Item 1 of this report, the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of this report and similar discussions in our other filings with the Securities and Exchange Commission (“SEC”) discuss some of the important risk factors that may affect our business, results of operations and financial condition. You should carefully consider those risks in addition to the other information in this report and in our other filings with the SEC before deciding to invest in our company or to maintain or increase your investment. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.
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PART I
ITEM 1. BUSINESS
OVERVIEW
We are a music entertainment company that combines an online music network and a record label business to provide an integrated offering for music fans, artists and marketing partners. The ARTISTdirect Network (www.artistdirect.com) is a network of Web sites offering multi-media content, music news and information, community around shared music interests, advertising sponsorships, music-related specialty commerce and digital music services. Through our co-venture record label, ARTISTdirect Records, we develop new musical artists and produce and distribute their recordings as an independent label utilizing traditional channels of distribution.
The ARTISTdirect Network consists of our music search engine and database containing information on more than 100,000 artists, retail e-commerce offering a wide selection of artist merchandise and music, our proprietary music guide that enables users to browse music by artist, genre or time period, a music-oriented online community and the ability for users to download and listen to music and view music videos.
• The Ultimate Band List (“UBL”) - a comprehensive online music search engine and resource for music information. The UBL provides information on more than 100,000 artists across numerous musical genres, featuring news, concert information, artist biographies, album reviews, contests, promotions, music samples and downloads. The UBL also offers links to numerous other Web sites in the online music community;
• Community - a music-oriented online community providing message boards relating to specific artists and general music topics. The Community area allows fans to communicate with others around the world to share interests and commentary about their favorite music and artists;
• The ARTISTdirect Shopping area - a retail site offering a wide selection of music titles and artist and lifestyle merchandise;
• Downloads - a feature that enables users to download and listen to music from a variety of artists. In addition, users can view a variety of current music videos featuring popular and emerging artists.
• Music Guide - a feature that allows users to navigate a large catalog of music by artist, genre or time period (e.g. 60’s Rock), facilitating both quick access to music known to the user and the discovery of music that may be new to the user. The music guide is designed to function with either short music clips or with full song files at such time as we are able to enter into music licensing agreements on terms acceptable to us;
Our two record labels have significantly reduced their operations in 2003. iMusic, a record label formed through our wholly-owned subsidiary, ARTISTdirect Digital, LLC, sold most of its rights regarding unreleased artists to a third party. There is no plan to add additional artists or release additional albums through this record label in the future.
Our other record label, ARTISTdirect Records, LLC, was formed as a co-venture between our wholly owned subsidiary, ARTISTdirect Recordings, Inc., and Radar Records Holdings, LLC, an entity wholly owned by our Chairman, Frederick W. (Ted) Field. Mr. Field also serves as the Chief Executive Officer of ARTISTdirect Records. During 2003, we have significantly downsized the ARTISTdirect Records operation and currently have no full-time employees. We are seeking additional financing to restructure the ARTISTdirect Records business, and will keep its operations minimal until such capital is obtained, if ever.
RECENT EVENTS
We underwent significant changes during the fiscal year ended December 31, 2003 as described below:
Nasdaq Delisting
In May 2003, our common stock was delisted from Nasdaq because we no longer complied with the stockholder’s equity, market capitalization and certain other requirements for continued listing on The Nasdaq National Market or for
moving our listing to The Nasdaq Small Cap Market. Our common stock now trades on the Over-The-Counter Bulletin Board under the symbol ARTD.
Changes in Accountant
In February 2004, we announced that we terminated KPMG LLP as our independent accountant and retained Gumbiner, Savett, Finkel, Fingleson & Rose, Inc. to act as our new independent accountant.
New Management
Since December 31, 2002, our management has undergone significant changes. In September 2003, Mr. Ted Field resigned as our Chief Executive Officer and serves solely as our Chairman. We appointed Mr. Jonathan Diamond as Chief Executive Officer that same month. On May 31, 2003, Mr. Marc Geiger resigned as our Vice-Chairman and President, Artist Services, and now serves solely as our director. In June 2003, Mr. James Carroll resigned as our Chief Financial Officer and he was replaced by Mr. Thomas Fuelling. In January 2004, we appointed Mr. Robert Weingarten as our Chief Financial Officer after Mr. Fuelling resigned in November 2003. On December 31, 2003, Mr. Keith Yokomoto stepped down as our Chief Operating Officer and now acts solely as a director.
Record Label Downsizing and Restructuring
iMUSIC
During 2002, our wholly owned subsidiary ARTISTdirect Digital, Inc. began operating a record label under the brand name iMusic. We transferred most of our rights and obligations regarding unreleased artists to a third party. In 2003, we executed an agreement with GC Music in which we assigned our rights and obligations to six unreleased artists in exchange for a profits interest in any projects GC Music had with such artists. We retained the distribution right to the albums previously released under the original terms of our distribution agreements with our other signed artists. We do not plan to sign any additional artists through our iMusic label or release any additional albums domestically or internationally and expect very minimal sales activity in the future, if at all.
ARTISTdirect RECORDS
In May 2001, we entered into an agreement with veteran entertainment executive Frederick W. (Ted) Field to become our Chairman and Chief Executive Officer and form a new record label in partnership with us. On June 29, 2001, our stockholders approved the employment of Mr. Field and the formation of the record label, ARTISTdirect Records, LLC, as a 50/50 co-venture between ARTISTdirect and Mr. Field where we agreed to provide a significant financial commitment. Through our co-venture record label, we develop new musical artists and produce and distribute their recordings as an independent label utilizing both traditional channels and emerging internet distribution channels. In addition to the formation of the record label and our financial commitment, we entered into a five-year employment agreement with Mr. Field to serve as Chairman and Chief Executive Officer. Mr. Field also serves as the Chief Executive Officer of ARTISTdirect Records.
We initially committed to fund a total of $50 million to ARTISTdirect Records over five years at the rate of $15.0 million per year, subject to a limit of $33 million in any three year period. Any funding in excess of these amounts required the approval of our Board of Directors. We have funded a total of $33.0 million through December 31, 2003.
In November 2001, ARTISTdirect Records agreed in principle to enter into a preliminary North America distribution agreement and worldwide license agreement with BMG Music, a wholly-owned partnership of Bertelsmann Music Group, Inc., the global music division of Bertelsmann AG (“BMG”). Under the terms of the agreement, BMG agreed to distribute the label’s releases in North America, and BMG licensed ARTISTdirect Records’ repertoire in territories throughout the world. In April 2002, the agreements with BMG were finalized, including BMG’s purchase of 5% of the equity of ARTISTdirect Records from us. As part of this transaction, BMG agreed to advance certain monies against net sales proceeds under the agreements and also assumed $5.0 million of our funding commitment to ARTISTdirect Records. As a result of the BMG equity purchase, our funding commitment was reduced to $45 million. In December 2002, BMG exercised its option to extend the term of the distribution and license agreement until September 2004.
Under the distribution and license agreements, BMG made non-returnable advances to ARTISTdirect Records of $2.5 million in 2001, $2.5 million in 2002 and $5.0 million in 2003 that are recoupable from net sales proceeds from
ARTISTdirect Records’ artist repertoire. The advances are to be recouped on a monthly basis based on a defined calculation. As of December 31, 2002 and 2003, the unrecouped balance related to distribution advances from BMG was $4.1 million and $8.7 million, respectively.
In August 2002, our Board of Directors approved an agreement (the “Accelerated Funding Agreement”) to accelerate up to $10 million of its funding commitment to ARTISTdirect Records. This funding was in addition to the $15 million that we were obligated to advance to ARTISTdirect Records in 2002 as part of the initial $50 million funding commitment. During 2002, we funded our $15 million commitment plus the additional $10 million bridge loan for total advances to the record label of $25.0 million in 2002 and $30.25 million from the inception of the record label through December 31, 2002. The $10 million of accelerated funding was credited toward the satisfaction of our overall funding commitment and funding obligation for 2003, resulting in a remaining funding commitment of $2.75 million for 2003 and $12.0 million for 2004. We advanced the $2.75 million during 2003. Our commitment to fund ARTISTdirect Records is subject to a guaranty for the benefit of BMG. Should we fail to meet our commitment, BMG may choose to enforce the guaranty or provide substitute financing that could result in dilution of our interest in ARTISTdirect Records.
As consideration for entering into the Accelerated Funding Agreement, we received an additional 20% interest in ARTISTdirect Records from Radar Records Holdings, L.L.C. (“RRH”), the entity through which Mr. Field owns his interest in ARTISTdirect Records, which resulted in an increase in our ownership share of ARTISTdirect Records from 45% to 65% and a decrease in Mr. Field’s ownership share from 50% to 30%. The Accelerated Funding Agreement also provides that any dilution from the issuance of equity interests in ARTISTdirect Records that would have been borne solely by us will be borne both by RRH and us pro rata with our then respective ownership interests. Furthermore, the Accelerated Funding Agreement provides for RRH to guarantee a 25% minimum annual compounded return to be realized from our advances and equity interests in ARTISTdirect Records. Due to the uncertainty with respect to the realization of such rate of return, we have not recorded any amounts related to the 25% minimum annual compounded return in our consolidated financial statements.
As of December 31, 2003, ARTISTdirect Records did not have sufficient working capital resources to conduct operations and accordingly had curtailed its operations. During the three months ended September 30, 2003, ARTISTdirect Records significantly reduced its overhead costs and operating activities and laid off the majority of its staff while it continued to restructure its operations and seek additional capital.
We do not have the resources to meet our remaining $12.0 million funding commitment to ARTISTdirect Records for 2004. ARTISTdirect Records requires additional capital in order to continue operations, and therefore we are continuing to pursue alternatives to raise additional capital for both ourselves and for ARTISTdirect Records. However, there can be no assurances that additional capital can be obtained by either our company or by ARTISTdirect Records on reasonable terms or at all. If additional funds are raised through the issuance of equity securities of either our company or ARTISTdirect Records, the percentage ownership of our current stockholders in our company and/or our company’s ownership of ARTISTdirect Records would be reduced. Failure to raise additional capital could seriously harm the business of ARTISTdirect Records. In such event, ARTISTdirect Records may seek to divest all or certain of its assets or we may seek to divest all or a part of its ownership of ARTISTdirect Records, in order to raise the capital necessary to sustain business operations of our company and/or ARTISTdirect Records.
As of December 31, 2003, ARTISTdirect Records had received $898,000 of loans from Ted Field and $1,150,000 of loans from outside investors (including $100,000 from Jonathan V. Diamond, our new President and Chief Executive Officer). The total loans of $2.048 million during 2003 were obtained through the issuance of convertible promissory notes (the “Bridge Notes”). The Bridge Notes accrue interest at 8% per annum, are due two years from the date of issuance, and will be converted into new equity of ARTISTdirect Records as part of its next equity financing.
The holders of the Bridge Notes also received warrants with a term of five years to purchase additional equity of ARTISTdirect Records at $0.01 per unit equivalent to the number of units of new equity into which their Bridge Notes are ultimately converted.
During the three months ended March 31, 2004, Mr. Field advanced an additional $1.89 million to ARTISTdirect Records to fund operating expenses and the settlement of artist contracts. In consideration for such advances, Mr. Field received Bridge Notes and warrants.
ARTISTdirect Network Downsizing
In 2003, because of declining revenue and in response to our liquidity problems, we reduced our staff handling the ARTISTdirect Network from eight persons to three persons.
Termination of Office Lease
In 2003, we reached an agreement to terminate of our lease for 64,000 square feet of office space with a term through April 2010. In conjunction with the termination, the landlord drew down the entire remaining $1.35 million letter of credit that we had provided as a security deposit. We also issued to the landlord warrants to purchase 200,000 shares of the Company’s common stock exercisable at $0.50 per share through September 8, 2008.
ARTISTdirect BUSINESS SEGMENTS
During the year ended December 31, 2003, the Company operated primarily through three reportable segments: Media Operations (“Media”), E-commerce operations (“E-commerce”), and Record Label operations (“Record Label”) through its iMusic record label.
Media. The ARTISTdirect Network is comprised of our Media and E-commerce operations. Our Media operations include our content-oriented web sites and our entertainment marketing initiatives. Revenue from Media operations is generated from the sale of online and offline advertising and integrated marketing solutions. We market and sell advertising on a cost-per-impression (CPM) basis to advertising agencies and to marketing personnel of various companies. Customers may purchase advertising space for the entire web site, or it may tailor advertising based on music genre (e.g., jazz, country, rock music) or based on functionality (e.g., directing advertising to customers using music download features or broadband-only features of the ARTISTdirect Network). Since we are increasingly aware of websites outside the ARTISTdirect Network that are frequently visited by artists and music fans, we have also offered our customers advertising space on behalf of third party websites.
E-Commerce. E-commerce operations includes sale of recorded music and music-related merchandise. Most of our sales comes from our ARTISTdirect Shopping area which offers a comprehensive selection of music CDs and broad range of artist and lifestyle merchandise.
Record Labels.
We began operating our iMusic record label in 2002. Operations consist primarily of the sale of compact discs by artists signed to the iMusic record label. iMusic’s concept was to focus on the signing of established artists with a proven sales base and an ability to generally make records less expensively than developing artists. In addition, we expected that substantially less would be spent on marketing and promotion of these releases than on those of new artists. In the second quarter of 2003, our management decided to scale back the activity of our iMusic label in order to conserve capital. In the third quarter of 2003, we entered into an agreement with GC Music, a company in which Marc P. Geiger, a director of the Company, is a partner, pursuant to which we assigned our rights and obligations to six unreleased artists in exchange for $100,000 and a profit interest in the projects. We retain the distribution rights to the albums previously released under the original terms of its distribution agreements with its other signed artists. We do not plan to sign any additional artists or release any additional albums domestically or internationally under the iMusic label and expects very minimal sales activity in the future.
In addition, we have significantly reduced operations of ARTISTdirect Records until additional financing is obtained. As of December 31, 2003, ARTISTdirect Records had signed recording agreements with six artists and had no full-time employees.
INFRASTRUCTURE AND OPERATIONS
TECHNOLOGY
Our infrastructure is designed to be integrated, scalable, reliable and secure. The software that we use supports the acquisition, management and publication of content on our Web sites. During 2003, the management of our Web sites and servers for content, applications, database and electronic commerce was handled internally. Our servers are maintained at IX2 Networks, LLC, a co-location facility in Los Angeles, California. Our operations depend on our and IX2’s ability to protect our systems against fire, power loss, telecommunications failure, break-ins and other events. All Web sites,
servers, and systems are monitored and periodic backups are stored at our downtown data center.
Our current e-commerce system is based on SAP software with certain enhancements provided to us by Pandesic, LLC, a joint venture between Intel and SAP that wound up operations in January 2001. Upon Pandesic’s cessation of operations, we received the source code and executables for the e-commerce system that had been provided previously by Pandesic, implemented SAP’s software in house under a two-year license from SAP. In December 2002, our two-year license expired and we entered into a perpetual license agreement with SAP.
ORDER PROCESSING AND FULFILLMENT
Our Web sites include an ordering system that is designed to facilitate convenient online purchasing of pre-recorded music and merchandise. Customers can add items to their “shopping cart” while surfing our Web sites. At any time they can securely “checkout”, at which time they need to register (if they are new customers), or enter a username and password to retrieve previously saved billing, shipping and credit card information. We verify orders submitted for credit card payment for fraud detection and sufficient funds before we release them for fulfillment. We also accept alternative modes of payment, such as checks and money orders. Credit card numbers are encrypted, and all customer, commerce and transactional data are stored in secure databases protected by firewalls. The transmission of information over the Internet uses Secure Socket Layer security technology verified by VeriSign.
Alliance Entertainment. In August 1998, we entered into a five-year agreement with Alliance Entertainment Corp. to be our primary supplier of music and music-related information for our ARTISTdirect Superstore. This agreement is now month-to-month. Alliance owns the All Music Guide, a comprehensive source of artist and album information that is supplied to our users primarily through its integration into the UBL. Alliance fulfills compact discs ordered by our customers and we pay Alliance the wholesale cost plus a fulfillment fee. In addition, Alliance provides warehouse space and fulfillment services pursuant to an oral agreement that Alliance may terminate at any time for a majority of the music-related merchandise that we offer which allows the consolidated shipping of customer orders for both music and merchandise. We have integrated our order processing system with Alliance’s information systems to assist in fulfillment tracking, inventory management and customer service. We purchase almost all of the music titles available for sale on our Web sites from inventory held by Alliance.
Benn Co. (formerly Old Glory). In November 2001, we entered into a six-month agreement with Old Glory Boutique Distributing Inc. (“Old Glory”) to be a wholesale supplier of music-related merchandise and provide fulfillment services for the products for which it sells to us. The agreement was renewed for a one-year period in May 2002 and automatically renewed for an additional year in May 2003. In December 2002, this agreement was assigned from Old Glory to Benn Co., LLC. This agreement is now month-to-month.
If we are unable to continue our agreements with these suppliers, or if Alliance ceases to provide fulfillment services for merchandise, our business could be adversely affected.
CUSTOMER SERVICE
In June 2001, we entered into a two-year agreement with AEC One-Stop Group, Inc. (“Alliance Entertainment”) to provide customer support services for our Web sites’ consumers and respond to customer inquiries, orders and other requests made by phone, fax, e-mail and regular mail. Prior to entering into the agreement with Alliance, we provided customer service with an internal staff of customer service representatives. This agreement is now month-to-month.
SALES AND MARKETING
ADVERTISING SALES
We sell advertising and sponsorships to advertisers seeking to reach one or more of the distinct demographic audiences viewing content in the ARTISTdirect Network. Advertisers may choose single elements such as targeted or run-of-network banners or sponsorship of fixed placement on our Web sites. Pricing is negotiated based upon the size of the target audience, the duration and intensity of the campaign and the size and placement of the advertisement. For the years ended December 31, 2003 and 2002, advertising represented 20% and 15%, respectively, of our revenue. AT&T Wireless accounted for 47% and 14% of our advertising revenues for the year ended December 31, 2003 and 2002, respectively.
MARKETING AND PROMOTION
We use a number of methods to create awareness of the ARTISTdirect Network and drive traffic to our Web sites. We have focused much of our marketing activity on e-mail direct marketing to communicate with registered users of specific artists and the ARTISTdirect Network. Campaigns have included direct notification of special merchandise offers, contests, promotions and music downloads.
COMPETITION
The market for the online promotion and distribution of music and music-related products and services is relatively new, highly competitive and rapidly changing. There are a large number of Web sites competing for the attention and spending of consumers and advertisers, and we expect that number to increase, because there are few barriers to entry to Internet commerce. In addition, the competition for advertising revenue, both on Web sites and in more traditional media, is intense. We compete as follows:
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for music consumers and advertisers with providers of music information, community and content such as MTV, America Online, MSN, Yahoo!, Listen.com and various other companies;
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with major online music retailers such as Amazon.com and CDnow in selling music and merchandise;
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for music consumers and artist relationships with traditional music industry companies, including BMG Entertainment, a unit of Bertelsmann AG, EMI Music, a unit of EMI Group, Sony Music Entertainment, a unit of Sony Corporation, Warner Music Group, and Universal Music Group, a unit of Vivendi. Some of these companies have recently established online presences to promote and distribute the music and tours of their respective artists;
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for music consumers and advertisers with publishers and distributors of traditional media, such as television, radio and print, including MTV, CMT, Rolling Stone and Spin and their Internet affiliates; and
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with traditional retailers targeting music consumers, including Tower Records and Virgin Megastore and their Internet affiliates, in selling music and merchandise.
Our competitors have worked together to offer music over the Internet, and we may face increased competitive pressures as a result. For instance, RealNetworks, Time Warner, Bertelsmann AG and EMI Group formed MusicNet, a digital music subscription platform featuring on-demand downloads and streaming. Sony Connect and various retailers such as BestBuy have cooperated to distribute music through the iTunes platform.
We believe that we are able to compete primarily on the bases of:
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the breadth and quality of our search, database and the community features of our site;
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the variety, availability and price of music-related merchandise on our sites; and
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the ease of use and consumer acceptance of the ARTISTdirect Network.
Competition is likely to increase significantly as new companies enter the market and current competitors expand their services. Many of our current and potential competitors in the Internet and music entertainment businesses may have substantial competitive advantages over us, including:
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longer operating histories;
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significantly greater financial, technical and marketing resources;
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greater brand name recognition;
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larger existing customer bases; and
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more popular content or artists.
These competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements and to devote greater resources to the development, promotion and sale of their products or services than we can. Web sites maintained by our existing and potential competitors may be perceived by consumers, artists, talent management companies and other music-related vendors or advertisers as being superior to ours. In addition, we may not be able to maintain or increase our Web site traffic levels, purchase inquiries and number of click-throughs on our online advertisements. Further, our competitors may experience greater growth in these areas than we do. Increased competition could result in advertising price reduction, reduced margins or loss of market share, any of which could harm our business.
GOVERNMENTAL REGULATION
The laws and regulations that govern our business change rapidly. Although our operations are currently based in California, the United States government and the governments of other states and foreign countries have attempted to regulate activities on the Internet. The following are some of the evolving areas of law that are relevant to our business:
CONTENT REGULATION
Federal, state and foreign governments have adopted and proposed laws governing the content of material transmitted over the Internet. These include laws relating to obscenity, indecency, libel and defamation. For example, the Child Online Protection Act, or COPA, prohibits and imposes criminal penalties and civil liability on anyone communicating material harmful to minors through the Internet for commercial purposes, unless access to such material is blocked to minors under age 17. The Third U.S. Circuit Court of Appeals has upheld a preliminary injunction precluding enforcement of COPA. In November 2001, the U.S. Supreme Court heard an appeal but no decision has been issued yet. We could be liable if the injunction against COPA is lifted and if content delivered by us or placed on our Web sites violates COPA. On March 6, 2003, the Third U.S. Circuit Court of Appeals issued a ruling that COPA restricts free speech because it is not narrowly focused is enough to only target pornography, and is therefore unconstitutional. The Department of Justice could appeal this ruling to the U.S. Supreme Court.
PRIVACY LAW
The state of privacy law is unsettled, and rapidly changing. Current and proposed federal, state and foreign privacy regulations and other laws restricting the collection, use and disclosure of personal information could limit our ability to use the information in our databases to generate revenues. In late 1998, the Children’s Online Privacy Protection Act, or COPPA, was enacted, mandating that measures be taken to safeguard minors under the age of 13. The FTC promulgated regulations implementing COPPA on October 21, 1999, which became effective on April 21, 2000. The principal COPPA requirement is that individually identifiable information about minors under the age of 13 not be collected, used or displayed without first obtaining informed parental consent that is verifiable in light of present technology. The FTC final regulations create a “sliding scale” of permissible methods for obtaining such consent. Consent for internal use of the individually identifiable information of children under the age of 13 can be obtained through e-mail plus an additional safeguard, such as confirming consent with a delayed e-mail, telephone call, or letter. Obtaining verifiable consent from a child’s parent to share that child’s information with a third party or enable the child to publicly distribute the information by, for example, allowing unrestricted access to a chat room or message board is significantly more burdensome. While the temporary “sliding scale implementation was due to expire on April 21, 2002, on October 31, 2001, the FTC extended the implementation period through April 21, 2005.
The FTC has required that parental consent for such higher risk activities be verified by more secure methods than e-mail, such as a credit card in connection with a transaction, print-and-sign forms, toll-free numbers staffed by trained operators, or digital signatures. Complying with the new requirements is costly and will likely dissuade some of our customers. While we are attempting to be fully compliant with the FTC requirements, our efforts may not be entirely successful. In addition, at times we rely upon outside vendors to maintain data-collection software, and there can be no assurance that they will at all times comply with our instructions to comply with COPPA. If our methods of complying with COPPA are inadequate, we may face litigation with the FTC or individuals, which would adversely affect our business.
Moreover, we have posted a Private Policy pertaining to all users and visitors to our Web site. By doing so, we have subjected ourselves to the jurisdiction of the FTC. Should any of our business practices be found to differ from our Private Policy, we could be subject to sanctions and penalties from the FTC. It is also possible that users or visitors could try to recover damages in a civil action as well.
LAWS GOVERNING SENDING OF UNSOLICITED COMMERCIAL E-MAIL
We typically provide our customers and other visitors to our Web sites with an opportunity to “opt-in,” or agree to receive e-mailings from us. The federal government recently signed the Controlling the Assault of Non-Solicited Pornography and Marketing Act of 2003 (CAN-SPAM) designed to limit unsolicited commercial e-mail commonly referred to as “spam.” In addition, California and a number of other states regulate the sending of e-mails for commercial purposes to third parties where there is no preexisting business relationship. Further, several states give Internet service providers (“ISPs”) a private right of action against those who send large e-mailings across their servers in contravention of the ISP’s posted policy. There is no guarantee that we will always be fully compliant in all of our communications at all times. Our failure to comply with applicable laws regarding these types of e-mails could result in significant fines, actual or statutory damages, and injunctive actions.
CONFORMANCE TO E-COMMERCE STATUTORY REQUIREMENTS FOR FORMATION OF CONTRACTS
We conduct e-commerce on our Web sites, and through affiliated Web sites. The applicable law on online formation of contracts has been unsettled and is evolving. On June 30, 2000, the federal government enacted the “E-Sign” statute, which in limited cases permits online formation of contracts. Similarly, on January 1, 2000, California adopted a standard version of the Uniform Electronic Transactions Act (“UETA”), which also permits electronic signatures and record-keeping for certain types of contracts. We attempt to comply with these laws, but there is no guarantee that we will be successful. Judicial interpretation of their application could result in customer contracts being set aside or modified. In that case, our e-commerce revenue could be materially adversely affected.
SALES TAX
The tax treatment of goods sold over the Internet is currently unsettled. We collect sales taxes for goods shipped to California and Florida, where we have a physical presence. A number of proposals have been made at the state and local level that would impose additional taxes on the sale of goods through the Internet. Such proposals, if adopted, could substantially impair the growth of electronic commerce and could adversely affect our opportunity to derive financial benefit from electronic commerce. While the Internet Tax Freedom Act (ITFA) has placed a moratorium on new state and local taxes on Internet commerce, the tax moratorium expired on November 1, 2003 and has not been re-enacted. At least some state legislatures that will convene during early 2004 have indicated that they will move to expand their sales taxes to cover Internet commerce, if the ITFA is not reinstated. Imposing state sales taxes on Internet-based commerce would adversely affect our business.
ONLINE CONTESTS AND SWEEPSTAKES
We conduct online promotional contests and sweepstakes. No purchase is necessary to participate. Our official rules, with all material terms, conditions of eligibility, dates of participation, methods of entry and limitations, if any, along with the odds and prize offerings, are posted on our Web sites. In order to comply with New York and Florida state law, our prizes are limited in value to less than $5,000, or we must comply with those states’ registration and bonding requirements. While we attempt to comply with the law of all fifty state jurisdictions, we may not be uniformly successful, and foreign jurisdictions may attempt to regulate or ban our promotional contests. In that event, we could lose an effective tool for increasing and keeping visitors to our Web site, and our business could be adversely affected.
INTELLECTUAL PROPERTY
OUR PROPRIETARY RIGHTS
Copyrighted material that we develop, as well as our service marks and domain names relating to the ARTISTdirect or UBL brands, and other proprietary rights are important to our business prospects. We seek to protect our common-law trademarks through federal registration, but these actions may be inadequate. Where consultants develop copyrighted content for us, our general policy is to use written agreements prior to content creation to obtain ownership of that content. In addition, we principally rely upon trademark, copyright, trade secret and contract law to protect our proprietary rights. We generally enter into confidentiality agreements, “work-made-for-hire” contracts and intellectual property licenses with our employees, consultants and corporate partners, respectively, as part of our efforts to control access to and distribution of our technologies, content and other proprietary information.
Despite our efforts to protect our proprietary rights from unauthorized use or disclosure, parties may attempt to disclose or use our customer lists, Web site content, service marks, domain names or confidential commercial data. The steps that we have taken may not prevent misappropriation of our proprietary rights, particularly in foreign countries where laws or law enforcement practices may not protect our proprietary rights at all, or as fully as in the United States. If
third parties were to use or otherwise misappropriate our copyrighted materials, trademarks or other proprietary rights without our consent or approval, our competitive position could be harmed, or we could become involved in costly and distracting litigation to enforce our rights.
OUR WEB SITES FEATURE CONTENT THAT IS COPYRIGHTED BY MULTIPLE THIRD-PARTIES
A copyright gives the owner divisible rights, including those of performance, reproduction and distribution. The music featured by us is typically comprised of copyrighted works owned, controlled or administered by multiple third parties, including record labels, artists, songwriters, music publishers and performance rights and licensing organizations such as The Harry Fox Agency, Broadcast Music Inc. and the American Society of Composers, Authors and Publishers. Each song often has multiple copyright owners, who control rights which may include performance, reproduction and distribution rights in the “musical composition” comprised of the lyrics and music, as well as with the “sound recording” of the artist’s interpretation of the “musical composition.” In the case of music videos, there are separate copyrights to the visual content, as well as “synchronization rights” for integrating the music and video. We, or our artists, may have different licensing arrangements with some or all of these parties to perform, reproduce and distribute works depending upon how the song or music video is used by us.
Our Web sites, depending upon the specific musical work, may offer audio streaming of part or all of an entire song or “Web casting,” or the downloading of an entire song in MP3 or other compressed audio formats. Full-length streaming only occurs in special instances after obtaining an oral license from the record label or band manager for the “sound recording.” In that case, an ASCAP or BMI blanket music license is also obtained by us or by our artists for rights to perform the associated underlying “musical composition.” Where we offer full-length downloads of songs in MP3 or other compressed audio formats, we seek to obtain the rights to transmit, reproduce and perform the “sound recording” in writing from the person or entity owning or controlling copyrights in such “sound recording.” With respect to rights in the “musical compositions” embodied in such “sound recordings” offered for download, we seek to clear rights in musical composition in one of the following three ways:
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a license agreement with the publisher, writer or other owner of such copyright in the “musical composition”;
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a waiver of any fees or royalties that would otherwise be required for such use; or
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a representation and warranty from the owner of the copyrights in the “sound recording” that no mechanical royalties are owed to any third parties.
In the event that the foregoing steps are insufficient to clear rights, or we otherwise fail to obtain rights, we could be exposed to claims of copyright infringement, with attendant disruption to our operations and liability including potential statutory or actual damages and loss of profits attributable to infringement, plus payment of attorneys’ fees to the claimant and entry of an injunction.
There are other situations, such as a limited 30-second sample of a song that is “streamed,” where we use content relying upon a sub-license from an artist’s record label. However, the laws in this area are uncertain, and we may be forced to obtain additional licenses or may be prevented from third party content use, and may further be liable to pay actual or statutory damages, profits attributable to any alleged infringement, as well as attorneys’ fees. Our licensing arrangements for third-party content vary from formal contracts to informal agreements based on the promotional nature of the content. In some cases we pay a fee to the licensor for use of the “sound recording,” “musical composition” or music video and in other cases the use is free. We also use other third-party content, including photographs, artist names, likenesses and concert reviews. While it is our general policy to obtain a written release or license for such use, in many instances we rely only upon an oral license for such use. We rely upon our positive working relationships with copyright owners to obtain licenses on favorable terms. Any changes in the nature or terms of these arrangements, including any requirement that we pay significant fees for the use of the content, could have a negative impact on the availability of content or our business.
For example, the Copyright Office recently opined that additional royalties, besides those collected for musical compositions by ASCAP or BMI, are due for Webcasted music that is selected by or on behalf of the recipient pursuant to 17 U.S.C. sec. 114(j)(7). If upheld, that ruling would prevent us from expanding our service to permit users to play a requested song via our Web site without paying additional royalties.
LINKING AND FRAMING OF THIRD-PARTY WEB SITES
We link to and “frame” third-party Web sites of our artists without express written permission to do so. In addition, in the past we have provided a search feature to allow users to find music residing elsewhere on the Internet. Those practices are controversial, and have, in instances not involving us, resulted in litigation. Various claims, including trademark and copyright infringement, unfair competition, and commercial misappropriation, as well as infringement of the right of publicity may be asserted against us as a result of these practices. The law regarding linking and framing remains unsettled; it is uncertain as to how existing laws, especially trademark and copyright law, will be applied by the judiciary to the Internet. Also, Congress is increasingly active in passing new laws related to the Internet, and there is uncertainty as to the impact of future potential laws, especially those involving domain names, databases and privacy.
DEFAMATION OR CONTRIBUTORY INFRINGEMENT
Our Web site features a community area where visitors can post comments We do not censor such comments and it is possible that a customer could use our Web sites as a forum to make false, misleading or disparaging remarks about others. Such on-line comments could lead to claims for defamation or infringement. As to libel claims brought in the United States, we believe that we qualify for safe harbor protection for third-party postings under 47 U.S.C. sec. 230(c)(1). However, other countries, notably the United Kingdom, may impose such liability, and it is possible we could be sued there for third-party postings. Separately, our Web sites allow consumers to use our personal Web publishing tools to post samples of their works. Such postings could be misused to post unlicensed copyrighted content of others. We have obtained limited safe-harbor protection under the recently enacted Digital Millennium Copyright Act against liability for infringing material of which we do not have control and knowledge.
SEASONALITY
The seasonality of our e-commerce segment affects our revenue. Our CDs and other online goods are most often purchased during the holiday season and also during the summer months, traditionally when artists go on tour.
EMPLOYEES
As of March 31, 2004, we had 13 full-time employees and four part-time consultants. None of our employees is represented by a labor union. We have not experienced any work stoppages and consider our employee relations to be good.
RISK FACTORS
Before investing in our company or deciding to maintain or increase your investment, you should carefully consider the risks described below, in addition to the other information contained in this report and in our other filings with the Securities and Exchange Commission. The risks and uncertainties described below are not the only ones facing our company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business operations. If any of these risks actually occur, our business, financial condition or results of operations could be seriously harmed. In that event, the market price for our common stock could decline and you may lose all or part of your investment.
We Face Substantial Doubt About Our Ability to Continue as a Going Concern Without Additional Restructuring and/or Additional Financing
We have incurred losses and negative cash flows from operations in every fiscal period since inception and have an accumulated deficit of $222.7 million as of December 31, 2003. For the year ended December 31, 2003, we incurred a net loss of $21.7 million and negative operating cash flows of $5.4 million. As of December 31, 2003, we had a net working capital deficiency of $9.5 million and a stockholders’ deficiency of $16.9 million.
Additionally, we have been funding substantially all of the operations of ARTISTdirect Records. Our operations to date and loans to ARTISTdirect Records have been funded by the sale of our preferred and common stock. Management expects our operating losses to continue for the foreseeable future. We do not currently anticipate that available cash resources will be sufficient to meet anticipated needs for working capital and capital expenditures over the next twelve months without additional capital.
We are attempting to mitigate our funding obligation and raise additional funding through various means. However, there can be no assurances that we will be successful in this regard. If sufficient funding is not available, then we may not be able to fund our operations or our remaining commitment to provide funding to ARTISTdirect Records. Failure to
raise additional capital could seriously harm the business of ARTISTdirect Records and impair the value of our investment in ARTISTdirect Records. We have reduced our operations and have divested certain of our assets in order to attempt to raise the capital necessary to sustain business operations. To the extent that we are unable to successfully restructure our funding obligation and/or obtain the capital necessary to fund our future cash requirements on a timely basis and under acceptable terms and conditions, we will not have sufficient cash resources to maintain operations, and may consider a formal or informal restructuring or reorganization.
Due to our current financial condition, our auditors have included an explanatory paragraph in their 2003 report on the financial statements of ARTISTdirect, Inc. and ARTISTdirect Records, LLC stating that there is substantial doubt about our ability to continue as a going concern. Our financial statements do not include any adjustments that might result from the outcome of this uncertainty.
It Is Difficult To Evaluate Our Business And Prospects Because We Have A Limited Operating History And Rapidly Evolving Business
Our limited operating history and rapidly evolving business make it difficult to evaluate our prospects or to accurately predict our future revenue or results of operations. Our revenue and income potential are unproven, and our business model is constantly and rapidly evolving. In particular, the Internet is constantly changing and we may need to modify our business model to adapt to these changes.
We Have A History Of Operating Losses And Anticipate Losses And Negative Cash Flow For The Foreseeable Future
To date, we have not been profitable on an annual or quarterly basis and have incurred accumulated losses of approximately $222.7 million as of December 31, 2003. For the years ended December 31, 2003 and 2002, we incurred net losses of approximately $21.7 million and $48.2 million, respectively, which represented approximately 363% and 771%, respectively, of our revenue for those periods. We expect our operating losses and negative cash flow to continue for at least the near future. We will need to generate significant additional revenue to achieve profitability. Consequently, it is possible that we may never achieve profitability, and even if we do achieve profitability, we may not sustain or increase profitability on a quarterly or annual basis in the future. If we do not achieve or sustain profitability in the future, then we will likely be unable to continue our operations.
Global Sales of Recorded Music Have Recently Declined and This Trend May Continue in the Future
Based on data compiled by the International Federation of the Phonographic Industry (IFPI), global sales of recorded music declined 1.3% in value and 1.2% in units from 1999 to 2000, declined 5.0% in value and 6.5% in units from 2000 to 2001, and declined 9.2% in value and 11.2% in units in the first half of 2002 compared with the first half of 2001. The IFPI attributes this decline, in part, to widespread copying and illegal Internet downloading of music. If this trend continues, it may affect our e-commerce business and have a material adverse effect on our revenue.
Our Prior Management Has Committed Substantial Amount Of Our Available Cash To The ARTISTdirect Records Co-Venture With Ted Field And, As A Result, The Amount Of Cash That We Will Have Available To Operate Our Other Businesses Has Been Substantially Reduced
The ARTISTdirect Records co-venture with Mr. Field represented a significant shift in the planned use of our cash resources. As of December 31, 2003, we had provided $33.0 million to ARTISTdirect Records, and are obligated to provide an additional $12.0 million in 2004. As of December 31, 2003, we had unrestricted cash and short-term investments totaling $726,000. Our commitment to fund ARTISTdirect Records is subject to a guaranty for the benefit of BMG. Should we fail to meet our commitment, BMG may choose to enforce the guaranty or provide substitute financing that could result in dilution of our interest in ARTISTdirect Records.
Despite the fact that third party investors and Mr. Field advanced $2.05 million of bridge loans to ARTISTdirect Records in 2003, and an additional $1.89 million during the three months ended March 31, 2004, ARTISTdirect Records will require additional capital in 2004.
We currently anticipate that our available cash resources, including short-term investments, will not be sufficient to meet our anticipated working capital requirements during 2004, including our $12.0 million funding commitment to
ARTISTdirect Records in 2004. We have reduced our operations and have divested certain of our assets in order to attempt to raise the capital necessary to sustain business operations, and we are exploring various alternatives to raise additional capital. There can be no assurance that additional capital can be obtained by either our company or by ARTISTdirect Records on reasonable terms, in a timely manner or at all. Failure to raise additional capital could seriously harm the business of ARTISTdirect Records and impair the value of our investment in ARTISTdirect Records.
If additional funds are raised through the issuance of equity securities of either our company or ARTISTdirect Records, the percentage ownership of current stockholders in our company and/or ARTISTdirect Records will be reduced. If we raise additional funds by issuing debt, we may be subject to limitations on our operations, including limitations on the payment of dividends, and any debt issued by ARTISTdirect Records may be senior to the obligations of ARTISTdirect Records to our company. To the extent that we are unable to successfully restructure our funding commitment and/or obtain the capital necessary to fund our future cash requirements on a timely basis and under acceptable terms and conditions, we will not have sufficient cash resources to maintain operations, and may consider a formal or informal restructuring or reorganization.
See “ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Liquidity and Capital Resources” for more information on our liquidity and capital resources.
Our Equity Interest In ARTISTdirect Records May Be Significantly Diluted If We Are Unable To Meet Our Financing Commitment
In the event that we fail to provide funding to ARTISTdirect Records as required under the terms of the operating agreement governing the co-venture, ARTISTdirect Records then has the right to secure substitute financing. Among other things, any advances made by us that are outstanding at the time will become subordinated to repayment of the substitute financing and we can be forced to divest certain of our equity interest in ARTISTdirect Records should the issuance of an equity interest to the substitute financier be required as a condition of the substitute financing.
If We are Unable To Grow Our Online Advertising Significantly In The Near Future, Our Business May Be Adversely Affected.
If we do not increase advertising revenue, our business will be adversely affected. Increasing our advertising revenue depends upon many factors, including our ability to:
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respond to and anticipate fluctuations in the demand for, and pricing of, online advertising;
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develop and maintain key advertising relationships and compete for advertisers with Internet and traditional media companies;
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conduct successful selling and marketing efforts aimed at advertising agencies and direct marketing departments;
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successfully develop, sell and execute entertainment marketing solutions;
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increase the size of our audience and the amount of time that our audience spends on our Web sites;
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accurately measure the size and demographic characteristics of our audience;
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offer advertisers the means to effectively target their advertisements to our audience; and
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increase the amount of revenue per advertisement.
Our failure to achieve one or more of these objectives could impair our ability to increase advertising revenue, which could adversely affect our business. In addition to the above factors, general economic conditions, as well as economic conditions specific to online advertising, electronic commerce and the music industry, could affect our ability to increase our advertising revenue. In particular, the growth of online advertising has declined since 2000, which has had, and in the future may continue to have, a significant adverse effect on our revenue from online advertising. In the past, we have traditionally relied on a limited number of customers for our advertising revenue. For instance, during the year ended December 31, 2003, AT&T Wireless accounted for 47% of our total media revenue.
We May Not Be Able To Develop Or Obtain Sufficiently Compelling Content To Attract And Retain Our Target Audience
For our business to be successful, we must provide content and services that attract consumers who will purchase music and related merchandise online. We may not be able to provide consumers with an acceptable mix of products, services, information and community to attract them to our Web sites or to encourage them to remain on our Web sites for an extended period of time. If our audience determines that our content does not reflect its tastes, then our audience size could decrease or the demographic characteristics of our audience could change and we may be unable to react to those changes effectively or in a timely manner. Any of these results would adversely affect our ability to attract advertisers and sell music and other related merchandise. Our ability to provide compelling content could be impaired by any of the following:
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reduced access to content controlled by record labels, music publishers and artists;
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diminished technical expertise and creativity of our production staff; and
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inability to anticipate and capitalize on trends in music.
If We Do Not Build And Maintain Strong Brands, We May Not Be Able To Attract A Significant Number Of Users To Our Web Sites
To attract users we must develop a brand identity for ARTISTdirect and increase public awareness of the ARTISTdirect Network; however to conserve cash, we have significantly decreased the amounts we have spent and plan to spend on our offline and online advertising and promotional efforts to increase brand awareness, traffic and revenue. Accordingly, our marketing activities may not result in increased revenue and, even if they do, any increased revenue may not offset the expenses we incur in building our brands. Moreover, despite these efforts we may be unable to increase public awareness of our brands, which would have an adverse effect on our results of operations.
Our Market Is Highly Competitive And We May Not Be Able To Compete Successfully Against Our Current And Future Competitors
The market for the online promotion and distribution of music and related merchandise is highly competitive and rapidly changing. There are a significant number of Web sites promoting and distributing music and related merchandise that compete for the attention and spending of consumers, advertisers and users. We face competitive pressures from numerous actual and potential competitors. Our competitors include America Online, MSN, Yahoo!, Listen.com, Amazon.com, CDnow, MTV, other web sites and traditional music companies.
Competition is likely to increase significantly as new companies enter the market and current competitors expand their services. Some of our competitors have announced agreements to work together to offer music over the Internet, and we may face increased competitive pressures as a result. Many of our current and potential competitors in the Internet and music entertainment businesses may have substantial competitive advantages relative to us, including:
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longer operating histories;
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significantly greater financial, technical and marketing resources;
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greater brand name recognition;
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larger existing customer bases; and
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more popular content or artists.
These competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements and devote greater resources to develop, promote and sell their products or services than we can. Consumers, artists, talent management companies and other music-related vendors or advertisers may perceive Web sites maintained by our existing and potential competitors as being superior to ours. In addition, increased competition could result in reduced advertising rates and margins and loss of market share, any of which could harm our business.
We Depend On A Limited Number Of Suppliers For Music Merchandise, Fulfillment And Distribution and If We Cannot Secure Alternate Suppliers, Our Business May Be Harmed
We rely to a large extent on timely distribution by third parties. During 2003, we relied on two vendors, Alliance Entertainment, and Benn Co. (formerly Old Glory Boutique Distributing, Inc.) to fulfill and distribute our orders for music and related merchandise. During the year ended December 31, 2003, approximately 86% and 14%, respectively, of our total customer orders were fulfilled by Alliance and Benn Co., respectively. We purchase a significant portion of our artist-licensed merchandise from Benn Co. and most all of our compact discs from Alliance Our contracts with Alliance and Benn Co. expired in August 2003 and April 2003, respectively, and we now operate with these vendors on a month-to-month basis. Our business could be significantly disrupted if Alliance or Benn Co. were to terminate or breach their agreements or suffer adverse developments that affect their ability to supply products to us. If, for any reason, Alliance, Benn Co. or other vendors are unable or unwilling to supply products to us in sufficient quantities and in a timely manner, we may not be able to secure alternative suppliers, on acceptable terms, in a timely manner or at all.
We Depend On Third Party Inventory And Financial Systems And Carrier Services
Because we rely on third parties to fulfill orders, we depend on their systems for tracking inventory and financial data. If our distributors’ systems fail or are unable to scale or adapt to changing needs, or if we cannot integrate our information systems with the systems of any new distributors, we may not have adequate, accurate or timely inventory or financial information. We also rely on third-party carriers for shipments to and from distribution facilities. We are therefore subject to the risks, including employee strikes and inclement weather, associated with our carriers’ ability to provide delivery services to meet our distribution and shipping needs. In the past, both Alliance and we have occasionally experienced an unusually high volume of orders, which resulted in shipping delays to our customers. These delays did not have a material adverse effect, however, our failure to deliver products to our customers in a timely and accurate manner in the future could harm our reputation, our relationship with customers, the ARTISTdirect brand and our results of operations.
Our Business Is Subject To Seasonality, Which Could Adversely Affect Our Operating Results
We have experienced and expect to continue to experience seasonal fluctuations in our online sales. These seasonal patterns will cause quarterly fluctuations in our operating results. In particular, a disproportionate amount of our online sales have been realized during the fourth calendar quarter and during the summer months, traditionally when artists go on tour. Due to our limited operating history, it is difficult to predict the seasonal pattern of our online sales and the impact of such seasonality on our business and operating results. Our seasonal online sales patterns may become more pronounced, strain our personnel, warehousing, and order shipment activities and cause our operating results to be significantly less than expected for any given period. This would likely cause our stock price to fall.
We May Be Subject To System Disruptions, Which Could Reduce Our Revenue
Our ability to attract and retain artists, users, advertisers and merchants for our online network depends on the performance, reliability and availability of our Web sites and network infrastructure. Our own staff performs the maintenance and operation of substantially all of our Internet communications hardware and servers. We have periodic maintenance windows, and we experience outages from time to time caused by temporary problems in our own systems or software. While we have implemented procedures to improve the reliability of our systems, these interruptions may continue to occur from time to time. Our users also depend on third party Internet service providers and Web site operators for access to our Web sites. These entities have experienced significant outages in the past, and could experience outages, delays and other difficulties due to system failures in the future which are unrelated to our systems, but which could nonetheless adversely affect our business.
Computer Viruses, Electronic Break-Ins Or Similar Disruptive Events Could Disrupt Our Online Services
Computer viruses, electronic break-ins or similar disruptive events could disrupt our online services. System disruptions could result in the unavailability or slower response times of our Web sites, which would reduce the number of advertisements delivered or commerce conducted on our Web sites and lower the quality of our users’ experience. Service disruptions could adversely affect our revenue and, if they were prolonged, would seriously harm our business and reputation. Our business interruption insurance may not be sufficient to compensate us for losses that may occur as a result of these interruptions.
The Loss Of Key Personnel, Including Ted Field or Jonathan Diamond, Could Adversely Affect Our Business Because These Individuals Are Important To Our Business
Our future success depends to a significant extent on the continued services of our senior management, particularly Ted Field and Jonathan Diamond. The loss of any of these individuals would likely have an adverse effect on our business. Competition for personnel throughout our industry is intense and we may be unable to retain these key employees or attract, integrate or retain other highly qualified employees in the future. We have in the past experienced, and we expect to continue to experience, difficulty in hiring and retaining highly skilled employees with appropriate qualifications. If we do not succeed in attracting new personnel or retaining and motivating our current personnel, our business could be adversely affected. Recent changes in corporate governance and securities laws and regulations, such as the Sarbanes-Oxley Act of 2002, could make it more difficult for us to attract and retain qualified executive officers or qualified members of our Board of Directors, particularly to serve on our audit committee.
If We Are Unable To Protect Our Intellectual Property Rights, Our Competitive Position Could Be Harmed Or We Could Be Required To Incur Expenses To Enforce Our Rights
We rely upon registered trademark rights in the United States for our commercial use of the ARTISTdirect, UBL, Ultimate Band List, and iMusic brand names and their respective associated domain names, and the ARTISTdirect logo. We seek to protect our trademarks, copyrights and other proprietary rights by registration and other means, but these actions may be inadequate. We have trademark applications pending in several jurisdictions, but our registrations may not be accepted or may be preempted by third parties and/or we may not be able to register our trademarks in all jurisdictions in which we intend to do business. We generally enter into confidentiality or license agreements with our employees, consultants and corporate partners, and generally control access to and distribution of our proprietary information. The steps we have taken may not prevent misappropriation of our proprietary rights, particularly in foreign countries where laws or law enforcement practices may not protect our proprietary rights as fully as in the United States. If third parties were to use or otherwise misappropriate our copyrighted materials, trademarks or other proprietary rights without our consent or approval, our competitive position could be harmed, or we could become involved in litigation to enforce our rights. In addition, policing unauthorized use of our content, trademarks and other proprietary rights could be very expensive, difficult or impossible, particularly given the global nature of the Internet.
Our Access To Copyrighted Content Depends Upon The Willingness Of Content Owners To Make Their Content Available
The music content available on the ARTISTdirect Network is typically comprised of copyrighted works owned or controlled by multiple third parties. Most of the content on our artist-specific Web sites is either owned or licensed by the artist. On other parts of the ARTISTdirect Network, depending on the nature of the content and how we use the music content, we typically license such rights from publishers, record labels, performing rights societies or artists. We frequently either do not have written contracts or have short-term contracts with copyright owners, and, accordingly, our access to copyrighted content depends upon the willingness of such parties to continue to make their content available. If the fees for music content increase substantially or if significant music content becomes unavailable, our ability to offer music content could be materially limited. We have not obtained a license for some of the content offered on the ARTISTdirect Network, including links to other music-related sites and thirty-second streamed song samples, because we believe that a license is not required under existing law. However, this area of law remains uncertain and may not be resolved for a number of years. When this area of law is resolved, we may be required to obtain licenses for such content, alter or remove the content from our Web sites and be forced to pay potentially significant financial damages for past conduct.
Intellectual Property Claims Against Us Could Be Costly And Could Result In The Loss Of Significant Rights
Third parties may assert trademark, copyright, patent and other types of infringement or unfair competition claims against us. If we are forced to defend against any such claims, whether they are with or without merit or are determined in our favor, we may face costly litigation, loss of access to, and use of, content, diversion of technical and management personnel, or product shipment delays. As a result of such a dispute, we may have to develop non-infringing technology or enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may be unavailable on terms acceptable to us, or at all. While we have resolved all such disputes in the past, we may not be able to do so in the future. If there is a successful claim of infringement against us and we are unable to develop non-infringing technology or license the infringed or similar technology or content on a timely basis, it could harm our business. In addition, we rely on third parties to provide services enabling our online product sales transactions, including credit card processing, order fulfillment, shipping and customer service. We could become subject to infringement actions by third parties based upon our use of intellectual property provided by our third-party providers. It is also possible that we could become subject to
infringement actions based upon the content licensed from third parties. Any such claims or disputes could subject us to costly litigation and the diversion of our financial resources and technical and management personnel. Further, if our efforts to enforce our intellectual property rights are unsuccessful or if claims by third parties against ARTISTdirect, the UBL and iMusic are successful, we may be required to change our trademarks, alter or remove content, pay financial damages, or alter our business practices. These changes of trademarks, alteration of content, payment of financial damages or alteration of practices may adversely affect our business.
If Our Online Security Measures Fail, We Could Lose Visitors To Our Sites And Could Be Subject To Claims For Damage From Our Users, Content Providers, Advertisers And Merchants
Our relationships with consumers would be adversely affected and we may be subject to claims for damage if the security measures that we use to protect their personal information, especially credit card numbers, are ineffective. We rely on security and authentication technology that we license from third parties to perform real-time credit card authorization and verification with our bank. We cannot predict whether events or developments will result in a compromise or breach of the technology we use to protect a customer’s personal information. Our infrastructure may be vulnerable to unauthorized access, physical or electronic computer break-ins, computer viruses and other disruptive problems. Internet service providers have experienced, and may continue to experience, interruptions in service as a result of the accidental or intentional actions of Internet users, current and former employees and others. Anyone who is able to circumvent our security measures could misappropriate proprietary information or cause interruptions in our operations. Security breaches relating to our activities or the activities of third-party contractors that involve the storage and transmission of proprietary information could damage our reputation and our relationships with our content providers, advertisers and merchants. We also could be liable to our content providers, advertisers and merchants for the damages caused by such breaches or we could incur substantial costs as a result of defending claims for those damages. We may need to expend significant capital and other resources to protect against such security breaches or to address problems caused by such breaches. Our security measures may not prevent disruptions or security breaches.
We May Be Subject To Liability If Private Information Provided By Our Users Were Misused
Our privacy policy discloses how we use individually identifiable information that we collect. This policy is displayed and accessible throughout the ARTISTdirect Network. Despite this policy, however, if third persons were able to penetrate our network security or otherwise misappropriate our users’ personal information or credit card information, we could be subject to liability. We could also be subject to liability for claims for unauthorized purchases with credit card information, impersonation or other similar fraud claims, or other misuses of personal information, such as for unauthorized marketing purposes. These claims could result in costly and time-consuming litigation.
Laws Or Regulations May Adversely Affect Our Ability To Collect Demographic And Personal Information From Users, Or To Display Certain Content On Our Sites, And Could Affect Our Ability To Attract Advertisers
Legislatures and government agencies have adopted and are considering adopting additional laws and regulations regarding the collection, use and disclosure of personal information obtained from individuals when accessing Web sites. For example, the Children’s Online Privacy Protection Act restricts the ability of Internet companies to collect information from children under the age of 13 without their parents’ consent. In addition, the Federal Trade Commission and state and local authorities have been investigating Internet companies regarding their use of personal information. Our privacy programs may not conform with laws or regulations that are adopted. In addition, these legislative and regulatory initiatives may adversely affect our ability to collect demographic and personal information from users, which could have an adverse effect on our ability to provide advertisers with demographic information. These initiatives may also affect our ability to conduct electronic commerce.
The European Union has adopted a directive that imposes restrictions on the collection and use of personal data. The directive imposes restrictions that are more stringent than current Internet privacy standards in the United States. If this directive were enforced against us, it could prevent us from collecting data from users in European Union member countries or subject us to liability for use of information in contravention of the directive. Other countries have adopted or may adopt similar legislation. We could incur additional expenses if new regulations regarding the use of personal information are introduced or if government authorities choose to investigate our privacy practices.
In addition, legislatures and government agencies have adopted and are considering adopting additional laws and regulations governing the content of material transmitted over the Internet. These include laws relating to obscenity, indecency, libel and defamation. For example, the Child Online Protection Act, or COPA, prohibits and imposes criminal penalties and civil liability on anyone communicating material harmful to minors through the Internet for commercial
purposes, unless access to such material is blocked to minors under age 17. The U.S. Supreme Court has maintained a preliminary injunction precluding enforcement of COPA, pending the decision on questions of COPA’s constitutionality that the U.S. Supreme Court remanded to the Third U.S. Circuit Court of Appeals. We could be liable if the injunction against COPA is lifted and if content delivered by us or placed on our Web sites violates COPA. Such a result may adversely affect our ability to attract users under age 17 and, consequently, may adversely affect our ability to attract advertisers.
We May Continue To Have Contingent Liability Due To Our Issuances Of Certain Unregistered Securities
Prior to our initial public offering, we issued a number of shares and options to purchase shares of our common stock to our employees and to artists and their managers and advisors. Due to the nature of the persons who received these shares and options in addition to our employees and the total number of shares and options issued to them and our employees, the issuance of some of these shares and options did not comply with the requirements of Rule 701 under the Securities Act of 1933, as amended (the “Securities Act”), or any other available exemptions from the registration requirements of Section 5 of the Securities Act, and may not have qualified for any exemption from qualification or registration under applicable state securities laws either.
As a result, in November 2001,we made a rescission offer to all these persons pursuant to a registration statement filed under the Securities Act and pursuant to applicable state securities law. In the rescission offer, we offered to repurchase from these persons all shares purchased by them pursuant to option exercises before the expiration of the rescission offer for an amount equal to the purchase or exercise price paid for these purchased shares, plus interest from the date of purchase until the expiration of the rescission offer, at the current statutory rate per year mandated by the state in which the shares were purchased, or at 7% per year if a “private placement” exemption was available in a particular state or if the shares were otherwise issued in compliance with state law (less any amounts received by those persons who had already sold their shares). We also offered to repurchase all unexercised options granted to these persons at 20% of the option exercise price times the number of option shares, plus interest from the date the options were granted until the rescission offer expires, at the current statutory rate per year mandated by the state in which the options were granted, or at 7% per year if a “private placement” exemption was available in a particular state or if the options were otherwise granted in compliance with state law. The rescission offer was completed in December 2001, resulting in 83,403 shares and 636,740 options being tendered in the rescission offer at a cost to us to repurchase such shares and options of approximately $10.2 million.
The Securities Act does not expressly provide that a rescission offer will terminate a purchaser’s right to rescind a sale of stock that was not registered under the Securities Act as required. Accordingly, we may continue to be contingently liable under the Securities Act to any offerees that rejected the rescission offer. In addition, it is possible that offerees may claim that the consideration offered to them in the rescission offer was insufficient, in which case we may have additional liability.
We May Be Sued For Content Available Or Posted On Our Website Or Products Through Our Web Sites Or For Linking And Framing Of Third-Party Web Sites
We may be liable to third parties for content published on our Web sites and other Web sites where our syndicated content appears if the music, artwork, text or other content available violates their copyright, trademark or other intellectual property rights or if the available content is defamatory, obscene or pornographic. Similar claims have been brought, sometimes successfully, against Web site operators in the past. We also may be liable for content uploaded or posted by our users on our Web sites, such as digitally distributed music files, postings on our message boards, chat room discussions and copyrightable works. In addition, we could have liability to some of our content licensors for claims made against them for content available on our Web sites. We also could be exposed to these types of claims for content that may be accessed from our Web sites or via links to other Web sites or for products sold through our Web site. While we have resolved all of these types of claims made against us in the past, we may not be able to do so in the future. We intend to implement measures to reduce exposure to these types of claims, but such measures may not be successful and may require us to expend significant resources. Any litigation as a result of defending these types of claims could result in substantial costs and damages. Our insurance may not adequately protect us against these types of claims or the costs of their defense or payment of damages. We link to and “frame” third-party Web sites of our artists without express written permission to do so. In addition, in the past we have provided a search feature to allow users to find music residing elsewhere on the Internet. Those practices are controversial, and have, in instances not involving us, resulted in litigation. Various claims, including trademark and copyright infringement, unfair competition, and commercial misappropriation, as well as infringement of the right of publicity may be asserted against us as a result. The law regarding linking and framing remains unsettled; it is uncertain as to how existing laws, especially trademark and copyright law, will be applied by the
judiciary to the Internet. Also, Congress is increasingly active in passing new laws related to the Internet, and there is uncertainty as to the impact of future potential laws, especially those involving domain names, databases and privacy.
We May Need To Change The Manner In Which We Conduct Our Business If Government Regulation Increases
There are currently few laws or regulations that specifically regulate communications or commerce on the Internet. Laws and regulations may be adopted in the future, however, that address issues such as user privacy, pricing, taxation, content, copyrights, distribution, security, and the quality of products and services. Several telecommunications companies have petitioned the Federal Communications Commission to regulate Internet service providers and online services providers in a manner similar to long distance telephone carriers and to impose access fees on these companies. Any imposition of access fees could increase the cost of transmitting data over the Internet. In addition, the growth and development of the market for online commerce may lead to more stringent consumer protection laws, both in the United States and abroad, that may impose additional burdens on us. The United States Congress has enacted Internet laws regarding children’s privacy, copyrights, taxation and the transmission of sexually explicit material. The law of the Internet, however, remains largely unsettled, even in areas where there has been some legislative action. Moreover, it may take years to determine the extent to which existing laws relating to issues such as property ownership, libel and personal privacy are applicable to the Web. Any new, or modifications to existing, laws or regulations relating to the Web could adversely affect our business. Prohibition and restriction of Internet content and commerce could reduce or slow Internet use, decrease the acceptance of the Internet as a communications and commercial medium and expose us to liability. Any of these outcomes could have a material adverse effect on our business, results of operations and financial condition. The growth and development of the market for Internet commerce may prompt calls for more stringent consumer protection laws, both in the United States and abroad, that may impose additional burdens on companies conducting business over the Internet.
The Internet Is Subject To Rapid Changes, Which Could Result In Significant Additional Costs
The market for Internet products and services is characterized by rapid change, evolving industry standards and frequent introductions of new technological developments. These new standards and developments could make our existing or future products or services obsolete. Keeping pace with the introduction of new standards and technological developments could result in significant additional costs or prove difficult or impossible for us. The failure to keep pace with these changes and to continue to enhance and improve the responsiveness, functionality and features of our Web sites could harm our ability to attract and retain users. Among other things, we will need to license or develop leading technologies, enhance our existing services and develop new services and technologies that address the varied needs of our users.
Our Net Sales Could Be Adversely Affected If We Become Subject To Sales And Other Taxes
If one or more states or any foreign country successfully asserts that we should collect sales or other taxes on our sale of products over the Internet, our net sales and results of operations could be harmed. We do not currently collect sales or other similar taxes for physical shipments of goods into states other than California and Florida. However, one or more states may seek to impose sales tax collection obligations on companies, such as ARTISTdirect, which engage in or facilitate online commerce. A number of proposals have been made at the state and local level that would impose additional taxes on the sale of goods and services through the Internet. Such proposals, if adopted, could substantially impair the growth of electronic commerce and could adversely affect our opportunity to derive financial benefit from electronic commerce. Moreover, if any state or foreign country were to successfully assert that we should collect sales or other taxes on the exchange of merchandise on its system, our results of operations could be adversely affected. In addition, any operations in states outside California and Florida could subject our shipments in such states to state sales taxes under current or future laws. Congress has enacted legislation limiting the ability of the states to impose taxes on Internet-based transactions. This legislation, known as the Internet Tax Freedom Act, imposes a moratorium ending on November 1, 2003 on state and local taxes on electronic commerce where such taxes are discriminatory and on Internet access unless such taxes were generally imposed and actually enforced before October 1, 1998. Failure to renew this legislation in the future would allow various states to impose taxes on Internet-based commerce.
ITEM 2.
ITEM 2. PROPERTIES
Our principal corporate offices are located in Los Angeles, California, where we sub-lease approximately 2,000 square feet of office space from a company controlled by our Chairman. During 2003, we terminated the lease of approximately 64,000 feet of office lease that we previously occupied.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
In June 2003, we initiated discussions with our landlord regarding the potential termination or restructuring of an office lease that had a term through April 2010. On June 24, 2003, the landlord filed suit against us for unlawful detainer of our premises and in July 2003 the landlord drew down the entire remaining $1.35 million letter of credit that we had provided as a security deposit in conjunction with the execution of the original lease. In September 2003, we reached an agreement to terminate our lease with the landlord. In conjunction with the termination, we issued to the landlord warrants to purchase 200,000 shares of the Company’s common stock exercisable at $0.50 per share through September 8, 2008. In October 2003, the legal proceedings against the Company were dismissed with prejudice.
From time to time, we may be involved in litigation relating to claims arising out of our ordinary course of business. We are not presently involved in any material legal proceedings.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
ARTISTdirect’s common stock is listed for quotation on the Over-The-Counter Bulletin Board under the symbol “ARTD” since May 9, 2003 and was listed on the Nasdaq National Market prior to that date. The following table sets forth, for the two most recent fiscal years, the high and low closing sale prices for our common stock as reported by Yahoo! Finance for 2002 and 2003:
On April 14, 2004, the closing sale price for our common stock as reported by America Online was $0.39 per share.
EQUITY COMPENSATION PLAN INFORMATION
See “ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS - Equity Compensation Plan Information” for information regarding the number of outstanding and reserved options, warrants and other derivative securities under our equity compensation plans.
HOLDERS
As of April 14, 2004, there were approximately 300 holders of record of our common stock.
DIVIDENDS
We have never paid any cash dividends on our common stock and we have no current plans to do so.
SALES OF UNREGISTERED SECURITIES
In September 2003, we issued warrants to purchase 200,000 shares of common stock at $0.50 per share as partial consideration for an office lease termination. In December 2003, we issued 40,000 shares of common stock to a consultant for services rendered which were valued at $0.50 per share. We made such issuances in reliance upon Section 4(2) of the Securities Act. The parties to whom securities were issued in connection with the foregoing, made an informed investment decision based upon negotiation with us and were provided with access to material information regarding our company. We believe that the party that acquired our securities pursuant to the foregoing had knowledge and experience in financial matters such that such party was capable of evaluating the merits and risks of acquisition of our securities. All certificates representing the shares issued pursuant to the foregoing bear an appropriate legend restricting the transfer of such shares, except in accordance with the Securities Act.
In September 2003, we issued an option to purchase 259,659 shares of common stock at $0.85 per share, the approximate fair market value of the stock at such time, to Jonathan V. Diamond in connection with his appointment as our President. The option may be exercisable until August 15, 2010. 75% of the common stock underlying the options are subject to a repurchase right at $0.85 per share by the Company upon his termination of employment. This repurchase right lapses in three equal installments such that, the repurchase right will lapse entirely upon the third anniversary of his employment. We made such issuance in reliance upon Section 4(2) of the Securities Act.
From May 2003 through December 31, 2003, ARTISTdirect Records had issued and sold from time to time, an aggregate of $2.048 million in convertible notes (the “Bridge Notes”) to nine individual investors. $898,000 of these notes were sold to our Chairman, Ted Field and $100,000 to Jonathan V. Diamond, our President and Chief Executive Officer. The Bridge Notes accrue interest at 8% per annum, are due two years from the date of issuance, and will be converted into new equity of ARTISTdirect Records as part of its next equity financing. The holders of the Bridge Notes also received warrants with a term of five years to purchase additional equity of ARTISTdirect Records at $0.01 per unit equivalent to the number of units of new equity into which their Bridge Notes are ultimately converted. We made issuances of such notes and warrants in reliance upon Section 4(2) of the Securities Act. The parties to whom securities were issued in connection with the foregoing, made an informed investment decision based upon negotiation with us and were provided with access to material information regarding our company. We believe that the party that acquired our securities pursuant to the foregoing had knowledge and experience in financial matters such that such party was capable of evaluating the merits and risks of acquisition of our securities. All certificates representing the shares issued pursuant to the foregoing bear an appropriate legend restricting the transfer of such shares, except in accordance with the Securities Act.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data with respect to ARTISTdirect’s consolidated statements of operations for the years ended December 31, 1999, 2000, 2001, 2002 and 2003 and consolidated balance sheets as of December 31, 1999, 2000, 2001, 2002 and 2003 are derived from the audited consolidated financial statements of the Company. The following information should be read in conjunction with the consolidated financial statements of the Company and the related notes thereto and Item 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with our consolidated financial statements and the notes to those financial statements included elsewhere in this Annual Report on Form 10-K. The following discussion contains forward-looking statements based on our current expectations, estimates and projections about our industry, management’s beliefs and certain assumptions made by us. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “may,” “will” or similar expressions are intended to identify forward-looking statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Such statements include, but are not limited to, statements concerning our business model, increased competition in the industry, our ability to generate revenues from our record label, online product sales, advertising and other revenue streams, ability to increase visits to our web site, ability to attract and retain artists, ability to adequately fund our operations and financial commitments, ability to offer compelling content, ability to fulfill on-line music and merchandise orders in a timely manner, ability to build brand recognition, ability to integrate acquisitions of technology and other businesses, ability to protect and/or obtain intellectual property rights, and ability to manage growth. Such statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. Factors that could cause or contribute to the differences are discussed in “Risk Factors” and elsewhere in this Annual Report on Form 10-K. We undertake no obligation to revise or update publicly any forward-looking statements for any reason. The information contained in this Annual Report on Form 10-K is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this Annual Report on Form 10-K and in our other filings with the Securities and Exchange Commission that discuss our business.
GENERAL
OVERVIEW
We are a music entertainment company that combines an online music network and a record label to provide an integrated offering for music fans, artists and marketing partners. The ARTISTdirect Network (www.artistdirect.com) is a network of Web sites offering multi-media content, music news and information, community around shared music
interests, music-related specialty commerce and digital music services.
In May 2001, we entered into an agreement with veteran entertainment executive Frederick W. (Ted) Field to become our Chairman and Chief Executive Officer and form a new record label in partnership with us. On June 29, 2001, our stockholders approved the employment of Mr. Field and the formation of the record label, ARTISTdirect Records, LLC, as a 50/50 co-venture between ARTISTdirect and Mr. Field where we agreed to provide a significant financial commitment. Through our co-venture record label, we develop new musical artists and produce and distribute their recordings as an independent label utilizing both traditional channels and emerging Internet distribution channels. In addition to the formation of the record label and our financial commitment, we entered into a five-year employment agreement with Mr. Field to serve as Chairman and Chief Executive Officer. Mr. Field also serves as the Chief Executive Officer of ARTISTdirect Records.
During the year ended December 31, 2003, we restructured senior operating management and significantly reduced overhead and operating activities at the parent company level and laid off the majority of our staff. In conjunction with this restructuring, effective September 29, 2003, we entered into an employment agreement with Jonathan V. Diamond to service as our President and Chief Executive Officer through August 15, 2006.
We initially committed to fund a total of $50 million to ARTISTdirect Records over five years at the rate of $15.0 million per year, subject to a limit of $33 million in any three year period. Any funding in excess of these amounts required the approval of our Board of Directors. We have funded a total of $33.0 million through December 31, 2003.
In November 2001, ARTISTdirect Records agreed in principle to enter into a preliminary North America distribution agreement and worldwide license agreement with BMG Music, a wholly-owned partnership of Bertelsmann Music Group, Inc., the global music division of Bertelsmann AG (“BMG”). Under the terms of the agreement, BMG agreed to distribute the label’s releases in North America, and BMG licensed ARTISTdirect Records’ repertoire in territories throughout the world. In April 2002, the agreements with BMG were finalized, including BMG’s purchase of 5% of the equity of ARTISTdirect Records from us. As part of this transaction, BMG agreed to advance certain monies against net sales proceeds under the agreements and also assumed $5.0 million of our funding commitment to ARTISTdirect Records. As a result of the BMG equity purchase, our funding commitment was reduced to $45 million. In December 2002, BMG exercised its option to extend the term of the distribution and license agreement until September 2004.
Under the distribution and license agreements, BMG made non-returnable advances to ARTISTdirect Records of $2.5 million in 2001, $2.5 million in 2002 and $5.0 million in 2003 that are recoupable from net sales proceeds from ARTISTdirect Records’ artist repertoire. The advances are to be recouped on a monthly basis based on a defined calculation. As of December 31, 2002 and 2003, the unrecouped balance related to distribution advances from BMG was $4.1 million and $8.7 million, respectively.
In August 2002, our Board of Directors approved an agreement (the “Accelerated Funding Agreement”) to accelerate up to $10 million of its funding commitment to ARTISTdirect Records. This funding was in addition to the $15 million that we were obligated to advance to ARTISTdirect Records in 2002 as part of the initial $50 million funding commitment. During 2002, we funded our $15 million commitment plus the additional $10 million bridge loan for total advances to the record label of $25.0 million in 2002 and $30.25 million from the inception of the record label through December 31, 2002. The $10 million of accelerated funding was credited toward the satisfaction of our overall funding commitment and funding obligation for 2003, resulting in a remaining funding commitment of $2.75 million for 2003 and $12.0 million for 2004. We advanced the $2.75 million during 2003. Our commitment to fund ARTISTdirect Records is subject to a guaranty for the benefit of BMG. Should we fail to meet our commitment, BMG may choose to enforce the guaranty or provide substitute financing that could result in dilution of our interest in ARTISTdirect Records.
As consideration for entering into the Accelerated Funding Agreement, we received an additional 20% interest in ARTISTdirect Records from Radar Records Holdings, L.L.C. (“RRH”), the entity through which Mr. Field owns his interest in ARTISTdirect Records, which resulted in an increase in our ownership share of ARTISTdirect Records from 45% to 65% and a decrease in Mr. Field’s ownership share from 50% to 30%. The Accelerated Funding Agreement also provides that any dilution from the issuance of equity interests in ARTISTdirect Records that would have been borne solely by us will be borne both by RRH and us pro rata with our then respective ownership interests. Furthermore, the Accelerated Funding Agreement provides for RRH to guarantee a 25% minimum annual compounded return to be realized from our advances and equity interests in ARTISTdirect Records. Due to the uncertainty with respect to the realization of such rate of return, we have not recorded any amounts related to the 25% minimum annual compounded return in our consolidated financial statements.
Because we did not have voting or operating control of ARTISTdirect Records, even with our majority ownership position, through December 31, 2003 we did not consolidate the results of ARTISTdirect Records; we recorded our share of losses based on the equity method of accounting as loss from equity investments in our consolidated statements of operations. Prior to the completion of BMG’s purchase of a 5% interest in ARTISTdirect Records in April 2002 and BMG’s assumption of 10% of our total funding commitment, we had committed to fund 100% of the operations of ARTISTdirect Records and had recorded 100% of the losses attributable to that venture from the inception of ARTISTdirect Records to April 30, 2002. From May 1, 2002 through December 31, 2002, we have recorded only our proportionate share, on the basis of remaining relative funding commitments, of any losses of ARTISTdirect Records. We have funded a total of $33.0 million of our funding commitment. We recognized $8.6 million, $29.3 million and $9.3 million of equity loss from ARTISTdirect Records for the years ended December 31, 2001, 2002 and 2003, respectively.
In February 2003, the Financial Accounting Standards Board issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which addresses the consolidation by business enterprises of variable interest entities. We adopted FIN 46 effective December 31, 2003. As a result of the adoption of FIN 46, the balance sheet of ARTISTdirect Records was consolidated as of December 31, 2003, and the operations of ARTISTdirect Records will be consolidated beginning January 1, 2004.
As of December 31, 2003, ARTISTdirect Records did not have sufficient working capital resources to conduct operations and accordingly had curtailed its operations. During the three months ended September 30, 2003, ARTISTdirect Records significantly reduced its overhead costs and operating activities and laid off the majority of its staff while it continued to restructure its operations and seek additional capital.
We do not have the resources to meet our remaining $12.0 million funding commitment to ARTISTdirect Records for 2004. ARTISTdirect Records requires additional capital in order to continue operations, and therefore we are continuing to pursue alternatives to raise additional capital for both ourselves and for ARTISTdirect Records. However, there can be no assurances that additional capital can be obtained by either our company or by ARTISTdirect Records on reasonable terms or at all. If additional funds are raised through the issuance of equity securities of either our company or ARTISTdirect Records, the percentage ownership of our current stockholders in our company and/or our company’s ownership of ARTISTdirect Records would be reduced. Failure to raise additional capital could seriously harm the business of ARTISTdirect Records and impair the value of our investment in ARTISTdirect Records. In such event, ARTISTdirect Records may seek to divest all or certain of its assets or we may seek to divest all or a part of its ownership of ARTISTdirect Records, in order to raise the capital necessary to sustain business operations of our company and/or ARTISTdirect Records.
GOING CONCERN
We have incurred losses and negative cash flows from operations in every fiscal period since inception and have an accumulated deficit of $222.7 million as of December 31, 2003. For the year ended December 31, 2003, we incurred a net loss of $21.7 million and negative operating cash flows of $5.4 million. As of December 31, 2003, we had a net working capital deficiency of $9.5 million and a stockholders’ deficiency of $16.9 million.
Additionally, we have been funding substantially all of the operations of ARTISTdirect Records. Our operations to date and loans to ARTISTdirect Records have been funded by the sale of our preferred and common stock. Management expects our operating losses to continue for the foreseeable future. We do not currently anticipate that available cash resources will be sufficient to meet anticipated needs for working capital and capital expenditures over the next twelve months without additional capital.
We are attempting to mitigate our funding obligation and raise additional funding through various means. However, there can be no assurances that we will be successful in this regard. If sufficient funding is not available, then we may not be able to fund our operations or our remaining commitment to provide funding to ARTISTdirect Records. Failure to raise additional capital could seriously harm the business of ARTISTdirect Records and impair the value of our investment in ARTISTdirect Records. We have reduced our operations and have divested certain of our assets in order to attempt to raise the capital necessary to sustain business operations. To the extent that we are unable to successfully restructure our funding obligation and/or obtain the capital necessary to fund our future cash requirements on a timely basis and under acceptable terms and conditions, we will not have sufficient cash resources to maintain operations, and may consider a formal or informal restructuring or reorganization.
As a result of the conditions described above, our auditors have included an explanatory paragraph in their opinion indicating that there is substantial doubt about our ability to continue as a going concern. Our financial statements do not include any adjustments that might result from the outcome of this uncertainty.
A summary of how we conduct our business is presented below.
REVENUE
We currently generate revenues from three sources: e-commerce, media and the record label.
E-Commerce Revenue. E-Commerce revenue includes the sale of music and related merchandise, such as apparel, collectibles and accessories, through the ARTISTdirect shopping mall of our Network. We recognize the gross amount of product sales and shipping revenue upon shipment of the item and record appropriate reserves for product returns. We have experienced seasonality with respect to our online product sales. In particular, our e-commerce sales in the fourth quarter have, on average, been higher than in other quarters. We believe that this trend may continue for the foreseeable future.
Media Revenue. Media revenue consists primarily of sales of banner advertisements and sponsorships. In sales of banner advertisements, we principally earn revenue based on the number of impressions or times an advertisement appears on pages viewed within our Web sites. Our banner advertising commitments generally range from one to six months. Banner advertising revenue is generally recognized as the impressions are served during the period in which the advertisement is displayed, provided that we have no significant remaining obligations and collection of the resulting receivable is probable. We typically guarantee a minimum number of impressions to the advertiser. To the extent that minimum guaranteed page deliveries are not met, we defer recognition of the corresponding revenue until the guaranteed impressions are delivered. We also sell to advertisers the sponsorship of a Web page or event for a specified period of time. We recognize sponsorship revenue over the period in which the sponsored page or event is displayed. To the extent that committed obligations under sponsorship agreements are not met, revenue recognition is deferred until the obligations are met. Since most of our sponsorship and advertising contracts are short-term in nature, our advertising revenue is susceptible to significant fluctuation.
Record Label Revenue.
iMusic. The iMusic record label generated revenue primarily from the sale of compact discs by artists signed to the iMusic record label. We recognized revenues upon the shipment of compact discs to retailers and independent wholesalers and recorded appropriate reserves for product returns. During the three months ended June 30, 2003, management of the Company decided to scale back the activity of its iMusic label in order to conserve capital. During the three months ended September 30, 2003, the Company executed an agreement with GC Music, pursuant to which the Company assigned its rights and obligations to six unreleased artists in exchange for a cash payment of $100,000 as a reduction to prior advances related to the six artists and a profit interest in the projects. The Company retains the distribution rights to the albums previously released under the original terms of its distribution agreements with its other signed artists. The Company does not plan to sign any additional artists or release any additional albums domestically or internationally under the iMusic label and expects very minimal sales activity in the future.
ARTISTdirect Records. ARTISTdirect Records generates revenue primarily from the sale of compact discs by artists signed to the record label.
We have recorded 100% of the losses attributable to that venture from May 31, 2001 through April 30, 2002 based on our commitment to fund 100% of its operations up to that time. From May 1, 2002 through December 31, 2002, we recorded approximately 83% of the losses of ARTISTdirect Records as a result of BMG’s equity purchase and their assumption of a portion of our funding commitment to the record label. For the year ended December 31, 2003, we recorded approximately 73% of the losses of ARTISTdirect Records. However, given that we did not have voting or operating control, even with our majority ownership position in ARTISTdirect Records, through December 31, 2003, we accounted for this investment under the equity method of accounting as income (loss) from equity investments in our consolidated statements of operations.
In February 2003, the Financial Accounting Standards Board issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which addresses the consolidation by business enterprises of variable interest entities. We adopted FIN 46 effective December 31, 2003. As a result of the adoption of FIN 46, the balance sheet of ARTISTdirect Records was consolidated as of December 31, 2003, and the operations of ARTISTdirect Records will be consolidated beginning January 1, 2004. As a result of the consolidation of the balance sheet of ARTISTdirect Records as of December 31, 2003, the Company’s balance sheet as of December 31, 2003 is not directly comparable to its balance sheet as of December 31, 2002. In addition, as a result of the consolidation of ARTISTdirect Records as of December 31, 2003, we
recorded a one-time charge to operations of $5.255 million in 2003 resulting from the cumulative effect on prior years of this change in accounting method.
COST OF REVENUE
Direct cost of product sales consists of the cost of merchandise sold, the amounts payable to artists for their share of net proceeds, online transaction costs, including credit card fees, warehousing and fulfillment charges and shipping costs. Direct cost of product sales also includes manufacturing costs and distribution fees payable. Other cost of revenue consists primarily of Web site hosting and maintenance costs, online content programming costs, online advertising serving costs, record royalties payable to artists and payroll and related expenses for staff involved with the Web site. Stock-based compensation included in cost of revenue represents the amortization of non-cash compensation expense related to vendor warrants and stock options granted to artists and their advisors in connection with entering into contractual commitments to operate their online commerce activities. Historically, our cost of revenue has generally exceeded our net revenue primarily as a result of the non-cash stock-based compensation expense and also due to other cost of revenue exceeding media revenues.
OPERATING EXPENSE
Web Site Development. Web site development expense consists primarily of expenses incurred to update the content and design of our Web sites and underlying technology infrastructure. These expenses primarily include payments to third-party service vendors and personnel costs.
Sales and Marketing. Sales and marketing expense consists primarily of advertising, marketing and promotion expenses incurred to promote our Web sites, as well as payroll and related expenses for personnel engaged in marketing and advertising sales activities.
General and Administrative. General and administrative expense consists of payroll and related expenses for executive and administrative personnel, professional services expenses, facilities expenses, travel and other general corporate expenses.
Provision for Doubtful Accounts. Provision for doubtful accounts consists of provisions related to uncollectible receivables.
Stock-based Compensation. We record stock-based compensation expense (exclusive of amounts recorded within cost of revenue) in connection with equity granted to employees, directors, professional firms, artists and artist advisors during this period. We may grant additional equity securities in the future to employees, directors and others. We record stock compensation for employee option grants equal to the excess of the fair value of our common stock over the exercise price on the grant date. We record the compensation over the vesting period. For options/warrants granted to non-employees, we record as stock compensation the fair value of the options/warrants (using the Black-Scholes option-pricing model) amortized over the related period of service.
Depreciation and Amortization. Depreciation and amortization expense consists of the depreciation of fixed assets and the amortization of acquired intangible assets, including goodwill. No intangible assets remained on the balance sheet at December 31, 2003.
Impairment of long-lived assets is monitored on a continuing basis, and is assessed based on the undiscounted cash flows generated by the underlying assets. In the event that the carrying amount of long-lived assets exceeds the undiscounted future cash flows, then the carrying amount of such assets is adjusted to their fair value.
Loss from Sale and Abandonment of Property and Equipment. Loss from sale and abandonment of property and equipment consists of the costs associated with the sale and abandonment of the property and equipment and leasehold improvements at our former offices. We determined that these assets were impaired during 2003 as a result of various factors. Accordingly, we reduced the carrying amount of these assets to their estimated fair value by recording a charge to operations during 2003. The leasehold improvements were subsequently abandoned when the Company vacated the premises, and most of the remaining assets were sold to third party liquidators for cash. This amount has been reported as a loss from sale and abandonment of property and equipment in the consolidated statement of operations for the year ended December 31, 2003.
CRITICAL ACCOUNTING POLICIES
We have identified the following as critical accounting policies: revenue recognition, stock-based compensation, and impairment of long-lived assets and goodwill.
The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, intangible assets, income taxes, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.
Revenue Recognition
E-commerce revenue consists primarily of the gross amount of sales revenue paid by the customer for recorded music and merchandise sold via the Internet, including shipping fees, and is recognized when the products are shipped. We record e-commerce revenue on a gross basis as we enter into sale transactions with customers, establish the prices of the products, choose the suppliers of the products, assume the risk of inventory loss and collect all amounts from the customers and assume the credit risk. E-commerce revenue is subject to amounts due to the respective artists based on their contracts, and such expense is recorded as part of direct cost of product sales.
We record amounts charged to customers for shipping and handling in accordance with Emerging Issues Task Force No. 00-10, “Accounting for Shipping and Handling Fees and Costs”. Pursuant to EITF No. 00-10, we record amounts charged to customers for shipping and handling as revenue, and records the related costs incurred for shipping and handling to direct cost of product sales in the consolidated statements of operations.
Media revenue consists primarily of the sale of advertisements and sponsorships, both online and offline, under short-term contracts. To date, the duration of our advertising and sponsorship commitments has generally averaged from one to three months, with certain programs lasting up to six months. Our online obligations typically include the guarantee of a minimum number of times (“impressions”) that an advertisement appears in pages viewed by the users of our online properties. Online advertising revenue is generally recognized as the impressions are served during the period in which the advertisement is displayed, provided that we have no significant remaining obligations and collection of the resulting receivable is reasonably assured. To the extent that minimum guaranteed page deliveries are not met, recognition of the corresponding revenue is deferred until the guaranteed impressions are delivered.
We recognize revenue for sponsorship arrangements, both online and offline, over the period during which the advertising is provided, generally on a straight-line basis. If the sponsorship arrangement is for the sponsorship of a specific event, we recognize revenue when the event occurs. We recognize revenue separately for each element of integrated entertainment marketing packages that offer advertisers a combination of off-line concert and tour sponsorships that are supported by on-line banner advertising, web page sponsorships, emails to our customers and custom content. We determine the fair value of each deliverable based on the fair value of the different deliverables when sold on a stand-alone basis. We recognize revenue for each deliverable as the services are provided. We recognize revenue for the banner impression deliverable as the banner impressions are delivered. We recognize revenue for the customer emails when the emails are sent. We recognize revenue for Web page sponsorships on a straight-line basis over the term of the sponsorship. We recognize revenue for the custom content when the content is provided to the customer. We recognize revenue for event sponsorships when the event has occurred.
Record label revenue consists primarily of the sale of compact discs by artists signed to iMusic. We recognize revenue upon the shipment of compact discs from our distributor to retailers and independent wholesalers and record appropriate reserves for product returns. At the time of the shipment of the product, the following criterion under Statement of Financial Accounting Standards No. 48, “Revenue Recognition When Right of Return Exists”, have been met: the seller’s price to the buyer is substantially fixed or determinable at the date of sale; the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product; the buyer’s obligation to the seller
would not be changed in the event of theft or physical destruction or damage of the product; the buyer acquiring the product for resale has economic substance apart from that provided by the seller; the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer; and the amount of future returns can be reasonably estimated.
Stock-Based Compensation
We account for stock-based employee compensation in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25 and FASB Interpretation No. 44 “, “Accounting for Certain Transactions Involving Stock Compensation” (“FIN 46”), and comply with the disclosure requirements of SFAS No. 123, “Accounting for Stock-Based Compensation”. Under APB No. 25, compensation expense is recorded based on the difference, if any, between the fair value of our stock and the exercise price on the measurement date. We account for stock issued to non-employees in accordance with SFAS No. 123, which requires entities to recognize as expense over the service period the fair value of all stock-based awards on the date of grant and EITF No. 96-18, “Accounting for Equity Investments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services”, which addresses the measurement date and recognition approach for such transactions.
We recognize compensation expense related to variable awards in accordance with FIN 28. For fixed awards, we recognize expense over the vesting period or the period of service.
Stock-based compensation included in cost of revenue represents the amortization of non-cash compensation expense related to vendor warrants and stock options granted to artists and their advisors in connection with entering into contractual commitments to operate their online commerce activities. We record the fair value of options/warrants granted to non-employees as compensation expense over the period of service. We determine the fair value of the options/warrants based on the Black-Scholes option-pricing model.
Stock-based compensation included in operating expenses represents the amortization of non-cash compensation expense related to equity instruments granted to employees, directors, professional firms, artists and artist advisors. Compensation for equity grants to non-employees is recorded in the same manner as described above. We record stock compensation for employee option grants equal to the excess of the fair value of our common stock over the exercise price on the grant date. We record the compensation over the vesting period.
Impairment of Long-Lived Assets and Goodwill
Effective January 1, 2002, we evaluate the impairment of goodwill by comparing the carrying amount of the goodwill at the reporting unit level to the fair value of the goodwill. The carrying amount of the goodwill is adjusted to its fair value in the event the fair value exceeds the carrying amount.
Impairment of long-lived assets is monitored on a continuing basis, and is assessed based on the undiscounted cash flows generated by the underlying assets. In the event that the carrying amount of long-lived assets exceeds the undiscounted future cash flows, then the carrying amount of such assets is adjusted to their fair value.
Presented below are the Company’s consolidated statements of operations for the years ended December 31, 2001, 2002 and 2003.
RESULTS OF OPERATIONS
Overview:
During the year ended December 31, 2003, we restructured senior operating management and significantly reduced overhead and operating activities at the parent company level and laid off the majority of our staff. In addition, during the year ended December 31, 2003, ARTISTdirect Records significantly reduced its overhead costs and operating activities and laid off the majority of its staff while it continued to restructure its operations and seek additional capital. This restructuring is expected to continue during 2004. As of December 31, 2003, ARTISTdirect Records did not have sufficient working capital resources to conduct operations and accordingly had curtailed its operations. In addition, at December 31, 2003, the parent company did not have sufficient resources to fund its remaining $12.0 million capital commitment to ARTISTdirect Records. Accordingly, for 2004, we are focusing on obtaining additional capital, both at
the parent company level and at ARTISTdirect Records, as well as enhancing the operations and margins of the Media business. We do not expect to be able to make significant further reductions to operating costs in 2004.
ARTISTDIRECT, INC.
YEARS ENDED DECEMBER 31, 2003 AND 2002
NET REVENUE
Net revenue from continuing operations for the year ended December 31, 2003 decreased to $6.0 million, from $6.3 million for the year ended December 31, 2002, which represented a decrease of 4%.
E-commerce revenue for the year ended December 31, 2003 decreased to $3.5 million, from $4.7 million for the year ended December 31, 2002, a decrease of 27%, primarily as a result of lower traffic to the Web site, fewer sales orders and a decline in demand for music and licensed artist merchandise in 2003.
Media revenue increased to $1.2 million for the year ended December 31, 2003, from $924,000 for the year ended December 31, 2002, an increase of 27%, as a result of an increase in the number of online advertisers and an increase in the CPM amounts earned from the sales of impression and non-impression based advertising and offline sponsorships. The increase in advertising revenues in 2003 is a reversal of the revenue decline in media revenues over the previous years. We expect to focus our efforts on increasing media revenue during 2004.
Record label revenue increased to $1.4 million for the year ended December 31, 2003, from $613,000 for the year ended December 31, 2002, an increase of 121%. This increase of approximately $739,000 is due to an increase in revenues from the iMusic record label, which was launched in the third quarter of 2002, due to more releases in 2003.
During the three months ended June 30, 2003, management decided to scale back the activity of its iMusic label in order to conserve capital. During the three months ended September 30, 2003, we executed an agreement with GC Music, pursuant to which we assigned our rights and obligations to six unreleased artists in exchange for a cash payment of $100,000 as a reduction to prior advances related to the six artists and a profit interest in the projects. We retain the distribution rights to the albums previously released under the original terms of its distribution agreements with our other signed artists. We do not plan to sign any additional artists or release any additional albums domestically or internationally under the iMusic label and expect very minimal sales activity in the future.
COST OF REVENUE
Direct cost of product sales. Direct cost of product sales decreased to $3.1 million for the year ended December 31, 2003, from $4.0 million for the year ended December 31, 2002, a decrease of 21%. This decrease of $851,000 is due primarily to the decrease in E-commerce revenues in 2003.
Other cost of revenue. Other cost of revenue decreased to $1.2 million for the year ended December 31, 2003, from $3.7 million for the year ended December 31, 2002, a decrease of 67%. This decrease was due primarily to an approximate $1.7 million decrease in Web site hosting and maintenance costs due to a reduction in headcount and a restructuring of our third party service provider agreements, and an approximate $800,000 decrease in iMusic record label artist advances.
Stock-based compensation. For the year ended December 31, 2003, we recorded non-cash stock-based compensation charges of $33,000 compared to $3.1 million for the year ended December 31, 2002, a decrease of 99%. Stock-based compensation expense relates primarily to the amortization of the estimated value of stock options, calculated pursuant to the Black-Scholes option-pricing model, previously issued to artists and their advisors in connection with the operation of their stores and is amortized over the life of the associated contracts. The decrease in stock-based compensation in 2003 is primarily due to completion of most of the amortization of stock-based compensation during 2002 as a result of the terms of a number of artist agreements expiring during 2002. The $3.1 million in stock-based compensation expense in 2002 consists of $2.1 million related to option grants to artists and advisors, $900,000 in compensation expense related to the rescission for which services were being provided by artists and advisors in 2002, and $79,000 of expense related to warrants granted to suppliers.
OPERATING EXPENSE
Web Site Development. Web site development expense decreased to $5,000 for the year ended December 31, 2003, from $53,000 for the year ended December 31, 2002, a decrease of 91%. This decrease was primarily attributable to lower fees paid to third party service vendors relating to the enhancement of our Web site.
Sales and Marketing. Sales and marketing expense decreased to $1.2 million for the year ended December 31, 2003, from $2.2 million for the year ended December 31, 2002, a decrease of 45%. The $1.0 million decrease was due primarily to an approximately $1.3 million decrease in online advertising expenditures resulting from the restructuring of our agreement with Ticketmaster and lower marketing, payroll and related costs, offset in part by an increase of approximately $350,000 in iMusic record label expenses.
General and Administrative. General and administrative expense decreased to $4.2 million for the year ended December 31, 2003, from $7.5 million for the year ended December 31, 2002, a decrease of 44%. The $3.3 million decrease was primarily attributable to a decrease in payroll costs associated with the reduced headcount of $2.3 million and an approximately $1.0 million decrease in outside services, facilities and insurance costs.
Provision for Doubtful Accounts. Bad debt expense increased to $83,000 for the year ended December 31, 2003, from $42,000 for the year ended December 31, 2002, as a result of higher level of uncollectible accounts receivable related to advertising revenues in 2003.
Stock-based Compensation. We recorded stock-based compensation expense of $527,000 for the year ended December 31, 2003 in connection with previous stock-based compensation issued to employees, directors, professional firms, artists and advisors for promotional services, a decrease of 72% from the $1.9 million expense for the year ended December 31, 2002. Stock-based compensation represented the remaining amortization of such prepaid compensation paid in prior years. The decrease in stock-based compensation in 2003 is primarily due to the amortization period for most of the stock-based compensation being completed in 2002.
Depreciation and Amortization. Depreciation and amortization expense decreased from $2.8 million for the year ended December 31, 2002 to $1.0 million for the year ended December 31, 2003, a decrease of 64%. This decrease of $1.8 million was primarily due to the write-down and abandonment of property and equipment during 2003.
Loss from Sale and Abandonment of Property and Equipment and Impairment of Goodwill. During the year ended December 31, 2003, we recorded a loss from the sale and abandonment of property and equipment of $2.2 million. This loss was mainly as a result of vacating our office space following the termination of our lease. During the year ended December 31, 2002, we recorded a loss on impairment of goodwill related to the write-off of the remaining goodwill associated with our online operations of $788,000. This write-down was recorded due to declines in advertising revenue on the Network and the determination that there was insufficient basis to support the carrying amounts of goodwill based upon the projected undiscounted future cash flows related to the underlying Network assets.
LOSS FROM EQUITY INVESTMENTS
Loss from equity investments decreased from $29.3 million for the year ended December 31, 2002 to $9.3 million for the year ended December 31, 2003. This equity loss related to the operations of ARTISTdirect Records. The decrease in the loss is due to a reduced level of activity at ARTISTdirect Records in 2003 as compared to 2002. We recorded as loss from equity investments 100% of ARTISTdirect Records’ loss through April 30, 2002 due to our commitment to fund 100% of its operations. From May 1, 2002 through December 31, 2002, we recorded approximately 83% of the venture’s loss based on our relative share of the remaining funding commitment to the venture. For the year ended December 31, 2003, we recorded approximately 73% of the losses of ARTISTdirect Records. The result of operations of ARTISTdirect Records will be consolidated beginning January 1, 2004.
INTEREST INCOME, NET
During the year ended December 31, 2003, net interest income was $146,000, as compared with net interest income of $748,000 for the year ended December 31, 2002. This net decrease in interest cost of approximately $602,000 is primarily due to lower average cash balances held during 2003 as compared with 2002.
FORGIVENESS OF DEBT BY OFFICER
During 2002, our Chairman’s employment agreement was amended whereby he agreed to defer his future salary until we raised new debt or equity financing of at least $20 million. During the three months ended June 30, 2003, our Chairman’s employment agreement was further amended whereby all deferred and any future salary, except a base amount, would be waived, even if new debt or equity financing is raised. Accordingly, during the year ended December 31, 2003, $411,000 of accrued compensation due to our Chairman was recorded as gain from forgiveness of debt in the consolidated statement of operations.
CUMULATIVE EFFECT OF CONSOLIDATION OF ARTISTDIRECT RECORDS, LLC
As a result of the consolidation of ARTISTdirect Records as of December 31, 2003, we recorded a one-time charge to operations of $5.255 million in 2003 resulting from the cumulative effect on prior years of the change in accounting method from equity to consolidation.
DISCONTINUED OPERATIONS
Income from discontinued operations decreased from $147,000 for the year ended December 31, 2002 to $0 for the year ended December 31, 2003. The decrease is due to the completion of the wind down of agency operations in 2002.
NET LOSS
Net loss decreased to $21.7 million for the year ended December 31, 2003, as compared to $48.2 million for the year ended December 31, 2002, a decrease of $26.5 million or 55%. This decrease is primarily attributable to a $6.1 million decrease in gross loss, a $1.0 million decrease in sales and marketing expense, a $3.3 million decrease in general and administrative expenses, a $19.9 million decrease in the loss from equity investments, a $1.4 million decrease in stock-based compensation, and a $1.8 million decrease in depreciation and amortization, partially offset by a $1.4 million increase in loss from sale and abandonment of property and equipment and impairment of goodwill and a cumulative loss adjustment of $5.3 million relating to the consolidation of ARTISTdirect Records.
YEARS ENDED DECEMBER 31, 2002 AND 2001
NET REVENUE
Net revenue from continuing operations for the year ended December 31, 2002 decreased to $6.3 million from $10.4 million for the year ended December 31, 2001, a decrease of 40%. The decrease was due to decreases in e-commerce and media that were partially offset by increase in iMusic record label revenues.
E-commerce revenue for the year ended December 31, 2002 decreased to $4.7 million from $7.5 million for the year ended December 31, 2001, a decrease of 38% primarily as a result of lower traffic to the site, fewer sales orders and a continued weak sales environment for music and licensed artist merchandise.
Advertising and other revenue decreased to $924,000 for the year ended December 31, 2002 from $2.9 million for the year ended December 31, 2001, a decrease of 68% as a result of a decrease in the number of online advertisers and a reduction in the sales of non-impression based advertising and offline sponsorships. The decrease in advertising revenues is attributed to general weakness in the United States economy, overall softness in the advertising market and a specific decline in the demand for online advertising.
iMusic record label revenue increased to $613,000 for the year ended December 31, 2000 from $0 for the year ended December 31, 2001, an increase of 100% as a result of the launch of the iMusic record label in the third quarter of 2002.
COST OF REVENUE
Direct cost of product sales. Direct cost of product sales decreased to $4.0 million for the year ended December 31, 2002 from $6.1 million for the year ended December 31, 2001, a decrease of 35%. This $2.1 million decrease corresponded with the decrease in online product sales revenue and was primarily attributable to a $2.0 million decrease in product costs and a $600,000 decrease in transaction costs partially offset by iMusic record label cost of sales of $400,000.
Other cost of revenue. Other cost of revenue decreased to $3.7 million for the year ended December 31, 2002, from $5.7 million for the year ended December 31, 2001, a decrease of 36%. This $2.0 million decrease was due primarily to an approximate $900,000 decrease in network payroll costs due to a reduction in headcount, an approximate $900,000
decrease in Web site hosting and maintenance costs due to a restructuring of our third party service provider agreements, and an approximate $800,000 decrease in entertainment marketing costs due to a reduction in event costs in connection with a decrease in related advertising revenue, offset partially by approximately $400,000 of iMusic record label distribution fees and royalty costs.
Stock-based compensation. For the year ended December 31, 2002, we recorded non-cash stock-based compensation charges of $3.1 million compared to $8.4 million for the year ended December 31, 2001, a decrease of 63%. The stock-based compensation expense relates primarily to the amortization of the estimated value of the options, using the Black-Scholes option- pricing model, issued to artists and their advisors in connection with the operation of their stores and is amortized over the life of the associated contracts. The decrease in stock-based compensation is primarily due to the expense of approximately $900,000 in 2001 related to the rescission offer and the completion of the terms of artist agreements during 2002. The $3.1 million in expense in 2002 consists of $2.1 million related to option grants to artists and advisors, $900,000 in compensation expense related to the rescission for which services were being provided by artists and advisors in 2002, and $79,000 of expense related to warrants granted to suppliers.
OPERATING EXPENSE
Web Site Development. Web site development expense decreased to $53,000 for the year ended December 31, 2002, from $3.7 million for the year ended December 31, 2001, a decrease of 99%. This decrease was primarily attributable to a $2.1 million decrease in payroll and related costs in 2002 from the elimination of our information technology development staff and an approximate $1.6 million decrease in fees paid to third party service vendors relating to the development and internal transition of our E-commerce system incurred in 2001.
Sales and Marketing. Sales and marketing expense decreased to $2.2 million for the year ended December 31, 2002 from $5.7 million for the year ended December 31, 2001, a decrease of 61%. The $3.5 million decrease was primarily attributable to a $1.0 million decrease in our online advertising expenditures resulting from the restructuring of our agreement with Ticketmaster, a $1.1 million reduction in payroll and related costs and an approximate $700,000 reduction in e-mail marketing expenses, publicity costs and other promotional expenses.
General and Administrative. General and administrative expense decreased to $7.6 million for the year ended December 31, 2002 from $13.3 million for the year ended December 31, 2001, a decrease of 44%. The $5.8 million decrease was primarily attributable to a $1.7 million decrease in payroll costs associated with reduced headcount in staff in 2001, $1.6 million decrease in outside services due in part to the rescission in 2001, $1.0 million decrease in facilities expenses, and $1.3 million decrease in travel and entertainment, communications and other general and administrative expenses.
Provision for Doubtful Accounts. Bad debt expense decreased to $42,000 for the year ended December 31, 2002 from $1.5 million for the year ended December 31, 2001 due to the write-off of a $1.5 million receivable due from one of the major records labels related to advertising and promotion services provided.
Stock-based Compensation. We recorded stock-based compensation expense of $1.9 million for the year ended December 31, 2002 in connection with stock issuances to employees, directors, professional firms, artists and advisors for promotional services, a decrease of 85% from the $12.4 million expense for the comparable period in 2001. Stock-based compensation in 2002 represented the remaining amortization of prepaid compensation paid in 2001 related to the value of options granted to artists and advisors. The decrease is primarily due to the expense recorded in 2001 of $6.1 million related to the rescission of options granted to employees, professional firms, artists and advisors, and due to the completion of promotion agreements with artists in 2002.
Depreciation and Amortization. Depreciation and amortization expense decreased to $2.8 million for the year ended December 31, 2002 from $6.5 million for the year ended December 31, 2001, a decrease of 57%. This $3.7 million decrease was primarily due to a decrease in the amortization of intangible assets as a result of the $11.4 write-off of goodwill in 2001 and goodwill no longer being amortized effective January 1, 2002.
Loss from Impairment of Goodwill. During the year ended December 31, 2002, we recorded a loss on impairment of goodwill related to the write-off of the remaining goodwill associated with our online operations in the amount of $788,000. During the year ended December 31, 2001 we recorded a loss on impairment of goodwill related to our acquisitions of Mjuice, iMusic and the UBL in the amount of $11.4 million. These write-downs were recorded due to declines in advertising revenue on the Network and the determination that there was insufficient basis to support the carrying amounts of goodwill based upon the projected undiscounted future cash flows related to the underlying Network
assets.
LOSS FROM EQUITY INVESTMENTS
Loss from equity investments increased to $29.3 million for the year ended December 31, 2002 from $9.0 million for the year ended December 31, 2001. The increase is due to an increase in the loss of ARTISTdirect Records. We recorded 100% of the venture’s loss through April 30, 2002 due to our commitment to fund 100% of its operations. From May 1, 2002 through December 31, 2002, we began recording approximately 83% of the venture’s loss based on our relative share of the remaining funding commitment to the venture.
INTEREST INCOME, NET
Interest income decreased to $748,000 for the year ended December 31, 2002 from $3.6 million for the year ended December 31, 2001, a decrease of 79%. This $2.9 million decrease is primarily due to lower average cash balances held during 2002 compared with 2001 and lower interest rates.
DISCONTINUED OPERATIONS
Income from discontinued operations increased to $147,000 for the year ended December 31, 2002 from $47,000 for the year ended December 31, 2001. The increase is due to the timing of touring activity and a reduction of expenses in 2002 during the wind-down of discontinued operations.
NET LOSS
Net loss decreased to $48.2 million for the year ended December 31, 2002, compared to $69.9 million for the year ended December 31, 2001, a decrease of $21.7 million or 31%. This decrease is primarily attributable to a $5.4 million decrease in the gross loss, a $10.7 million decrease in the loss from impairment of goodwill, a $10.5 million decrease in stock-based compensation, a $5.8 million decrease in general and administrative expense, a $3.7 million decrease in depreciation and amortization, a $3.7 million decrease in Web site development, a $3.5 million decrease in sales and marketing expense, and a $1.4 million decrease in provision for doubtful accounts, partially offset by a $20.3 million increase in the loss from equity investments and a $2.8 million decrease in interest income.
ARTISTDIRECT RECORDS, LLC
YEARS ENDED DECEMBER 31, 2003 AND 2002
NET REVENUE
Net revenue decreased to $1.4 million for the year ended December 31, 2003, as compared to $3.7 million for the year ended December 31, 2002. Net revenues in 2003 and 2002 are presented net of a provision for actual and estimated future returns of $888,000 and $1.7 million, respectively. Net revenue decreased in 2003 as compared to 2002 as a result the reduction in operating activities as described below.
During the year ended December 31, 2003, ARTISTdirect Records significantly reduced its overhead costs and operating activities and laid off the majority of its staff while it continued to restructure its operations and seek additional capital. This restructuring is expected to continue during 2004. As of December 31, 2003, ARTISTdirect Records did not have sufficient working capital resources to conduct operations and accordingly had curtailed its operations. In addition, at December 31, 2003, we did not have sufficient resources to fund our remaining capital commitment to ARTISTdirect Records. Accordingly, for 2004, ARTISTdirect Records is focusing on obtaining additional capital. Due to the financial condition of ARTISTdirect Records and the impact of its restructuring during 2003, it is currently anticipated that revenues from ARTISTdirect Records will be substantially less in 2004 as compared to 2003.
COST OF REVENUE
Direct cost of product revenue includes manufacturing costs and distribution fees payable to BMG and the provision for artist advances and royalty expense. Manufacturing and distribution expenses for the year ended December 31, 2003 were $420,000, as compared to $1.3 million for the year ended December 31, 2002. Artist advances and recording costs relate to signed artists as well as an advance against future royalties paid to a producer. The provision for advances and royalties
for the year ended December 31, 2003 was $1.4 million, as compared to $8.8 million for the year ended December 31, 2002. The decrease was due to a reduction in the level of operating activities in 2003 as compared to 2002.
OPERATING EXPENSE
Sales and Marketing. Sales and marketing expense represents costs of sales, marketing, promotion, publicity and video production related to albums released by ARTISTdirect Records during the period. Sales and marketing expense for the year ended December 31, 2003 was $3.3 million, as compared to $12.0 million for the year ended December 31, 2002. The decrease was due to a reduction in the level of operating activities in 2003 as compared to 2002.
General and Administrative. General and administrative expense represents payroll and related expenses, costs for travel and entertainment, outside legal fees and general office and communication expenses. General and administrative expense for the year ended December 31, 2003 was $6.5 million, as compared to $14.4 million for the year ended December 31, 2002. The decrease was due to ARTISTdirect Records significantly reducing its overhead costs and operating activities and laying off the majority of its staff during mid-2003 while it continued to restructure its operations and seek additional capital. This restructuring is expected to continue during 2004. It is not expected that ARTISTdirect Records will be able to make significant further reductions to operating costs in 2004.
Depreciation and Amortization. Depreciation and amortization expense was $39,000 for the year ended December 31, 2003, as compared to $36,000 for the year ended December 31, 2002.
Loss from Sale and Abandonment of Property and Equipment. During the year ended December 31, 2003, ARTISTdirect Records recorded a loss from the sale and abandonment of property and equipment of $100,000. This loss was primarily as a result of ARTISTdirect Records vacating its office space following the termination of its lease.
INTEREST EXPENSE
Interest expense primarily represents the accrual of interest on loan advances made to ARTISTdirect Records by ARTISTdirect, Inc. and by BMG. Loan advances aggregated $37.75 million and $35.0 million at December 31, 2003 and 2002, respectively, and bear interest at LIBOR plus 4%. Interest expense for the year ended December 31, 2003 was $2.4 million, as compared to $1.1 million for the year ended December 31, 2002. The increase is due primarily to an increase in the level of advances made during 2003 as compared to 2002.
During the year ended December 31, 2003, ARTISTdirect Records also recognized $203,000 as interest expense with respect to the amortization of the fair value of Bridge Note warrants (see “Liquidity and Capital Resources - ARTISTdirect Records, LLC” below), which was included in the $2.4 million of interest expense in 2003.
NET LOSS
Net loss was $12.7 million for the year ended December 31, 2003, and consisted primarily of a gross loss of $372,000, total operating expenses of $9.9 million and interest expense of $2.2 million. Net loss was $34.0 million for the year ended December 31, 2002, and consisted primarily of a gross loss of $6.4 million, total operating expenses of $26.4 million and interest expense of $1.1 million.
YEAR ENDED DECEMBER 31, 2002 AND PERIOD FROM MAY 31, 2001 (INCEPTION) TO DECEMBER 31, 2001
NET REVENUE
Net revenue increased to $3.7 million for the year ended December 31, 2002 from $0 for the period from May 31, 2001 (inception) to December 31, 2001. During 2002, ARTISTdirect Records released seven albums. Net revenues in 2002 are presented net of a provision for actual and estimated future returns of $1.7 million. During 2001, the Company did not release any albums.
COST OF REVENUE
Direct cost of product revenue includes manufacturing costs and distribution fees payable to BMG and the provision for artist advances and royalty expense. Manufacturing and distribution expenses for the year ended December 31, 2002 were
$1.3 million, as compared with $0 for the period ended December 31, 2001. Artist advances and recording costs relate to signed artists as well as an advance against future royalties paid to a producer. The provision for advances and royalties for the year ended December 31, 2002 was $8.8 million, as compared with $3.2 million for the period ended December 31, 2001. The increase was due to an increase in the number of artists signed and the level of recording activity in 2002 as compared to 2001.
OPERATING EXPENSE
Sales and Marketing. Sales and marketing expense represents costs of sales, marketing, promotion, publicity and video production related to albums released by ARTISTdirect Records during the period, as well as the related costs for additional expected releases being set up for release during 2003. Sales and marketing expense for the year ended December 31, 2002 was $12.0 million, compared with $799,000 for the period ended December 31, 2001.
General and Administrative. General and administrative expense represents payroll and related expenses, costs for travel and entertainment, outside legal fees and general office and communication expenses. General and administrative expense for the year ended December 31, 2002 was $14.4 million, as compared with $4.5 million for the period ended December 31, 2001. The increase is due primarily to a full year’s amount of expense in 2002 and an increase in headcount and related activity to support the first releases of the label during 2002.
Depreciation and Amortization. Depreciation and amortization expense was $36,000 for the year ended December 31, 2002, as compared to $2,000 for the period ended December 31, 2001.
INTEREST EXPENSE
Interest expense represents the accrual of interest on loan advances made to ARTISTdirect Records by ARTISTdirect, Inc. and by BMG. Loan advances aggregated $35.0 million and $5.25 million at December 31, 2002 and 2001, respectively, and bear interest at LIBOR plus 4%. Interest expense for the year ended December 31, 2002 was $1.1 million, as compared with $126,000 for the period ended December 31, 2001. The increase is due to an increase in the level of advances made during 2002 and the accrual of a full year’s interest in 2002 as compared with the prior year.
NET LOSS
Net loss was $34.0 million for the year ended December 31, 2002, and consisted primarily of a gross loss of $6.4 million, total operating expenses of $26.4 million and interest expense of $1.1 million. Net loss for the period ended December 31, 2001 was $8.7 million, and consisted primarily of a gross loss of $3.2 million, total operating expenses of $5.4 million and interest expense of $126,000.
LIQUIDITY AND CAPITAL RESOURCES
ARTISTDIRECT, INC.
We have financed our activities during the past few years from the sale of our equity securities. As of December 31, 2003, we had $726,000 of unrestricted cash and cash equivalents and held $1.0 million in short-term investments. We had a working capital deficiency of $9.5 million at December 31, 2003, primarily because of the net liability to BMG of $8.7 million at such date (see Note 11 to the ARTISTdirect, Inc. consolidated financial statements for a further description of the liability to BMG). As of December 31, 2003, the balance sheet of ARTISTdirect Records was consolidated, resulting in an increase in long-term debt of $6.5 million.
During the year ended December 31, 2003, we restructured senior operating management and significantly reduced overhead and operating activities and laid off the majority of our staff. At December 31, 2003, we did not have sufficient resources to meet our remaining $12.0 million funding commitment to ARTISTdirect Records. Accordingly, for 2004, we are focusing on obtaining additional capital, as well as enhancing the operations and margins of the Media business. We do not expect to be able to make significant further reductions to operating costs in 2004.
Operating. Net cash used in operating activities was $5.4 million, $11.2 million and $22.2 million for the years ended December 31, 2003, 2002 and 2001, respectively. Net cash used in operating activities for each of these periods consisted primarily of net losses, partially offset by non-cash items such as loss from equity investments, stock-based compensation, depreciation and amortization, and loss from impairment of goodwill and sale and abandonment of property and equipment.
Investing. Net cash provided by investing activities was $2.4 million for the year ended December 31, 2003, which consisted primarily of $5.0 million from the maturity/sale of short-term investments, partially offset by our advance of $2.75 million to ARTISTdirect Records. Net cash used in investing activities for the year ended December 31, 2002 was $12.8 million, which consisted of $25.0 million of advances to ARTISTdirect Records, offset by approximately $12.3 million of proceeds from the maturity/sale of short-term investments. Net cash provided by investing activities was $11.6 million for the year ended December 31, 2001, which consisted primarily of $18.0 million of proceeds from the maturity/sale of short-term investments, partially offset by $5.3 million of advances to ARTISTdirect Records.
Financing. Net cash provided by financing activities was $1.8 million for the year ended December 31, 2003, which consisted of a $1.8 million reduction in restricted cash, of which approximately $1.3 million was paid out to our landlord in conjunction with the termination of our facilities lease. Net cash provided by financing activities was $855,000 for the year ended December 31, 2002, which was primarily a result of the release of restricted cash related to two letters of credit held by third parties related to our office lease and e-commerce credit card processor. Net cash used in financing activities was $15.9 million for the year ended December 31, 2001, and consisted of payments made for the rescission of certain shares and options issued to employees, artists, advisors and professional firms of $10.2 million, the repurchase of common stock of $2.7 million, and approximately $3.0 million held as restricted cash related to our lease agreement for our Los Angeles office and our E-commerce business.
ARTISTDIRECT RECORDS, LLC
ARTISTdirect Records has relied primarily on advances from ARTISTdirect, Inc. and from BMG to fund its operations since inception in 2001. During 2003, ARTISTdirect Records also received loans aggregating $2.048 million from Ted Field and from outside investors (see “Financing” below). At December 31, 2003, ARTISTdirect Records had $7,000 of cash.
ARTISTdirect Records had a working capital deficiency of $10.9 million at December 31, 2003, primarily because of the net liability to BMG of $8.7 million at such date (see Note 8 to the ARTISTdirect Records, LLC financial statements for a further description of the liability to BMG).
As of December 31, 2003, ARTISTdirect Records did not have sufficient working capital resources to conduct operations and accordingly had curtailed its operations. ARTISTdirect, Inc. does not have the resources to meet its remaining $12.0 million funding commitment to ARTISTdirect Records for 2004. Since ARTISTdirect Records requires additional capital in order to continue operations, it is continuing to pursue alternatives to raise additional capital. However, there can be no assurances that additional capital can be obtained on reasonable terms or at all.
Operating. Net cash used in operating activities was $7.1 million, $31.0 million and $5.4 million for the years ended December 31, 2003 and 2002 and the period ended December 31, 2001, respectively. Net cash used in operating activities for 2003, 2002 and 2001 consisted primarily of net losses, partially offset by an increase in the net liability to BMG during 2003, 2002 and 2001 of $3.7 million, $813,000 and $2.5 million, respectively, relating to certain recoupable distribution advances in conjunction with its North American distribution agreement and worldwide license agreement with ARTISTdirect Records.
Under the distribution and license agreements, BMG made non-returnable advances to ARTISTdirect Records of $5.0 million, $2.5 million and $2.5 million in 2003, 2002 and 2001, respectively, that are recoupable from net sales proceeds from ARTISTdirect Records’ artist repertoire. The advances are to be recouped on a monthly basis based on a defined calculation. As of December 31, 2003 and 2002, the unrecouped balances related to distribution advances from BMG were $8.7 million and $4.1 million, respectively.
Investing. Net cash provided by investing activities was $52,000 for the year ended December 31, 2003, and consisted of proceeds from the sale of property and equipment. Net cash used in investing activities for the year ended December 31, 2002 and the period ended December 31, 2001 was $246,000 and $23,000, respectively, which consisted of the purchases of property and equipment.
Financing. Net cash provided by financing activities was $7.0 million for the year ended December 31, 2003, which consisted of the proceeds from bridge notes of $2.048 million, an advance from ARTISTdirect, Inc. of $2.75 million, and a net increase in interest payable of $2.2 million. Net cash provided by financing activities was $31.1 million for the year ended December 31, 2002, which consisted primarily of the proceeds from loan advances from ARTISTdirect, Inc. and BMG of $25.0 million and $4.75 million, respectively, and a net increase in interest payable of $1.1 million. Net cash provided by financing activities was $5.5 million for the period ended December 31, 2001, and consisted primarily of the proceeds from loan advances from ARTISTdirect, Inc. of $5.25 million.
As of December 31, 2003, ARTISTdirect Records had received $898,000 of loans from Ted Field and $1,150,000 of loans from outside investors (including $100,000 from Jonathan V. Diamond, our new President and Chief Executive Officer). The total loans of $2.048 million during 2003 were obtained through the issuance of convertible promissory notes (the “Bridge Notes”). The Bridge Notes accrue interest at 8% per annum, are due two years from the date of issuance, and will be converted into new equity of ARTISTdirect Records as part of its next equity financing.
The holders of the Bridge Notes also received warrants with a term of five years to purchase additional equity of ARTISTdirect Records at $0.01 per unit equivalent to the number of units of new equity into which their Bridge Notes are ultimately converted. The relative fair value of the warrants issued was $1.024 million (one-half of the amount funded by the investors in the Bridge Notes), which was recorded as a reduction to the carrying amount of the Bridge Notes and a credit to capital, and is being charged to operations as interest expense over the specified term of the Bridge Notes.
In addition, since the Bridge Notes are convertible into equity based on their face amount, this results in a beneficial conversion feature with a relative fair value of $1.024 million. Since the commitment date for the beneficial conversion feature is contingent upon the completion of ARTISTdirect’s next equity financing, the fair value of the beneficial conversion feature will be charged to operations over the remaining life of the Bridge Notes at that time.
During the year ended December 31, 2003, ARTISTdirect Records recognized $203,000 as interest expense with respect to the amortization of the fair value of the Bridge Note warrants. Additional interest expense of $821,000 will be recognized ratably in 2004 and 2005 over the remaining term of the Bridge Notes.
PRINCIPAL COMMITMENTS - ARTISTDIRECT, INC. AND ARTISTDIRECT RECORDS, LLC
As of December 31, 2003, our principal commitments consisted of our remaining funding obligation to ARTISTdirect Records of $12.0 million due in 2004 and other funding commitments as summarized below. During 2003, our main operating lease commitment for our office space was terminated. A summary of our contractual cash obligations, excluding the ARTISTdirect Records funding commitment, as of December 31, 2003, is as follows:
At December 31, 2003, the Company did not have any material commitments for capital expenditures or have any transactions, obligations or relationships that could be considered off-balance sheet arrangements.
LIQUIDITY - ARTISTDIRECT, INC. AND ARTISTDIRECT RECORDS, LLC
We currently anticipate that our available cash resources, including short-term investments, will not be sufficient to meet our anticipated working capital requirements during 2004, including our $12.0 million funding commitment to ARTISTdirect Records in 2004. We have reduced our operations and have divested certain of our assets in order to attempt to raise the capital necessary to sustain business operations, and we are exploring various alternatives to raise additional capital. There can be no assurance that additional capital can be obtained by either our company or by ARTISTdirect Records on reasonable terms, in a timely manner or at all. Failure to raise additional capital could seriously harm the business of ARTISTdirect Records and impair the value of our investment in ARTISTdirect Records.
If additional funds are raised through the issuance of equity securities of either our company or ARTISTdirect Records, the percentage ownership of current stockholders in our company and/or ARTISTdirect Records will be reduced. If we raise additional funds by issuing debt, we may be subject to limitations on our operations, including limitations on the payment of dividends, and any debt issued by ARTISTdirect Records may be senior to the obligations of ARTISTdirect Records to our company. To the extent that we are unable to successfully restructure our funding
commitment and/or obtain the capital necessary to fund our future cash requirements on a timely basis and under acceptable terms and conditions, we will not have sufficient cash resources to maintain operations, and may consider a formal or informal restructuring or reorganization. Due to our current financial condition, our auditors have included an explanatory paragraph in their 2003 report on the financial statements of ARTISTdirect, Inc. and ARTISTdirect Records, LLC stating that there is substantial doubt about our ability to continue as a going concern.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In August 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (“SFAS No. 143”). SFAS No. 143 addresses the diverse accounting practices for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The Company adopted SFAS No. 143 effective January 1, 2003. The adoption of SFAS No. 143 did not have a significant effect on the Company’s financial statement presentation or disclosures.
In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. While SFAS No. 144 supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of”, it retains many of the fundamental provisions of that statement. The Company adopted SFAS No. 144 effective January 1, 2002. The adoption of SFAS No. 144 did not have a material impact on the Company’s financial statement presentation or disclosures.
In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections”. SFAS No. 145 rescinds SFAS 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. Upon adoption of SFAS No. 145, the Company will be required to apply the criteria in APB Opinion No. 30, “Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” (Opinion No. 30), in determining the classification of gains and losses resulting from the extinguishment of debt. Additionally, SFAS No. 145 amends SFAS No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions to be accounted for in the same manner as sale-leaseback transactions. The Company adopted SFAS No. 145 effective January 1, 2003. The adoption of SFAS No. 145 for long-lived assets held for use did not have a material impact on the Company’s financial statement presentation or disclosures.
In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit and Disposal Activities”. SFAS No. 146 nullifies Emerging Issues Task Force (“EITF”) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)”. Under EITF Issue No. 94-3, a liability for an exit cost is recognized at the date of an entity’s commitment to an exit plan. Under SFAS No. 146, the liabilities associated with an exit or disposal activity will be measured at fair value and recognized when the liability is incurred and meets the definition of a liability in the FASB’s conceptual framework. SFAS No. 146 is effective for exit or disposal activities initiated after December 31, 2002. The adoption of SFAS 146 did not have a material impact on the Company’s financial statement presentation or disclosures.
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure-an amendment of SFAS No. 123”. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also amends the disclosure requirements of SFAS No. 123 and APB Opinion No. 28, “Interim Financial Reporting”, to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company implemented SFAS No. 148 effective December 31, 2002. The Company has determined that it will continue to account for stock-based employee compensation in accordance with APB No. 25.
In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”. SFAS No. 149 amends and clarifies under what circumstances a contract with initial investments meets the characteristics of a derivative and when a derivative contains a financing component. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS No. 149 did not have a significant effect on the Company’s financial statement presentation or disclosures.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. SFAS No. 150 establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003 and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. SFAS No. 150 is to be implemented by reporting the cumulative effect of a change in accounting principle for financial instruments created before the issuance date of SFAS No. 150 and still existing at the beginning of the interim period of adoption. Restatement is not permitted. The adoption of SFAS No. 150 did not have a significant effect on the Company’s financial statement presentation or disclosures.
In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others” (“FIN 45”), an interpretation of FASB Statements Nos. 5, 57 and 107 and a rescission of FASB Interpretation No. 34. FIN 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees issued. FIN 45 also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken. The initial recognition and measurement provisions of FIN 45 are applicable to guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN 45 are effective for financial statements of interim and annual periods ended after December 15, 2002. The adoption of FIN 45 did not have a material effect on the Company’s financial statement presentation or disclosures.
In November 2002, the FASB’s Emerging Issues Task Force (“EITF”) issued EITF No. 00-21 “Revenue Arrangements with Multiple Deliverables”. EITF No. 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. Specifically, EITF No. 00-21 addresses how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. In applying EITF No. 00-21, separate contracts with the same entity or related parties that are entered into at or near the same time are presumed to have been negotiated as a package and should, therefore, be evaluated as a single arrangement in considering whether there are one or more units of accounting. That presumption may be overcome if there is sufficient evidence to the contrary. EITF No. 00-21 also addresses how arrangement consideration should be measured and allocated to the separate units of accounting in the arrangement. The guidance in EITF No. 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The Company adopted EITF No. 00-21 effective July 1, 2003. The adoption of EITF No. 00-21 has not had any significant impact on the Company’s financial statement presentation or disclosures.
In February 2003, the Financial Accounting Standards Board issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which addresses the consolidation by business enterprises of variable interest entities, which have one or both of the following characteristics: (1) the equity investment at risk is not sufficient to permit the entity to finance its activities without additional financial support from other parties, or (2) the equity investors lack one or more of the following essential characteristics of a controlling financial interest: (a) the direct or indirect ability to make decisions about the entity’s activities through voting or similar rights, (b) the obligation to absorb the expected losses of the entity if they occur, or (c) the right to receive the expected residual returns of the entity if they occur. In addition, FIN 46 contains detailed disclosure requirements. FIN 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period ending after March 15, 2004, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. Early adoption is permitted. The Company adopted FIN 46 as of December 31, 2003. The adoption of FIN 46 on such date had a significant impact on the Company’s consolidated balance sheet. The Company had previously accounted for its investment in ARTISTdirect Records under the equity method. The Company consolidated the balance sheet of ARTISTdirect Records as of December 31, 2003, and will consolidate the operations of ARTISTdirect Records beginning January 1, 2004.
ITEM 7A.
ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market rate risk for changes in interest rates is related primarily to our investment portfolio. We have not used derivative financial instruments in our investment portfolio. At December 31, 2003, our short-term investments are comprised of United States corporate and bank debt. Interest rate fluctuations impact the carrying value of the portfolio. We do not believe that the future market risks related to the above securities will have material adverse impact on our financial position, results of operations or liquidity.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our consolidated financial statements and schedule, as listed under Item 15, appear in a separate section of this Annual Report on Form 10-K beginning on page 59.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Effective February 6, 2004, we dismissed KPMG LLP (“KPMG”) as our independent accountant. The dismissal of KPMG was recommended by our Audit Committee and approved by our Board of Directors.
KPMG’s reports on our financial statements for the years ended December 31, 2001 and 2002 did not contain an adverse opinion or a disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope, or accounting principles, except that KPMG’s report, dated February 14, 2003, for the years ended December 31, 2002 and 2001 contained an explanatory paragraph stating that “the Company has incurred substantial operating losses and negative cash flows from operations to date and has funding commitments related to its record label joint venture. The Company needs additional capital to fund its operations and the operations of the record label joint venture. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.”
During the years ended December 31, 2001 and 2002, and the period from January 1, 2003 through February 6, 2004, there were no disagreements with KPMG on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements, if not resolved to the satisfaction of KPMG, would have caused KPMG to make reference to the subject matter of the disagreements in connection with its reports on the our financial statements. In addition, none of the events described in Item 304(a)(1)(v) of Regulation S-K occurred during such periods.
Effective February 17, 2004, we retained Gumbiner, Savett, Finkel, Fingleson & Rose, Inc. (“GSFFR”) as our independent accountant. The retention of GSFFR was recommended by our Audit Committee and approved by our Board of Directors.
During the years ended December 31, 2002 and 2003, and the subsequent interim period from January 1, 2004 through February 16, 2004, we did not, nor did anyone on our behalf, consult with GSFFR regarding either: (i) the application of accounting principles to a specified transaction, either completed or proposed; or the type of audit opinion that might be rendered on our financial statements, and no written report or oral advice was provided that GSFFR concluded was an important factor considered by us in reaching a decision as to the accounting, auditing or financial reporting issue; or (ii) any matter that was either the subject of a disagreement as defined at Item 304(a)(1)(iv) or a reportable event as defined at Item 304 (a)(1)(v) of Regulation S-K.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures
Disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports filed or submitted under the Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the rules and forms of the Securities and Exchange Commission. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports filed under the Exchange Act of 1934 is accumulated and communicated to management, including its principal executive and financial officers, as appropriate, to allow timely decisions regarding required disclosure.
We carried out an evaluation, under the supervision and with the participation of our management, including its principal executive officer and financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based upon and as of the date of that evaluation, our principal executive officer and financial officer concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed in the reports we file and submit under the Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.
(b) Changes in Internal Controls
There were no changes in our internal controls or in other factors that could have significantly affected those controls subsequent to the date of our most recent evaluation.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
Directors, Executive Officers and Key Employees
The following table sets forth certain information regarding our directors, executive officers and certain key employees as of April 15, 2004:
The following is a brief description of the capacities in which each of our directors, executive officers and key employees has served during the past five years.
Frederick W. Field has served as our Chairman of the Board since June 2001 and served as our Chief Executive Officer from June 2001 until September 2003. Mr. Field also currently serves as Chief Executive Officer of ARTISTdirect Records, LLC (a joint venture among ARTISTdirect Recordings, Inc., our wholly-owned subsidiary, Radar Records, LLC, an entity controlled by Mr. Field, and BMG Entertainment) and as Chairman of the Board and Chief Executive Officer of Radar Pictures, Inc., a film production company. From 1990 to 2001, Mr. Field served as Co-Chairman of Interscope Records, a music production company. From 1979 to 1997, Mr. Field served as Chairman of the Board and Chief Executive Officer of Interscope Communications, Inc.
Jonathan V. Diamond. Mr. Diamond has served our Chief Executive Officer and director since September 2003. From January 2003 to the present, he has also served as the Chairman, Chief Executive Officer and a director of Youthstream Media Networks, Inc., a publicly traded company. He was the co-founder of N2K, Inc. and served as its Vice Chairman and Chief Executive Officer through its 1999 merger with CDnow, Inc., an e-commerce company. He continued to serve as Chairman of the combined company until its sale to Bertelsmann Music Group in August 2000. Mr. Diamond is a former partner in GRP Records, an independent music label acquired by MCA in 1990. Mr. Diamond holds an M.B.A. from the Columbia University Graduate School of Business and a B.A. in Economics and Music from the University of Michigan.
Robert N. Weingarten. Mr. Weingarten was appointed Chief Financial Officer and Secretary of the Company in January 2004. From July 1992 to present, Mr. Weingarten has been the sole shareholder of Resource One Group, Inc., a financial consulting and advisory company. From February 2003 to present, he has served as the Chief Financial Officer of Youthstream Media Networks, Inc., a publicly traded company. Since 1979, Mr. Weingarten has served as a consultant to numerous public companies in various stages of development, operation or reorganization. Mr. Weingarten received an M.B.A. Degree in Finance from the University of Southern California in 1975 and a B.A. Degree in Accounting from the University of Washington in 1974. Mr. Weingarten currently serves as President and Chief Financial Officer of Aries Ventures Inc. and Resource Ventures, Inc., both of which are public companies.
Marc P. Geiger co-founded ARTISTdirect, Inc. and has served as a director since June 2001. He served as our
President, Artist Services and Vice-Chairman of the Board from June 2001 to May 2003. Mr. Geiger served as Chief Executive Officer from our inception to June 2001 and as our Chairman of the Board from July 1998 to June 2001. From January 1992 to December 1996, Mr. Geiger was the Senior Vice President of Marketing, A&R and New Media at American Recordings, Inc. From 1984 to 1991, Mr. Geiger worked as a talent agent for Regency Artists, that was later acquired by the William Morris Agency. In 1990, Mr. Geiger co-founded the Lollapalooza concert tour.
Stephen M. Krupa has served as a director since May 1999. Mr. Krupa is a founding member and Managing Director of Psilos Group Managers, LLC, a private venture capital fund focused on the digital media, information technology and health care sectors. Mr. Krupa is currently a director of several private technology and healthcare companies. From February 1995 to July 1998, Mr. Krupa held various positions at Wasserstein Perella & Co., most recently as a Vice President where he specialized in mergers and acquisitions advisory work. Mr. Krupa received his B.S. in Mechanical Engineering from the University of South Florida and his M.B.A. from the Wharton School of the University of Pennsylvania.
Benjamin S. A. Moody has served as a director since March 2001. Mr. Moody is the co-founder and Managing Member of Pan American Finance, LLC, an investment banking firm focused on providing advisory services to companies in the Latin American, Caribbean and the U.S. Hispanic markets. Mr. Moody currently serves as a director of several private media and technology companies. From June 1998 to June 2001, Mr. Moody served as Vice Chairman and Chief Financial Officer of Cisneros Television Group, a media entertainment company, as well as Managing Director and Chief Financial Officer of Ibero-American Media Partners II, Ltd., a joint venture between the Cisneros Group of Companies and Hicks, Muse, Tate & Furst. From June 1996 to June 1998, Mr. Moody was a Managing Director of Violy, Byorum and Partners, LLC, a mergers and acquisitions advisory firm. From June 1992 to June 1996, Mr. Moody was a Vice President of Citicorp Securities, Inc. Mr. Moody received his B.A. in English Language and Literature from Saint Benet’s Hall, Oxford University.
Keith K. Yokomoto co-founded ARTISTdirect, Inc. and has served as a director since July 1998 and as a consultant since January 2004. He served as our President from July 1999 to December 2003, as Chief Operating Officer from January 1997 to December 2003. From September 1985 to January 1997, Mr. Yokomoto was a manager of new ventures and business development and a project engineer at Hughes Electronics. Mr. Yokomoto received his B.S. in Mechanical Engineering from the University of California at San Diego and his M.B.A. from the University of Southern California.
Our executive officers are elected by the Board of Directors on an annual basis and serve until their successors have been duly elected and qualified. There are no family relationships among any of the directors or executive officers of ARTISTdirect.
Compensation Committee Interlocks and Insider Participation
The Compensation Committee of our Board of Directors currently consists of Messrs. Krupa and Moody. Jerry Rubinstein served as a member of our Compensation Committee from September 2002 until his resignation in August 2003. None of these individuals was an officer or employee of ARTISTdirect at any time during the 2003 fiscal year or at any other time. Messrs. Diamond and Weingarten are also directors and executive officers of Youthstream Media Networks, Inc., a publicly-traded company. No current executive officer of ARTISTdirect has ever served as a member of the board of directors or compensation committee of any other entity that has or has had one or more executive officers serving as a member of our Board of Directors or Compensation Committee.
Director Compensation
Directors who are not employees of ARTISTdirect or one of its subsidiaries do not currently receive any cash compensation from ARTISTdirect for their service as members of our Board of Directors or any Board committee. However, directors are reimbursed for all reasonable travel and lodging expenses incurred by them in attending Board and committee meetings. All directors are eligible to participate in the ARTISTdirect 1999 Employee Stock Option Plan.
Meetings and Committees of the Board of Directors
The Board of Directors held 10 meetings during the fiscal year ended December 31, 2003 (“Fiscal Year 2003”). The Board has an Audit Committee and a Compensation Committee. Each Director attended or participated in 75% or more of the aggregate of (i) the total number of meetings of the Board and (ii) the total number of meetings held by all committees of the Board on which such Director served during Fiscal Year 2003.
The Audit Committee reviews, acts on and reports to the Board of Directors with respect to various auditing and accounting matters, including the selection of the Company’s independent auditors, the scope of the annual audits, fees to be paid to the auditors, the performance of the independent auditors and the Company’s accounting practices. The board of directors has established Audit and Compensation Committees.
The Company does not currently have an audit committee financial expert serving on its Audit Committee, as the Company has limited resources and is continuing its restructuring efforts. The Company intends to attempt to add a qualified board member to serve as an audit committee financial expert in the future.
The members of the Audit Committee are Messrs. Moody and Krupa, each non-employee directors of the Company. The Audit Committee as currently configured held five meetings during the Fiscal Year 2003.
The Compensation Committee reviews and approves the compensation and benefits of our key executive officers, administers our employee benefit plans and makes recommendations to the Board regarding such matters. The Compensation Committee as currently configured held four meetings during the Fiscal Year 2003.
Compliance with Section 16(a) of the Securities Exchange Act of 1934
The members of our Board of Directors, our executive officers and persons who hold more than 10% of our outstanding common stock are subject to the reporting requirements of Section 16(a) of the Securities Exchange Act of 1934 which require them to file reports with respect to their ownership of our common stock and their transactions in such common stock. Based upon (i) the copies of Section 16(a) reports which we received from such persons for their 2003 fiscal year transactions in our common stock and their holdings of our common stock, and (ii) the written representations received from one or more of such persons that no annual Form 5 reports were required to be filed by them for the 2003 fiscal year, Mr. Diamond filed one late Form 4 report covering one transaction. Other than the foregoing instances, we believe that the reporting requirements under Section 16(a) for such fiscal year were met in a timely manner by our other directors, executive officers and greater than ten percent beneficial owners.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Summary of Cash and Certain Other Compensation
The following table provides certain summary information concerning the compensation earned by ARTISTdirect’s Chief Executive Officer and each of the three other most highly compensated executive officers of ARTISTdirect whose salary and bonus for the 2003 fiscal year was in excess of $100,000, for services rendered in all capacities to ARTISTdirect and its subsidiaries for the fiscal years ended December 31, 2000, 2001 and 2003. No other executive officers who would have otherwise been includable in such table on the basis of salary and bonus earned for the 2003 fiscal year has been excluded by reason of his or her termination of employment or change in executive status during that year. The listed individuals shall be hereinafter referred to as the named executive officers.
SUMMARY COMPENSATION TABLE
Stock Options and Stock Appreciation Rights
In September 2003, we issued to Mr. Jonathan Diamond, options to purchase 259,659 shares of our common stock at $0.85 per share. These options expire on August 15, 2010. The options will also terminate if Mr. Diamond is no longer an employee of the our company. 75% of the shares underlying the options are subject to repurchase rights upon his termination. These rights expire in three annual installments such that upon the third anniversary of his employment, all repurchase rights shall lapse.
No stock options or stock appreciation rights were granted to any of the other named executive officers during the 2003 fiscal year.
Aggregated Option.Fiscal Year-End Value
The following table provides information, with respect to the named executive officers, concerning unexercised options held by them at the end of the 2003 fiscal year. None of the named executive officers exercised any stock appreciation rights during the 2003 fiscal year and no stock appreciation rights were held by the named executive officers at the end of such year.
AGGREGATED FISCAL YEAR-END OPTION VALUES
Employment Contracts, Termination of Employment and Change in Control Arrangements
ARTISTdirect has entered into employment agreements with its named executive officers. The compensation and dates of employment under the employment agreements are as follows:
Frederick Field
In May 2001, ARTISTdirect entered into an employment agreement and stock option agreements with Frederick Field, its Chairman of the Board and Chief Executive Officer. The employment agreement generally provides for the following:
•
Mr. Field is paid an annual base salary of $500,000, plus bonus pool participation.
•
The term of the agreement expires May 31, 2006.
•
The employment agreement provides that if ARTISTdirect terminates Mr. Field’s employment other than for cause, disability or death, or Mr. Field terminates his employment for good reason, he will receive a lump sum payment equal to the amount of his annual base salary for:
(1)
50% of the remaining term of the employment agreement if the termination occurs within the first 3 years of his employment,
(2)
12 months if the termination occurs in the fourth year of his employment, or
(3)
the full remaining term of the employment agreement if the termination occurs in the fifth year of his employment.
•
The above payments also will be made if Mr. Field terminates his employment by written notice upon the commencement of any arbitration proceeding to determine whether or not his employment with ARTISTdirect Records may be terminated for good reason and Mr. Field’s employment with ARTISTdirect Records is terminated for good reason.
•
If Mr. Field terminates his employment by written notice upon the commencement of any arbitration proceeding to determine whether or not his employment with ARTISTdirect Records may be terminated for cause and Mr. Field remains employed at ARTISTdirect Records because the arbitrator determines that ARTISTdirect Records is not entitled to terminate Mr. Field’s employment for cause, then the above payments will be made, but the applicable pay period will be reduced by 50%.
ARTISTdirect also granted Mr. Field three non-plan, non-qualified stock options to purchase 444,480 shares of common stock at an exercise price of $7.50 per share, under the following stock option agreements:
•
One of the stock option agreements generally provides that Mr. Field’s right to purchase 302,370 shares is immediately exercisable subject to a right of repurchase, and vests in a series of 60 successive equal monthly installments from June 29, 2001. The vesting fully accelerates upon a change of control or upon Mr. Field’s cessation of service with ARTISTdirect pursuant to an involuntary termination. An involuntary termination includes (i) ARTISTdirect’s termination of Mr. Field’s employment for reasons other than for cause, (ii) a cessation of services pursuant to Mr. Field’s permanent disability or death and (iii) Mr. Field’s voluntary resignation for good reason, as set forth in the employment agreement. Permanent disability exists if Mr. Field becomes unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that is expected to result in death or has lasted or can be expected to last for a continuous period of at least 12 months. In addition, if Mr. Field terminates his employment upon written notice in connection with the commencement of any arbitration proceeding to determine whether or not his employment with ARTISTdirect Records may be terminated for cause and Mr. Field remains employed at ARTISTdirect Records because the arbitrator determined that ARTISTdirect Records was not entitled to terminate Mr. Field’s employment for cause, then 50% of the then unvested option shares will automatically accelerate so that they are immediately fully vested and exercisable.
•
A second stock option agreement generally provides that Mr. Field’s right to purchase 75,588 shares vests and becomes exercisable upon the occurrence prior to June 29, 2004 of any one of the following events: (i) the 30-day average closing sale price of ARTISTdirect’s common stock or the consideration paid per share in an acquisition of ARTISTdirect reaches a minimum of $35.00 per share; (ii) ARTISTdirect’s common stock is re-listed on The Nasdaq National Market following a delisting; (iii) a change of control occurs; or (iv) Mr. Field’s service with ARTISTdirect ceases pursuant to an involuntary termination. If none of the foregoing events occurs by June 29, 2004, then the option will terminate and none of the option shares subject to the second stock option agreement will vest or become exercisable by Mr. Field.
•
The third stock option agreement generally provides that Mr. Field’s right to purchase 66,522 shares vests and becomes exercisable upon the occurrence prior to June 29, 2004 of any one of the following events: (i) the 30-day average closing sale price of ARTISTdirect’s common stock or the consideration paid per share in an acquisition of ARTISTdirect reaches a minimum of $70.00 per share; (ii) ARTISTdirect’s common stock is re-listed on The Nasdaq National Market following a delisting; (iii) a change of control occurs; or (iv) Mr. Field’s service with ARTISTdirect ceases pursuant to an involuntary termination. If none of the foregoing events occurs by June 29, 2004, then the option will terminate and none of the option shares subject to the third option agreement will vest or become exercisable by Mr. Field.
All three stock options expire no later than May 30, 2008. All three stock options may also terminate prior to the expiration date as follows: (i) upon the later of the 12 month anniversary of Mr. Field’s cessation of service or the expiration of Mr. Field’s initial five-year employment term with ARTISTdirect if Mr. Field’s employment with ARTISTdirect ceases pursuant to an involuntary termination; (ii) upon the earlier of the 12 month anniversary of Mr. Field’s cessation of service or the expiration of Mr. Field’s initial five-year employment term with ARTISTdirect if Mr. Field terminates his employment pursuant to a termination with justification; (iii) upon the earlier of the 90-day anniversary of Mr. Field’s cessation of service or the expiration date of the stock option if Mr. Field ceases to remain in ARTISTdirect’s service for any reason other than an involuntary termination or a termination with justification; (iv) immediately if ARTISTdirect
terminates Mr. Field’s employment for cause; (v) upon the earlier of the 12 month anniversary of Mr. Field’s death or the expiration date of the stock option if Mr. Field ceases to remain in ARTISTdirect’s service due to his death; and (vi) upon the latter of the 12 month anniversary of Mr. Field’s cessation of service with ARTISTdirect or the expiration of Mr. Field’s initial five-year employment term with ARTISTdirect if Mr. Field ceases to remain in ARTISTdirect’s service due to his permanent disability.
In addition, Mr. Field also serves as the Chief Executive Officer of ARTISTdirect Records. Mr. Field has a five-year employment agreement with ARTISTdirect Records, pursuant to which he is paid an annual base salary of $1,000,000 plus certain benefits. If Mr. Field terminates his employment with ARTISTdirect Records for good reason, he will receive a lump sum payment equal to the amount of his annual base salary for (i) 50% of the remaining term of the employment agreement if the termination occurs within the first 3 years of his employment, (ii) 12 months if the termination occurs in the fourth year of his employment or (iii) the full remaining term of the employment agreement if the termination occurs in the fifth year of his employment. ARTISTdirect Records may not terminate Mr. Field’s employment other than for cause or due to his disability or death.
From July 16, 2002, Mr. Field has elected to defer salary that he would have earned under his employment agreements with ARTISTdirect and ARTISTdirect Records. In December 2002, ARTISTdirect and ARTISTdirect Records amended Mr. Field’s employment agreements to provide that the amount of Mr. Field’s deferred salary, net of applicable tax withholdings, will be paid in a cash lump sum by ARTISTdirect and ARTISTdirect Records, respectively, within thirty days after the consummation of a private financing of at least $20,000,000 or, if earlier, the occurrence of (i) a merger, consolidation, sale of fifty percent (50%) or more of the voting securities or sale of all or substantially all of the assets of ARTISTdirect or ARTISTdirect Records, respectively, (ii) Mr. Field’s attainment of age 65, or (iii) the termination of Mr. Field’s employment with ARTISTdirect or ARTISTdirect Records, respectively.
In May 2003, Mr. Field agreed to reduce his annual salary under his employment agreements with ARTISTdirect and ARTISTdirect Records to $28,080 under each agreement. Mr. Field’s employment agreement was further amended whereby all deferred salary totaling approximately $411,000 and $822,000, respectively, was waived, even if new debt or equity financing is raised.
Jonathan V. Diamond
In September 2003, ARTISTdirect had entered into a two-year employment agreement with Jonathan V. Diamond, its Chief Executive Officer and director, which provided for the following:
•
Mr. Diamond was paid an annual salary of $185,000 and a discretionary bonus of up to $50,000 and a formula-based bonus of up to $50,000 determined by the Board, pro rated for any partial fiscal year. Mr. Diamond also received a signing bonus of $4,315.
•
The agreement provided for the payment of salary for eighteen months after the date of termination (or, if a shorter period, the remaining term under his employment agreement) and full vesting of his stock option if the termination was:
(1)
other than due to a disability,
(2)
other than for “cause,” such as the commission of a felony, material dishonesty against ARTISTdirect, or gross negligence in the performance of duties,
(3)
other than due to Mr. Diamond’s death, or
(4)
for “good reason,” such as an adverse change of duties, a reassignment of location, or a material breach of ARTISTdirect’s obligations to Mr. Diamond.
•
The agreement also provided that if Mr. Diamond’s employment was terminated for cause or disability, or he resigned for other than good reason, he would be prohibited, for a period of the later of one year after the early termination of his employment, or the expiration of the term of his employment agreement, from attempting to hire any ARTISTdirect employees.
•
Mr. Diamond also received a stock option to purchase 259,659 shares of common stock at $0.85 per share, the approximate fair market value of the stock at such time. The option may be exercisable until August 15, 2010. 75%
0f the common stock underlying the options are subject to a repurchase right at $0.85 per share by the Company upon his termination of employment. This repurchase right lapses in three equal installments such that, the repurchase right will lapse entirely upon the third anniversary of his employment.
Marc Geiger
In July 1998, ARTISTdirect had entered into an employment agreement with Marc Geiger, its Vice-Chairman and President, Artist Services, which provided for the following:
(1)
other than due to a disability,
(2)
other than for “cause,” such as the commission of a felony, material dishonesty against ARTISTdirect, or gross negligence in the performance of duties,
(3)
other than due to Mr. Geiger’s death, or
(4)
for “good reason,” such as an adverse change of duties, a reassignment of location, or a material breach of ARTISTdirect’s obligations to Mr. Geiger.
•
The agreement also provided that if Mr. Geiger’s employment was terminated for cause or disability, or he resigned for other than good reason, he would be prohibited, for a period of the later of one year after the early termination of his employment, or the expiration of the term of his employment agreement, from competing with ARTISTdirect or attempting to hire any ARTISTdirect employees.
In June 2001, Mr. Geiger resigned his position as Chairman of the Board and Chief Executive Officer and took the position of Vice Chairman of the Board and President, Artist Services. Mr. Geiger also executed an agreement with ARTISTdirect, effective as of April 27, 2001, agreeing that such changes in his title and duties would not constitute “good reason” that would entitle him to the severance pay described above if he chooses to terminate his employment.
In July 2001, ARTISTdirect amended Mr. Geiger’s original employment agreement to provide for the following:
•
Mr. Geiger is paid an annual salary of $500,000 (to be reviewed annually for any increases by ARTISTdirect’s Compensation Committee in consultation with ARTISTdirect’s Chief Executive Officer), is entitled to four weeks’ vacation each year, and is eligible to participate in ARTISTdirect’s executive performance bonus pool and in the Artists & Repertoire Bonus Plan of ARTISTdirect Records, LLC.
•
The initial term of the amended agreement expires June 30, 2006. Beginning July 1, 2006, and on each anniversary, the term of the amended agreement will automatically be extended for an additional one-year period unless written notice is provided otherwise.
•
Mr. Geiger is entitled to receive a one-time lump sum advance of $300,000, representing a pre-payment of $60,000 against any monies otherwise becoming payable to Mr. Geiger under ARTISTdirect’s executive performance bonus pool for each year of the initial five-year term of the amended agreement.
•
The amended agreement provides for the payment of $1,000,000 plus one years’ salary (or whatever shorter period remains in the term of the amended agreement) upon the termination of Mr. Geiger’s employment if the termination was:
(1)
other than due to a disability,
(2)
other than for “cause,” such as the commission of a felony, fraud or embezzlement, gross negligence or willful misconduct in the performance of duties, material breach of the amended agreement, or misappropriation of a corporate opportunity,
(3)
other than due to Mr. Geiger’s death, or
(4)
for “good reason,” such as a material and substantial reduction in title, responsibilities or duties, a reassignment of location, or a material breach of ARTISTdirect’s obligations to Mr. Geiger.
•
The amended agreement provides that prior to the termination of his employment, Mr. Geiger is prohibited from competing with ARTISTdirect. In addition, for a period of one year after the expiration of the amended agreement, Mr. Geiger is prohibited from hiring any of ARTISTdirect’s employees.
From November 1, 2002, Mr. Geiger has elected to defer 50% of the salary that he would have earned under his employment agreement with ARTISTdirect. In December 2002, ARTISTdirect amended Mr. Geiger’s employment agreement to provide that the amount of Mr. Geiger’s deferred salary, net of applicable tax withholdings, will be paid in a cash lump sum by ARTISTdirect within thirty days after the consummation of a private financing of at least $20,000,000 or, if earlier, the occurrence of (i) a merger, consolidation, sale of fifty percent (50%) or more of the voting securities or sale of all or substantially all of the assets of ARTISTdirect, (ii) Mr. Geiger’s attainment of age 65, or (iii) the termination of Mr. Geiger’s employment with ARTISTdirect.
Effective May 31, 2003, Mr. Geiger resigned as an officer of the Company, although he remains as a director of the Company. Mr. Geiger’s July 2001 amended employment agreement, which had an initial term extending through June 30, 2006, provided for an annual salary of $500,000 plus certain benefits. The amended employment agreement also provided that under certain conditions, Mr. Geiger would receive a payment of $1,000,000 plus one year’s salary upon the termination of his employment with the Company. In February 2001, the Company loaned Mr. Geiger $150,000, with interest at 7%. The term of the loan was initially one year, but was extended in September 2001 to five years commensurate with the amendment of Mr. Geiger’s employment agreement in July 2001. Mr. Geiger was obligated to repay the loan in five equal annual principal payments of $30,000, along with accrued interest to date, beginning in September 2002. In consideration for Mr. Geiger terminating his employment agreement effective as of the date of his resignation and waiving all rights to compensation under the employment agreement, we paid Mr. Geiger his accrued compensation and benefits of approximately $184,000, and Mr. Geiger repaid the $150,000 loan plus accrued interest.
Keith Yokomoto
In July 2001, ARTISTdirect entered into an employment agreement with Keith Yokomoto, its President and Chief Operating Officer, which provides for the following:
•
Mr. Yokomoto is paid an annual salary of $500,000 (to be reviewed annually for any increases by ARTIST direct’s Compensation Committee in consultation with ARTISTdirect’s Chief Executive Officer), is entitled to four weeks’ vacation each year, and is eligible to participate in ARTISTdirect’s executive performance bonus pool and in the Artists & Repertoire Bonus Plan of ARTISTdirect Records, LLC.
•
Mr. Yokomoto is entitled to receive a one-time lump sum advance of $300,000, representing a pre-payment of $60,000 against any monies otherwise becoming payable to Mr. Yokomoto under the executive performance bonus pool for each year of the initial five-year term of the agreement.
•
Mr. Yokomoto also is entitled to receive a performance-based stock option to purchase shares of ARTISTdirect’s common stock at a per share exercise price equal to the fair market value of its common stock on the date of the option grant. The exact number of shares and terms of the stock option will be determined by the Compensation Committee in consultation with ARTISTdirect’s Chief Executive Officer.
term of the agreement) upon the termination of Mr. Yokomoto’s employment if the termination was:
(1)
other than due to a disability,
(2)
other than for “cause,” such as the commission of a felony, fraud or embezzlement, gross negligence or willful misconduct in the performance of duties, material breach of the agreement, or misappropriation of a corporate opportunity,
(3)
other than due to Mr. Yokomoto’s death, or
(4)
for “good reason,” such as a material and substantial reduction in title, responsibilities or duties, a reassignment of location, or a material breach of ARTISTdirect’s obligations to Mr. Yokomoto.
•
The agreement provides that prior to the termination of his employment, Mr. Yokomoto is prohibited from competing with ARTISTdirect. In addition, for a period of one year after the expiration of the agreement, Mr. Yokomoto is prohibited from hiring any of ARTISTdirect’s employees.
From August 1, 2002 through August 31, 2002, Mr. Yokomoto has elected to defer 33% of the salary that he would have earned under his employment agreement with ARTISTdirect, and from September 1, 2002, Mr. Yokomoto has elected to defer 50% of the salary that he was due to receive. In December 2002, ARTISTdirect amended Mr. Yokomoto’s employment agreement to provide that the amount of Mr. Yokomoto’s deferred salary, net of applicable tax withholdings, will be paid in a cash lump sum by ARTISTdirect within thirty days after the consummation of a private financing of at least $20,000,000 or, if earlier, the occurrence of (i) a merger, consolidation, sale of fifty percent (50%) or more of the voting securities or sale of all or substantially all of the assets of ARTISTdirect, (ii) Mr. Yokomoto’s attainment of age 65, or (iii) the termination of Mr. Yokomoto’s employment with ARTISTdirect.
Effective December 31, 2003, Mr. Yokomoto entered into a Termination Agreement and Mutual General Release. Mr. Yokomoto remains as a director of the Company. Mr. Yokomoto’s July 2001 employment agreement, which had an initial term extending through June 30, 2006, provided for an annual salary of $500,000 plus certain benefits, and a commencement advance of $300,000, representing a pre-payment of $60,000 against any monies that would otherwise become payable to Mr. Yokomoto under the Company’s executive performance bonus pool for each year of the initial five-year term of the employment agreement. The employment agreement also provided that under certain conditions, Mr. Yokomoto would receive a payment of $350,000 plus one year’s salary upon the termination of his employment with the Company. In consideration for Mr. Yokomoto terminating his employment agreement effective as of December 31, 2003 and waiving all rights to $1.25 million of remaining compensation under the employment agreement, we paid Mr. Yokomoto his accrued but unpaid salary at the rate of $500,000 per year through December 31, 2003 aggregating $412,847 and his accrued but unused vacation pay through December 31, 2003 aggregating $76,924, and Mr. Yokomoto repaid us the unearned portion of the commencement advance of $150,000.
Effective January 1, 2004, we entered into a one-year consulting agreement with Mr. Yokomoto. Under this consulting agreement, we will pay Mr. Yokomoto $120,000 per year in twelve equal installments in exchange for 20 hours of services per week as determined by the Company but consisting of assistance in connection with business development and corporate strategy, efforts to secure financing, implementation of a digital music initiative, and coordinating advertising and sales activities. Mr. Yokomoto also receives 10,000 immediately exerciseable options and 50,000 options which become exerciseable upon accomplishing certain milestones. These options are exerciseable at $0.50 per share. Mr Yokomoto also agreed, prior to the date that is one year after the termination of this Agreement, not to hire or offer to hire any officer, employee, agent, client, performer or songwriter of the Company to discontinue his or her relationship with the Company.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The following table sets forth certain information known to ARTISTdirect with respect to the beneficial ownership of ARTISTdirect’s common stock as of April 23, 2004 by (i) all persons who are beneficial owners of five percent (5%) or
more of ARTISTdirect’s common stock, (ii) each current director, (iii) the executive officers named in the Summary Compensation Table of the Executive Compensation section of this Form 10-K/A and (iv) all current directors and executive officers as a group. As of April 23, 2004, there were 3,502,117 shares of common stock outstanding. Unless otherwise indicated, each of the stockholders has sole voting and investment power with respect to the shares beneficially owned, subject to community property laws, where applicable.
*
Represents less than 1%.
(1)
Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission and includes voting or investment power with respect to the securities. Common stock subject to options or warrants that are currently exercisable or exercisable within 60 days of March 17, 2003 are deemed to be outstanding and to be beneficially owned by the person or group holding such options or warrants for the purpose of computing the percentage ownership of such person or group but are not treated as outstanding for the purpose of computing the percentage ownership of any other person or group. Unless otherwise indicated, the address for each of the individuals listed in the table is care of ARTISTdirect, Inc., 10900 Wilshire Boulevard, Suite 1400, Los Angeles, California, 90024. Unless otherwise indicated by footnote, the persons named in the table have sole voting and sole investment power with respect to all shares of ARTISTdirect common stock shown as beneficially owned by them, subject to applicable community property laws. Percentage of beneficial ownership is based on 3,502,117 shares of common stock outstanding as of April 23, 2004 and reflects the effect of ARTISTdirect’s rescission offer that was consummated in December 2001, pursuant to which ARTISTdirect purchased approximately 83,403 shares of its common stock, as well as the effect of ARTISTdirect’s one-for-ten reverse stock split effected in July 2001.
(2)
Consists of (a) 226,379 shares held by Constellation Venture Capital, L.P. and (b) 48,734 shares held by Constellation Ventures (BVI), Inc. One of ARTISTdirect’s former directors, Clifford Friedman, is President and Chief Executive Officer of Constellation Ventures (BVI), Inc. and a member of Constellation Ventures Management, LLC, the general partner of Constellation Venture Capital, L.P. As such, Mr. Friedman may be deemed to exercise voting and investment power over such shares. Mr. Friedman disclaims beneficial ownership of such shares, except to the extent of his proportionate interest therein.
(3)
Consists of 302,370 shares subject to immediately exercisable options.
(4)
Consists of 259,659 shares subject to immediately exercisable options.
(5)
Includes (a) 37,102 shares held by Mr. Yokomoto as trustee of the Geiger Children’s Trust, (b) 37,102 shares held by Mr. Yokomoto as trustee of the Muller Children’s Trust and (c) 10,000 shares subject to immediately exercisable options. Mr. Yokomoto has sole voting and dispositive power over these shares. Mr. Yokomoto disclaims beneficial ownership of these shares.
(6)
Consists of (a) 78,353 shares held by Psilos Group Partners, L.P., (b) 393 shares held by Psilos Group Investors, LLC and (c) 10,000 shares subject to immediately exercisable options. Mr. Krupa is a member of Psilos Group Investors, LLC, which is the general partner of Psilos Group Partners, L.P. As such, Mr. Krupa may be deemed to exercise voting and investment power over such shares. Mr. Krupa disclaims beneficial ownership of such shares, except to the extent of his proportionate interest therein.
(7)
Includes 10,000 shares subject to immediately exercisable options.
(8)
Includes the information set forth in notes 3-7 above.
Equity Compensation Plan Information
The following table provides information as of December 31, 2003 with respect to the shares of our common stock that may be issued under our existing equity compensation plans. The table does not include information with respect to shares subject to outstanding options granted under equity compensation plans assumed by ARTISTdirect in connection with mergers and acquisitions of the companies that originally granted those options. Footnote (6) to the table sets forth the total number of shares of our common stock issuable upon the exercise of those assumed options as of December 31, 2003, and the weighted average exercise price of those options. We do not intend to grant further options under those assumed plans.
(1)
Consists solely of the 1999 Employee Stock Purchase Plan and the stock options granted to our Chairman and former Chief Executive Officer, Frederick Field, as part of an individual compensation arrangement in connection with his initial employment agreement with ARTISTdirect.
(2)
Consists solely of the 1999 Employee Stock Option Plan, the 1999 Artist Stock Option Plan, the 1999 Artist and Artist Advisor Stock Option Plan and the stock options granted to our current Chief Executive Officer, Jonathan Diamond, as part of an individual compensation arrangement in connection with his initial employment agreement with ARTISTdirect..
(3)
Excludes purchase rights accruing under ARTISTdirect’s 1999 Employee Stock Purchase Plan that has a shareholder approved initial reserve of 50,000 shares. Under the Purchase Plan, each eligible employee may purchase up to 75 shares of common stock at semi-annual intervals on the last business day of April and October each year at a purchase price per share equal to 85% of the lower of (i) the fair market value per share of common stock on the employee’s entry date into the two-year offering period in which that semi-annual purchase date occurs or (ii) the fair market value per share on the semi-annual purchase date.
(4)
Consists of shares available for future issuance under the 1999 Employee Stock Purchase Plan. As of December 31, 2003, an aggregate of 112,831 shares of common stock were available for issuance under the 1999 Employee Stock Purchase Plan. The number of shares of common stock available for issuance under the 1999 Employee Stock Purchase Plan automatically increases on the first trading day of January each calendar year by an amount equal to 1.0% of the total number of shares of common stock outstanding on the last trading day of December in the immediately preceding calendar year, but in no event will any such annual increase exceed 25,000 shares of common stock.
(5)
Consists of shares available for future issuance under the 1999 Employee Stock Option Plan, the 1999 Artist Stock Option Plan and the 1999 Artist and Artist Advisor Stock Option Plan. As of December 31, 2003, an aggregate of
The 1999 Employee Stock Option Plan
The 1999 Employee Stock Option Plan became effective on October 6, 1999 in connection with our conversion from ARTISTdirect, LLC into ARTISTdirect, Inc. All options to purchase membership units in the limited liability company which were outstanding at the time of such conversion were assumed by the corporation and converted into options for shares of our common stock. The number of shares subject to each assumed and converted option was equal to the number of membership units in the limited liability company which were subject to that option immediately prior to the conversion, and the exercise price per share remained the same as the per unit exercise price in effect under the option at the time of conversion. Except for the conversion of the securities subject to the option into shares of our common stock, each option will continue to be governed by the terms of the agreement evidencing that option at the time of our conversion into a corporation.
The 1999 Employee Stock Option Plan is a non-shareholder approved plan under which options may be granted to employees, non-employee members of our Board of Directors, and consultants and other independent advisors in our employ or service. The number of shares of common stock issuable over the term of the 1999 Employee Stock Option Plan was initially 650,000 shares and increased by 75,592 shares and 69,235 shares on January 1, 2002 and 2003, respectively, for a total of 870,420 on December 31, 2003 (subject to adjustment for certain changes in our capital structure). The share reserve will automatically increase on the first trading day in January each calendar year by an amount equal to 2.0% of the total number of shares of our common stock outstanding on the last trading day in December in the immediately preceding calendar year, but in no event will any such annual increase exceed 87,500 shares.
All option grants under the 1999 Employee Stock Option Plan will have an exercise price per share equal to the fair market value per share of our common stock on the grant date. Each option will vest in installments over the optionee’s period of service with ARTISTdirect. The options will vest on an accelerated basis in the event ARTISTdirect is acquired and those options are not assumed or replaced by the acquiring entity. The options that were granted while we were a limited liability company, however, will terminate in the event ARTISTdirect is acquired and those options are not assumed by the acquiring entity (unless their vesting is accelerated by our Compensation Committee). Each option will have a maximum term (not to exceed 10 years) set by the plan administrator (our Compensation Committee) at the time of grant, subject to earlier termination following the optionee’s cessation of employment. All options are non-statutory options under the Federal tax law, unless they are incentive stock options granted to employees.
The 1999 Artist Stock Option Plan
The 1999 Artist Stock Option Plan became effective on October 6, 1999 in connection with our conversion from ARTISTdirect, LLC into ARTISTdirect, Inc. All options to purchase membership units in the limited liability company which were outstanding at the time of such conversion were assumed by the corporation and converted into options for shares of our common stock. The number of shares subject to each assumed and converted option was equal to the number of membership units in the limited liability company which were subject to that option immediately prior to the conversion, and the exercise price per share remained the same as the per unit exercise price in effect under the option at the time of conversion. Except for the conversion of the securities subject to the option into shares of our common stock,
each option will continue to be governed by the terms of the agreement evidencing that option at the time of our conversion into a corporation.
The 1999 Artist Stock Option Plan is a non-shareholder approved plan under which options were granted to performing artists who provided products and services through the ARTISTchannel Web sites we operate and maintain for them pursuant to ARTISTchannel agreements. The number of shares of common stock issuable over the term of the 1999 Artist Stock Option Plan was initially 400,000 shares and increased by 75,592 shares and 69,235 shares on January 1, 2002 and 2003, respectively, for a total of 620,420 as of December 31, 2003 (subject to adjustment for certain changes in our capital structure). The share reserve will automatically increase on the first trading day in January each calendar year by an amount equal to 2.0% of the total number of shares of our common stock outstanding on the last trading day in December in the immediately preceding calendar year, but in no event will any such annual increase exceed 87,500 shares.
All option grants under the 1999 Artist Stock Option Plan have an exercise price per share equal to the fair market value per share of our common stock on the grant date. Each option vests in installments over the period the optionee’s ARTISTchannel agreement remains in effect. The options will vest on an accelerated basis in the event ARTISTdirect is acquired and those options are not assumed or replaced by the acquiring entity. Each option has a maximum term (not to exceed 10 years) set by the plan administrator (our Compensation Committee) at the time of grant, subject to earlier termination following the termination of the optionee’s ARTISTchannel agreement. All options are non-statutory options under the Federal tax law.
The 1999 Artist and Artist Advisor Stock Option Plan
The 1999 Artist and Artist Advisor Stock Option Plan became effective on October 6, 1999 in connection with our conversion from ARTISTdirect, LLC into ARTISTdirect, Inc. All options to purchase membership units in the limited liability company which were outstanding at the time of such conversion were assumed by the corporation and converted into options for shares of our common stock. The number of shares subject to each assumed and converted option was equal to the number of membership units in the limited liability company which were subject to that option immediately prior to the conversion, and the exercise price per share remained the same as the per unit exercise price in effect under the option at the time of conversion. Except for the conversion of the securities subject to the option into shares of our common stock, each option will continue to be governed by the terms of the agreement evidencing that option at the time of our conversion into a corporation.
The 1999 Artist and Artist Advisor Stock Option Plan is a non-shareholder approved plan under which options were granted to performing artists and their attorneys, business managers, agents and other advisors who provided services to us. The number of shares of common stock issuable over the term of the 1999 Artist and Artist Advisor Stock Option Plan was initially 185,000 shares and increased by 37,500 and 34,617 shares on January 1, 2002 and 2003, respectively to a total of 294,617 as of December 31, 2003 (subject to adjustment for certain changes in our capital structure). The share reserve will automatically increase on the first trading day in January each calendar year by an amount equal to 1.0% of the total number of shares of our common stock outstanding on the last trading day in December in the immediately preceding calendar year, but in no event will any such annual increase exceed 37,500 shares.
All option grants under the 1999 Artist and Artist Advisor Stock Option Plan have an exercise price per share equal to the fair market value per share of our common stock on the grant date. Each option vests in installments over the optionee’s period of service with ARTISTdirect. The options will vest on an accelerated basis in the event ARTISTdirect is acquired and those options are not assumed or replaced by the acquiring entity. Each option has a maximum term (not to exceed 10 years) set by the plan administrator (our Compensation Committee) at the time of grant, subject to earlier termination following the termination of the optionee’s service for cause. All options are non-statutory options under the Federal tax law.
Share issuances under the 1999 Employee Stock Option Plan, the 1999 Artist Stock Option Plan and the 1999 Artist and Artist Advisor Stock Option Plan will not reduce or otherwise affect the number of shares of common stock available for issuance under the 1999 Employee Stock Purchase Plan, and share issuances under 1999 Employee Stock Purchase Plan will not reduce or otherwise affect the number of shares of common stock available for issuance under the 1999 Employee Stock Option Plan, the 1999 Artist Stock Option Plan and the 1999 Artist and Artist Advisor Stock Option Plan.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Since January 1, 2003 there has not been any transaction or series of similar transactions to which ARTISTdirect was or is a party in which the amount involved exceeded or exceeds $60,000 and in which any director, executive officer,
holder of more than 5% of any class of our voting securities, or any member of the immediate family of any of the foregoing persons had or will have a direct or indirect material interest, other than as set forth above under “Executive Compensation” or as described below.
Sublease with Frederick Field Affiliate
We relocated our administrative offices to a site leased by a company owned by Ted Field. We sub-lease these offices on a month-to-month basis. During the year ended December 31, 2003, we accrued $56,000 as rent expense, which represents occupancy costs for September through December 2003.
ARTISTdirect Records Financing
As of December 31, 2003, ARTISTdirect Records had received $898,000 and $100,000 of loans from Ted Field and Jonathan V. Diamond, respectively. The Notes accrue interest at 8% per annum, are due two years from the date of issuance, and will be converted into new equity of ARTISTdirect Records as part of its next equity financing. Mr. Field and Mr. Diamond also received warrants with a term of five years to purchase additional equity of the Company at $0.01 per unit equivalent to the number of units of new equity into which their Bridge Notes are ultimately converted.
Diamond Employment Agreement
In September 2003, we entered into an employment agreement with Jonathan Diamond in connection with his appointment as our chief executive officer. See the section above titled “Employment Contracts, Termination of Employment and Change in Control Arrangements” for information on these agreements.
Termination Agreements
In the 2003 fiscal year, we entered into agreements with Keith Yokomoto and Marc Geiger to terminate their officer positions. See the section above titled “Employment Contracts, Termination of Employment and Change in Control Arrangements” for information on these agreements.
Yokomoto Consulting Agreement.
On January 1, 2004, we entered into a consulting agreement with a director, Keith Yokomoto, to provide services on a part-time basis for one year. See the section above titled “Employment Contracts, Termination of Employment and Change in Control Arrangements” for information on these agreement.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Audit and Audit Related Fees:
KPMG LLP (“KPMG”) was our independent accountant for the year ended December 31, 2002 and for the interim periods ended September 30, 2003. Services provided to us by KPMG with respect to such periods consisted primarily of the audit of our financial statements and the financial statements of ARTISTdirect Records, LLC and limited reviews of the Form 10-QSB Quarterly Reports for the interim periods included therein pursuant to Statement on Auditing Standards No. 100. Charges by KPMG with respect to these matters aggregated approximately $42,000 and $217,500, respectively, for the years ended December 31, 2003 and 2002.
Gumbiner, Savett, Finkel, Fingleson & Rose, Inc. (“GSFFR”) was our independent accountant in preparing financial statements for the year ended December 31, 2003. Services provided to us by GSFFR with respect to such periods consisted primarily of the audit of our financial statements and the financial statements of ARTISTdirect Records, LLC. Charges billed to date by GSFFR with respect to these matters aggregated approximately $47,060 for the year ended December 31, 2003.
Tax Fees:
KPMG prepared the corporate income tax returns for our company and for ARTISTdirect Records for the year ended December 31, 2002. Charges by KPMG with respect to these matters aggregated approximately $24,250 for the year ended December 31, 2002.
Charges billed to date by GSFFR for tax matters was $1,155 for the year ended December 31, 2003.
Pre-Approval Policies and Procedures:
The Audit Committee meets periodically to review and approve the scope of the services to be provided to us by our independent accountant, as well to review and discuss any issues that may arise during an engagement. The Audit Committee considers various issues with respect to the services to be provided by our independent accountant, including the complexity of any engagement, its expected cost, the knowledge and expertise of the independent accountant’s staff, any complex accounting or disclosure issues, new accounting pronouncements, and the capability of our financial staff.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1). FINANCIAL STATEMENTS
ARTISTdirect financial statements appear in a separate section of this Annual Report on Form 10-K beginning on the pages referenced below:
ARTISTdirect, Inc. and Subsidiaries Consolidated Financial Statements
(2) FINANCIAL STATEMENT SCHEDULES
Financial statement schedules have been omitted as they are not applicable, not required, or the information is included in the consolidated financial statements or the notes thereto.
(3) EXHIBITS
A list of exhibits required to be filed as part of this Annual Report on Form 10-K is set forth in the Index to Exhibits, which immediately precedes such exhibits, and is incorporated herein by reference.
(b) REPORTS ON FORM 8-K
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
ARTISTDIRECT, INC.
Date: May 13, 2004
By: /s/ Jonathan V. Diamond
Jonathan V. Diamond
Chief Executive Officer
We, the undersigned officers and directors of ARTISTdirect, Inc., do hereby constitute and appoint Jon Diamond and Robert Weingarten and each of them, our true and lawful attorneys-in-fact and agents, each with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Report, and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that each of said attorneys-in-fact and agents, or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
ARTISTDIRECT, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2002 AND 2003
INDEPENDENT AUDITORS REPORT
To the Board of Directors
ARTISTdirect, Inc.
We have audited the accompanying consolidated balance sheet of ARTISTdirect, Inc. and subsidiaries (the “Company”) as of December 31, 2003 and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity (deficiency) and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. 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 audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of ARTISTdirect, Inc. and subsidiaries as of December 31, 2003 and the consolidated results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the consolidated financial statements, as of December 31, 2003 the Company changed its method of accounting for its investment in its record label joint venture, ARTISTdirect Records, LLC.
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As more fully described in Note 1, the Company has incurred substantial operating losses and negative cash flows from operations to date. The Company needs additional capital to fund its operations. As of December 31, 2003, the Company has a net working capital deficiency of $9,464,000 and stockholders’ deficiency of $16,945,000. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ GUMBINER, SAVETT, FINKEL, FINGLESON & ROSE, INC.
Santa Monica, California
April 6, 2004
ARTISTDIRECT, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT FOR SHARE DATA)
See accompanying notes to consolidated financial statements.
ARTISTDIRECT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT FOR SHARE DATA)
See accompanying notes to consolidated financial statements.
ARTISTDIRECT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(IN THOUSANDS)
See accompanying notes to consolidated financial statements.
ARTISTDIRECT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIENCY)
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
[Additional columns below]
[Continued from above table, first column(s) repeated]
See accompanying notes to consolidated financial statements.
ARTISTDIRECT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
See accompanying notes to consolidated financial statements.
ARTISTDIRECT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2001, 2002 AND 2003
1. BASIS OF PRESENTATION
ORGANIZATION
ARTISTdirect, Inc. (“ADI”) was formed on October 6, 1999 upon its merger with ARTISTdirect, LLC (the “Capital Reorganization”). The Capital Reorganization was only a change in the form of ownership of ADI. ARTISTdirect, LLC was organized as a California limited liability company and commenced operations on August 8, 1996. ARTISTdirect, LLC had a 99% ownership interest in ARTISTdirect Agency LLC, Kneeling Elephant Records, LLC and ARTISTdirect New Media, LLC (the “Affiliated Companies”) and has consolidated their results since inception.
On May 31, 2001, the Company, through its wholly-owned subsidiary, ARTISTdirect Recordings, Inc., entered into an agreement to acquire a 50% equity interest in a co-venture with Frederick W. (Ted) Field to form a new record label, ARTISTdirect Records, LLC (“ARTISTdirect Records”). This transaction became effective as of June 29, 2001. In April 2002, ADI’s ownership position in ARTISTdirect Records decreased to 45% as a result of a sale of a 5% interest to BMG (see Note 11). However, ADI’s ownership position increased to 65% during 2002, as a result of ADI’s agreement to accelerate its funding commitment to ARTISTdirect Records in 2002 (see Note 11).
Unless the context indicates otherwise, ARTISTdirect, Inc. and its subsidiaries are referred to herein as the “Company”.
BUSINESS ACTIVITIES
The Company is a music entertainment company, headquartered in Los Angeles, California, that combines an on-line music network and a record label to provide an integrated offering for music fans, artists and marketing partners. The ARTISTdirect Network (www.artistdirect.com) is a network of Web sites offering multi-media content, music news and information, community around shared music interests, music-related specialty commerce and digital music services. Through the Company’s subsidiary, ARTISTdirect Records, the Company develops new musical artists and produces and distributes their recordings as an independent label utilizing both traditional channels and emerging Internet distribution channels.
PRINCIPLES OF CONSOLIDATION
The accompanying financial statements include the consolidated accounts of ADI and its subsidiaries in which it has controlling interests. All significant intercompany accounts and transactions have been eliminated for all periods presented. ADI has recorded 100% of the losses attributable to ARTISTdirect Records from May 31, 2001 through April 30, 2002 based on ADI’s commitment to fund 100% of ARTISTdirect’s operations during that time. From May 1, 2002 through December 31, 2002, ADI recorded approximately 83% of the losses of ARTISTdirect Records as a result of BMG’s equity purchase and from an assumption of a portion of ADI’s funding commitment to the record label. For the year ended December 31, 2003, ADI recorded approximately 73% of the losses of ARTISTdirect Records. However, given that ADI did not have voting or operational control, even with its majority ownership position in ARTISTdirect Records, through December 31, 2003, ADI accounted for this investment under the equity method of accounting as income (loss) from equity investments in the consolidated statements of operations.
In February 2003, the Financial Accounting Standards Board issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which addresses the consolidation by business enterprises of variable interest entities. ADI adopted FIN 46 as of December 31, 2003. As a result of the adoption of FIN 46, the balance sheet of ARTISTdirect Records was consolidated as of December 31, 2003, and the operations of ARTISTdirect Records will be consolidated beginning January 1, 2004 (see Notes 2 and 11).
As a result of the consolidation of the balance sheet of ARTISTdirect Records as of December 31, 2003, the Company’s balance sheet as of December 31, 2003 is not directly comparable to its balance sheet as of December 31, 2002. The cumulative effect of this change on prior years was to increase the loss for 2003 by $5.3 million ($1.52 per share). The financial statements for 2002 have not been restated, and the cumulative effect of the change of $5.3 million ($1.52 per share) is shown as a one-time charge to operations in the 2003 statement of operations.
GOING CONCERN
The Company has incurred losses and negative cash flows from operations in every fiscal period since inception and has an accumulated deficit of $222.7 million as of December 31, 2003. For the year ended December 31, 2003, the Company incurred a net loss of $21.7 million and negative operating cash flows of $5.4 million. As of December 31, 2003, the Company had a net working capital deficiency of $9.5 million and a stockholders’ deficiency of $16.9 million. Additionally, ADI has been funding substantially all of the operations of ARTISTdirect Records. ADI’s operations to date and loans to ARTISTdirect Records have been funded by the sale of its preferred and common stock. Management expects the Company’s operating losses to continue for the foreseeable future. The Company does not currently anticipate that its available cash resources will be sufficient to meet anticipated capital needs over the next twelve months without additional capital. The Company restructured its operations, laid off most of its staff and reduced operating costs during 2003, and is attempting to mitigate its funding obligation and raise additional funding through various means. However, there can be no assurances that the Company will be successful in this regard. If sufficient capital is not available, then the Company may not be able to fund its operations or its remaining funding commitment to ARTISTdirect Records. Failure to raise additional capital could seriously harm the business of ARTISTdirect Records and impair the value of the Company’s investment in ARTISTdirect Records. To the extent that the Company is unable to successfully restructure its funding obligation and/or obtain the capital necessary to fund its future cash requirements on a timely basis and under acceptable terms and conditions, the Company will not have sufficient cash resources to maintain operations, and may consider a formal or informal restructuring or reorganization. The conditions described above raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
2. SIGNIFICANT ACCOUNTING POLICIES
CASH EQUIVALENTS
Cash equivalents consist of investments, which are readily convertible into cash and have maturities of three months or less at the time of purchase.
RESTRICTED CASH
As of December 31, 2002, restricted cash consisted of a letter of credit posted for the benefit of the Company’s landlord of approximately $1.8 million and a letter of credit posted for the benefit of the Company’s e-commerce credit card processor of $350,000. As of December 31, 2003, restricted cash consisted of the letter of credit related to the e-commerce credit card processor.
SHORT-TERM INVESTMENTS
The Company classifies its short-term investments as available-for-sale and has recorded the investments at fair value, with the difference between amortized cost and fair value being recorded as a component of stockholders’ equity (deficiency). The Company invests primarily in fixed income securities with maturities of one year or less at the time of purchase.
DEPRECIATION
Depreciation is provided using the straight-line method over the following estimated useful lives as follows:
Computer equipment and software
3 years
Furniture and fixtures
7 years
Leasehold improvements
Lesser of estimated useful life or term of lease (10 years)
REVENUE RECOGNITION
E-commerce revenue consists primarily of the gross amount of sales revenue paid by the customer for recorded music and merchandise sold via the Internet, including shipping fees, and is recognized when the products are shipped. The Company records e-commerce revenue on a gross basis as the Company enters into the sale transactions with customers, establishes the prices of the products, chooses the suppliers of the products, assumes the risk of inventory loss and collects all amounts from the customers and assumes the credit risk. E-commerce revenue is subject to amounts due to the respective artists based on their contracts, and such expense is recorded as part of direct cost of product sales.
The Company records amounts charged to customers for shipping and handling in accordance with Emerging Issues Task Force No. 00-10, “Accounting for Shipping and Handling Fees and Costs” (“EITF No. 00-10”). Pursuant to EITF No. 00-10, the Company records amounts charged to customers for shipping and handling as revenue, and records the related costs incurred for shipping and handling to direct cost of product sales in the consolidated statements of operations. For the years ended December 31, 2001, 2002 and 2003, the Company recorded $1.5 million, $1.0 million and $806,000, respectively, as revenue for shipping and handling fees charged to customers. For the years ended December 31, 2001, 2002 and 2003, the Company recorded $1.1 million, $736,000 and $523,000, respectively, of shipping and handling costs as direct cost of product sales in the consolidated statements of operations.
Media revenue consists primarily of the sale of advertisements and sponsorships, both online and offline, under short-term contracts. To date, the duration of the Company’s advertising and sponsorship commitments has generally averaged from one to three months with certain programs lasting up to six months. The Company’s online obligations typically include the guarantee of a minimum number of times (“impressions”) that an advertisement appears in pages viewed by the users of the Company’s online properties. Online advertising revenue is generally recognized as the impressions are served during the period in which the advertisement is displayed, provided that no significant obligations of the Company remain and collection of the resulting receivable is reasonably assured. To the extent that minimum guaranteed page deliveries are not met, recognition of the corresponding revenue is deferred until the guaranteed impressions are delivered.
The Company recognizes revenue for sponsorship arrangements, both online and offline, over the period during which the advertising is provided, generally on a straight-line basis. If the sponsorship arrangement is for the sponsorship of a specific event, the Company recognizes revenue when the event occurs. The Company recognizes revenue separately for each element of integrated entertainment marketing packages that offer advertisers a combination of off-line concert and tour sponsorships that are supported by on-line banner advertising, web page sponsorships, emails to the Company’s customers and custom content. The Company determines the fair value of each deliverable based on the fair value of the different deliverables when sold on a stand-alone basis. The Company recognizes revenue for each deliverable as the services are provided. The Company recognizes revenue for the banner impression deliverable as the banner impressions are delivered. The Company recognizes revenue for the customer emails when the emails are sent. The Company recognizes revenue for web page sponsorships on a straight-line basis over the term of the sponsorship. The Company recognizes revenue for the custom content when the content is provided to the customer. The Company recognizes revenue for event sponsorships when the event has occurred.
Record label revenue consists primarily of the sale of compact discs by artists under contract with the Company through the iMusic record label. The Company recognizes revenues upon the shipment of compact discs from its distributor to retailers and independent wholesalers and records appropriate reserves for product returns. At the time of the shipment of the product, the following criterion under Statement of Financial Accounting Standards No. 48, “Revenue Recognition When Right of Return Exists”, have been met: the seller’s price to the buyer is substantially fixed or determinable at the date of sale; the buyer has paid the seller, or the buyer is obligated to pay the seller, and the obligation is not contingent on resale of the product; the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product; the buyer acquiring the product for resale has economic substance apart from that provided by the seller; the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer; and the amount of future returns can be reasonably estimated.
The Company estimates the provision for returns on a quarterly basis by album based on the amount of time since the initial album release, the actual returns to date, the trend of sales activity (sales by the retailers and wholesalers) and the number of unsold units at retailers and wholesalers. Returns to the Company’s distributor are deemed to be returns to the Company.
COST OF REVENUE
Direct cost of product sales consists of amounts payable to artists related to e-commerce sales, which includes the cost of merchandise sold and the artists’ share of net proceeds, and online commerce transaction costs, including credit card fees, fulfillment charges and shipping costs.
Direct cost of product sales also includes manufacturing costs and distribution fees payable. Manufacturing costs consist of the cost of pressing compact discs, manufacturing printed booklets and packaging materials and a provision for the obsolescence of finished goods and components. Distribution expenses consist of various distribution costs, including the cost of processing returns and warehousing inventory. Artist advances and royalty expenses consist of payments made to artists and others in connection with the recording of an album.
Other cost of revenue consists primarily of Web site hosting and maintenance costs, online content programming costs, online advertising serving costs, record royalties payable and payroll and related expenses for staff involved with the Website. Stock-based compensation expense relates to non-cash charges in connection with options issued to artists and their advisors for the right to operate their stores and warrants issued to vendors. Amounts payable to artists and transaction costs are recognized upon shipment. Web site-related costs are recognized immediately when incurred.
Payroll and related expenses are recognized in the period incurred. Non-cash stock-based compensation charges are recognized over the period of the related agreements.
ARTIST ADVANCES
Artist advances consists of the amounts advanced to artists in connection with the recording of their albums. In addition, included in artist advances are costs expended for producer fees, musician fees, engineering and studio costs, equipment costs, mastering and remix costs, sample clearances and artist living expenses during recording. Artist advances are typically recoupable from artist royalties earned from the sale of compact discs. The Company expenses these advances when incurred as the Company’s artists have limited or no history of album sales.
DISCONTINUED OPERATIONS
The Company has accounted for its agency division as a discontinued operation in accordance with Accounting Principles Board (APB) No. 30, “Accounting for Discontinued Operations”, and recorded the net results of this business segment in a single line entitled income from discontinued operations in the consolidated statements of operations for the years ended December 31, 2001 and 2002. The classification of the agency division as a discontinued operation was made prior to the initial application of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”.
INVENTORIES
Inventories, net of a provision for obsolescence, are included in prepaid expenses and other current assets, and consist of compact discs maintained in the warehouse of the Company’s distributor and music-related merchandise. Inventories are stated at the lower of cost or net realizable value. Cost is determined using the first-in, first-out method.
INCOME TAXES
The Company accounts for income taxes under the asset and liability method whereby 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 the statement of operations in the period that includes the enactment date. A valuation allowance is recognized if management cannot determine that it is more likely than not that some portion or all of the tax asset will be realized.
WEB SITE DEVELOPMENT COSTS
Web site development costs consist primarily of third-party development costs and payroll and related expenses for in-house Web site development costs incurred in the start-up and production of the Company’s content and services. These costs are expensed as incurred.
ADVERTISING COSTS
Advertising costs are expensed as incurred and totaled $2.7 million, $1.0 million and $333,000 during the years ended December 31, 2001, 2002 and 2003, respectively.
IMPAIRMENT OF LONG-LIVED ASSETS AND GOODWILL
Prior to January 1, 2002, the Company periodically reviewed the carrying amount of long-lived assets and goodwill to determine whether current events or circumstances warranted adjustments to such carrying amounts. An impairment adjustment was necessary
in the event the net book value of such long-lived assets and goodwill exceeded the future undiscounted cash flows attributable to such assets. In such an event, the loss would be measured by the amount that the carrying value of such assets exceeded their fair value, as determined based on estimated discounted cash flows.
In 2001, the Company determined that the remaining goodwill associated with the acquisition of Mjuice was fully impaired due to the Company’s decision to wind down the related operation and recorded a loss from impairment of $4.5 million. In addition, due to the decline in advertising revenues, the Company determined that there was insufficient basis to support the entire carrying amount of goodwill associated with the 1999 acquisitions of iMusic and UBL based upon the projected undiscounted future cash flows related to the underlying assets of these goodwill amounts and recorded a loss from impairment of $7.0 million based on the estimated discounted cash flows. For the year ended December 31, 2001, the Company recorded an aggregate $11.4 million loss from impairment of goodwill. Both of these write-downs were reflected in the Media segment operations.
Prior to January 1, 2002, the Company amortized goodwill, which represents the excess of the purchase price over the net assets acquired in business acquisitions, over 5 years. In January 2002, the Company adopted SFAS No. 142, “Goodwill and Other Intangible Assets”, and as a result ceased to amortize goodwill. Instead, the Company was required to perform a transitional impairment review of its goodwill as of January 1, 2002 and an annual impairment review thereafter. The Company evaluated the impact of the adoption of SFAS No. 142 and determined that no impairment charge was required upon adoption of this standard. The impairment test was performed through comparison of the fair value of the reporting units with the carrying value of their assets. During the three months ended June 30, 2002, the Company determined the remaining goodwill associated with the iMusic and UBL acquisitions of $788,000 was impaired due to a continuing decline in e-commerce and advertising revenues, and recorded a loss from impairment of that amount. This write-down was reflected in the Media segment operations. The fair value of the reporting unit to which the goodwill impairment related was determined based on the discounted estimated future cash flows. The discount rate used in the discounted cash flow analysis was determined based on the estimated cost of capital in the industry in which the Media segment operates. As of December 31, 2002, no goodwill or intangible assets remained on the Company’s balance sheet.
Impairment of long-lived assets is monitored on a continuing basis, and is assessed based on the undiscounted cash flows generated by the underlying assets. In the event that the carrying amount of long-lived assets exceeds the undiscounted future cash flows, then the carrying amount of such assets is adjusted to their fair value.
See Note 7 for write-downs in 2003 with respect to the Company’s property and equipment.
CONCENTRATION OF RISK
Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash, short-term investments and trade accounts receivable. The Company places its cash and short-term investments in high credit quality instruments. Cash balances at certain financial institutions may exceed the FDIC insurance limits. The Company performs ongoing credit evaluations of its customers but does not require collateral. Exposure to losses on receivables is principally dependent on each customer’s financial condition. The Company monitors its exposure to credit losses and maintains allowances for anticipated losses.
The Company purchases a large percentage of its music-related merchandise inventory from a limited number of suppliers. The Company is subject to risk in the event that any of the suppliers is unable to fulfill their orders. However, there are a number of different suppliers who can provide manufacturing services for the Company.
During the year ended December 31, 2003, AT&T Wireless accounted for $550,000 or 47% of total media revenue. No other advertiser accounted for more than 10% of the Company’s media revenue during 2002 or 2003. There were no amounts due from AT&T Wireless at December 31, 2003.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts of financial instruments, which include cash and cash equivalents, short-term investments, accounts receivable, accounts payable and accrued expenses, approximate fair value because of the short maturity of these instruments.
The carrying amount of the Bridge Notes payable approximates fair value as the related effective interest rate (including the discount) approximates rates currently available to the Company.
LIABILITY ASSOCIATED WITH INVESTMENTS IN AFFILIATED COMPANIES
Investments in affiliated companies in which ADI’s voting interest is greater than 20% and does not have a controlling financial interest, or in which ADI is able to exert significant influence in instances where the voting interest is less than 20%, are accounted for under the equity method of accounting. Under this method, the investment, originally recorded at cost, is adjusted to recognize ADI’s share of the net earnings or losses of the affiliates as they occur rather than as dividends or other distributions are received. ADI’s share of losses is generally limited to the extent of its investment in and advances to the investee. However, ADI recorded losses in excess of its investment when funding commitments exist. Through December 31, 2003, ADI accounted for its investment in ARTISTdirect Records on the equity method of accounting since ADI did not have voting or operational control of the investee. ADI had committed to fund 100% of the operations of ARTISTdirect Records and recorded 100% of the losses attributable to that venture from May 31, 2001 to April 30, 2002. From May 1, 2002 to December 31, 2003, ADI’s funding commitment was reduced by the sale of 5% of the equity of ARTISTdirect Records to BMG and therefore ADI recorded only its proportionate share, on the basis of relative funding commitments, of the losses of ARTISTdirect Records.
ADI has not recorded a valuation allowance for its loans to ARTISTdirect Records as the carrying amount of the loans has been reduced to zero as a result of ADI recording its share of losses of ARTISTdirect Records during the years ended December 31, 2001, 2002 and 2003.
See Notes 2 and 11 with respect to consolidation of ARTISTdirect Records as of December 31, 2003.
LOSS PER COMMON SHARE
The Company computes net loss per share in accordance with SFAS No. 128, “Earnings per Share” and Securities and Exchange Commission Staff Accounting Bulletin No. 98 (“SAB 98”). SFAS No. 128 requires companies with complex capital structures to present basic and diluted EPS. Basic EPS is measured as the income or loss available to common shareholders divided by the weighted average outstanding common shares for the period. Diluted EPS is similar to basic EPS but presents the dilutive effect on a per share basis of potential common shares (e.g., convertible securities, options and warrants) as if they had been converted at the beginning of the periods presented. Potential common shares that have an anti-dilutive effect (i.e., those that increase income per share or decrease loss per share) are excluded from the calculation of diluted EPS. During the year ended December 31, 2001, interest on the rescission offer balance was added to the net loss in determining the net loss attributable to common shareholders.
The calculation of diluted loss per share excludes approximately 820,000, 780,000 and 1,111,000 of potential common shares for the years ended December 31, 2001, 2002 and 2003, respectively, since the effect would be anti-dilutive.
STOCK-BASED COMPENSATION
The Company accounts for stock-based employee compensation in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25 and FASB Interpretation No. 44 (“FIN 44”), “Accounting for Certain Transactions Involving Stock Compensation”, and complies with the disclosure requirements of SFAS No. 123, “Accounting for Stock-Based Compensation”. Under APB No. 25, compensation expense is recorded based on the difference, if any, between the fair value of the Company’s stock and the exercise price on the measurement date. The Company accounts for stock issued to non-employees in accordance with SFAS No. 123, which requires entities to recognize as expense over the service period the fair value of all stock-based awards on the date of grant and EITF No. 96-18, “Accounting for Equity Investments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services”, which addresses the measurement date and recognition approach for such transactions.
The Company recognizes compensation expense related to variable awards in accordance with FIN 28. For fixed awards, the Company recognizes expense over the vesting period or the period of service.
In addition to stock-based compensation classified as cost of revenue, stock-based compensation is comprised of sales and marketing expense of $6.3 million, $1.9 million and $0 for the years ended December 31, 2001, 2002 and 2003, respectively, and general and administrative expense of $6.1 million, $31,000 and $527,000 for the years ended December 31, 2001, 2002 and 2003, respectively.
Prior to the Company’s initial public offering in March 2000, the Company issued shares or options to purchase shares to employees, artists and advisors. The issuance of these shares or options did not fully comply with certain requirements under the Securities Act, or available exemptions thereunder, and as a result the Company made a rescission offer to all these persons pursuant to a registration statement filed under the Securities Act and pursuant to California securities law.
As a result of completing the rescission offer in December 2001, the Company incurred stock-based compensation expense for the repurchase of unexercised stock options held by employees and non-employees and shares of common stock held by employees and non-employees pursuant to the exercise of stock options. The compensation expense recorded for the repurchase of unexercised stock options (vested and unvested) from employees was the sum of the intrinsic value at the original measurement date (less any expense related to the intrinsic value recorded up to the acceptance of the rescission offer) and the amount of cash paid to the holder that exceeds the lesser of the intrinsic value at the original measurement date or upon the completion of the rescission offer. Such amount was recorded as expense immediately upon the completion of the rescission offer.
The compensation expense recorded for the repurchase of unexercised non-employee options (vested and unvested) was calculated as the difference between the amount of cash paid for the repurchase of the options and the fair value of the options on the closing date of the rescission offer. This compensation expense was recorded over the period over which the non-employee provided services to the Company pursuant to a contract. The fair value of the options was determined using the Black-Scholes option-pricing model over the remaining life of the options. Any unamortized expense at the time of repurchase related to the initial grant of the options to the non-employees continued to be amortized over the remaining service period related to the original option grants. The key assumptions used in the Black-Scholes option-pricing model for the purpose of the calculation were: a risk free rate of 6%; a volatility factor of 98%; no expected dividends; and an expected life which was equal to the remaining contractual life of the options as of December 31, 2001.
The compensation expense for the repurchase of shares issued pursuant to the exercise of options (by employees and non-employees) was calculated as the difference between the amount of cash paid for the repurchase of the shares and the fair value of the shares on the date the repurchase. The compensation expense related to the repurchase of shares from employees was recorded at the time of repurchase, and the compensation expense related to the repurchase of shares from non-employees was recorded over the period over which services were being provided.
Pro forma information regarding net loss per share is required by SFAS 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of such statement. The fair value for these options was estimated at the date of grant using the Black-Scholes option-pricing model. The assumptions used in the model and the weighted average fair value of each option granted for 2001, 2002 and 2003 are as follows:
For purpose of pro forma disclosures, the estimated fair value of the options is amortized to operations over the vesting period of the options or the expected period of benefit. The Company’s pro forma information follows (in thousands, except per share amount):
COMPREHENSIVE LOSS
The Company has adopted the provisions of Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive Income” (“SFAS No. 130”). SFAS No. 130 establishes standards for the reporting and display of comprehensive income, its components and accumulated balances in a full set of general purpose financial statements. SFAS No. 130 defines comprehensive
income (loss) to include all changes in equity except those resulting from investments by owners and distributions to owners, including adjustments to minimum pension liabilities, accumulated foreign currency translation, and unrealized gains or losses on marketable securities.
The Company’s only component of other comprehensive income is the unrealized gain (loss) on available for sale securities, consisting of a gain of $146,000 for the year ended December 31, 2001 and a loss of $78,000 and $58,000 for the years ended December 31, 2002 and 2003, respectively. These amounts have been recorded as a separate component of stockholders’ equity (deficiency).
ESTIMATES
In preparing financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Some of the more significant estimates include allowances for bad debts, impairment of long-lived assets and goodwill, impairment of fixed assets, stock-based compensation and the valuation allowance on deferred tax assets. Actual results could differ from those estimates.
3. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In August 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (“SFAS No. 143”). SFAS No. 143 addresses the diverse accounting practices for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The Company adopted SFAS No. 143 effective January 1, 2003. The adoption of SFAS No. 143 did not have a significant effect on the Company’s financial statement presentation or disclosures.
In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. While SFAS No. 144 supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of”, it retains many of the fundamental provisions of that statement. The Company adopted SFAS No. 144 effective January 1, 2002. The adoption of SFAS No. 144 did not have a material impact on the Company’s financial statement presentation or disclosures.
In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections”. SFAS No. 145 rescinds SFAS 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. Upon adoption of SFAS No. 145, the Company will be required to apply the criteria in APB Opinion No. 30, “Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” (Opinion No. 30), in determining the classification of gains and losses resulting from the extinguishment of debt. Additionally, SFAS No. 145 amends SFAS No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions to be accounted for in the same manner as sale-leaseback transactions. The Company adopted SFAS No. 145 effective January 1, 2003. The adoption of SFAS No. 145 for long-lived assets held for use did not have a material impact on the Company’s financial statement presentation or disclosures.
In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit and Disposal Activities”. SFAS No. 146 nullifies Emerging Issues Task Force (“EITF”) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)”. Under EITF Issue No. 94-3, a liability for an exit cost is recognized at the date of an entity’s commitment to an exit plan. Under SFAS No. 146, the liabilities associated with an exit or disposal activity will be measured at fair value and recognized when the liability is incurred and meets the definition of a liability in the FASB’s conceptual framework. SFAS No. 146 is effective for exit or disposal activities initiated after December 31, 2002. The adoption of SFAS 146 did not have a material impact on the Company’s financial statement presentation or disclosures.
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure-an amendment of SFAS No. 123”. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also amends the disclosure requirements of SFAS No. 123 and APB Opinion No. 28, “Interim Financial Reporting”, to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company implemented SFAS No. 148 effective December 31, 2002. The Company has determined that it will continue to account for stock-based employee compensation in accordance with APB No. 25.
In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”. SFAS No. 149 amends and clarifies under what circumstances a contract with initial investments meets the characteristics of a derivative and when a derivative contains a financing component. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS No. 149 did not have a significant effect on the Company’s financial statement presentation or disclosures.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. SFAS No. 150 establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003 and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. SFAS No. 150 is to be implemented by reporting the cumulative effect of a change in accounting principle for financial instruments created before the issuance date of SFAS No. 150 and still existing at the beginning of the interim period of adoption. Restatement is not permitted. The adoption of SFAS No. 150 did not have a significant effect on the Company’s financial statement presentation or disclosures.
In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others” (“FIN 45”), an interpretation of FASB Statements Nos. 5, 57 and 107 and a rescission of FASB Interpretation No. 34. FIN 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees issued. FIN 45 also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken. The initial recognition and measurement provisions of FIN 45 are applicable to guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN 45 are effective for financial statements of interim and annual periods ended after December 15, 2002. The adoption of FIN 45 did not have a material effect on the Company’s financial statement presentation or disclosures.
In November 2002, the FASB’s Emerging Issues Task Force (“EITF”) issued EITF No. 00-21 “Revenue Arrangements with Multiple Deliverables”. EITF No. 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. Specifically, EITF No. 00-21 addresses how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. In applying EITF No. 00-21, separate contracts with the same entity or related parties that are entered into at or near the same time are presumed to have been negotiated as a package and should, therefore, be evaluated as a single arrangement in considering whether there are one or more units of accounting. That presumption may be overcome if there is sufficient evidence to the contrary. EITF No. 00-21 also addresses how arrangement consideration should be measured and allocated to the separate units of accounting in the arrangement. The guidance in EITF No. 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The Company adopted EITF No. 00-21 effective July 1, 2003. The adoption of EITF No. 00-21 has not had any significant impact on the Company’s financial statement presentation or disclosures.
In February 2003, the Financial Accounting Standards Board issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which addresses the consolidation by business enterprises of variable interest entities, which have one or both of the following characteristics: (1) the equity investment at risk is not sufficient to permit the entity to finance its activities without additional financial support from other parties, or (2) the equity investors lack one or more of the following essential characteristics of a controlling financial interest: (a) the direct or indirect ability to make decisions about the entity’s activities through voting or similar rights, (b) the obligation to absorb the expected losses of the entity if they occur, or (c) the right to receive the expected residual returns of the entity if they occur. In addition, FIN 46 contains detailed disclosure requirements. FIN 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period ending after March 15, 2004, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. Early adoption is permitted. The Company adopted FIN 46 as of December 31, 2003. The adoption of FIN 46 on such date had a significant impact on the Company’s consolidated balance sheet. The Company had previously accounted for its investment in ARTISTdirect Records under the equity method. The Company
consolidated the balance sheet of ARTISTdirect Records as of December 31, 2003, and will consolidate the operations of ARTISTdirect Records beginning January 1, 2004.
4. SUPPLEMENTAL DISCLOSURES TO CONSOLIDATED STATEMENTS OF CASH FLOWS
Significant non-cash investing and financing activities are as follows:
The following is the adjustment resulting from the change to consolidation from equity accounting for ARTISTdirect Records, LLC effective December 31, 2003:
As a result of the consolidation of ARTISTdirect Records effective December 31, 2003, the Company recorded a credit to additional paid-in capital of $800,000, which consisted of the net 65% majority interest portion of the total debt forgiven in 2003 by the Chairman of ARTISTdirect Records of $534,000 ($822,000 x 65%), and other adjustments aggregating $266,000.
5. SHORT-TERM INVESTMENTS
The Company’s short-term investments consist of the following:
6. ARTIST ADVANCES
As of December 31, 2003, ARTISTdirect Records had signed recording agreements with six artists and had advanced a total of $1.238 million through such date with respect to these artists. The amount of these advances is recoupable against royalties to be
earned by the artists based on sales. However, given that most of the artists signed by the record label have no previous track record, the advances have been expensed by ARTISTdirect Records as incurred. As of December 31, 2003, ARTISTdirect Records is contractually committed to additional minimum artist advances of approximately $1.5 million, all of which is payable in 2004.
7. PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost and consist of the following:
In June 2003, the Company initiated discussions with its landlord regarding the potential termination or restructuring of its office lease that had a term through April 2010. On June 24, 2003, the landlord filed suit against the Company for unlawful detainer of its premises and in July 2003 the landlord drew down the entire remaining $1.35 million letter of credit that the Company had provided as a security deposit in conjunction with the execution of the original lease. In September 2003, the Company reached an agreement to terminate its lease with the landlord. In conjunction with the termination, the Company issued to the landlord warrants to purchase 200,000 shares of the Company’s common stock exercisable at $0.50 per share through September 8, 2008. In October 2003, the legal proceedings against the Company were dismissed with prejudice. As a result, the Company recorded an expense of $429,000, comprised of $1.35 million under the letter of credit which was funded by the Company, plus $100,000 of expense related to the issuance of the warrants to the landlord, calculated pursuant to the Black-Scholes option-pricing model, offset by deferred rent obligations and other credits of $1.021 million.
Impairment of fixed assets is monitored on a continuing basis, and is assessed based on the undiscounted cash flows generated by the underlying assets. In the event the carrying amount of fixed assets exceeds the undiscounted future cash flows, then the carrying amount of such assets is adjusted to their fair value. There was no impairment of long-lived assets as of December 31, 2002, as undiscounted expected cash flows exceeded net book value. During the three months ended June 30, 2003, the Company determined that its fixed assets were impaired due to continuing losses, going concern issues, the delisting of its common stock from the NASDAQ Stock Market, and the likelihood that the majority of these assets would likely be abandoned in the near future. The Company determined that these factors were indicators of impairment and thus reduced the carrying amount of the fixed assets to their estimated fair value by recording a write-off of $2.225 million during the three months ended June 30, 2003. The leasehold improvements were subsequently abandoned when the Company vacated the premises, and most of the Company’s remaining property and equipment was subsequently sold to third party liquidators for cash. This amount has been reported as a loss from sale and abandonment of property and equipment in the consolidated statement of operations for the year ended December 31, 2003.
8. ALLOWANCES FOR DOUBTFUL ACCOUNTS AND SALES RETURN RESERVE
A summary of the activity with respect to the allowance for doubtful accounts is as follows:
A summary of the activity with respect to the reserve for sales returns is as follows:
9. GOODWILL
The Company adopted SFAS No. 142 in January 2002. The following table reconciles the reported net loss for the year ended December 31, 2001 to the adjusted amount, excluding previously reported goodwill amortization expense, which is no longer recorded under the provisions of SFAS No. 142. The Company did not record any goodwill amortization expense in the years ended December 31, 2002 or 2003.
While not contemplated by the disclosure requirements of SFAS No. 142, the elimination of goodwill amortization in the year ended December 31, 2001 would have increased the related recorded balances of goodwill in this period and accordingly would have increased the loss from impairment of goodwill in 2002 by an aggregate amount equal to the eliminated goodwill amortization.
10. ACCRUED EXPENSES
Accrued expenses are comprised of the following:
11. INVESTMENT IN ARTISTDIRECT RECORDS, LLC
In May 2001, ADI entered into an agreement with Frederick W. (Ted) Field to become Chairman and Chief Executive Officer of ADI and through its wholly-owned subsidiary, ARTISTdirect Recordings, Inc., to form a new record label, ARTISTdirect Records, LLC (“ARTISTdirect Records”), in partnership with ADI. On June 29, 2001, ADI’s stockholders approved the employment of Mr. Field and the formation of the ARTISTdirect Records record label. ARTISTdirect Records was formed as a 50/50 co-venture between ADI and Mr. Field. Mr. Field is the Chief Executive Officer of ARTISTdirect Records. The primary business activity of ARTISTdirect Records is the sale of compact discs by artists signed to the record label.
ADI initially committed to fund a total of $50 million to ARTISTdirect Records over five years at the rate of $15.0 million per year, subject to a limit of $33 million in any three year period. Any funding in excess of these amounts required the approval of ADI’s Board of Directors. ADI has funded $33.0 million through December 31, 2003.
In November 2001, ARTISTdirect Records agreed in principle to enter into a preliminary North America distribution agreement and worldwide license agreement with BMG Music, a wholly-owned partnership of Bertelsmann Music Group, Inc., the global music division of Bertelsmann AG (“BMG”). Under the terms of the agreement, BMG agreed to distribute the label’s releases in North America, and BMG licensed ARTISTdirect Records’ repertoire in territories throughout the world. In April 2002, the agreements with BMG were finalized, including BMG’s purchase of 5% of the equity of ARTISTdirect Records from ADI. As part of this transaction, BMG agreed to advance certain monies against net sales proceeds under the agreements and also assumed $5.0 million of ADI’s funding commitment to ARTISTdirect Records. As a result of the BMG equity purchase, ADI’s funding commitment was reduced to $45 million. In December 2002, BMG exercised its option to extend the term of the distribution and license agreement until September 2004.
Under the distribution and license agreements, BMG made non-returnable advances to ARTISTdirect Records of $2.5 million in 2001, $2.5 million in 2002 and $5.0 million in 2003 that are recoupable from net sales proceeds from ARTISTdirect Records’ artist repertoire. The advances are to be recouped on a monthly basis based on a defined calculation. As of December 31, 2002 and 2003, the unrecouped balance related to distribution advances from BMG was $4.1 million and $8.7 million, respectively.
In August 2002, ADI’s Board of Directors approved an agreement (the “Accelerated Funding Agreement”) to accelerate up to $10 million of its funding commitment to ARTISTdirect Records. This funding was in addition to the $15 million that ADI was obligated to advance to ARTISTdirect Records in 2002 as part of the initial $50 million funding commitment. During 2002, ADI funded its $15 million commitment plus the additional $10 million bridge loan for total advances to the record label of $25.0 million in 2002 and $30.25 million from the inception of the record label through December 31, 2002. The $10 million of accelerated funding was credited toward the satisfaction of ADI’s overall funding commitment and funding obligation for 2003, resulting in a remaining funding commitment of $2.75 million for 2003 and $12.0 million for 2004. ADI advanced the $2.75 million during 2003. ADI’s commitment to fund ARTISTdirect Records is subject to a guaranty for the benefit of BMG. Should ADI fail to meet its commitment, BMG may choose to enforce the guaranty or provide substitute financing that could result in dilution of ADI’s interest in ARTISTdirect Records.
As consideration for entering into the Accelerated Funding Agreement, ADI received an additional 20% interest in ARTISTdirect Records from Radar Records Holdings, L.L.C. (“RRH”), the entity through which Mr. Field owns his interest in ARTISTdirect Records, which resulted in an increase in ADI’s ownership share of ARTISTdirect Records from 45% to 65% and a decrease in Mr. Field’s ownership share from 50% to 30%. The Accelerated Funding Agreement also provides that any dilution from the issuance of equity interests in ARTISTdirect Records that would have been borne solely by ADI will be borne both by RRH and ADI pro rata with their then respective ownership interests. Furthermore, the Accelerated Funding Agreement provides for RRH to guarantee a 25% minimum annual compounded return to be realized from ADI’s advances and equity interests in ARTISTdirect Records. Due to the uncertainty with respect to the realization of such rate of return, ADI has not recorded any amounts related to the 25% minimum annual compounded return in its consolidated financial statements.
Because ADI did not have voting or operating control of ARTISTdirect Records, even with its majority ownership position, through December 31, 2003 it did not consolidate the results of ARTISTdirect Records; ADI recorded its share of losses based on the equity method of accounting as loss from equity investments in its consolidated statements of operations. Prior to the completion of BMG’s purchase of a 5% interest in ARTISTdirect Records in April 2002 and BMG’s assumption of 10% of ADI’s total funding commitment, ADI had committed to fund 100% of the operations of ARTISTdirect Records and had recorded 100% of the losses attributable to that venture from the inception of ARTISTdirect Records to April 30, 2002. From May 1, 2002 through December 31, 2003, ADI has recorded only its proportionate share, on the basis of remaining relative funding commitments, of any losses of ARTISTdirect Records. ADI has funded a total of $33.0 million of its funding commitment. ADI recognized $8.6 million, $29.3 million and $9.3 million of equity loss from ARTISTdirect Records for the years ended December 31, 2001, 2002 and 2003,
respectively.
In February 2003, the Financial Accounting Standards Board issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which addresses the consolidation by business enterprises of variable interest entities. The Company adopted FIN 46 effective December 31, 2003. As a result of the adoption of FIN 46, the balance sheet of ARTISTdirect Records was consolidated as of December 31, 2003, and the operations of ARTISTdirect Records will be consolidated beginning January 1, 2004.
ADI charged ARTISTdirect Records $200,000, $1.35 million and $563,000 in 2001, 2002 and 2003, respectively, for the reimbursement of overhead costs, including rent and other occupancy costs, telephone and internet services, and the services of certain ADI personnel primarily in the areas of accounting, legal, information technology, human resources and administration. These amounts are reflected as a reduction to general and administrative expense in ADI’s consolidated statements of operations for such periods.
The carrying amount of ADI’s investment in ARTISTdirect Records at December 31, 2002 represents the difference between ADI’s investment and advances and ADI’s share of losses from ARTISTdirect Records. Through December 31, 2003, ADI continued to record the losses of ARTISTdirect Records. ADI recorded its loan advances to ARTISTdirect Records as additional equity investments. As of December 31, 2002, ADI’s share of losses exceeded the amount of ADI’s investment and advances at that date, resulting in a credit balance of approximately $7.7 million, which was classified as a liability on ADI’s consolidated balance sheet at December 31, 2002. As of December 31, 2003, the Company consolidated the balance sheet of ARTISTdirect Records.
ADI had no recorded investment in its loans to ARTISTdirect Records, as the carrying amount of the loans had been reduced to zero as a result of ADI recording its share of losses of ARTISTdirect Records during the years ended December 31, 2001, 2002 and 2003. ADI does not record interest income on the loans to ARTISTdirect Records.
The loan advances provided to ARTISTdirect Records by ADI and BMG bear interest at a rate of LIBOR plus four percent and the principal and interest are not repayable until December 31, 2015 or upon such time as ARTISTdirect Records achieves certain defined levels of excess cash flow and available cash. As of December 31, 2002 and 2003, ARTISTdirect Records had loans payable to ADI of $30.25 million and $33.0 million, respectively, which have been eliminated in consolidation in 2003, and to BMG of $4.75 million. In addition, as of December 31, 2002 and 2003, ARTISTdirect Records had accrued interest payable to ADI of $1.1 million and $3.0 million, respectively, and to BMG of $189,000 and $447,000, respectively. During the year ended December 31, 2003, Mr. Field loaned $898,000 to ARTISTdirect Records (see Note 13).
The $898,000 of loans from Mr. Field has been classified as bridge notes payable in the consolidated balance sheet at December 31, 2003.
A roll forward schedule of ADI’s net investment balance for the years ended December 31, 2002 and 2003 is as follows:
As of December 31, 2003, ARTISTdirect Records did not have sufficient working capital resources to conduct operations. During the three months ended September 30, 2003, ARTISTdirect Records significantly reduced its overhead costs and operating activities and laid off the majority of its staff while it continued to restructure its operations and seek additional capital.
ADI does not have the resources to meet its remaining $12.0 million funding commitment to ARTISTdirect Records for 2004. ARTISTdirect Records requires additional capital in order to continue operations, and therefore ADI is continuing to pursue alternatives to raise additional capital for both itself and for ARTISTdirect Records. However, there can be no assurance that additional capital can be obtained by either ADI or by ARTISTdirect Records on reasonable terms or at all. If additional funds are
raised through the issuance of equity securities of either ADI or ARTISTdirect Records, the percentage ownership of ADI’s current stockholders in ADI and/or the ADI’s ownership of ARTISTdirect Records would be reduced. Failure to raise additional capital could seriously harm the business of ARTISTdirect Records and impair the value of ADI’s investment in ARTISTdirect Records. In such event, ARTISTdirect Records may seek to divest all or certain of its assets or ADI may seek to divest all or a part of its ownership of ARTISTdirect Records, in order to raise the capital necessary to sustain business operations of ADI and/or ARTISTdirect Records. Should this fail, ARTISTdirect Records may consider a formal or informal restructuring or reorganization, potentially resulting in a total loss of ADI’s investment in ARTISTdirect Records.
12. INVESTMENTS IN OTHER AFFILIATED COMPANIES
The Company had a 45% ownership in SnoCore, LLC and accounted for this investment under the equity method through December 31, 2003. The Company recorded equity income (loss) of $48,000, $(16,000) and $(64,000) with respect to this investment for the years ended December 31, 2001, 2002 and 2003, respectively. Effective December 31, 2003, the Company exchanged its 45% ownership interest in SnoCore, LLC for a 9% net profits interest. The Company did not record any gain or loss on this transaction at December 31, 2003.
During the year ended December 31, 2000, the Company entered into a joint venture, ARTISTdirect Latin America, LLC, in which the Company held a 50% ownership interest. The Company made investments of $250,000 and $395,000 during the years ended December 31, 2000 and 2001, respectively, and recorded these amounts as its share of losses under the equity method. During the year ended December 31, 2002, the venture ceased operations and no additional investment was made or loss recognized by the Company.
13. BRIDGE NOTES PAYABLE
As of December 31, 2003, ARTISTdirect Records had received $898,000 of loans from Ted Field and $1.150 million of loans from outside investors (including $100,000 from Jonathan V. Diamond, the Company’s new President and Chief Executive Officer). The total loans of $2.048 million during 2003 were obtained through the issuance of convertible promissory notes (the “Bridge Notes”). The Bridge Notes accrue interest at 8% per annum, are due two years from the date of issuance, and will be converted into new equity of ARTISTdirect Records as part of its next equity financing. The $1.150 million of loans from outside investors has been presented as bridge notes payable in the consolidated balance sheet at December 31, 2003.
The holders of the Bridge Notes also received warrants with a term of five years to purchase additional equity of ARTISTdirect Records at $0.01 per unit equivalent to the number of units of new equity into which their Bridge Notes are ultimately converted. The relative fair value of the warrants issued was $1.024 million (one-half of the amount funded by the investors in the Bridge Notes), which was recorded as a reduction to the carrying amount of the Bridge Notes and a credit to capital, and is being charged to operations as interest expense over the specified term of the Bridge Notes.
In addition, since the Bridge Notes are convertible into equity based on their face amount, this results in a beneficial conversion feature with a relative fair value of $1.024 million. Since the commitment date for the beneficial conversion feature is contingent upon the completion of ARTISTdirect Record’s next equity financing, the fair value of the beneficial conversion feature will be charged to operations over the remaining life of the Bridge Notes at that time.
During the year ended December 31, 2003, ARTISTdirect Records recognized $203,000 as interest expense with respect to the amortization of the fair value of the warrants. Additional interest expense of $821,000 will be recognized ratably in 2004 and 2005 over the remaining term of the Bridge Notes. As of December 31, 2003, the carrying amount of the Bridge Notes, including accrued interest of $67,000, was $1.294 million.
A reconciliation of bridge notes payable issued by ARTISTdirect Records during 2003 to amounts presented in the consolidated balance sheet at December 31, 2003 is presented below. During the year ended December 31, 2003, ARTISTdirect Records recorded costs with respect to such bridge notes as summarized below.
14. iMUSIC
During 2002, the Company’s wholly-owned subsidiary, ARTISTdirect Digital, Inc., began operating a record label under the brand name iMusic. Operations consist primarily of the sale of compact discs by artists signed to the iMusic record label. iMusic’s concept was to focus on the signing of established artists with a proven sales base and an ability to generally make records less expensively than developing artists. In addition, the Company expected that substantially less would be spent on marketing and promotion of these releases than on those of new artists. During the three months ended June 30, 2003, management of the Company decided to scale back the activity of its iMusic label in order to conserve capital. During the three months ended September 30, 2003, the Company executed an agreement with GC Music, pursuant to which the Company assigned its rights and obligations to six unreleased artists in exchange for a cash payment of $100,000 as a reduction to prior advances related to the six artists and a profit interest in the projects. The Company retains the distribution rights to the albums previously released under the original terms of its distribution agreements with its other signed artists. The Company does not plan to sign any additional artists or release any additional albums domestically or internationally under the iMusic label and expects very minimal sales activity in the future. During the years ended December 31, 2002 and 2003, revenues generated by the iMusic label were $613,000 and $1,352,000, respectively. At December 31, 2003, accounts receivable relating to the iMusic label were $106,000.
15. DISCONTINUED OPERATIONS
In December 2001, the Company decided to exit the music talent agency business and as a result this segment has been classified as a discontinued operation in the consolidated statement of operations for years ended December 31, 2001 and 2002 and its net results are reflected as income from discontinued operations. The agency business did not have any significant assets or liabilities associated with it and no gain or loss was recognized related to its disposal. The wind up of operations of the agency business was completed during 2002. A summary of the statements of operations of the agency business segment is as follows:
16. INCOME TAXES
Income taxes differ from the amount computed using a tax rate of 35% as a result of the following:
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at December 31, 2002 and 2003 are presented below:
At December 31, 2003, the Company had net operating loss carryforwards totaling approximately $142 million for Federal income tax purposes expiring beginning in 2020 and California state net operating loss carryforwards of $127 million expiring beginning in 2008. Due to the uncertainty surrounding the realization of the benefits of its tax attributes, primarily net operating loss carryforwards as of December 31, 2003, the Company has recorded a 100% valuation allowance against its net deferred tax assets as of December 31, 2002 and 2003.
In assessing the potential realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the Company attaining future taxable income during the periods in which those temporary differences become deductible.
In addition, Internal Revenue Code Section 382 substantially restricts the ability of a corporation to utilize existing net operating losses in the event of an “ownership change”. Accordingly, a portion of the Company’s net operating losses for Federal income tax purposes may be limited due to previous changes in ownership.
17. SIGNIFICANT CONTRACTS
In February 2002, the Company amended an existing agreement with Ticketmaster pursuant to which the Company agreed to purchase online advertising totaling $2.0 million from Ticketmaster and in conjunction became entitled to certain non-exclusive opportunities to “pre-sell” tickets on the ARTISTdirect website. The Company recognized as sales and marketing expense the amount paid on a straight-line basis, which approximated how the services were received, over the amended term of the agreement. The term of the amended agreement expired in April 2003.
In connection with the issuance of Series C Preferred shares in 1999 and 2000, the Company entered into strategic relationships with four record labels. Under the terms of these agreements, the Company had the right to purchase certain content related to each of the respective companies’ artists on terms generally made available to other online music companies. Under one of the agreements, the Company provided marketing and promotional services on its network and recognized advertising and sponsorship revenues of $1,000,000 and $500,000 in the years ended December 31, 2000 and 2001, respectively. The Company never received any content as expected under the agreement and during 2001 it determined that the collectibility of this receivable either in the form of cash or acceptable content was impaired. Consequently, a provision for doubtful accounts of $1.5 million was recorded in the consolidated statement of operations during the year ended December 31, 2001. The Company did not provide or receive any services or benefits from any of the other labels and did not record any revenues or expenses related to these other agreements.
In November 2001, ARTISTdirect Records agreed in principle to enter into a preliminary North American distribution agreement and worldwide license agreement with BMG. Under the terms of the agreement, BMG distributes ARTISTdirect Records releases in North America, and BMG licenses ARTISTdirect Records repertoire in territories throughout the world. In April 2002, the agreements with BMG were finalized, including BMG’s purchase of 5% of the equity of ARTISTdirect Records from the Company. In connection with the purchase of equity, BMG agreed to assume $5.0 million of the Company’s funding commitment to ARTISTdirect Records. This loan advance bears interest at a rate of LIBOR plus 4%, and the principal and interest are not repayable until December 31, 2015, or upon such time as ARTISTdirect Records achieves certain defined levels of excess cash flow and available cash.
Under the distribution and license agreements, BMG made non-returnable advances to ARTISTdirect Records, of $2.5 million in 2001, $2.5 million in 2002 and $5.0 million in 2003 that are recoupable from net sales proceeds from ARTISTdirect Records’ artist repertoire. The advances are to be recouped on a monthly basis based on a defined calculation. As of December 31, 2002 and 2003, the unrecouped balances related to distribution advances from BMG were $4.1 million and $8.7 million, respectively.
18. RELATED PARTY TRANSACTIONS
For the years ended December 31, 2001, 2002 and 2003, the Company incurred legal expenses of approximately $364,000, $260,000 and $156,000, respectively, for legal services provided by Lenard & Gonzalez LLP and its successor firm, Lenard, Brisbin & Klotz LLP. Allen Lenard, one of the Company’s former directors who resigned from the board in September 2002, was Managing Partner of Lenard & Gonzalez LLP and is managing partner of Lenard, Brisbin & Klotz LLP. In addition, during 2001, ADI also paid legal fees of $530,000 to Lenard, Brisbin & Klotz in connection with the ARTISTdirect Records transaction, which has been treated as an advance to ARTISTdirect Records under the operating agreement.
During the three months ended September 30, 2003, the Company significantly reduced its overhead costs and operating activities and laid off the majority of its staff while it continued to restructure its operations and seek additional capital. The Company also relocated its administrative offices to a site leased by a company owned by Ted Field. The Company sub-leases these offices on a month-to-month basis. During the year ended December 31, 2003, the Company accrued $56,000 as rent expense, which represents occupancy costs for September through December 2003.
See Notes 11, 13, 19, 20, 21 and 23 for additional related party transactions.
19. RESCISSION OFFER
In December 2001, the Company completed a rescission offer in which it rescinded the purchase of 83,403 shares of its common stock purchased upon the exercise of options and the issuance of vested and unvested unexercised options to purchase 636,740 shares of common stock. The shares of stock were repurchased at prices ranging from $12.40 to $40.00 per share and the unexercised options that were rescinded had exercise prices ranging from $12.40 to $140.00 per share. In aggregate, the Company paid $10.2 million to rescind the shares and options.
As a result of the completion of the rescission offer, the Company recorded stock compensation expense of $6.9 million and $1.9 million in 2001 and 2002, respectively. The $6.9 million of compensation expense recognized in 2001 consisted of $859,000 reflected in cost of revenues and $6.1 million included in operating expenses as stock-based compensation. The $1.9 million of compensation expense recognized in 2002 consisted of $900,000 reflected in cost of revenues and $1.0 million reflected in operating expenses. No additional compensation expense related to the rescission offer was recorded in 2003.
As of December 31, 2001, the Company reclassified $2.7 million of unearned compensation (related to the original option grants subject to the rescission offer) to prepaid stock-based compensation in the balance sheet, as the underlying equity instruments were no longer outstanding as a result of the rescission of the instruments in December 2001.
The Company’s Chief Financial Officer at the time of the rescission offer in December 2001 tendered outstanding options to purchase 45,918 shares of the Company’s common stock in exchange for $390,340, as a result of which the options were cancelled.
The Company did not record any compensation expense related to the shares and options of those holders who chose not to accept the rescission offer. The Securities Act of 1933, as amended (the "Securities Act"), does not expressly provide that a rescission offer will terminate a purchaser's right to rescind a sale of stock that was not registered under the Securities Act as required. However, federal courts in the past have ruled that a person who rejects or fails to accept a rescission offer is precluded from later seeking similar relief. The Company believes that subsequent to the rescission offer, any rights to rescind will be contingent upon legal rulings, the outcome of which are not currently determinable. Accordingly, the Company has accounted for shares and options that were not rescinded in the rescission offer as if there is no right of rescission. In the event any rescissions occur subsequent to the expiration of the rescission offer in December 2001, the Company will account for those rescissions, if any, in the manner described above at the time those rescissions are completed.
20. STOCKHOLDERS’ EQUITY
COMMON STOCK
In April 2001, the Company completed a tender offer in which it repurchased 200,000 shares of common stock for a total cost of $2.5 million. The repurchased shares are reflected as treasury stock in the balance sheets as of December 31, 2002 and 2003.
In May 2001, the Company authorized the purchase of up to $2 million worth of the Company’s common stock. During 2001, the Company repurchased in the open market or in privately negotiated transactions 39,499 shares of common stock for an aggregate purchase price of approximately $234,000. This repurchase was separate from the Company’s tender offer described above, and is reflected as treasury stock in the balance sheets as of December 31, 2002 and 2003. No shares were repurchased by the Company in 2002 or 2003.
On July 5, 2001, the Company effected a 1-for-10 reverse stock split. The outstanding common securities, options and warrants have been retroactively adjusted to reflect the reverse stock split. All discussion of equity amounts in these financial statements reflects the effect of the reverse stock split.
During December 2003, the Company issued 40,000 shares of common stock to a consultant for services rendered which were valued at $0.50 per share, resulting in a charge to operations of $20,000.
WARRANTS
During 1999, the Company issued warrants, which were immediately exercisable, to purchase 35,967 shares of common stock at $40.00 per share to two vendors from whom it purchased merchandise. None of the warrants had been exercised as of December 31, 2003. The value of the warrants was $864,000, of which $322,000, $79,000 and $32,000 was recognized as stock based compensation in cost of revenues for the years ended December 31, 2001, 2002 and 2003, respectively. The term of the agreements expired in 2003. The warrants expire in June 2007.
In January 2000, the Company issued warrants to purchase 6,250 shares of common stock at $139.28 per share in connection with an office lease. The warrants were exercisable upon grant and expire in January 2005. As of December 31, 2003, none of these warrants had been exercised. The warrants were valued at $568,000 and were being amortized over the term of the related lease. During the years ended December 31, 2001, 2002 and 2003, $57,000, $57,000 and $379,000, respectively, had been recorded as stock-based compensation expense with respect to these warrants. As a result of the termination of this office lease in 2003 (see Note 7), the unamortized portion of these warrants was written off during 2003.
In September 2003, the Company issued warrants to purchase 200,000 shares of common stock as part of the consideration for an office lease termination (see Note 7).
21. STOCK OPTION AND STOCK PURCHASE PLANS
EMPLOYEE OPTION PLAN
In October 1999, the Company implemented the 1999 Employee Stock Option Plan that replaced the 1998 Unit Option Plan. The plan has currently reserved 870,420 shares of the Company’s common stock for issuance to employees, non-employee members of the board of directors and consultants. This share reserve automatically increases on the first trading day in January each calendar year by an amount equal to two percent (2%) of the total number of shares of the Company’s common stock outstanding on the last trading day of December in the prior calendar year, but in no event will this annual increase exceed 87,500 shares. No option may have a term in excess of 10 years. The options generally vest within three years. As of December 31, 2003, 758,492 shares remained available for future option grant.
The Company accounts for its employee stock option plan in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees”, Interpretation No. 44, and other related interpretations. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price.
Summary stock option activity for 1999 Employee Stock Option Plan during the years ended December 31, 2001, 2002 and 2003
is as follows:
The Company recorded stock-based compensation of $2.7 million, $31,000 and $0 related to stock options granted to employees under the 1999 Employee Stock Option Plan during the years ended December 31, 2001, 2002 and 2003, respectively.
The following table summarizes information regarding options outstanding and options exercisable at December 31, 2003:
In May 2001, the Company granted an officer three non-qualified stock options, which are not part of any stock option plan maintained by the Company, to purchase 444,480 shares of common stock at an exercise price of $7.50 per share. Options on 302,370 shares are exercisable immediately (the underlying shares pursuant to the exercise of this option vests over five years from the date of the option grant), options on 75,588 shares are exercisable in the event the 30-day average closing price of the Company’s common stock on NASDAQ equals or exceeds $35.00 per share within three years from the grant date, and options on 66,522 shares are exercisable in the event the 30-day average closing price of the Company’s common stock on NASDAQ equals or exceeds $70.00 per share within three years of the grant date. The two options that are not exercisable upon grant shall also become exercisable in the event of a de-listing of the Company’s common stock from NASDAQ and a subsequent re-listing, a change in control of the Company or an involuntary termination of the officer (within three years of the date of grant). If not vested by June 29, 2004, the options for 75,588 shares and 66,522 shares will terminate.
In September 2001, the Company granted options to purchase 35,687 shares of its common stock at an exercise price of $7.50 per share to outside legal counsel. The fair value of the stock options granted to the outside legal counsel was $171,000 and was recorded as stock based compensation during the year ended December 31, 2001 as the grant related to past services.
ADVISOR OPTION PLAN
In June 1999 and as amended in October 1999 and March 2000 the Company adopted the 1999 Artist and Artist Advisor Stock Option Plan (the “Advisor Plan”). The Advisor Plan has currently reserved 294,617 shares of common stock for issuance to artists for whom the Company entered into agreements related to online and e-commerce activities and their agents, business managers, attorneys and other advisors. This share reserve automatically increases on the first trading day in January each calendar year by an
amount equal to one percent (1%) of the total number of shares of the Company’s common stock outstanding on the last trading day of December in the prior calendar year, but in no event will this annual increase exceed 37,500 shares. As of December 31, 2003, 259,081 shares remained available for future option grants. The options expire seven years from the date of grant and vesting generally varies between one to three years. In December 2001, a majority of the outstanding options under the Advisor plan were rescinded and cancelled. No new option grants under this plan were made during 2002 or 2003.
Summary stock option activity for the Advisor Plan options during the years ended December 31, 2001, 2002 and 2002 is as follows:
The weighted average fair value of options granted under the Advisor Plan was $66.50 per option in 2000 resulting in a total value for options granted of $2.1 million. Of the $2.1 million, $1.8 million was expensed in 2000 and $300,000 was expensed in 2001.
The following table summarizes information regarding options outstanding and options exercisable at December 31, 2003:
ARTIST OPTION PLAN
In June 1999 and as amended in October 1999, the Company adopted the 1999 Artist Stock Plan (the “Artist Plan”). The Artist Plan currently has reserved 620,420 shares of common stock for issuance to artists for whom the Company entered into agreements related to their online and e-commerce activities. This share reserve automatically increases on the first trading day in January each calendar year by an amount equal to two percent (2%) of the total number of shares of the Company’s common stock outstanding on the last trading day of December in the prior calendar year, but in no event will this annual increase exceed 87,500 shares. As of December 31, 2003, 596,546 shares remained available for future option grants. The options expire seven years from the date of grant and vesting generally varies between one to three years. In December 2001, a majority of the outstanding options under the Advisor plan were rescinded and cancelled. No new option grants under this plan were made during 2002 or 2003.
Summary stock option activity for the Artist Option Plan during the years ended December 31, 2001, 2002 and 2003 is as follows:
The following table summarizes information regarding options outstanding and options exercisable at December 31, 2003:
Total compensation expense related to the Advisor Plan and the Artist Option Plan (excluding the impact of the rescission offer) was $10.6 million, $2.9 million and $540,000 for the years ended December 31, 2001, 2002 and 2003, respectively, of which $7.2 million, $2.1 million and $33,000, respectively, was included in cost of revenue, and $3.4 million, $800,000 and $527,000, respectively, was included in operating expenses.
For the year ended December 31, 2001, the decrease in unearned compensation of $2.4 million was a result of the cancellation of unvested compensatory employee options.
EMPLOYEE STOCK PURCHASE PLAN
In October 1999, the Company adopted the 1999 Employee Stock Purchase Plan that has reserved 100,000 shares of common stock for issuance under this plan. This share reserve automatically increases on the first trading day in January each calendar year, by an amount equal to one percent (1%) of the total number of the Company’s common stock outstanding on the last trading day of December in the prior calendar year, but in no event will this annual increase exceed 25,000 shares. Terms of the plan permit eligible employees to purchase common stock through payroll deduction of up to 15% of each employee’s compensation. The accumulated deductions will be applied to the purchase of shares on each semi-annual purchase date at a purchase price per share equal to 85% of the fair market value per share on the participant’s entry date into the offering period or the semi-annual purchase date, whichever is lower. Pursuant to the provisions of APB No. 25, shares issued to employees under this plan are considered non-compensatory. During the years ended December 31, 2001, 2002 and 2003, 3,902 shares, 1,134 shares and 375 shares, respectively, were issued under this plan for total proceeds of $17,000, $4,000 and $440, respectively.
See Note 23 for a description of non-plan stock options to purchase 259,659 shares of common stock issued to the Company’s President and Chief Executive Officer, and non-plan stock options to purchase 444,480 shares of common stock issued to the Company’s Chairman, who is also the Chief Executive Officer of ARTISTdirect Records.
22. 401(K) PLAN
The Company has adopted the Cash or Deferred Profit Sharing Plan and Trust under Section 401(k) of the Internal Revenue Code (the 401(k) Plan). Under the 401(k) Plan, participating employees may defer a percentage (not to exceed 15%) of their eligible pretax earnings up to the Internal Revenue Service’s annual contribution limit. All employees of the Company age 21 years or older who complete three months of service are eligible to participate in the 401(k) Plan. The Company does not match participants’ contributions to the 401(k) Plan. Accordingly, there is no related expense for the years ended December 31, 2001, 2002 and 2003.
23. COMMITMENTS AND CONTINGENCIES
LEASE COMMITMENTS
Future minimum lease payments under operating leases for certain equipment are as follows:
Rent expense under operating leases for the years ended December 31, 2001, 2002 and 2003 was $1,961,000, $1,806,000 and $2,144,000 (including $56,000 to a related party in 2003), respectively.
EMPLOYMENT CONTRACTS
Future payments under employment and consulting contracts are as follows:
Effective September 29, 2003, the Company entered into an employment agreement with Jonathan V. Diamond to serve as the Company’s President and Chief Executive Officer through August 15, 2006 with a base annual salary of $185,000 plus certain benefits. In conjunction with the employment agreement, the Company granted Mr. Diamond a non-plan, non-qualified stock option to purchase 259,659 shares of common stock at an exercise price of $0.85 per share, which was the approximate fair market value of the common stock at the date of grant.
Effective May 31, 2003, Marc P. Geiger, the Company’s former Vice Chairman of the Board of Directors and President - Artist Services, resigned as an officer of the Company. Mr. Geiger remains as a director of the Company. Mr. Geiger’s July 2001 amended employment agreement, which had an initial term extending through June 30, 2006, provided for an annual salary of $500,000 plus certain benefits. The amended employment agreement also provided that under certain conditions, Mr. Geiger would receive a payment of $1,000,000 plus one year’s salary upon the termination of his employment with the Company. In February 2001, the Company loaned Mr. Geiger $150,000, with interest at 7%. The term of the loan was initially one year, but was extended in September 2001 to five years commensurate with the amendment of Mr. Geiger’s employment agreement in July 2001. Mr. Geiger was obligated to repay the loan in five equal annual principal payments of $30,000, along with accrued interest to date, beginning in September 2002. In consideration for Mr. Geiger terminating his employment agreement effective as of the date of his resignation and waiving all rights to compensation under the employment agreement, the Company paid Mr. Geiger his accrued compensation and benefits of approximately $184,000, and Mr. Geiger repaid the $150,000 loan plus accrued interest.
Effective December 31, 2003, Keith Yokomoto, the Company’s former President and Chief Operating Officer, entered into a Termination Agreement and Mutual General Release. Mr. Yokomoto remains as a director of the Company. Mr. Yokomoto’s July 2001 employment agreement, which had an initial term extending through June 30, 2006, provided for an annual salary of $500,000 plus certain benefits, and a commencement advance of $300,000, representing a pre-payment of $60,000 against any monies that would otherwise become payable to Mr. Yokomoto under the Company’s executive performance bonus pool for each year of the initial five-year term of the employment agreement. The employment agreement also provided that under certain conditions, Mr. Yokomoto would receive a payment of $350,000 plus one year’s salary upon the termination of his employment with the Company. In consideration for Mr. Yokomoto terminating his employment agreement effective as of December 31, 2003 and waiving all rights to $1.25 million of remaining compensation under the employment agreement, the Company paid Mr. Yokomoto his accrued but unpaid salary at the rate of $500,000 per year through December 31, 2003 aggregating $412,847 and his accrued but unused vacation pay through December 31, 2003 aggregating $76,924, and Mr. Yokomoto repaid the Company the unearned portion of the commencement advance of $150,000.
Effective January 1, 2004, the Company entered into a one-year consulting agreement with Mr. Yokomoto that provides for total compensation of $120,000. Effective January 9, 2004, the Company also issued to Mr. Yokomoto two non-qualified stock options to purchase 10,000 shares and 50,000 shares at $0.50 per share, which was not less than the fair market value on the date of grant, exercisable through January 9, 2011. The option for 10,000 shares was immediately vested upon issuance. The option for 50,000 shares vests in increments of 10,000 shares on February 1, 2004, March 31, 2004, June 30, 2004, September 30, 2004 and December 31, 2004, based on the accomplishment of certain milestones by each respective date.
In May 2001, the Company entered into an agreement with Frederick W. (Ted) Field to serve as Chairman and Chief Executive Officer of the Company and to form a new record label, ARTISTdirect Records, as a co-venture with the Company. On June 29, 2001, the Company’s stockholders approved the employment of Mr. Field and the formation of the ARTISTdirect Records record label. ARTISTdirect Records was formed as a 50/50 co-venture between the Company and Mr. Field. Mr. Field is the Chief Executive Officer of ARTISTdirect Records. In conjunction therewith, the Company entered into an employment agreement and stock option agreement with Mr. Field.
Mr. Field’s employment agreement, which has an initial term extending through May 31, 2006, provided for an annual base salary of $500,000 plus certain benefits. The employment agreement also provided that under certain conditions, Mr. Field would receive a lump-sum payment equal to his annual base salary for (i) 50% of the remaining term of the employment agreement if termination occurs within the first three years of his employment, (ii) his annual base salary for one year if termination occurs in the fourth year of his employment, and (iii) his annual base salary for the full remaining term of the employment agreement if termination occurs in the fifth year of his employment.
In May 2001, the Company also granted Mr. Field three non-qualified stock options, which are not part of any stock option plan maintained by the Company, to purchase 444,480 shares of common stock at an exercise price of $7.50 per share. Options on 302,370 shares are exercisable immediately (the underlying shares pursuant to the exercise of this option vests over five years from the date of the option grant), options on 75,588 shares are exercisable in the event the 30-day average closing price of the Company’s common stock on NASDAQ equals or exceeds $35.00 per share within three years from the grant date, and options on 66,522 shares are exercisable in the event the 30-day average closing price of the Company’s common stock on NASDAQ equals or exceeds $70.00 per share within three years of the grant date. The two options that are not exercisable upon grant shall also become exercisable in the event of a de-listing of the Company’s common stock from NASDAQ and a subsequent re-listing, a change in control of the Company or an involuntary termination of the officer (within three years of the date of grant). If not vested by June 29, 2004, the options for 75,588 shares and 66,522 shares will terminate.
During 2002, Mr. Field’s employment agreement was amended whereby Mr. Field agreed to defer his future salary until the Company raised new debt or equity financing of at least $20 million. During the three months ended June 30, 2003, Mr. Field’s employment agreement was further amended whereby all deferred and any future salary, except a base amount, would be waived, even if new debt or equity financing is raised. Accordingly, during the year ended December 31, 2003, $411,000 of accrued compensation due to Mr. Field by the Company was recorded as gain from forgiveness of debt in the consolidated statement of operations.
LITIGATION
The Company is subject to various pending and threatened legal actions which arise in the normal course of business. The Company’s management believes that the impact of such litigation will not have a material adverse impact on its financial position or results of operations.
24. REPORTABLE SEGMENTS
Information with respect to the Company’s operating segments for the years ended December 31, 2001, 2002 and 2003 is presented below. During the year ended December 31, 2003, the Company operated primarily through three reportable segments: E-commerce operations (“E-commerce”), Media Operations (“Media”) and Record Label operations (“Record Label”). Record label operations consisted primarily of the iMusic record label. Since the Company accounted for its interest in ARTISTdirect Records on the equity method of accounting during 2001, 2002 and 2003, the operations of ARTISTdirect Records are not included for such periods.
In prior years, the Company also considered its talent agency business to be a segment, but the Company decided in December 2001 to exit this business and as a result it has been shown as a discontinued operation in the consolidated statements of operations. The Company also previously considered digital music to be a separate segment; however, this business did not develop as quickly as initially anticipated and it is no longer considered a separate reportable segment. The segment data below has been restated for all periods to reflect the current segment structure.
E-commerce revenue is generated from the sale of recorded music and music-related merchandise. Media revenue is generated from the sale of advertising and sponsorships, both online and offline. Record label revenue is generated from the sale of recorded music performed by artists signed to the Company’s iMusic record label.
The factors for determining reportable segments were based on services and products. Each segment is responsible for executing a unique marketing and business strategy. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on EBITDA (earnings or loss before interest, taxes, depreciation and amortization, including stock-based compensation, impairment losses, and minority interest). Included in EBITDA are direct operating expenses for the segment. The following table summarizes the revenue and EBITDA by segment for the years ended December 31, 2001, 2002 and 2003. Corporate expenses consist of general operating expenses that are not directly related to the operations of the segments.
Assets as of December 31, 2002 and 2003 are summarized as follows:
Assets by segment are those assets used in the Company operations in each segment. Corporate assets are principally made up of cash and cash equivalents, short-term investments, prepaid expenses, computer equipment, leasehold improvements and other assets.
As of December 31, 2002 and 2003, the Company had advanced $30.25 million and $33.0 million to its record label venture, ARTISTdirect Records, and had recorded losses of approximately $8.6 million, $29.3 million and $9.3 million with respect to this investment for the years ended December 31, 2001, 2002 and 2003, respectively (see Note 11).
25. QUARTERLY RESULTS OF OPERATIONS
The following table sets forth unaudited quarterly results of operations for the years ended December 31, 2002 and 2003. This unaudited quarterly information has been derived from the Company’s unaudited financial statements and, in the Company’s opinion, includes all adjustments, including normal recurring adjustments, necessary for a fair presentation of the information for the periods covered. The operating results for any quarter are not necessarily indicative of the operating results for any future period.
26. SUBSEQUENT EVENTS (UNAUDITED)
During the three months ended March 31, 2004, Mr. Field advanced an additional $1.89 million to ARTISTdirect Records to fund operating expenses and the settlement of artist contracts. In consideration for such advances, Mr. Field received Bridge Notes and warrants as described at Note 13.
ARTISTDIRECT RECORDS, LLC
INDEPENDENT AUDITORS REPORT
The Members
ARTISTdirect Records, LLC
We have audited the accompanying balance sheet of ARTISTdirect Records, LLC (the “Company”) as of December 31, 2003 and the related statements of operations, members’ deficit and cash flows for the year then ended. 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 audit.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. 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 audit provides 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 ARTISTdirect Records, LLC as of December 31, 2003 and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
The accompanying financial statements have been prepared assuming that ARTISTdirect Records, LLC will continue as a going concern. As more fully described in Note 1, the Company has incurred substantial operating losses and negative cash flows from operations to date. The Company needs additional capital to fund its operations. As of December 31, 2003, the Company has a net working capital deficiency of $10.9 million and a members’ deficit of $53.355 million. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ GUMBINER, SAVETT, FINKEL, FINGLESON & ROSE, INC.
Santa Monica, California
April 6, 2004
ARTISTDIRECT RECORDS, LLC
BALANCE SHEETS
(IN THOUSANDS)
See accompanying notes to financial statements.
ARTISTDIRECT RECORDS, LLC
STATEMENTS OF OPERATIONS
(IN THOUSANDS)
See accompanying notes to financial statements.
ARTISTDIRECT RECORDS, LLC
STATEMENTS OF MEMBERS’ DEFICIT
(IN THOUSANDS)
See accompanying notes to financial statements.
ARTISTDIRECT RECORDS, LLC
STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
See accompanying notes to financial statements.
ARTISTDIRECT RECORDS, LLC
NOTES TO FINANCIAL STATEMENTS
PERIOD FROM MAY 31, 2001 (INCEPTION) TO DECEMBER 31, 2001,
AND YEARS ENDED DECEMBER 31, 2002 AND 2003
1. BASIS OF PRESENTATION
ORGANIZATION AND BUSINESS ACTIVITIES
ARTISTdirect Records, LLC (the “Company”) was formed in May 2001 as a 50/50 co-venture between ARTISTdirect, Inc. (“ADI”) and Radar Records Holdings, LLC (“Radar Records”), an entity owned and controlled by Frederick W. (Ted) Field, the then Chairman and Chief Executive Officer of ADI. At its formation, the Company issued 10,000,000 membership units for total proceeds of $100,000. The Company commenced operations in July 2001. The Company, headquartered in Los Angeles, California, develops new musical artists and produces and distributes their recordings as an independent label utilizing both traditional channels and emerging Internet distribution channels.
At the time of formation of the Company, ADI committed to provide funding of up to $50 million over five years at the rate of $15.0 million per year, subject to a limit of $33 million in any three year period. Any funding in excess of these amounts required the approval of ADI’s Board of Directors. ADI has funded $33.0 million through December 31, 2003.
In November 2001, ADI agreed to sell a 5% equity interest in the Company to BMG Music, a wholly-owned partnership of Bertelsmann Music Group, Inc., the global music division of Bertelsmann AG (“BMG”), in connection with entering into a North American distribution agreement and a worldwide licensing agreement. In April 2002, these agreements were formally executed. As part of these transactions, BMG agreed to advance certain monies against net sales proceeds under the agreements and also assumed $5.0 million of ADI’s funding commitment to the operations of the Company. As a result of the BMG equity purchase, ADI’s funding commitment was reduced to $45 million. In December 2002, BMG exercised its option to extend the term of the distribution and license agreement until September 2004.
In August 2002, ADI’s Board of Directors approved an agreement (the “Accelerated Funding Agreement”) to accelerate up to $10 million of its funding commitment to the Company. This funding was in addition to the $15 million that ADI was obligated to advance to the Company in 2002 as part of the initial $50 million funding commitment. During 2002, ADI funded its $15 million commitment plus the additional $10 million bridge loan for total advances to the record label of $25.0 million in 2002 and $30.25 million from the inception of the record label through December 31, 2002. The $10 million of accelerated funding was credited toward the satisfaction of ADI’s overall funding commitment and funding obligation for 2003, resulting in a remaining funding commitment of $2.75 million for 2003 and $12.0 million for 2004. ADI advanced the $2.75 million during 2003. ADI’s commitment to fund the Company is subject to a guaranty for the benefit of BMG. Should ADI fail to meet its commitment, BMG may choose to enforce the guaranty or provide substitute financing that could result in dilution of ADI’s interest in the Company.
As consideration for entering into the Accelerated Funding Agreement, ADI received an additional 20% interest in the Company from Radar Records Holdings, L.L.C. (“RRH”), the entity through which Mr. Field owns his interest in the Company, which resulted in an increase in ADI’s ownership share of the Company from 45% to 65% and a decrease in Mr. Field’s ownership share from 50% to 30%. BMG’s ownership percentage remained at 5%. The Accelerated Funding Agreement also provides that any dilution from the issuance of equity interests in the Company that would have been borne solely by ADI will be borne both by RRH and ADI pro rata with their then respective ownership interests. Furthermore, the Accelerated Funding Agreement provides for RRH to guarantee a 25% minimum annual compounded return to be realized from ADI’s advances and equity interests in the Company.
The loan advances provided to the Company by ADI bear interest at a rate of LIBOR plus 4% and the principal and interest are not repayable until December 31, 2015 or upon such time as the Company achieves certain defined levels of excess cash flow and available cash. As of December 31, 2002 and 2003, the Company had loans payable to ADI of $30.25 million and $33.0 million, respectively. In addition, as of December 31, 2002 and 2003, the Company had accrued interest payable to ADI of $1.1 million and $3.0 million, respectively.
GOING CONCERN
The Company has incurred losses and negative cash flows from operations since inception in 2001 and has an accumulated deficit of $53.4 million as of December 31, 2003. For the year ended December 31, 2003, the Company incurred a net loss of $12.7 million and had negative working capital of $10.9 million at December 31, 2003. The Company has relied on loan and distribution advances to fund its operations to date. During 2003, the Company received loan advances of $2.75 million from ADI and has received a total of $37.75 million of loan advances through December 31, 2003. As of December 31, 2003, the Company did not have sufficient working capital resources to conduct operations. Management expects the Company to continue to incur operating losses for the foreseeable future.
During the three months ended September 30, 2003, the Company significantly reduced its overhead costs and operating activities and laid off the majority of its staff while it continued to restructure its operations and seek additional capital. During 2003, the Company relied on $898,000 of loans from Ted Field and $1,150,000 of loans from outside investors to fund operations. The total loans of $2.048 million during 2003 were obtained through the issuance of convertible promissory notes (the “Bridge Notes”) (see Note 10).
ADI does not have the resources to meet its remaining $12.0 million funding commitment to the Company for 2004. The Company requires additional capital in order to continue operations, and is therefore continuing to pursue alternatives to raise additional capital. However, there can be no assurances that additional capital can be obtained on reasonable terms or at all. Failure to raise additional capital could seriously harm the Company’s business. In such event, the Company may seek to divest all or certain of its assets in order to raise the capital necessary to sustain business operations. Should this fail, the Company may consider a formal or informal restructuring or reorganization.
The conditions described above raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
2. SIGNIFICANT ACCOUNTING POLICIES
REVENUE RECOGNITION
Revenue consists primarily of the sale of compact discs by artists signed under contract with the Company. The Company recognizes revenues upon the shipment of compact discs from its distributor to retailers and independent wholesalers and records appropriate reserves for product returns. At the time of the shipment of the product, the following criterion under Statement of Financial Accounting Standards (SFAS) No. 48, “Revenue Recognition When Right of Return Exists,” have been met: the seller’s price to the buyer is substantially fixed or determinable at the date of sale; the buyer has paid the seller, or the buyer is obligated to pay the seller, and the obligation is not contingent on resale of the product; the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product; the buyer acquiring the product for resale has economic substance apart from that provided by the seller; the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer; and the amount of future returns can be reasonably estimated.
The Company estimates the provision for returns on a quarterly basis by album based on the amount of time since the initial album release, the actual returns to date, the trend of sales activity (sales by the retailers and wholesalers) and the number of unsold units at retailers and wholesalers. Returns to the Company’s distributor are deemed to be returns to the Company. Revenues recorded for the years ended December 31, 2002 and 2003 are net of a provision for actual and estimated future returns of $1.7 million and $888,000, respectively.
COST OF REVENUE
Manufacturing expenses consist of the cost of pressing compact discs, manufacturing printed booklets and packaging materials, and a provision for the obsolescence of finished goods and components. Distribution expenses consist of the distribution fee payable to BMG and other distribution expenses, including the cost of processing returns and warehousing inventory. Artist advances and royalty expenses consist of payments made to artists and others in connection with the recording of an album.
ARTIST ADVANCES
Artist advances consists of the amounts advanced to artists in connection with the recording of their albums. In addition, included in artist advances are costs expended for producer fees, musician fees, engineering and studio costs, equipment costs, mastering and
remix costs, sample clearances and artist living expenses during recording. Artist advances are typically recoupable from artist royalties earned from the sale of compact discs. The Company expenses these advances when incurred as the Company’s artists have limited or no history of album sales.
INVENTORY
Inventory, net of a provision for obsolescence, consists of finished albums maintained in the warehouse of the Company’s distributor and is stated at the lower of cost or net realizable value. Cost is determined using the first-in, first-out method. Inventory has been fully reserved at December 31, 2003.
DEPRECIATION
Depreciation is provided using the straight-line method over the following estimated useful lives:
Computer equipment and software
3 years
Furniture and fixtures
7 years
Studio equipment
7 years
INCOME TAXES
The Company is treated as a limited liability company for federal and state income tax reporting purposes whereby its income (loss) is reported in the individual income tax returns of the Company’s members.
STOCK-BASED COMPENSATION
The Company accounts for stock-based employee compensation in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25 and FASB Interpretation No. 44 (“FIN 44”), “Accounting for Certain Transactions Involving Stock Compensation”, and complies with the disclosure requirements of SFAS No. 123, “Accounting for Stock-Based Compensation”. Under APB No. 25, compensation expense is recorded based on the difference, if any, between the fair value of the Company’s stock and the exercise price on the measurement date. The Company accounts for stock issued to non-employees in accordance with SFAS No. 123, which requires entities to recognize as expense over the service period the fair value of all stock-based awards on the date of grant and EITF 96-18, “Accounting for Equity Investments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services”, which addresses the measurement date and recognition approach for such transactions. The Company recognizes compensation expense related to variable awards in accordance with FIN 28. For fixed awards, the Company recognizes expense over the vesting period or the period of service
The Company did not record any stock-based compensation expense for the period ended December 31, 2001 and the years ended December 31, 2002 and 2003.
IMPAIRMENT OF LONG-LIVED ASSETS
Impairment of long-lived assets is monitored on a continuing basis, and is assessed based on the undiscounted cash flows generated by the underlying assets. In the event that the carrying amount of long-lived assets exceeds the undiscounted future cash flows, then the carrying amount of such assets is adjusted to their fair value.
See Note 5 for write-downs in 2003 with respect to the Company’s property and equipment.
CONCENTRATION OF CREDIT RISK AND SUPPLIER RISK
Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of trade accounts receivable. The Company’s exposure to losses on receivables is dependent upon the financial condition of its distributor, BMG, which is responsible for credit losses from retail and wholesale customers.
The Company purchases its inventory from a limited number of suppliers. However, there are a number of alternative suppliers who can provide manufacturing services for the Company.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts of financial instruments, which include cash and cash equivalents, accounts receivable, accounts payable and accrued expenses, approximate fair value because of the short maturity of these instruments.
The carrying amount of the Bridge Notes payable approximates fair value as the related effective interest rate (including the discount) approximates rates currently available to the Company.
COMPREHENSIVE LOSS
The Company has adopted the provisions of Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive Income” (“SFAS No. 130”). SFAS No. 130 establishes standards for the reporting and display of comprehensive income, its components and accumulated balances in a full set of general purpose financial statements. SFAS No. 130 defines comprehensive income (loss) to include all changes in equity except those resulting from investments by owners and distributions to owners, including adjustments to minimum pension liabilities, accumulated foreign currency translation, and unrealized gains or losses on marketable securities. The Company did not have any items of comprehensive income (loss) during 2001, 2002 or 2003 except the net loss.
ESTIMATES
In preparing financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Some of the more significant estimates are the allowance for sales returns and inventory obsolescence. Actual results could differ from those estimates.
3. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In August 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (“SFAS No. 143”). SFAS No. 143 addresses the diverse accounting practices for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The Company adopted SFAS No. 143 effective January 1, 2003. The adoption of SFAS No. 143 did not have a material impact on the Company’s financial statement presentation or disclosures.
In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. While SFAS No. 144 supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of”, it retains many of the fundamental provisions of that statement. The Company adopted SFAS No. 144 effective January 1, 2002. The adoption of SFAS No. 144 did not have a material impact on the Company’s financial statement presentation or disclosures.
In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections”. SFAS No. 145 rescinds SFAS 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. Upon adoption of SFAS No. 145, the Company will be required to apply the criteria in APB Opinion No. 30, “Reporting the Results of Operations - Reporting the Effects of a Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” (Opinion No. 30), in determining the classification of gains and losses resulting from the extinguishment of debt. Additionally, SFAS No. 145 amends SFAS No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions to be accounted for in the same manner as sale-leaseback transactions. The Company adopted SFAS No. 145 effective January 1, 2003. The adoption of SFAS No. 145 for long-lived assets held for use did not have a material impact on the Company’s financial statement presentation or disclosures.
In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit and Disposal Activities”. SFAS No. 146 nullifies Emerging Issues Task Force (“EITF”) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)”. Under EITF Issue No. 94-3, a liability for an exit cost is recognized at the date of an entity’s commitment to an exit plan. Under SFAS No. 146, the liabilities associated with an exit or disposal activity will be measured at fair value and recognized when the liability is incurred and meets the definition of a liability in the FASB’s conceptual framework. SFAS No. 146 is effective for exit or disposal activities initiated after December 31, 2002. The adoption of SFAS 146 did not have a material impact on the Company’s financial statement presentation or disclosures.
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure-an amendment of SFAS No. 123”. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also amends the disclosure requirements of SFAS No. 123 and APB Opinion No. 28, “Interim Financial Reporting”, to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company implemented SFAS No. 148 effective December 31, 2002. The Company has determined that it will continue to account for stock-based employee compensation in accordance with APB No. 25.
In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”. SFAS No. 149 amends and clarifies under what circumstances a contract with initial investments meets the characteristics of a derivative and when a derivative contains a financing component. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS No. 149 did not have a material impact on the Company’s financial statement presentation or disclosures.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. SFAS No. 150 establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003 and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. SFAS No. 150 is to be implemented by reporting the cumulative effect of a change in accounting principle for financial instruments created before the issuance date of SFAS No. 150 and still existing at the beginning of the interim period of adoption. Restatement is not permitted. The adoption of SFAS No. 150 did not have a material impact on the Company’s financial statement presentation or disclosures.
In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others” (“FIN 45”), an interpretation of FASB Statements Nos. 5, 57 and 107 and a rescission of FASB Interpretation No. 34. FIN 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees issued. FIN 45 also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken. The initial recognition and measurement provisions of FIN 45 are applicable to guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN 45 are effective for financial statements of interim and annual periods ended after December 15, 2002. The adoption of FIN 45 did not have a material impact on the Company’s financial statement presentation or disclosures.
In November 2002, the FASB’s Emerging Issues Task Force (“EITF”) issued EITF No. 00-21 “Revenue Arrangements with Multiple Deliverables”. EITF No. 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. Specifically, EITF No. 00-21 addresses how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. In applying EITF No. 00-21, separate contracts with the same entity or related parties that are entered into at or near the same time are presumed to have been negotiated as a package and should, therefore, be evaluated as a single arrangement in considering whether there are one or more units of accounting. That presumption may be overcome if there is sufficient evidence to the contrary. EITF No. 00-21 also addresses how arrangement consideration should be measured and allocated to the separate units of accounting in the arrangement. The guidance in EITF No. 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The Company adopted EITF No. 00-21 effective July 1, 2003. The adoption of EITF No. 00-21 did not have a material impact on the Company’s financial statement presentation or disclosures.
In February 2003, the Financial Accounting Standards Board issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which addresses the consolidation by business enterprises of variable interest entities, which have one or both of the following characteristics: (1) the equity investment at risk is not sufficient to permit the entity to finance its activities without
additional financial support from other parties, or (2) the equity investors lack one or more of the following essential characteristics of a controlling financial interest: (a) the direct or indirect ability to make decisions about the entity’s activities through voting or similar rights, (b) the obligation to absorb the expected losses of the entity if they occur, or (c) the right to receive the expected residual returns of the entity if they occur. In addition, FIN 46 contains detailed disclosure requirements. FIN 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period ending after March 15, 2004, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. Early adoption is permitted. The Company adopted FIN 46 as of December 31, 2003. The adoption of FIN 46 did not have a material impact on the Company’s financial statement presentation or disclosures. However, as a result of the adoption of FIN 46 by ADI as of December 31, 2003, the Company’s balance sheet was consolidated with ADI’s balance sheet at December 31, 2003, and the Company’s operations will be consolidated with ADI’s operations beginning January 1, 2004. ADI previously accounted for the Company’s operations under the equity method of accounting.
4. ARTIST ADVANCES
As of December 31, 2003, the Company had signed recording agreements with six artists and had advanced a total of $1.238 million through such date with respect to these artists. The amount of these advances is recoupable against royalties to be earned by the artists based on sales. However, given that most of the artists signed by the record label have no previous track record, the advances have been expensed by the Company as incurred. As of December 31, 2003, the Company is contractually committed to additional minimum artist advances of approximately $1.5 million, all of which is payable in 2004.
5. PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost and consist of the following:
Impairment of fixed assets is monitored on a continuing basis, and is assessed based on the undiscounted cash flows generated by the underlying assets. In the event the carrying amount of fixed assets exceeds the undiscounted future cash flows, then the carrying amount of such assets is adjusted to their fair value. There was no impairment of long-lived assets as of December 31, 2002. During the three months ended June 30, 2003, the Company determined that its fixed assets were impaired due to continuing losses, going concern issues, and the likelihood that the majority of these assets would likely be abandoned in the near future. The Company determined that these factors were indicators of impairment and thus reduced the carrying amount of the fixed assets to their estimated fair value by recording a write-off of $100,000 during the three months ended June 30, 2003. Most of the Company’s property and equipment was subsequently sold to third party liquidators for cash. This amount has been reported as a loss from sale and abandonment of property and equipment in the statement of operations for the year ended December 31, 2003.
6. ALLOWANCE FOR SALES RETURN RESERVE
A summary of the activity with respect to the reserve for sales returns for the periods indicated is as follows:
7. ACCRUED EXPENSES
Accrued expenses are comprised of the following:
8. SIGNIFICANT CONTRACTS
In November 2001, the Company agreed in principle to enter into a preliminary North American distribution agreement and worldwide license agreement with BMG Music (“BMG”), the global music division of Bertelsmann AG. Under the terms of the agreement, BMG distributes the Company’s releases in North America, and BMG licenses the Company’s repertoire in territories throughout the world. In April 2002, the agreements with BMG were finalized, including BMG’s purchase of 5% of the equity of the Company from ADI. As part of this transaction, BMG agreed to advance certain monies against net sales proceeds under the agreements and also assumed $5.0 million of ADI’s funding commitment to the Company, which was advanced during 2002. As a result of the BMG equity purchase, ADI’s funding commitment was reduced to $45 million. In December 2002, BMG exercised its option to extend the term of the distribution and license agreement until September 2004.
Under the distribution and license agreements, BMG made non-returnable advances to the Company of $2.5 million in 2001, $2.5 million in 2002 and $5.0 million in 2003 that are recoupable from net sales proceeds from the Company’s artist repertoire. The advances are to be recouped on a monthly basis based on a defined calculation. As of December 31, 2002 and 2003, the unrecouped balances related to distribution advances from BMG were $4.1 million and $8.7 million, respectively.
The loan advances provided to the Company by BMG bear interest at a rate of LIBOR plus 4% and the principal and interest are not repayable until December 31, 2015 or upon such time as the Company achieves certain defined levels of excess cash flow and available cash. As of December 31, 2002 and 2003, the Company had loans payable to BMG of $4.75 million. In addition, as of December 31, 2002 and 2003, the Company had accrued interest payable to BMG of $189,000 and $447,000, respectively.
9. RELATED PARTY TRANSACTIONS
During 2001, ADI paid legal fees of $530,000 to Lenard, Brisbin & Klotz LLP in connection with the transaction pursuant to which the Company was formed and capitalized, which has been treated as an advance to the Company under the operating agreement. Allen Lenard, one of ADI’s former directors who resigned from its board of directors in September 2002, is managing partner of Lenard, Brisbin & Klotz LLP. During the year ended December 31, 2003, the Company paid $155,000 of legal fees to Lenard, Brisbin & Klotz LLP.
ADI charged the Company $200,000, $1.35 million and $563,000 in 2001, 2002 and 2003, respectively, for the reimbursement of overhead costs, including rent and other occupancy costs, telephone and internet services, and the services of certain ADI personnel primarily in the areas of accounting, legal, information technology, human resources and administration. These amounts were included in general and administrative expense.
During the three months ended September 30, 2003, the Company significantly reduced its overhead costs and operating activities and laid off the majority of its staff while it continued to restructure its operations and seek additional capital. The Company also
relocated its administrative offices to offices leased by a company owned by Ted Field. The Company sub-leases these offices on a month-to-month basis. Rent expense for the period September through December 2003 was not material.
The Company entered into an employment agreement with Ted Field to serve as Chief Executive Officer, which had an initial term extending through May 31, 2006, and which provided for an annual base salary of $1,000,000 plus certain benefits. The employment agreement also provided that under certain conditions, Mr. Field would receive a lump-sum payment equal to his annual base salary for (i) 50% of the remaining term of the employment agreement if termination occurs within the first three years of his employment, (ii) his annual base salary for one year if termination occurs in the fourth year of his employment, and (iii) his annual base salary for the full remaining term of the employment agreement if termination occurs in the fifth year of his employment.
During 2002, Mr. Field’s employment agreement was amended whereby Mr. Field agreed to defer his future salary until the Company raised new debt or equity financing of at least $20 million. During the three months ended June 30, 2003, Mr. Field’s employment agreement was further amended whereby all deferred and any future salary, except a base amount, would be waived, even if new debt or equity financing is raised. Accordingly, during the year ended December 31, 2003, $822,000 of accrued compensation due to Mr. Field by the Company was credited to capital in the statement of members’ deficit.
See Notes 1, 10 and 14 for additional related party transactions.
10. BRIDGE NOTES PAYABLE
As of December 31, 2003, the Company had received $898,000 of loans from Ted Field and $1,150,000 of loans from outside investors (including $100,000 from Jonathan V. Diamond, ADI’s new President and Chief Executive Officer). The total loans of $2.048 million during 2003 were obtained through the issuance of convertible promissory notes (the “Bridge Notes”). The Bridge Notes accrue interest at 8% per annum, are due two years from the date of issuance, and will be converted into new equity of the Company as part of its next equity financing. The $1,150,000 of loans from outside investors has been presented as bridge notes payable in the balance sheet at December 31, 2003. The $898,000 of loans from Mr. Field has been presented as bridge notes payable in the balance sheet at December 31, 2003.
The holders of the Bridge Notes also received warrants with a term of five years to purchase additional equity of the Company at $0.01 per unit equivalent to the number of units of new equity into which their Bridge Notes are ultimately converted. The relative fair value of the warrants issued was $1.024 million (one-half of the amount funded by the investors in the Bridge Notes), which was recorded as a reduction to the carrying amount of the Bridge Notes and a credit to capital, and is being charged to operations as interest expense over the specified term of the Bridge Notes.
In addition, since the Bridge Notes are convertible into equity based on their face amount, this results in a beneficial conversion feature with a relative fair value of $1.024 million. Since the commitment date for the beneficial conversion feature is contingent upon the completion of the Company’s next equity financing, the fair value of the beneficial conversion feature will be charged to operations over the remaining life of the Bridge Notes at that time.
During the year ended December 31, 2003, the Company recognized $203,000 as interest expense with respect to the amortization of the fair value of the warrants. Additional interest expense of $821,000 will be recognized ratably in 2004 and 2005 over the remaining term of the Bridge Notes. As of December 31, 2003, the carrying amount of the Bridge Notes, including accrued interest of $67,000, was $1.294 million.
A reconciliation of bridge notes payable issued by the Company during 2003 to amounts presented in the balance sheet at December 31, 2003 is presented below.
11. 401(K) PLAN
In 2001, the Company adopted ADI’s Cash or Deferred Profit Sharing Plan and Trust under Section 401(k) of the Internal Revenue Code (the 401(k) Plan). Under the 401(k) Plan, participating employees may defer a percentage (not to exceed 15%) of their eligible pretax earnings up to the Internal Revenue Service’s annual contribution limit. All employees of the Company age 21 years or older who complete three months of service are eligible to participate in the 401(k) Plan. The Company does not match contributions by participants to the 401(k) Plan. Accordingly, there is no related expense for the period from May 31, 2001 (inception) to December 31, 2001 and the years ended December 31, 2002 and 2003.
12. LITIGATION
The Company is subject to various pending and threatened legal actions, which arise in the normal course of business. The Company’s management believes that the impact of such litigation will not have a material adverse impact on its financial position or results of operations.
13. SUPPLEMENTAL DISCLOSURES TO STATEMENTS OF CASH FLOWS
Significant non-cash investing and financing activities are as follows:
14. SUBSEQUENT EVENTS (UNAUDITED)
During the three months ended March 31, 2004, Mr. Field advanced an additional $1.89 million to the Company to fund operating expenses and the settlement of artist contracts. In consideration for such advances, Mr. Field received Bridge Notes and warrants as described at Note 10.
EXHIBIT INDEX