ARTISTDIRECT INC (Form: 10QSB, Received: 11/14/2007 16:07:22)

ARTISTdirect, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

(amounts in thousands, except for share data)

	September 30, 2007			December 31, 2006
	(Unaudited)
Assets
Current assets:
Cash and cash equivalents	$	6,360		$	5,602
Restricted cash	278			364
Accounts receivable, net of allowance for doubtful accounts of $393 at September 30, 2007 and $421 at December 31, 2006	6,640			6,928
Income taxes refundable	330			—
Finished goods inventory	—			281
Prepaid expenses and other current assets	627			204
Total current assets	14,235			13,379

Property and equipment	4,362			4,197
Less accumulated depreciation and amortization	(2,322		)	(1,729		)
Property and equipment, net	2,040			2,468

Other assets:
Intangible assets:
Customer relationships, net	629			1,195
Proprietary technology, net	2,112			4,012
Non-competition agreements, net	481			728
Goodwill	31,085			31,085
Total intangible assets, net	34,307			37,020
Deferred financing costs, net	1,455			2,084
Deposits	20			21
Total other assets	35,782			39,125
	$	52,057		$	54,972

(continued)

ARTISTdirect, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets (continued)

(amounts in thousands, except for share data)

	September 30, 2007				December 31, 2006
	(Unaudited)
Liabilities and Stockholders’ Deficiency
Current liabilities:
Accounts payable	$		1,406		$	1,832
Accrued expenses	2,882				1,575
Accrued interest payable	2,323				67
Deferred revenue	298				39
Income taxes payable	147				495
Liquidated damages payable under registration rights agreements, net of advance payments of $500	2,558				3,777
Warrant liability	3,073				4,715
Derivative liability	11,300				18,356
Senior secured notes payable, net of discount of $766 and $1,110 at September 30, 2007 and December 31, 2006, respectively (in default)	12,541				12,197
Subordinated convertible notes payable, net of discount of $4,554 and $6,516 at September 30, 2007 and December 31, 2006, respectively (in default)	23,104				21,142
Total current liabilities	59,632				64,195

Long-term liabilities:
Deferred rent	189				199
Deferred income taxes payable	264				264
Total long-term liabilities	453				463

Commitments and contingencies

Stockholders’ deficiency:
Common stock, $0.01 par value -
Authorized – 60,000,000 shares
Issued and outstanding – 10,333,127 shares and 10,188,445 shares at September 30, 2007 and December 31, 2006, respectively	103				102
Additional paid-in-capital	234,988				233,197
Accumulated deficit	(243,119			)	(242,985			)
Total stockholders’ deficiency	(8,028			)	(9,686			)
	$	52,057			$		54,972

See accompanying notes to condensed consolidated financial statements.

ARTIST direct, Inc. and Subsidiaries

Condensed Consolidated Statements of Operations (Unaudited)

(amounts in thousands, except for share data)

	Three Months Ended September 30,							Nine Months Ended September 30,
	2007			2006				2007				2006
				(Restated)								(Restated)
Net revenue:
E-commerce	$	337		$	663			$	1,340			$		1,917
Media	1,974			1,572				5,139				3,937
Anti-piracy and file-sharing marketing services	3,627			4,158				11,498				11,781
Total net revenue	5,938			6,393				17,977				17,635
Cost of revenue:
E-commerce	353			612				1,378				1,799
Media	969			709				2,562				2,110
Anti-piracy and file-sharing marketing services	2,414			2,040				6,928				5,617
Total cost of revenue	3,736			3,361				10,868				9,526
Gross profit	2,202			3,032				7,109				8,109
Operating expenses:
Sales and marketing	553			296				1,439				839
General and administrative, including stock-based compensation of $702 and $652 for the three months ended September 30, 2007 and 2006, respectively, and $1,690 and $1,736 for the nine months ended September 30, 2007 and 2006, respectively	2,982			2,107				8,490				6,896
Development and engineering	106			—				419				—
Write-off of fixed assets	—			—				97				—
Total operating costs	3,641			2,403				10,445				7,735
Income (loss) from operations	(1,439		)	629				(3,336			)	374
Other income (expense):
Interest income	59			45				160				76
Interest expense	(1,805		)	(1,472			)	(5,733			)	(4,411			)
Loss on foreign currency transactions	—			—				(14			)	—
Other income	—			10				—				63
Reduction in liquidated damages payable under registration rights agreements	—			—				719				—
Change in fair value of warrant liability	512			1,139				1,643				(1,818			)
Change in fair value of derivative liability	2,702			1,236				7,056				(2,765			)
Reduction in exercise price of warrants	—			—				—				(641			)
Amortization of deferred financing costs	(212		)	(212			)	(629			)	(646			)
Write-off of unamortized discount on debt and deferred financing costs resulting from principal payments on senior secured notes payable and conversion of subordinated convertible notes payable	—			—				—				(1,580			)
Income (loss) before income taxes	(183		)	1,375				(134			)	(11,348			)
Provision for income taxes	—			536				—				797
Net income (loss)	$	(183	)	$	839			$	(134		)	$	(12,145		)

Net income (loss) per common share:
Basic	$	(0.02	)	$		0.03		$		(0.01	)	$	(1.46		)
Diluted	$	(0.02	)	$		0.03		$		(0.01	)	$	(1.46		)

Weighted average common shares outstanding:
Basic	10,292,611			27,933,889				10,228,904				8,296,876
Diluted	10,292,611			30,543,558				10,228,904				8,296,876

See accompanying notes to condensed consolidated financial statements.

ARTISTdirect, Inc. and Subsidiaries

Condensed Consolidated Statement of Stockholders’ Deficiency (Unaudited)

(amounts in thousands, except for share data)

	Common Stock			Additional Paid-In			Accumulated			Total Stockholders’
	Shares	Amount		Capital			Deficit			Deficiency
Balance at January 1, 2007	10,188,445	$	102	$		233,197	$	(242,985	)	$	(9,686	)
Fair value of stock options granted	—	—		1,633			—			1,633
Common stock issued for consulting services	17,307	—		57			—			57
Common stock issued upon exercise of stock options	127,375	1		101			—			102
Net loss	—	—		—			(134		)	(134		)
Balance at September 30, 2007	10,333,127	$	103	$	234,988		$	(243,119	)	$	(8,028	)

See accompanying notes to condensed consolidated financial statements.

ARTISTdirect, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows (Unaudited)

(amounts in thousands)

	Nine Months Ended September 30,
	2007			2006
				(Restated)
Cash flows from operating activities:
Net loss	$	(134	)	$	(12,145	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization	6,371			6,229
Write-off of unamortized discount on debt and deferred financing costs resulting from principal payments on senior secured notes payable and conversion of subordinated convertible notes payable	—			1,580
Provision for doubtful accounts	10			(67		)
Stock-based compensation	1,690			1,736
Deferred income taxes	—			(1		)
Other	—			(88		)
Change in fair value of warrant liability	(1,643		)	1,818
Change in fair value of derivative liability	(7,056		)	2,765
Reduction in exercise price of warrants	—			641
Reduction in liquidated damages payable under registration rights agreements	(719		)	—
Write-off of fixed assets	97			—
Sub-total	(1,384		)	2,468
Changes in operating assets and liabilities:
(Increase) decrease in -
Accounts receivable	278			(2,342		)
Finished goods inventory	281			(40		)
Prepaid expenses and other current assets	(423		)	(183		)
Income taxes refundable	(330		)	828
Deposits	1			4
Increase (decrease) in -
Accounts payable	(426		)	109
Accrued expenses	1,307			(32		)
Accrued interest payable	2,256			(545		)
Deferred revenue	259			(321		)
Deferred rent	(10		)	200
Income taxes payable	(348		)	—
Liquidated damages payable under registration rights agreements	(500		)	—
Net cash provided by operating activities	961			146

Cash flows from investing activities:
Purchases of property and equipment	(391		)	(955		)
Net cash used in investing activities	(391		)	(955		)

Cash flows from financing activities:
Proceeds from exercise of stock options	102			71
Proceeds from exercise of warrants	—			5,212
Principal payments on senior secured notes payable	—			(1,693		)
(Increase) decrease in restricted cash	86			(4		)
Net cash provided by financing activities	188			3,586

Cash and cash equivalents:
Net increase	758			2,777
Balance at beginning of period	5,602			3,102
Balance at end of period	$	6,360		$	5,879

(continued)

ARTISTdirect, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows (Unaudited) (continued)

(amounts in thousands)

	Nine Months Ended September 30,
	2007			2006
				(Restated)
Supplemental disclosure of cash flow information:
Cash paid for -
Interest	$	1,139		$				2,585
Income taxes	$		678	$				—

Non-cash investing and financing activities:
Warrant liability transferred to additional paid-in capital as a result of exercise of warrants	$		—	$			9,311
Common stock issued upon conversion of subordinated convertible notes payable	$		—	$		3,275
Derivative liability transferred to additional paid-in capital as a result of conversions of subordinated convertible notes payable	$		—	$	3,915

See accompanying notes to condensed consolidated financial statements.

ARTISTdirect, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

Three Months and Nine Months Ended September 30, 2007 and 2006 (2006 restated)

1. ORGANIZATION AND BUSINESS ACTIVITIES

ARTISTdirect, Inc., a Delaware corporation (“ADI”), was formed on October 6, 1999 upon its merger with ARTISTdirect, LLC. ARTISTdirect, LLC was organized as a California limited liability company and commenced operations on August 8, 1996. Unless the context indicates otherwise, ADI and its subsidiaries are referred to herein as the “Company”. The Company is headquartered in Santa Monica, California.

On July 28, 2005, the Company completed the acquisition of MediaDefender, Inc., a privately-held Delaware corporation (“MediaDefender”) (see Note 3). This transaction was accounted for as a purchase in accordance with SFAS No. 141, “Business Combinations”, and the operations of the two companies have been consolidated commencing August 1, 2005. MediaDefender is a leading provider of anti-piracy solutions in the Internet-piracy-protection (“IPP”) industry. During the year ended December 31, 2006, MediaDefender also began to offer file-sharing marketing services, wherein MediaDefender redirects, for a fee, specific peer-to-peer traffic on the Internet to designated client destinations.

The Company is a digital media entertainment company that is home to an online music network and, through its MediaDefender subsidiary, is a leading provider of anti-piracy solutions in the IPP industry. The ARTISTdirect Network (www.artistdirect.com) is a network of web-sites appealing to music fans, artists and marketing partners that offers multi-media content, music news and information, communities organized around shared music interests, music-related specialty commerce and digital music services.

Restatement of Financial Statements:

On December 20, 2006, the Company determined that it was necessary to restate the financial statements contained in its previously-filed Annual Report on Form 10-KSB/A for the fiscal year ended December 31, 2005 and Quarterly Reports on Form 10-QSB or Form 10-QSB/A for the quarterly periods ended September 30, 2005, March 31, 2006, June 30, 2006 and September 30, 2006 (collectively, the “Financial Statements”). The determination was made by the Company’s Audit Committee following receipt by the Company of comments from the staff (the “Staff”) of the Securities and Exchange Commission (the “SEC”), and following consultation with the Company’s senior management, financial advisors and independent registered public accounting firm.

The Staff advised the Company to consider EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock” (“EITF 00-19”), and, in light of the guidance set forth in EITF 00-19, to further evaluate the accounting treatment of certain embedded derivatives contained in the outstanding Sub-Debt Notes (as subsequently defined) issued by the Company in July 2005, as well as the accounting treatment of certain warrants issued to the Company’s lenders in July 2005, in conjunction with the financing of the acquisition of MediaDefender. The Company filed the restated Financial Statements on April 19, 2007. On May 11, 2007, the Staff provided additional comments to the Company regarding the Financial Statements, to which the Company subsequently responded. On June 11, 2007, the Staff advised the Company that it would have no further comments. The adjustments to the Financial Statements with respect to the restatements were non-cash in nature and were not caused by or related to any changes in the underlying operating performance of the Company’s business, including its revenues, operating costs and expenses, operating income or loss, operating cash flows or adjusted EBITDA. However, such restatements had a material negative impact on the Company’s previously reported results of operations and earnings per share, current liabilities, net working capital and shareholders’ equity (deficiency). Additionally, as a result of the restatements, the Company triggered various events of default under its financing documents (see Note 4).

The Sub-Debt Notes contain reset, anti-dilution and change-in-control provisions that the Company has determined caused such debt instruments to be classified as “non-conventional” debt. Upon evaluation of such debt instruments under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”) and EITF 00-19, it was determined that the Company was required to bifurcate and value certain rights embedded in the Sub-Debt Notes on the date of issuance (including, specifically, the initial $1.55 per share fixed conversion feature, which was in excess of the $1.43 per share fair market value of the Company’s common stock on the date of issuance) and to classify such rights as either assets or liabilities. The fair value of these bifurcated derivatives, as determined by an independent valuation firm as of July 28, 2005, was calculated in accordance with SFAS No. 133 Implementation Issue No. B15, “Embedded Derivatives: Separate Accounting for Multiple Derivative Features Embedded in a Single Hybrid Instrument”, using a binomial lattice model, and utilized highly subjective and theoretical assumptions that can materially affect fair values from period to period.

The following table presents the impact of the restatement on the effected balance sheet categories at September 30, 2006 (amounts in thousands):

	As Previously Reported			Restatement Adjustments			Adjustment Legend	As Restated

Deferred financing costs	$	2,139		$	166		(c)	$	2,305
Warrant liability	6,209			1,620			(c), (d)	7,829
Derivative liability	—			29,052			(a), (b)	29,052
Discount on senior secured notes payable	864			362			(c), (d)	1,226
Discount on subordinated convertible notes payable	540			6,673			(a), (b), (c)	7,213
Additional paid-in capital	225,348			6,724			(e)	232,072
Accumulated deficit	$	(220,045	)	$	(30,195	)	(a), (b), (c), (d)	$	(250,240	)

The following table presents the impact of the restatement on the statements of operations for the three months and nine months ended September 30, 2006 (amounts in thousands, except per share data):

		Three Months Ended September 30, 2006									Nine Months Ended September 30, 2006
	Adjustment Legend	As Previously Reported			Restatement Adjustments			As Restated			As Previously Reported			Restatement Adjustments			As Restated
Income (loss) from operations		$	629		$	—		$	629		$	374		$	—		$	374
Interest income		45			—			45			76						76
Other income		10			—			10			63			—			63
Interest expense	(a), (c)	(825		)	(647		)	(1,472		)	(2,449		)	(1,962		)	(4,411		)
Amortization of deferred financing costs	(c)	(197		)	(15		)	(212		)	(600		)	(46		)	(646		)
Change in fair value of warrant liability	(c), (d)	887			252			1,139			(9,452		)	7,634			(1,818		)
Change in value of derivative liability	(a), (b)	—			1,236			1,236			—			(2,765		)	(2,765		)
Write-off of unamortized discount on debt and deferred financing costs due to conversion of subordinated convertible notes payable and principal payments on senior secured notes payable	(a), (c)	—			—			—			(537		)	(1,043		)	(1,580		)
Reduction in exercise price of warrants	(c), (d)	—			—			—			(797		)	156			(641		)
Income (loss) before income taxes		549			826			1,375			(13,322		)	1,974			(11,348		)
Provision for income taxes		(536		)	—			(536		)	(797		)	—			(797		)
Net income (loss)		$	13		$	826		$	839		$	(14,119	)	$	1,974		$	(12,145	)

Net income (loss) per share – basic		$	0.00					$	0.03		$	(1.70	)				$	(1.46	)
Net income (loss) per share - diluted		$	0.00					$	0.03		$	(1.70	)				$	(1.46	)

Going Concern:

The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which contemplate continuation of the Company as a going concern. As a result of the matters described herein, the Company’s independent registered public accounting firm, in its report on the Company’s 2006 consolidated financial statements, expressed substantial doubt about the Company’s ability to continue as a going concern. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that could result from the outcome of this uncertainty.

As a result of communications with the Staff of the SEC in 2006, in particular regarding the application of accounting rules and interpretations related to embedded derivatives associated with the Company’s subordinated convertible notes payable issued in July 2005, the Company determined that it was necessary to restate previously issued financial statements. As a result, in December 2006, the Company was required to suspend the use of its then effective registration statement for the holders of its senior and subordinated indebtedness, which then triggered an event of default with respect to its registration rights agreements with the holders of such indebtedness. Accordingly, beginning January 18, 2007, the Company began to incur liquidated damages under its registration rights agreements aggregating approximately $540,000 per month, and the interest rate on its subordinated convertible notes payable increased from 4.0% per annum to 12.0% per annum, an increase of approximately $183,000 per month.

The adjustments to the financial statements with respect to the restatements were non-cash in nature and were not caused by or related to any changes in the underlying operating performance of the Company’s business, including revenues, operating costs and expenses, operating income or loss, income taxes, operating cash flows or adjusted EBITDA. The fair value of these bifurcated derivatives of $10,534,000, as determined by an independent valuation firm, was calculated using a binomial lattice option-pricing model utilizing highly subjective and theoretical assumptions that can materially affect fair values from period to period. The recognition of these derivative amounts, initially recorded as a reduction to the related debt and being amortized to interest expense through the life of the debt, with the resulting changes in fair value of the liability being included as other income (expense) in the statement of operations each subsequent reporting period, did not have any impact on the Company’s revenues, operating expenses, income taxes or cash flows. However, such restatements had a material negative impact on the Company’s previously reported results of operations and earnings per share, current liabilities, net working capital and shareholders’ equity (deficiency).

During 2005 and 2006 and the nine months ended September 30, 2007, the Company’s consolidated operations generated sufficient cash flows from operations to enable the Company to fund its operating requirements and its originally scheduled (i.e., undefaulted) debt service obligations to both the senior and subordinated debt holders, and management currently anticipates that cash flows from operations will be adequate to fund operating and debt service requirements (based on the original terms as contemplated in the senior and subordinated loan agreements and excluding the registration penalty amounts) for the remainder of 2007 and generate operating cash flows in excess of pre-default amounts for at least the next twelve months.

Primarily as a result of the requirement to restate previously issued financial statements, which resulted in the recording of an embedded derivative liability, the reclassification of the senior and subordinated indebtedness to current liabilities, and the recording of estimated liquidated damages payable under registration rights agreements, the Company was not in compliance with certain of its financial covenants under both the Senior Financing and the Sub-Debt Financing at September 30, 2007 and December 31, 2006. Notwithstanding such developments, the Company believes that it would have been out of compliance with certain of its financial covenants at September 30, 2007.

As of September 30, 2007 and December 31, 2006, approximately $13,307,000 principal amount was outstanding with respect to the Senior Financing, and approximately $27,658,000 principal amount was outstanding with respect to the Sub-Debt Financing. In addition, at September 30, 2007, approximately $775,000 and $1,783,000 was outstanding with respect to accrued registration delay penalties to the holders of the Senior Financing and the Sub-Debt Financing, respectively, and approximately $116,000 and $2,207,000 was outstanding with respect to accrued interest payable to the holders of the Senior Financing and the Sub-Debt Financing, respectively. The Company has not paid the registration delay penalties to either the holders of the Senior Notes or the Sub-Debt Notes, although it has made advance payments to the holders of the Senior Notes aggregating $500,000. As a result of the registration failure, the failure to pay the registration delay penalties and the various financial covenant and other breaches of the terms of the Senior Financing and the Sub-Debt Financing, multiple events of default exist under the Senior Financing and the Sub-Debt Financing. The terms of the Subordination Agreement among the Company and the creditor parties thereto (the “Subordination Agreement”) prevent the Company from making any cash payments to the Sub-Debt Note holders until the events of default under the Senior Financing are either cured or waived. Furthermore, upon the occurrence of an event of default, holders of at least 25% of the outstanding senior indebtedness may declare the outstanding principal and accrued interest on all senior notes immediately due and payable upon written notice to the Company, and each holder of outstanding subordinated indebtedness may only demand redemption of all or any portion of their respective notes under certain circumstances as described in the Subordination Agreement.

On October 16, 2007, the Company received an Event of Default Redemption Notice from the holders of approximately $2,693,000 principal amount of Sub-Debt Notes demanding that the Company redeem their Sub-Debt Notes. The Company believes and has advised these Sub-Debt Note holders that redemption (including the demand for redemption) is not permitted under the terms of the Subordination Agreement. On November 1, 2007, the Company received a copy of a letter to the Sub-Debt Note holders from Senior Note holders representing approximately 66% of the Senior Notes. The letter advised the Sub-Debt Note holders that the Subordination Agreement prohibits the Company from redeeming any Sub-Debt Notes and prohibits any Sub-Debt Note holder from pursuing any remedies. The letter further stated that the Senior Note holders were inclined to give the Company until November 30, 2007 to either cure the existing events of default or to pay off the obligations to the Senior Note holders in full, or the Senior Note holders expect they will likely begin to exercise additional remedies to obtain payment of their outstanding obligations. The Company does not have the capital resources necessary to cure the existing events of default, or to repay any accelerated indebtedness or redemption or penalty amounts.

All quarterly interest payments due on the outstanding senior and subordinated indebtedness were timely paid by the Company through December 2006. In addition, the quarterly interest paymen

Delaware	95-4760230
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification Number)

1601 Cloverfield Boulevard, Suite 400 South
Santa Monica, California	90404
(Address of principal executive offices)	(Zip Code)

		Page No.

PART I. FINANCIAL INFORMATION
ITEM 1.	FINANCIAL STATEMENTS
	CONDENSED CONSOLIDATED BALANCE SHEETS — SEPTEMBER 30, 2007 (UNAUDITED) AND DECEMBER 31, 2006	3
	CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) — THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006	5
	CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ DEFICIENCY (UNAUDITED) — NINE MONTHS ENDED SEPTEMBER 30, 2007	6
	CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) — NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006	7
	NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) — THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006	9
ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION	39
ITEM 3.	CONTROLS AND PROCEDURES	58
PART II. OTHER INFORMATION		59
ITEM 1.	LEGAL PROCEEDINGS	59
ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	59
ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	59
ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	59
ITEM 5.	OTHER INFORMATION	59
ITEM 6.	EXHIBITS	59
SIGNATURES		60

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

x	QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

	FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2007

o	TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934