registrant and certain shareholders of the Registrant.# 10.4 CDnow, Inc. 1996 Equity Compensation Plan.# 10.5 Amendment 1997-1 to the CDnow, Inc. 1996 Equity Compensation Plan.# 10.6 Warrant dated August 5, 1997 issued by the Registrant to Alex. Brown & Sons Incorporated.# 10.7 Warrant dated August 5, 1997 issued by the Registrant to Grotech Capital Group IV, L.L.P.# 10.8+ Linking Agreement dated September 30, 1997 by and between the Registrant and Excite, Inc.# 10.9+ Advertising and Promotion Agreement dated as of August 21, 1997 by and between the Registrant and Yahoo! Inc.# 10.10 Stock Purchase and Shareholders' Agreement dated December 6, 1996 among Registrant and others.# 10.11+ Order Fulfillment Agreement dated as of June 24, 1997 between Registrant and Sound Delivery.# 10.12 Amendment 1998-1 to the CDnow, Inc. 1996 Equity Compensation Plan.# 10.13+ Linking Agreement dated March 26, 1998 between the Registrant and Lycos, Inc.** 11.1 Statement re: Computation of Per Share Earnings.@ 23.1 Consent of Arthur Andersen LLP.* 23.2 Consent of Morgan, Lewis & Bockius LLP (included in its opinion filed as Exhibit 5.1 hereto).* 24.1 Power of Attorney (included on the signature page to this Registration Statement).@ 27.1 Financial Data Schedule.* - --------------------- * Filed herewith. **Incorporated by reference to Exhibit 10.13 to the Registrant's Form 10-Q/A for the three months ended March 31, 1998 filed with the Commission on June 4, 1998. # Incorporated by reference to the Registrant's Registration Statement on Form S-1 (File No. 333-41241). @ Previously filed. + Portions of this Exhibit were omitted and filed separately with the Secretary of the Commission pursuant to an application for confidential treatment filed with the Commission pursuant to Rule 406 under the Securities Act.