UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-QSB

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

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2006

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

Commission File Number:  000-30063

ARTISTdirect, Inc.

(Exact name of small business issuer as specified in its charter)

(310) 956-3300

 (Issuer’s telephone number, including area code)

Not applicable

(Former name, former address and former fiscal year, if changed since last report.)

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the issuer was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes ý  No o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No ý

As of May 1, 2006, the Company had 9,980,488 shares of common stock, par value $0.01 per share, issued and outstanding.

Transitional Small Business Disclosure Format:  Yes o  No ý

Documents incorporated by reference:  None.

ARTISTDIRECT, INC. AND SUBSIDIARIES

INDEX

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In addition to historical information, this Quarterly Report on Form 10-QSB (“Quarterly Report”) for ARTISTdirect, Inc. (“ARTISTdirect” or the “Company”) contains “forward-looking” statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), including statements that include the words “may,” “will,” “believes,” “expects,” “anticipates,” or similar expressions.  These forward-looking statements may include, among others, statements concerning the Company’s expectations regarding its business, growth prospects, revenue trends, operating costs, working capital requirements, competition, results of operations and other statements of expectations, beliefs, future plans and strategies, anticipated events or trends, and similar expressions concerning matters that are not historical facts.  The forward-looking statements in this Quarterly Report involve known and unknown risks, uncertainties and other factors that could cause our actual results, performance or achievements to differ materially from those expressed or implied by the forward-looking statements contained herein.

Each forward-looking statement should be read in context with, and with an understanding of, the various disclosures concerning the Company’s business made elsewhere in this Quarterly Report, as well as other public reports filed by the Company with the United States Securities and Exchange Commission.  Investors should not place undue reliance on any forward-looking statement as a prediction of actual results or developments.  Except as required by applicable law or regulation, the Company undertakes no obligation to update or revise any forward-looking statement contained in this Quarterly Report.

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ARTISTdirect, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

(amounts in thousands, except for share data)

(continued)

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ARTISTdirect, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets (continued)

(amounts in thousands, except for share data)

See accompanying notes to condensed consolidated financial statements.

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ARTISTdirect, Inc. and Subsidiaries

Condensed Consolidated Statements of Operations (Unaudited)

(amounts in thousands, except for share data)

See accompanying notes to condensed consolidated financial statements.

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ARTISTdirect, Inc. and Subsidiaries

Condensed Consolidated Statement of Stockholders’ Equity (Deficiency) (Unaudited)

(amounts in thousands, except for share data)

See accompanying notes to condensed consolidated financial statements.

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ARTISTdirect, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows (Unaudited)

(amounts in thousands)

(continued)

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ARTISTdirect, Inc. and Subsidiaries

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

(amounts in thousands)

See accompanying notes to condensed consolidated financial statements.

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ARTISTdirect, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited)

Three Months Ended March 31, 2006 and 2005

1.  BASIS OF PRESENTATION

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.  The Company is headquartered in Santa Monica, California.

On May 31, 2001, the Company, through its wholly-owned subsidiary, ARTISTdirect Recordings, Inc., a Delaware corporation (“ARTISTdirect Recordings”), entered into an agreement to acquire a 50% equity interest in a co-venture with Radar Records Holdings, LLC (“Radar Records”), an entity owned by Frederick W. (Ted) Field, the Company’s Chairman, to form a new record label, ARTISTdirect Records, LLC (“ARTISTdirect Records”).  This transaction became effective as of June 29, 2001.

Effective September 30, 2004, the Company reorganized its operating structure by transferring its media and e-commerce business operations to a wholly-owned subsidiary, ARTISTdirect Internet Group, Inc., a Delaware corporation.  This reorganization did not have any effect on the Company’s business operations or consolidated financial statements.  The Company conducts these business operations through an online music network appealing to 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, communities organized around shared music interests, music-related specialty commerce and digital music services.

On February 28, 2005, the Company completed the sale of all of its interest in ARTISTdirect Recordings to Radar Records.  In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, the Company determined that it complied with the provisions of SFAS No. 144 at December 31, 2004 with respect to the classification of the operations of ARTISTdirect Records as a discontinued operation.  Accordingly, the Company has accounted for its interest in ARTISTdirect Records as a discontinued operation for all periods presented, and the assets and liabilities of ARTISTdirect Records were classified as “held for sale” through February 28, 2005.

On July 28, 2005, the Company completed the acquisition of MediaDefender, Inc., a privately-held Delaware corporation (“MediaDefender”).  MediaDefender was founded in July 2000 and is headquartered in Marina del Rey, California.  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 provider of anti-piracy solutions in the high-growth Internet-piracy-protection (“IPP”) industry and offers services designed to thwart Internet piracy and encourage consumers to pay for online content.

Unless the context indicates otherwise, ARTISTdirect, Inc. and its subsidiaries in which it has controlling interests are referred to herein as the “Company”.

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Principles of Consolidation:

The accompanying financial statements include the consolidated accounts of ADI and its subsidiaries in which it has controlling financial interests.  All intercompany accounts and transactions have been eliminated in consolidation for all periods presented.

Interim Financial Information:

The unaudited interim financial statements of the Company included herein have been prepared in accordance with the instructions for Form 10-QSB under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Item 310 of Regulation S-B under the Securities Act of 1933, as amended (the “Securities Act”).  Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations relating to interim financial statements.

In the opinion of management, the accompanying unaudited interim consolidated financial statements reflect all adjustments, including normal recurring accruals, those relating to the acquisition of MediaDefender and those relating to the accrued warrant liability discussed in Note 2, necessary to present fairly the financial position of the Company at March 31, 2006, the results of operations for the three months ended March 31, 2006 and 2005, and the cash flows for the three months ended March 31, 2006 and 2005.  The results of operations for the three months ended March 31, 2006 are not necessarily indicative of the expected results of operations for the full year or any future period.  The balance sheet as of December 31, 2005 is derived from the Company’s audited financial statements.  These financial statements should be read in conjunction with the consolidated financial statements and footnotes included in the Company’s December 31, 2005 Annual Report on Form 10-KSB, as amended, as filed with the Securities and Exchange Commission (the “SEC”).

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.  Actual results could differ materially from those estimates.

Reclassification:

Certain amounts have been reclassified in 2005 to conform to the presentation in 2006.  Such reclassifications did not have any effect on income (loss) from operations or net income (loss).

Net Income (Loss) per Common Share:

The Company computes net income (loss) per common share in accordance with SFAS No. 128, “Earnings per Share” and SEC 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 common shares outstanding 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, or issuance date, if later.  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.

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The calculation of diluted weighted average common shares outstanding for the three months ended March 31, 2005 and 2006 is based on the average of the closing price of the Company’s common stock as quoted on the OTC Bulletin Board during such period.

The calculation of diluted income (loss) per share excluded approximately 1,082,000 shares and 2,094,000 shares of common stock for the three months ended March 31, 2006 and 2005, respectively, since their effect would have been anti-dilutive.

Stock-Based Compensation:

Through December 31, 2005, the Company accounted for stock-based employee compensation in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”, and Financial Accounting Standards Board (“FASB”) Interpretation No. 44 (“FIN 44”), “Accounting for Certain Transactions Involving Stock Compensation”, and complied with the disclosure requirements of SFAS No. 123, “Accounting for Stock-Based Compensation”.  Under APB No. 25, compensation expense was 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 accounted for stock issued to non-employees in accordance with SFAS No. 123, which required 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 addressed the measurement date and recognition approach for such transactions.

The Company recognized compensation expense related to variable awards in accordance with FASB Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans” (“FIN 28”).  For fixed awards, the Company recognized expense over the vesting period or the period of service.

In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share Based Payment” (“SFAS No. 123R”), a revision to SFAS No. 123, “Accounting for Stock-Based Compensation”.  SFAS No. 123R superseded APB Opinion No. 25 and amended SFAS No. 95, “Statement of Cash Flows”.  Effective January 1, 2006, SFAS No. 123R requires that the Company measure the cost of employee services received in exchange for equity awards based on the grant date fair value of the awards, with the cost to be recognized as compensation expense in the Company’s financial statements over the vesting period of the awards.

The Company adopted SFAS No. 123R effective January 1, 2006, and is using the modified prospective method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS No. 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123R for all awards granted to employees prior to the effective date of SFAS No. 123R that remain unvested on the effective date.

Accordingly, the Company recognizes compensation cost for equity-based compensation for all new or modified grants issued after December 31, 2005.  The Company did not have any new or modified grants during the three months ended March 31, 2006.  During the three months ended March 31, 2006, the Company issued 65,906 shares of common stock upon the exercise of stock options and received cash proceeds of approximately $56,000.  The stock options exercised had an intrinsic value of approximately $200,000.  The Company received no income tax benefit from the exercise of these stock options.

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In addition, commencing January 1, 2006, the Company is required to recognize the unvested portion of the grant date fair value of awards issued prior to the adoption of SFAS No. 123R based on the fair values previously calculated for disclosure purposes over the remaining vesting period of the outstanding stock options and warrants.  During the three months ended March 31, 2006, the Company recorded $514,000 as a charge to operations to recognize the unvested portion of the grant date fair value of awards issued prior to the adoption of SFAS No. 123R.

A summary of stock option activity under the Company’s 1999 Employee Stock Option Plan for the three months ended March 31, 2006 is shown below.  The Company did not have any activity under any of its other stock option plans during the three months ended March 31, 2006.

Pro forma information regarding net income (loss) per share for the three months ended March 31, 2005, as formerly required by SFAS No. 123, was determined as if the Company had accounted for its employee stock options under the fair value method of SFAS No. 123.  The fair value for these options was estimated at the date of grant using the Black-Scholes option-pricing model.  For the purpose of pro forma disclosures, the estimated fair value of the options was amortized to operations over the vesting period of the options or the expected period of benefit.  The Company’s unaudited pro forma information for the three months ended March 31, 2005 was as follows (amounts are in thousands, except for share data):

At March 31, 2006, the unvested portion of the grant date fair value of awards issued prior to adoption of SFAS No. 123R on January 1, 2006 (excluding milestone–vested options), based on the fair values previously calculated, will be

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charged to operations ratably over the remaining vesting period of the outstanding options and warrants as follows (amounts are in thousands):

Recent Accounting Pronouncements and Developments:

In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, “Accounting Changes and Error Corrections” (“SFAS No. 154”).  SFAS No. 154 is a replacement of APB Opinion No. 20, “Accounting Changes” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements — (an Amendment of APB Opinion No. 28)” and provides guidance on the accounting for and reporting of accounting changes and error corrections.  SFAS No. 154 establishes retrospective application as the required method for reporting a change in accounting principle, and provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable.  Retrospective application is the application of a different accounting principle to a prior accounting period as if that principle had always been used or as the adjustment of previously issued financial statements to reflect a change in the reporting entity.  SFAS No. 154 also addresses the reporting of the correction of an error by restating previously issued financial statements.  Although the Company adopted SFAS No. 154 effective January 1, 2006, it has had no impact on the Company’s operations.

On September 22, 2005, the SEC issued rules to delay by one-year the required reporting by management on internal controls over financial reporting for non-accelerated filers.  The new SEC rule extends the compliance date for such registrants to fiscal years ending on or after July 15, 2007.  Accordingly, the Company qualifies for the deferral until its year ending December 31, 2007 to comply with the internal control reporting requirements.

2.  ACQUISITION OF MEDIADEFENDER, INC. AND RELATED TRANSACTIONS

On July 28, 2005, the Company consummated the acquisition (the “Acquisition”) of MediaDefender, Inc., a privately-held Delaware corporation (“MediaDefender”), pursuant to the terms of an Agreement and Plan of Merger (the “Merger Agreement”) entered into by and among the Company, ARTISTdirect Merger Sub, Inc., a Delaware corporation and wholly-owned subsidiary of the Company (“Merger Sub”), and MediaDefender.  Under the terms of the Merger Agreement, Merger Sub merged with and into MediaDefender, the separate corporate existence of Merger Sub ceased and MediaDefender survived as a wholly-owned subsidiary of the Company.  The stockholders of MediaDefender received aggregate consideration of $42.5 million in cash, subject to a holdback of $4.25 million that was placed into an escrow account to cover any indemnification claims under the Merger Agreement by the parties through June 30, 2006.  Pursuant to the terms of the Merger Agreement, $2.0 million of the holdback had been disbursed to the shareholders of MediaDefender through March 31, 2006.  The amount of consideration paid by the Company upon the closing of the Acquisition was determined in arm’s-length negotiations among the parties thereto.  Prior to entering into the agreement discussed above, there were no material relationships between or among the Company or any of its affiliates, officers or directors, or

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associates of any such officers or directors, on the one hand, and MediaDefender or any of its affiliates, officers or directors, or associates of any such officers or directors, on the other.

MediaDefender is a provider of anti-piracy solutions in the high-growth Internet-piracy-protection (“IPP”) industry and offers services designed to thwart Internet piracy and encourage consumers to pay for online content.

In accordance with the Merger Agreement, the Company acknowledged the terms of Employment Agreements entered into on July 28, 2005 by MediaDefender with each of Randy Saaf, who serves as Chief Executive Officer of MediaDefender, and Octavio Herrera, who serves as President of MediaDefender.  Mr. Saaf and Mr. Herrera will each earn a base salary of no less than $350,000 per annum during the initial term of the agreements, which shall continue until December 31, 2008, and are also entitled to receive performance bonuses of up to $350,000, per year, if MediaDefender achieves specified earnings targets in fiscal 2007 and 2008.  Mr. Saaf and Mr. Herrera are each entitled to receive 12 months of severance pay at the rate of 100% of their monthly salary and the pro-rata portion of the performance bonus referenced above if they are terminated “without cause”.  In addition, the Company granted stock options to purchase up to 200,000 shares of common stock to each of Mr. Saaf and Mr. Herrera, exercisable for a period of 5 years at $3.00 per share.

The Company also acknowledged the terms of Non-Competition Agreements entered into on July 28, 2005 by MediaDefender and Mr. Saaf and Mr. Herrera.  The Non-Competition Agreements prohibit Mr. Saaf and Mr. Herrera from (i) engaging in certain competitive business activities, (ii) soliciting customers of MediaDefender or the Company, (iii) soliciting existing employees of MediaDefender or the Company, and (iv) disclosing any confidential information regarding MediaDefender or the Company.  Each agreement has a term of 4 years and shall continue to remain in force and effect in the event the above-referenced Employment Agreements are terminated prior to the end of the 4 year term of the Non-Competition Agreements.  In consideration, Mr. Saaf and Mr. Herrera are each entitled to a cash payment of $525,000 from MediaDefender to be paid on December 31, 2006.

As a result of these agreements, effective July 28, 2005, the Company recorded an asset of $1,050,000 for the non-compete agreements and a related liability of $1,050,000 for the guaranteed payments to MediaDefender management.  The $1,050,000 allocated to non-compete agreements is being amortized over the life of the employment agreements.

Mr. Saaf and Mr. Herrera have each invested $2,250,000 in the convertible subordinated debt transaction described below on the same terms and conditions as the other investors in such financing, as described below.

Concurrent with the consummation of the Acquisition, the Company completed a $15 million senior secured debt transaction (the “Senior Financing”) and a $30 million convertible subordinated debt transaction (the “Sub-Debt Financing”).  Legal fees paid or reimbursed by the Company for services provided by the respective legal counsels for the lenders were recorded as a charge to deferred financing costs and are being amortized over the terms of the related debt.

The Senior Financing was completed in accordance with the terms set forth in the Note and Warrant Purchase Agreement entered into on July 28, 2005 by the Company, each of the investors indicated on the schedule of buyers attached thereto and U.S. Bank National Association as Collateral Agent (the “Note Purchase Agreement”).  Pursuant to the terms of the Note Purchase Agreement, each investor received a note with a term of three years and eleven months that bears interest at the rate of 11.25% per annum (each a “Senior Note”), payable quarterly, with any unpaid principal and accrued interest due and payable at maturity.  Termination and payment of the Senior Notes by the Company prior

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to maturity will not result in a prepayment fee.  As collateral for the $15 million Senior Financing, the investors received a first priority security interest in all existing and future assets of the Company and its subsidiaries, tangible and intangible, including, but not limited to, cash and cash equivalents, accounts receivable, inventories, other current assets, furniture, fixtures and equipment and intellectual property.  The Company is required to comply with certain financial covenants, including minimum working capital, maximum capital expenditures, minimum leverage ratio, minimum EBITDA and minimum fixed charge coverage ratio.

In addition, not later than ninety days after the close of each fiscal year, the Company is obligated to apply 60% of its excess cash flow, as defined in the Note Purchase Agreement, to prepay the principal amount of the Notes, which the Company determined to be $390,000 for the year ended December 31, 2005, which was shown as a current liability at December 31, 2005 and at March 31, 2006, and which was paid in early April 2006.  At March 31, 2006, the Company also classified $65,000 of the Senior Notes as a current liability, reflecting an estimate of 60% the Company’s defined excess cash flow for the three months ended March 31, 2006.

The Senior Financing investors also received five year warrants to purchase up to an aggregate of 3,250,000 shares of the Company’s common stock at an exercise price of $2.00 per share, subject to certain anti-dilution adjustments (collectively, the “Senior Warrant Shares”).  The warrants were valued at $1,397,500 based on a valuation report prepared by an independent valuation firm and were recorded as a discount to the $15 million senior secured debt, and are being amortized over the term of the debt.  See Note 9 for additional information with regard to these warrants subsequent to March 31, 2006.

The Senior Warrant Shares are subject to certain registration rights requiring the Company to file and maintain effective a registration statement with the SEC covering the shares of common stock underlying such warrants.  In accordance with EITF No. 00-19, the fair value of the warrants is recorded as warrant liability in the Company’s financial statements.  The carrying value of the warrants is being adjusted to reflect any material changes in such liability from the date of issuance to the end of each reporting period, with any such changes included in the statement of operations as other income (expense).

Due to the accounting classification of the warrants issued in conjunction with the Senior Financing and the Sub-Debt Financing as a current liability, the Company was not in compliance with certain of these financial covenants at December 31, 2005.  On April 7, 2006, the lenders provided waivers with respect to such non-compliance under the Senior Notes and amended their loan documents such that the warrant liability and any change thereto in future periods will not affect future covenant and excess cash flow calculations.  The Company was in compliance with these financial covenants at March 31, 2006.

The Sub-Debt Financing was completed in accordance with the terms set forth in the Securities Purchase Agreement entered into on July 28, 2005 by the Company and each of the investors indicated on the schedule of buyers attached thereto (the “Securities Purchase Agreement”).  Pursuant to the terms of the Securities Purchase Agreement, each investor received a convertible subordinated note with a term of four years that bears interest at the rate of 4.00% per annum (each a “Sub-Debt Note”), with any unpaid principal and accrued interest due and payable at maturity.  Commencing September 30, 2006, interest is payable quarterly in cash or shares of common stock, at the option of the Company.  Each Sub-Debt Note has an initial conversion price of $1.55 per share, subject to certain anti-dilution and change-of-control adjustments.

In addition, following effectiveness of a registration statement filed by the Company for the securities issued in the Sub-Debt financing, two times within any twelve month period, the Company has

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the right to require the holder of each Sub-Debt Note to convert all or a portion equal to not less than 25% of the note conversion amount (limited to 50% of the note conversion amount if pursuant to clause (a) below) into shares of the Company’s common stock in the event that (a) the closing sale price of the Company’s common stock equals or exceeds $2.32 per share for each of any fifteen consecutive trading days, with a minimum trading volume of 200,000 shares of common stock on each such trading day, (b) the closing sale price of the Company’s common stock equals or exceeds $3.10 per share on each trading day during the fifteen consecutive trading day period, with a minimum trading volume of 200,000 shares of common stock on each such trading day, subject in both cases to appropriate adjustments for stock splits, stock dividends, stock combinations and other similar transactions after the issuance date, or (c) completion of an equity financing (including the issuance of securities convertible into equity securities, or long-term debt securities issued as a unit with equity securities, of the Company) at a price per share of not less than $2.50 generating aggregate gross proceeds of at least $20,000,000 from outside third party investors.

The Sub-Debt Financing investors also received five year warrants to purchase up to 1,596,774 shares of common stock at an exercise price of $1.55 per share, subject to certain anti-dilution adjustments (collectively, the “Sub-Debt Warrant Shares”).  The warrants were valued at $878,026 based on a valuation report prepared by an independent valuation firm and were recorded as a discount to the $30 million of convertible subordinated debt, and are being amortized over the term of the debt.  See Note 9 for additional information with regard to these warrants subsequent to March 31, 2006.

The Sub-Debt Notes and the Sub-Debt Warrant Shares are subject to certain registration rights requiring the Company to file and maintain effective a registration statement with the SEC covering the shares of common stock underlying such notes and warrants.  In accordance with EITF No. 00-19, the fair value of the warrants is recorded as warrant liability in the Company’s financial statements.  The carrying value of the warrants is being adjusted to reflect any material changes in such liability from the date of issuance to the end of each reporting period, with any such changes included in the statement of operations as other income (expense).

Under the Securities Purchase Agreement, the Company is required to comply with certain financial covenants, including minimum working capital, maximum capital expenditures, minimum leverage ratio, minimum EBITDA and minimum fixed charge coverage ratio.  Due to the accounting classification of the warrants issued in conjunction with the Senior Financing and the Sub-Debt Financing as a current liability, the Company was not in compliance with certain of these financial covenants at December 31, 2005.  On April 7, 2006, the lenders provided waivers with respect to such non-compliance under the Sub-Debt Notes and amended their loan documents such that the warrant liability and any change thereto in future periods will not affect future covenant calculations.

In connection with the Company’s obligations under the Note Purchase Agreement and the Securities Purchase Agreement, the Company filed a resale registration statement on Form SB-2 with the SEC that was originally declared effective on December 9, 2005.  The Company filed Post-Effective Amendment No. 1 to the registration statement on Form SB-2, which was declared effective on May 1, 2006.

To induce the Senior Financing investors to participate in the above referenced transaction, the Sub-Debt Financing investors entered into a Subordination Agreement for the benefit of the Senior Financing investors pursuant to which the Sub-Debt Financing investors agreed to subordinate their rights to the holders of the senior debt.

If all of the securities issued in the Senior Financing and the Sub-Debt Financing are converted or exercised into shares of the Company’s common stock in accordance with their respective terms, it will

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result in significant dilution to the Company’s existing stockholders.  If all of the Company’s outstanding equity-based instruments are converted or exercised into shares of the Company’s common stock in accordance with their respective terms, including those issued in conjunction with the Acquisition, there will be a total of approximately 38,000,000 shares of the Company’s common stock issued and outstanding.

A change in control of the Company could occur as a result of the Senior Financing and the Sub-Debt Financing.  Assuming maximum conversion of the securities issued in the Senior Financing and Sub-Debt Financing occurs, the Senior Financing investors would own approximately 9% of the Company’s voting stock, on a fully diluted basis, and the Sub-Debt investors would own approximately 55% of the Company’s voting stock, on a fully diluted basis.

The securities issued by the Company in the Senior Financing and the Sub-Debt Financing were offered and sold in reliance upon exemptions from registration pursuant to Section 4(2) under the Securities Act and Rule 506 promulgated thereunder.  Each of the investors qualified as an “accredited investor,” as specified in Rule 501 under the Securities Act.

Pursuant to the terms of a letter agreement, dated July 15, 2005, by and between the Company and Broadband Capital Management LLC (“Broadband”), the Company issued to Broadband a Sub-Debt Note in the amount of $1,460,500 (in addition to the $30 million referred to above) and warrants to purchase up to 1,516,935 shares of common stock with an exercise price of $1.55 per share.  The notes and warrants issued to Broadband or its affiliates were issued on the same terms and conditions granted to the other Sub-Debt Financing investors.  The securities were issued as partial consideration for Broadband’s services as the Company’s placement agent in the Sub-Debt Financing and the Senior Financing.  The securities were issued in reliance upon exemptions from registration pursuant to Section 4(2) under the Securities Act and Rule 506 promulgated thereunder.  The warrants were valued at $834,314, based on a valuation report prepared by an independent valuation firm.  The aggregate value of the Sub-Debt Note, the warrants and additional cash payments to Broadband aggregating $299,500 were charged to deferred financing costs and are being amortized over the term of the debt.  See Note 9 for additional information with regard to these warrants subsequent to March 31, 2006.

The Sub-Debt Notes and the Sub-Debt Warrant Shares issued to Broadband are subject to certain registration rights requiring the Company to file and maintain effective a registration statement with the SEC covering the shares of common stock underlying such warrants and notes.  In accordance with EITF No. 00-19, the fair value of the warrants is recorded as warrant liability in the Company’s financial statements.  The carrying value of the warrants is being adjusted to reflect any material changes in such liability from the date of issuance to the end of each reporting period, with any such changes included in the statement of operations as other income (expense).

Pursuant to the terms of a letter agreement, dated June 21, 2005, by and between the Company and Libra FE, LP (“Libra”), the Company issued to Libra warrants to purchase up to 237,500 shares of its common stock with an exercise price of $2.00 per share upon the closing of the Senior Financing (the “Libra Warrant Shares”).  The warrants were issued as partial consideration for Libra’s services as the Company’s placement agent in the Senior Financing described above.  The Company entered into a Registration Rights Agreement with Libra on July 28, 2005 (the “Libra Registration Rights Agreement”), pursuant to which the Company would include the Libra Warrant Shares in the registration statement covering the securities issued in the Senior Financing and the Sub-Debt Financing described above.  The warrants were issued in reliance upon exemptions from registration pursuant to Section 4(2) under the Securities Act and Rule 506 promulgated thereunder.  The warrants were valued at $149,625, based on a valuation report prepared by an independent valuation firm.  The aggregate value of the warrants and additional payments to Libra of $450,997 were charged to deferred financing costs and are being

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amortized over the term of the debt.  See Note 9 for additional information with regard to these warrants subsequent to March 31, 2006.

The Libra Warrant Shares are subject to certain registration rights requiring the Company to file and maintain effective a registration statement with the SEC covering the shares of common stock underlying such warrants and notes.  In accordance with EITF No. 00-19, the fair value of the warrants is recorded as warrant liability.  The carrying value of the warrants is being adjusted to reflect any material changes in such liability from the date of issuance to the end of each reporting period, with any such changes included in the statement of operations as other income (expense).

As of and through December 31, 2005, based on a report prepared by an independent valuation firm, there was no change in the fair value of the warrants that were recorded as warrant liability at July 28, 2005.  As of March 31, 2006 and for the three months then ended, the calculation of the warrant liability was based on the fair value of the underlying common stock.  For the three months ended March 31, 2006, the Company recorded an aggregate (non-cash) charge to operations of $14,644,000 to reflect an increase in warrant liability to arrive at the Company’s estimate of liquidated damages should the option holders be unable to exercise their options.  A summary of warrant liability at December 31, 2005 and March 31, 2006 is presented below (amounts are in thousands):

During April 2006, as a result of the exercise by the warrant holders of certain of the Senior Warrant Shares and of the Libra Warrant Shares (see Note 9), approximately $7,635,000 of the warrant liability of $17,904,000 included in current liabilities at March 31, 2006 will be reclassified to additional paid-in capital.

Upon the closing of the Acquisition, the Company issued 1,109,032 shares of common stock and a warrant to purchase up to 114,985 shares of common stock with an exercise price of $1.55 per share to WNT07 Holdings, LLC, which was approved by the disinterested members of the Company’s Board of Directors.  The managers of WNT07 Holdings, LLC are Eric Pulier and Teymour Boutros-Ghali, both members of the Company’s Board of Directors.  The shares and warrants were issued as consideration for services provided by Mr. Pulier and Mr. Boutros-Ghali as consultants to the Company in connection with the Acquisition.  The shares and warrants were issued in reliance upon exemptions from registration pursuant to Section 4(2) under the Securities Act and Rule 506 promulgated thereunder.

On July 28, 2005, the Company entered into a Non-Competition Agreement with WNT07 Holdings, LLC, Eric Pulier and Teymour Boutros-Ghali (collectively, the “Advisors”).  The Non-Competition Agreement prohibits any of the Advisors (i) from engaging in certain competitive business

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activities and (ii) from soliciting existing employees of the Company or its subsidiaries.  The covenants not to compete or solicit expire on the earlier of April 1, 2007 or the date of termination of Advisor’s services with the Company.

The shares of common stock were valued at $1,585,916 ($1.43 per share) and the warrants were valued at $83,939, based on a valuation report prepared by an independent valuation firm, for an aggregate value of $1,669,855, of which $333,971 was allocated to the covenant not to compete and the remaining $1,335,884 was included in total costs that the Company incurred to acquire MediaDefender. The amount allocated to the covenant not to compete is being amortized through April 1, 2007.

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.  The fair value of the intangible assets acquired and their respective amortization periods was determined by an independent valuation firm.  The following table summarizes the assets acquired and liabilities assumed of MediaDefender at July 28, 2005 (amounts are in thousands).

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The following pro forma operating data presents the results of operations for the three months ended March 31, 2005, as if the acquisition had occurred on the first day of such period.  Discontinued operations, impairment losses and non-recurring items for such period are not included.  The pro forma results are not necessarily indicative of the financial results that might have occurred had the acquisition actually taken place on such date, or of future results of operations.  The pro forma calculations assume that there were no principal payments on the Senior Notes or conversions of the Sub-Debt Notes during 2005.  Amounts are presented in thousands, except for share data.

3.  DISCONTINUED OPERATIONS – ARTISTDIRECT RECORDS

On February 28, 2005, ADI completed the sale of 100% of the common stock of ARTISTdirect Recordings to Radar Records pursuant to a Transfer Agreement for a cash payment of $115,000, as a result of which ADI no longer had any equity or other economic interest in ARTISTdirect Records, and Radar Records became the owner of a majority of the membership interests in ARTISTdirect Records and also acquired the receivable reflecting the $33.0 million of loan advances previously provided to ARTISTdirect Records by ADI.  In conjunction with this transaction, at February 28, 2005, ADI wrote-off the intercompany balance due from ARTISTdirect Records of $80,000, which was eliminated in consolidation.

The amount of consideration received by ADI was determined with reference to various factors, including, but not limited to, ADI’s future business plans and intention to focus on its internet and web-site operations, ARTISTdirect Records’ current limited capital resources and substantially reduced level of operations, ARTISTdirect Records’ future business plans and capital requirements and the likelihood of obtaining such capital on a timely basis and under reasonable terms and conditions, the unpaid costs that ADI has advanced ARTISTdirect Records to date and would be required to continue to advance ARTISTdirect Records in the future, and the probability of ADI obtaining a return on its investment to date of $33.0 million in ARTISTdirect Records.

As a result of the existence of various conflicts of interest with respect to this transaction, full disclosure of these conflicts of interest was made to ADI’s Board of Directors and the required approval by the disinterested members of ADI’s Board of Directors was obtained prior to the closing of the transaction.

As a result of the sale of all of ADI’s interest in ARTISTdirect Recordings to Radar Records effective February 28, 2005, ADI accounted for its interest in ARTISTdirect Records as a discontinued operation for all periods presented in accordance with SFAS No. 144, and the assets and liabilities of ARTISTdirect Records were classified as “held for sale” through February 28, 2005.

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As a result of the disposition of ADI’s interest in ARTISTdirect Records effective February 28, 2005, ADI recognized a gain (primarily non-cash) in its consolidated statement of operations for the three months ended March 31, 2005 of $21,079,000, primarily as a result of the elimination of the liabilities of ARTISTdirect Records.

4.  RELATED PARTY TRANSACTIONS

From the third quarter of 2003 through March 2006, the Company’s administrative offices were located in an office leased by Radar Pictures, Inc., a company owned by Ted Field, the Chairman of the Board of Directors of the Company, pursuant to a month-to-month arrangement.  For the year ended December 31, 2004, the Company accrued $168,000 to Radar Pictures, Inc. as rent and facilities usage expense.  On February 28, 2005, the Company paid Radar Pictures, Inc. accrued rent through December 31, 2004.  Commencing January 1, 2005, the Company began paying rent at a rate of $7,500 per month for these facilities.  The Company relocated to new office facilities in March 2006.

On May 15, 2006, the Company entered into a one-year consulting agreement with Eric Pulier, a director of the Company, which provides for annual compensation of $170,000, effective as of January 1, 2006.  This consulting agreement was approved by the disinterested members of the Board of Directors.

During the three months ended March 31, 2005, the Company accrued bonuses of $75,000 and $50,000 to its Chief Executive Officer and Chief Financial Officer, respectively, which were subsequently paid during 2005.

For the year ending December 31, 2006, each non-employee member of the Company’s Board of Directors will receive a cash retainer of $15,000, payable in equal installments of $7,500 in the third and fourth quarters of fiscal 2006, and a grant of stock options having a value (based upon the appropriate Black-Scholes option valuation methodology) equal to $35,000.  The strike price for the options will be set on the date of grant and the options will vest entirely on December 31, 2006.  In addition, each director that serves on a Committee of the Board of Directors will receive, for each committee served, an additional cash retainer of $10,000, payable in equal installments of $5,000 in the third and fourth quarters of fiscal 2006, and a grant of stock options having a value equal to $15,000, having the same terms and conditions as options granted to all non-employee members of the Board of Directors generally.

Any new directors joining the Company’s Board of Directors in 2006 will receive a one-time grant of stock options having a value equal to $25,000, a three-year vesting term and otherwise having the same terms and conditions as options granted to all non-employee members of the Board of Directors generally.  Fred Davis, who joined the Company’s Board of Directors in November 2005, and who did not receive any board compensation in 2005, will be considered a new director for purposes of the foregoing in 2006.

5.  EQUITY-BASED TRANSACTIONS

On May 6, 2005, the Company issued to three consultants stock options to purchase an aggregate of 78,000 shares of the Company’s common stock pursuant to the Company’s 1999 Employee Stock Option Plan exercisable for a period of five years at $1.00 per share, the market price on the date of the grant, pursuant to short-term consulting agreements with a duration approximating one year.  The fair value of these options, calculated pursuant to the Black-Scholes option-pricing model, was determined to be $79,000, of which $60,000 was charged to operations during the year ended December 31, 2005 and $19,000 was recorded as deferred compensation at December 31, 2005.  With respect to the $19,000

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recorded as deferred compensation at December 31, 2006, $18,000 was amortized to operations during the three months ended March 31, 2006 and $1,000 will be amortized to operations during the three months ending June 30, 2006.

On May 6, 2005, the Company issued to a consultant a stock option to purchase an aggregate of 22,000 shares of the Company’s common stock pursuant to the Company’s 1999 Employee Stock Option Plan exercisable for a period of five years at $1.00 per share, the market price on the date of the grant, pursuant to a short-term consulting agreement.  The option was subject to milestones, one of which was partially attained during the three months ended March 31, 2006, as a result of which options for 10,000 shares vested during the three months ended March 31, 2006.  The fair value of the vested portion of this option, calculated pursuant to the Black-Scholes option-pricing model, was determined to be $35,000, and was charged to operations during the three months ended March 31, 2006.

During the three months ended March 31, 2006, the Company issued 65,906 shares of common stock upon the exercise of stock options previously issued to employees and consultants on March 29, 2005, and received cash proceeds of approximately $56,000.

During the three months ended March 31, 2006, the Company issued 2,012,902 shares of common stock upon the conversion of $3,120,000 of subordinated convertible notes payable.  As a result, a total of $314,000 was charged to operations during the three months ended March 31, 2006, consisting of related deferred financing costs of $232,000 and debt discount costs of $82,000.

6.  INCOME TAXES

At December 31, 2005, the Company had net operating loss carryforwards totaling approximately $111 million for Federal income tax purposes expiring beginning in 2020 and California state net operating loss carryforwards of approximately $102 million expiring beginning in 2008.

Due to the restrictions imposed by Internal Revenue Code Section 382 regarding substantial changes in the stock ownership of companies with loss carryforwards, the utilization of the Company’s federal net operating loss carryforward was severely limited as a result of the change in the effective stock ownership of the Company resulting from the debt financings arranged in conjunction with the acquisition of MediaDefender.

Due to the uncertainty surrounding the realization of the benefits of the Company’s tax attributes, primarily net operating loss carryforwards as of December 31, 2005, the Company recorded a 100% valuation allowance against its net deferred tax assets as of December 31, 2005.

As a result of the profitable operations of MediaDefender during the three months ended March 31, 2006, the non-deductibility of certain non-cash charges for tax reporting purposes, and permanent limitations on the Company’s ability to utilize its net operating loss carryforwards, the Company recorded a provision for income taxes of $100,000 for the three months ended March 31, 2006.

7.  COMMITMENTS AND CONTINGENCIES

On January 30, 2006, the Company entered into a sub-lease agreement for new office facilities in Santa Monica, California through November 30, 2011.  The effective date of the sub-lease agreement was February 2, 2006.  The new office facilities will house both ADI and MediaDefender.  In connection with the sub-lease agreement, the Company provided an irrevocable standby bank letter of credit for $180,000

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as security for the Company’s obligations under the sub-lease, which was secured by cash of $180,000, which has been classified as restricted cash in the Company’s balance sheet.  The letter of credit will be reduced to $90,000 on the 13th month of the sub-lease, provided the Company is in compliance with all terms under the sub-lease.

This lease contains predetermined fixed increases in the minimum rental rate during the initial lease term.  The Company began to recognize the related rent expense on a straight-line basis on the effective date of the lease.  The Company records the difference between the amount charged to expense and the rent paid as deferred rent on the Company’s balance sheet.

8.  SEGMENT INFORMATION AND CONCENTRATIONS

Information with respect to the Company’s operating segments for the three months ended March 31, 2005 and 2006 is presented below.  During the three months ended March 31, 2005, the Company’s continuing operations consisted of two reportable segments:  e-commerce and media.  During the three months ended March 31, 2006, the Company’s continuing operations consisted of three reportable segments:  e-commerce, media and anti-piracy services.

E-commerce revenue is generated from the sale of recorded music and music-related merchandise sold via the Internet.  Media revenue is generated from the sale of advertising and sponsorships, both online and offline, under short-term contracts.  Anti-piracy services revenue is generated from anti-piracy services.

During the three months ended March 31, 2005 and 2006, approximately 70% and 60%, respectively, of e-commerce revenues were generated from the products related to a single music merchandising entity.

During the three months ended March 31, 2005 and 2006, the Company’s media revenues were generated primarily by a single outside sales organization that represented the Company with respect to advertising and sponsorship sales on the Company’s web-site and through affiliated web-sites.

During the three months ended March 31, 2006, approximately 71% of MediaDefender’s consolidated revenues were from three customers, with one customer accounting for 31%, a second customer accounting for 30%, and a third customer accounting for 10%.  At March 31, 2006, the amounts due from these customers were $690,000, $778,000 and $383,000, respectively, which were included in accounts receivable.

During the three months ended March 31, 2006, MediaDefender purchased approximately 74% of its bandwidth from two suppliers.  At March 31, 2006, there were no amounts due to these suppliers.  Although there are other suppliers of bandwidth, a change in suppliers would cause delays, which could adversely affect operations in the short-term.

Information with respect to the three months ended March 31, 2005 does not include the operations of MediaDefender, which was acquired effective July 28, 2005.

The Company’s presentation of financial results includes “Adjusted EBITDA” as a financial measure, which is not a measure of performance calculated in accordance with accounting principles generally accepted in the United States (“GAAP”).  Adjusted EBITDA is a non-GAAP financial measure that represents income or loss from continuing operations before net interest expense, provision for income taxes, depreciation and amortization, and also excludes certain other items, including stock-based

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compensation, adjustment to warrant liability, impairment losses, and non-recurring gains and losses.  Management excludes these items in assessing financial performance, primarily due to their non-operational nature or because they are outside of the Company’s normal operations.  The Company has provided this information because management believes that it is useful to investors in understanding the Company’s financial condition and results of operations.  Included in Adjusted EBITDA are direct operating expenses for each segment.  Corporate expenses consist of general operating expenses that are not directly related to the operations of the segments.

The following table summarizes net revenue and Adjusted EBITDA by operating segment for the three months ended March 31, 2005 and 2006.  A reconciliation of Net Income (Loss) to Adjusted EBITDA is also provided.  Amounts are presented in thousands.

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Assets as of December 31, 2005 and March 31, 2006 are summarized below.  Assets by segment are those assets used in or employed by the operations of each segment.  Corporate assets are principally made up of cash and cash equivalents, prepaid expenses and deposits, computer equipment, leasehold improvements and certain intangible assets.  Amounts are presented in thousands.

9.  SUBSEQUENT EVENTS

During the period from April 1, 2006 through April 27, 2006, the Company issued 100,000 shares of common stock upon the conversion of $155,000 of subordinated convertible notes payable.

Effective April 7, 2006, the Company entered into various agreements with the investors in its Senior Financing and Sub-Debt Financing (see Note 2) to amend their respective registration rights agreements and to amend and waive certain financial covenants.  In consideration thereof, the Company offered to temporarily reduce the exercise price of the 3,250,000 warrants held by the investors in the Senior Financing from $2.00 to $1.85 per share through April 30, 2006, and agreed to permanently reduce the exercise price of the 1,596,744 warrants held by the investors in the Sub-Debt Financing from $1.55 to $1.43 per share on certain terms and conditions.  Any exercise of the aforementioned warrants at the reduced exercise price was required to be for cash only.  The conversion price of the Sub-Debt Notes of $1.55 per share was not affected.  The Company also entered into similar agreements, as applicable, and provided identical temporary and permanent reductions to warrant exercise prices, with Broadband Capital Management LLC (1,516,935 warrants originally exercisable at $1.55 per share) and Libra FE, LP (237,500 warrants originally exercisable at $2.00 per share).  The Company also agreed to utilize 25% of the net proceeds from the exercise of the warrants held by the investors in the Senior Financing to reduce the respective principal balances on the Senior Notes payable held by such exercising investors, and to pay any related unpaid accrued interest on such principal payments.

Effective April 19, 2006, Libra FE, LP exercised its warrants on a cashless basis at $2.00 per share, resulting in the issuance of 123,864 shares of common stock.  Effective April 27, 2006, certain of the investors in the Senior Financing exercised their warrants to purchase 2,816,667 shares of common stock at $1.85 per share, resulting in the issuance of 2,816,667 shares of common stock in exchange for cash proceeds of $5,211,000, of which $1,303,000 was used to reduce the respective principal balances on the Senior Notes payable held by such exercising investors.

As a result of the exercise of the warrants by certain of the Senior Financing investors and by Libra FE, LP in April 2006, approximately $7,635,000 of the warrant liability of $17,904,000 included in current liabilities at March 31, 2006 will be reclassified to additional paid-in capital (see Note 2).

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The following pro forma condensed consolidated balance sheet as of March 31, 2006 gives effect to the aforementioned warrant exercises and related transactions as if such transactions had occurred as of that date, and is based on management’s estimate of the effects of such transactions based on certain assumptions that the Company believes are reasonable under the circumstances.  The pro forma condensed consolidated balance sheet as of March 31, 2006 is unaudited.  Amounts are presented in thousands.

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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

Overview:

The Company conducts its media and e-commerce business operations through an online music network appealing to 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, communities organized around shared music interests, music-related specialty commerce and digital music services.

The Company, through its MediaDefender subsidiary acquired effective July 28, 2005 as described below, provides anti-piracy solutions in the high-growth Internet-piracy-protection (“IPP”) industry and offers services designed to thwart Internet piracy and encourage consumers to pay for online content.

Acquisition of MediaDefender, Inc. and Related Transactions:

On July 28, 2005, the Company consummated the acquisition (the “Acquisition”) of MediaDefender, Inc., a privately-held Delaware corporation (“MediaDefender”), pursuant to the terms of an Agreement and Plan of Merger (the “Merger Agreement”) entered into by and among the Company, ARTISTdirect Merger Sub, Inc., a Delaware corporation and wholly-owned subsidiary of the Company (“Merger Sub”), and MediaDefender.  Under the terms of the Merger Agreement, Merger Sub merged with and into MediaDefender, the separate corporate existence of Merger Sub ceased and MediaDefender survived as a wholly-owned subsidiary of the Company.  The stockholders of MediaDefender received aggregate consideration of $42.5 million in cash, subject to a holdback of $4.25 million that was placed into an escrow account to cover any indemnification claims under the Merger Agreement by the parties through June 30, 2006.  Pursuant to the terms of the Merger Agreement, $2.0 million of the holdback had been disbursed to the shareholders of MediaDefender through March 31, 2006.

Concurrent with the consummation of the Acquisition, the Company completed a $15 million senior secured debt transaction (the “Senior Financing”) and a $30 million convertible subordinated debt transaction (the “Sub-Debt Financing”).  Legal fees paid or reimbursed by the Company for services provided by the respective legal counsels for the lenders were recorded as a charge to deferred financing costs and are being amortized over the terms of the related debt.

The Senior Financing was completed in accordance with the terms set forth in the Note and Warrant Purchase Agreement entered into on July 28, 2005 by the Company, each of the investors indicated on the schedule of buyers attached thereto and U.S. Bank National Association as Collateral Agent (the “Note Purchase Agreement”).  Pursuant to the terms of the Note Purchase Agreement, each investor received a note with a term of three years and eleven months that bears interest at the rate of 11.25% per annum (each a “Senior Note”), payable quarterly, with any unpaid principal and accrued interest due and payable at maturity.  Termination and payment of the Senior Notes by the Company prior to maturity will not result in a prepayment fee.  As collateral for the $15 million Senior Financing, the investors received a first priority security interest in all existing and future assets of the Company and its subsidiaries, tangible and intangible, including, but not limited to, cash and cash equivalents, accounts receivable, inventories, other current assets, furniture, fixtures and equipment and intellectual property.  The Company is required to comply with certain financial covenants, including minimum working capital, maximum capital expenditures, minimum leverage ratio, minimum EBITDA and minimum fixed charge coverage ratio.

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In addition, not later than ninety days after the close of each fiscal year, the Company is obligated to apply 60% of its excess cash flow, as defined in the Note Purchase Agreement, to prepay the principal amount of the Notes, which the Company determined to be $390,000 for the year ended December 31, 2005, which was shown as a current liability at December 31, 2005 and at March 31, 2006, and which was paid in early April 2006.  At March 31, 2006, the Company also classified $65,000 of the Senior Notes as a current liability, reflecting an estimate of 60% the Company’s defined excess cash flow for the three months ended March 31, 2006.

The Senior Financing investors also received five year warrants to purchase up to an aggregate of 3,250,000 shares of the Company’s common stock at an exercise price of $2.00 per share, subject to certain anti-dilution adjustments (collectively, the “Senior Warrant Shares”).  The warrants were valued at $1,397,500 based on a valuation report prepared by an independent valuation firm and were recorded as a discount to the $15 million senior secured debt, and are being amortized over the term of the debt. See “Recent Developments” at “Liquidity and Capital Resources — March 31, 2006” for additional information with regard to these warrants subsequent to March 31, 2006.

The Senior Warrant Shares are subject to certain registration rights requiring the Company to file and maintain effective a registration statement with the Securities and Exchange Commission (the “SEC”) covering the shares of common stock underlying such warrants.  In accordance with EITF No. 00-19, the fair value of the warrants is recorded as warrant liability in the Company’s financial statements.  The carrying value of the warrants is being adjusted to reflect any material changes in such liability from the date of issuance to the end of each reporting period, with any such changes included in the statement of operations as other income (expense).

Due to the accounting classification of the warrants issued in conjunction with the Senior Financing and the Sub-Debt Financing as a current liability, the Company was not in compliance with certain of these financial covenants at December 31, 2005.  On April 7, 2006, the lenders provided waivers with respect to such non-compliance under the Senior Notes and amended their loan documents such that the warrant liability and any change thereto in future periods will not affect future covenant and excess cash flow calculations.  The Company was in compliance with these financial covenants at March 31, 2006.

The Sub-Debt Financing was completed in accordance with the terms set forth in the Securities Purchase Agreement entered into on July 28, 2005 by the Company and each of the investors indicated on the schedule of buyers attached thereto (the “Securities Purchase Agreement”).  Pursuant to the terms of the Securities Purchase Agreement, each investor received a convertible subordinated note with a term of four years that bears interest at the rate of 4.00% per annum (each a “Sub-Debt Note”), with any unpaid principal and accrued interest due and payable at maturity.  Commencing September 30, 2006, interest is payable quarterly in cash or shares of common stock, at the option of the Company.  Each Sub-Debt Note has an initial conversion price of $1.55 per share, subject to certain anti-dilution and change-of-control adjustments.

In addition, following effectiveness of a registration statement filed by the Company for the securities issued in the Sub-Debt financing, two times within any twelve month period, the Company has the right to require the holder of each Sub-Debt Note to convert all or a portion equal to not less than 25% of the note conversion amount (limited to 50% of the note conversion amount if pursuant to clause (a) below) into shares of the Company’s common stock in the event that (a) the closing sale price of the Company’s common stock equals or exceeds $2.32 per share for each of any fifteen consecutive trading days, with a minimum trading volume of 200,000 shares of common stock on each such trading day, (b) the closing sale price of the Company’s common stock equals or exceeds $3.10 per share on each trading day during the fifteen consecutive trading day period, with a minimum trading volume of 200,000 shares

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of common stock on each such trading day, subject in both cases to appropriate adjustments for stock splits, stock dividends, stock combinations and other similar transactions after the issuance date, or (c) completion of an equity financing (including the issuance of securities convertible into equity securities, or long-term debt securities issued as a unit with equity securities, of the Company) at a price per share of not less than $2.50 generating aggregate gross proceeds of at least $20,000,000 from outside third party investors.

The Sub-Debt Financing investors also received five year warrants to purchase up to 1,596,774 shares of common stock at an exercise price of $1.55 per share, subject to certain anti-dilution adjustments (collectively, the “Sub-Debt Warrant Shares”).  The warrants were valued at $878,026 based on a valuation report prepared by an independent valuation firm and were recorded as a discount to the $30 million of convertible subordinated debt, and are being amortized over the term of the debt.  See “Recent Developments” at “Liquidity and Capital Resources – March 31, 2006” for additional information with regard to these warrants subsequent to March 31, 2006.

The Sub-Debt Notes and the Sub-Debt Warrant Shares are subject to certain registration rights requiring the Company to file and maintain effective a registration statement with the SEC covering the shares of common stock underlying such notes and warrants.  In accordance with EITF No. 00-19, the fair value of the warrants is recorded as warrant liability in the Company’s financial statements.  The carrying value of the warrants is being adjusted to reflect any material changes in such liability from the date of issuance to the end of each reporting period, with any such changes included in the statement of operations as other income (expense).

Under the Securities Purchase Agreement, the Company is required to comply with certain financial covenants, including minimum working capital, maximum capital expenditures, minimum leverage ratio, minimum EBITDA and minimum fixed charge coverage ratio.  Due to the accounting classification of the warrants issued in conjunction with the Senior Financing and the Sub-Debt Financing as a current liability, the Company was not in compliance with certain of these financial covenants at December 31, 2005.  On April 7, 2006, the lenders provided waivers with respect to such non-compliance under the Sub-Debt Notes and amended their loan documents such that the warrant liability and any change thereto in future periods will not affect future covenant calculations.

In connection with the Company’s obligations under the Note Purchase Agreement and the Securities Purchase Agreement, the Company filed a resale registration statement on Form SB-2 with the SEC that was originally declared effective on December 9, 2005.  The Company filed Post-Effective Amendment No. 1 to the registration statement on Form SB-2, which was declared effective on May 1, 2006.

To induce the Senior Financing investors to participate in the above referenced transaction, the Sub-Debt Financing investors entered into a Subordination Agreement for the benefit of the Senior Financing investors pursuant to which the Sub-Debt Financing investors agreed to subordinate their rights to the holders of the senior debt.

If all of the securities issued in the Senior Financing and the Sub-Debt Financing are converted or exercised into shares of the Company’s common stock in accordance with their respective terms, it will result in significant dilution to the Company’s existing stockholders.  If all of the Company’s outstanding equity-based instruments are converted or exercised into shares of the Company’s common stock in accordance with their respective terms, including those issued in conjunction with the Acquisition, there will be a total of approximately 38,000,000 shares of the Company’s common stock issued and outstanding.

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A change in control of the Company could occur as a result of the Senior Financing and the Sub-Debt Financing.  Assuming maximum conversion of the securities issued in the Senior Financing and Sub-Debt Financing occurs, the Senior Financing investors would own approximately 9% of the Company’s voting stock, on a fully diluted basis, and the Sub-Debt investors would own approximately 55% of the Company’s voting stock, on a fully diluted basis.

The securities issued by the Company in the Senior Financing and the Sub-Debt Financing were offered and sold in reliance upon exemptions from registration pursuant to Section 4(2) under the Securities Act of 1933, as amended (the “Securities Act”), and Rule 506 promulgated thereunder.  Each of the investors qualified as an “accredited investor,” as specified in Rule 501 under the Securities Act.

Pursuant to the terms of a letter agreement, dated July 15, 2005, by and between the Company and Broadband Capital Management LLC (“Broadband”), the Company issued to Broadband a Sub-Debt Note in the amount of $1,460,500 (in addition to the $30 million referred to above) and warrants to purchase up to 1,516,935 shares of common stock with an exercise price of $1.55 per share.  The notes and warrants issued to Broadband or its affiliates were issued on the same terms and conditions granted to the other Sub-Debt Financing investors.  The securities were issued as partial consideration for Broadband’s services as the Company’s placement agent in the Sub-Debt Financing and the Senior Financing.  The securities were issued in reliance upon exemptions from registration pursuant to Section 4(2) under the Securities Act and Rule 506 promulgated thereunder.  The warrants were valued at $834,314, based on a valuation report prepared by an independent valuation firm.  The aggregate value of the Sub-Debt Note, the warrants and additional cash payments to Broadband aggregating $299,500 were charged to deferred financing costs and are being amortized over the term of the debt.  See “Recent Developments” at “Liquidity and Capital Resources – March 31, 2006” for additional information with regard to these warrants subsequent to March 31, 2006.

The Sub-Debt Notes and the Sub-Debt Warrant Shares issued to Broadband are subject to certain registration rights requiring the Company to file and maintain effective a registration statement with the SEC covering the shares of common stock underlying such warrants and notes.  In accordance with EITF No. 00-19, the fair value of the warrants is recorded as warrant liability in the Company’s financial statements.  The carrying value of the warrants is being adjusted to reflect any material changes in such liability from the date of issuance to the end of each reporting period, with any such changes included in the statement of operations as other income (expense).

Pursuant to the terms of a letter agreement, dated June 21, 2005, by and between the Company and Libra FE, LP (“Libra”), the Company issued to Libra warrants to purchase up to 237,500 shares of its common stock with an exercise price of $2.00 per share upon the closing of the Senior Financing (the “Libra Warrant Shares”).  The warrants were issued as partial consideration for Libra’s services as the Company’s placement agent in the Senior Financing described above.  The Company entered into a Registration Rights Agreement with Libra on July 28, 2005 (the “Libra Registration Rights Agreement”), pursuant to which the Company would include the Libra Warrant Shares in the registration statement covering the securities issued in the Senior Financing and the Sub-Debt Financing described above.  The warrants were issued in reliance upon exemptions from registration pursuant to Section 4(2) under the Securities Act and Rule 506 promulgated thereunder.  The warrants were valued at $149,625, based on a valuation report prepared by an independent valuation firm.  The aggregate value of the warrants and additional payments to Libra of $450,997 were charged to deferred financing costs and are being amortized over the term of the debt.  See “Recent Developments” at “Liquidity and Capital Resources — March 31, 2006” for additional information with regard to these warrants subsequent to March 31, 2006.

The Libra Warrant Shares are subject to certain registration rights requiring the Company to file and maintain effective a registration statement with the SEC covering the shares of common stock

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underlying such warrants and notes.  In accordance with EITF No. 00-19, the fair value of the warrants is recorded as warrant liability.  The carrying value of the warrants is being adjusted to reflect any material changes in such liability from the date of issuance to the end of each reporting period, with any such changes included in the statement of operations as other income (expense).

As of and through December 31, 2005, based on a report prepared by an independent valuation firm, there was no change in the fair value of the warrants that were recorded as warrant liability at July 28, 2005.  As of March 31, 2006 and for the three months then ended, the calculation of the warrant liability was based on the fair value of the underlying common stock.  For the three months ended March 31, 2006, the Company recorded an aggregate (non-cash) charge to operations of $14,644,000 to reflect an increase in warrant liability to arrive at the Company’s estimate of liquidated damages should the option holders be unable to exercise their options.  A summary of warrant liability at December 31, 2005 and March 31, 2006 is presented below (amounts are in thousands):

During April 2006, as a result of the exercise by the warrant holders of certain of the Senior Warrant Shares and of the Libra Warrant Shares (see “Recent Developments” under “Liquidity and Capital Resources – March 31, 2006” below), approximately $7,635,000 of the warrant liability of $17,904,000 included in current liabilities at March 31, 2006 will be reclassified to additional paid-in capital.

Upon the closing of the Acquisition, the Company issued 1,109,032 shares of common stock and a warrant to purchase up to 114,985 shares of common stock with an exercise price of $1.55 per share to WNT07 Holdings, LLC, which was approved by the disinterested members of the Company’s Board of Directors.  The managers of WNT07 Holdings, LLC are Eric Pulier and Teymour Boutros-Ghali, both members of the Company’s Board of Directors.  The shares and warrants were issued as consideration for services provided by Mr. Pulier and Mr. Boutros-Ghali as consultants to the Company in connection with the Acquisition.  The shares and warrants were issued in reliance upon exemptions from registration pursuant to Section 4(2) under the Securities Act and Rule 506 promulgated thereunder.

 On July 28, 2005, the Company entered into a Non-Competition Agreement with WNT07 Holdings, LLC, Eric Pulier and Teymour Boutros-Ghali (collectively, the “Advisors”).  The Non-Competition Agreement prohibits any of the Advisors (i) from engaging in certain competitive business activities and (ii) from soliciting existing employees of the Company or its subsidiaries.  The covenants not to compete or solicit expire on the earlier of April 1, 2007 or the date of termination of Advisor’s services with the Company.

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The shares of common stock were valued at $1,585,916 ($1.43 per share) and the warrants were valued at $83,939, based on a valuation report prepared by an independent valuation firm, for an aggregate value of $1,669,855, of which $333,971 was allocated to the covenant not to compete and the remaining $1,335,884 was included in total costs that the Company incurred to acquire MediaDefender. The amount allocated to the covenant not to compete is being amortized through April 1, 2007.

On April 7, 2006, the Company entered into amendments to certain of the transaction documents governing the terms of the Senior Financing and the Sub-Debt Financing to amend their respective registration rights agreements and to amend and waive certain financial covenants.  In consideration, the Company agreed to temporarily reduce the exercise price of the 3,250,000 Senior Warrant Shares held by the Senior Financing investors from $2.00 per share to $1.85 per share through April 30, 2006 and to permanently reduce the exercise price of the 1,596,744 Sub-Debt Warrant Shares held by the Sub-Debt Financing investors and 1,516,935 Sub-Debt Warrant Shares held by Broadband affiliates from $1.55 per share to $1.43 per share on certain terms and conditions.  Any exercise of these warrants at the reduced exercise price shall be for cash only.  The conversion price of the Sub-Debt Notes of $1.55 per share was not impacted by these amendments.  The Company also entered into a similar agreement with Libra to temporarily reduce the exercise price of the 237,500 Libra Warrant Shares from $2.00 per share to $1.85 per share through April 30, 2006.

Due to the restrictions imposed by Internal Revenue Code Section 382 regarding substantial changes in the stock ownership of companies with loss carry-forwards, the utilization of our federal net operating loss carry-forward was severely limited as a result of the change in our effective stock ownership resulting from the financings arranged in conjunction with the Acquisition.

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.  The fair value of the intangible assets acquired and their respective amortization periods was determined by an independent valuation firm.  The following table summarizes the assets acquired and liabilities assumed of MediaDefender at July 28, 2005 (amounts are in thousands).