UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-KSB

Commission File Number:  000-30063

ARTISTdirect, Inc.
(Name of Small Business Issuer in Its Charter)

1601 Cloverfield Boulevard, Suite 400 South, Santa Monica, California 90404-4082
(Address of Principal Executive Offices, including Zip Code)

Issuer’s Telephone Number, Including Area Code:  (310) 956-3300

Securities registered pursuant to Section 12(b) of the Act:  None

Securities registered pursuant to Section 12(g) of the Act:  Common stock, $0.01 par value

Check whether the issuer is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act. o

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 registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure will be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB 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 x

State issuer’s revenues for its most recent fiscal year. $24,171,000.

As of March 24, 2008, the aggregate market value of the voting common stock held by non-affiliates of the registrant was approximately $1,609,402, based on the closing price per share of $0.41 for the registrant’s common stock as reported on the Over-the-Counter Bulletin Board on such date.

As of March 24, 2008, there were 10,344,666 shares of the registrant’s common stock, par value $0.01 per share, issued and outstanding.

Transitional Small Business Disclosure Format. Yes o No x

Documents incorporated by reference:  None.

ARTISTDIRECT INC.
ANNUAL REPORT ON FORM 10-KSB

TABLE OF CONTENTS

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NOTE CONCERNING FORWARD-LOOKING STATEMENTS

In addition to historical information, this Annual Report on Form 10-KSB (“Annual Report”) for ARTISTdirect, Inc. (“ARTISTdirect,” the “Company,” “we,” “our”  or “us”) contains “forward-looking” statements within the meaning of the United States Private Securities Litigation Reform Act of 1995, including statements that include the words “may,” “will,” “believes,” “expects,” “anticipates,” or similar expressions. These forward looking statements may include, among others, statements concerning our expectations regarding our business, growth prospects, revenue trends, operating costs, accounting, 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 Annual 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 our business made elsewhere in this Annual Report, as well as other public reports filed by us 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 of developments. Except as required by applicable law or regulation, we undertake no obligation to update or revise any forward-looking statement contained in this Annual Report.

PART I

ITEM 1.                             DESCRIPTION OF BUSINESS

General

Incorporated under the laws of the State of Delaware in July 1999, we were exclusively a digital media entertainment company that is home to an on-line music network. Through our acquisition of MediaDefender, Inc., a Delaware corporation (“MediaDefender”), in July 2005, we also became a provider of anti-piracy solutions in the Internet piracy protection industry and in the second quarter of 2006, became a provider of Internet-based marketing services.  Below is an overview of our three business segments:

·                  Internet Piracy Prevention. Our Internet piracy prevention (“IPP”) segment is currently operated by MediaDefender, as a wholly-owned subsidiary of ARTISTdirect. MediaDefender’s proprietary suite of IPP solutions offers significant levels of protection on major peer-to-peer (“P2P”) file-sharing networks. MediaDefender’s uber-level solutions are capable of providing up to 95% effectiveness in preventing unauthorized downloads of customer-specified content. Our IPP segment accounted for approximately 61% and approximately 62% of our revenue during the fiscal years ended December 31, 2007 and December 31, 2006 respectively.  Refer to “MediaDefender Overview - Internet Anti-Piracy Segment below for more information.

·                  Media. Our media operations include our content-oriented web-sites, a network of third party music sites, our advertising and other marketing initiatives. Revenue from media operations is generated from the sale of online advertising and integrated marketing solutions. We market and sell advertising on a cost-per-impression basis to advertising agencies and directly to various companies as part of their marketing programs. Customers may purchase advertising space for the entire ARTISTdirect network, or they may tailor advertising based on music genre (e.g., jazz, country or rock music) or based on functionality (e.g., directing advertising to customers using music download features or broadband-only features of the ARTISTdirect network). Since we are increasingly aware of web-sites outside the ARTISTdirect network that are frequently visited by artists and music fans, we have also offered our customers advertising space on behalf of third party music-related web-sites. Our media segment accounted for approximately 33% and approximately 27% of our revenue during the fiscal years ended December 31, 2007 and 2006, respectively. Refer to “ARTISTdirect Overview-Media and E-Commerce Segments” below for additional information.

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·                  E-Commerce. E-commerce operations consist of the sale of recorded music and artist-related merchandise on our web-sites. Most of our sales come from our ARTISTdirect shopping area, which offers a comprehensive selection of music CDs and a  range of artist and lifestyle merchandise. Effective August 31, 2007, the Company restructured the relationship with its merchandising partner to eliminate merchandise sales and focus on music sales. Our e-commerce segment accounted for approximately 6% and approximately 11% of our revenue during the fiscal years ended December 31, 2007 and 2006, respectively.

Refer to “ARTISTdirect Overview-Media and E-Commerce Segments” below for additional information.

At December 31, 2007, we employed 80 full-time employees, none of whom are covered by a collective bargaining agreement. We believe that our relationship with our employees and consultants is good.

Recent Developments

Engagement of Investment Banking Firm

On February 7, 2008 the Company retained the services of Salem Partners, LLC, to serve as a fianancial advisor to the Company in connection with the sale, merger, consolidation, reorganization or other business combination and the restructuring of the material terms of the Registrant’s Senior Notes and/or Subordinated Convertible Notes.

Forbearance and Consent Agreement

On March 17, 2008, the Company entered into a Forbearance and Consent Agreement with the investors in the Company’s Senior Debt Financing, which was effective as of February 20, 2008, whereby the investors agreed to forbear from exercising any of their rights and remedies under the Senior Financing transaction documents through December 31, 2008 in exchange for an adjustment in the interest rate associated with the Senior Notes from 11.25% to 15%, provided the loan is repaid prior to September 30, 2008 or 16%, if the loan remains outstanding subsequent to that date.

Management and Director Changes

On February 25, 2008, the company announced that Mr. Neil McCarthy, provided notice that he was resigning as Interim Chief Financial Officer of the Company effective March 31, 2008.

Effective March 6, 2008, the Company announced that, Mr. Jon Diamond’s employment as Chief Executive Officer had ended and he was appointed Chairman of the Board of Directors.  Mr. Fredrick W.(Ted) Field, who had been serving as the Company’s Chairman, agreed to continue serving as a Director of the Company.  Mr. Dimitri Villard, who had been serving as a Director and Member of the Company’s Audit and Compensation Committees agreed, in addition to those duties, to serve as Interim Chief Executive Officer.

On March 24, 2008, Mr. James Lane advised the Company that he would no longer serve as a Director and member of the Audit Committee.  As Mr. Lane was, at that time, the only independent member of the Audit Committee, the Company has suspended the activities of the Audit Committee until a new independent Director is appointed. In the interim, the functions of the audit committee have been assumed by the Board of Directors.

MediaDefender Overview- Internet Anti-Piracy Segment

MediaDefender was incorporated under the laws of the State of Delaware in July 2000 as a provider of anti-piracy solutions. We completed the acquisition of MediaDefender in the third quarter of fiscal 2005. MediaDefender’s solutions have been adopted by major entertainment companies as a practical means to thwart Internet piracy and drive consumers to pay for digitized content distributed through authorized Internet sites.  MediaDefender charges customers per file it distributes to the massive P2P audience.

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Internet-Based Piracy. Piracy has long been and continues to be a problem for the global content industries. The International Intellectual Property Alliance (“IIPA”) estimates that the worldwide cost of music and computer software piracy costs content providers as much as $35 billion per year in lost sales. Due to the relatively small size of MP3 files, music was the first industry to be severely impacted by Internet piracy.  Retail music sales decreased 10% in 2007, an increase from the 6.5% decrease in 2006.  According to the RIAA, the decline, in sales has been due in part, to widespread copying and illegal Internet downloading of music.  The growth of broadband Internet access is now making larger-sized files, such as movies, software and video games, similarly vulnerable to Internet-based piracy. Already, the majority of motion pictures are available in some form on the Internet before theatrical release.

To date, attempts to limit Internet-piracy have been largely unsuccessful. Litigation, legislation, education, commercial innovation, packaged media and digital rights management (“DRM”) anti-piracy technologies have been employed with limited impact.

IPP Solutions. MediaDefender employs a wide array of technical countermeasures on P2P networks to frustrate users’ attempts to find, copy and share unauthorized copyrighted materials. MediaDefender’s customers specify the timing, duration, scope and level of effectiveness of desired protection on a track-by-track, album-by-album or movie-by-movie basis. Users of P2P networks attempting  to download a file that is successfully protected by MediaDefender either cannot begin the downloading process, download the specified file to find that it is not the content for which they were searching, or download a file to find that it works for the first few seconds and then reverts to white noise or static. By making it more difficult for P2P users to access unauthorized content on the Internet, MediaDefender induces consumers to pay for content distributed through legitimate means, such as Apple Corporation’s iTunes.

Suite of Solutions. MediaDefender’s solutions are a practical and proven means of thwarting Internet piracy and driving consumers to pay for online content. MediaDefender’s piracy-detection techniques can pinpoint the initial leak of content onto the Internet and allow MediaDefender to direct its efforts to limit replication at the point of origin. Customers also receive access to MediaDefender’s secure on-line reporting system, which provides critical information regarding the number of attempted and blocked illegal downloads per specified title.

The primary means by which MediaDefender’s solutions hinder illegal Internet file-sharing and downloading include:

·                  Spoofing. Spoofs are false signals that represent themselves as legitimate content.

·                  Swarming. Swarms are corrupt data packet segments that are spliced into existing copies and subsequent downloads of illegitimate files of specified titles.

·                  Decoying. Decoys are false files that are named and titled so as to appear to be legitimate content.

·                  Interdiction. Interdiction creates long lines that inhibit would-be pirates from obtaining access to protected copyrighted materials.

·                  Monitoring. In addition to providing IPP solutions, MediaDefender also tracks attempts by P2P users to access files illegally and provides such information to its customers in the form of weekly monitoring reports. By continuously monitoring the Internet to detect leaks of copyrighted material, MediaDefender is able to advise its customers concerning the origination of such leaks and help determine when MediaDefender’s IPP solutions are needed. Customers often employ MediaDefender’s monitoring capabilities in anticipation of executing a full-scale IPP solutions contract. This early monitoring allows its customers to observe the level of piracy affecting their copyrighted materials and has proven to be an effective marketing tool for MediaDefender’s IPP solutions.

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In addition to an automated web crawler device that monitors leaks, MediaDefender also employs several individuals who detect customer content leaks by monitoring activity on the various networks web-sites and chat rooms. MediaDefender is able to make customers aware of any leaks per day seven days per week. This awareness enables customers to better manage their relationships with creative talent by demonstrating control and knowledge of the situation. Monitoring reports contain information that allows customers to determine:

·                  The piracy problem’s size and nature for each individual release;

·                  When particular copyrighted materials should be protected;

·                  The IP addresses of individuals who are downloading copyrighted content;

·                  How often a specific title is requested;

·                  How often a title is illegally shared; and

·                  Demographics of illegal sharers.

Ancillary Solutions. MediaDefender can provide ancillary solutions to customers to achieve a number of different goals. MediaDefender has assisted customers in identifying the IP address responsible for the origination of illegal content on P2P networks allowing customers to pursue legal action against the source of the piracy.

Next-Generation Solutions. Due to the rapidly evolving nature of the P2P environment, MediaDefender must continually adapt its technologies in order to offer customers increasing levels of effectiveness against the latest Internet-piracy threats. In the third quarter of 2003, MediaDefender commercially released its next-generation solution, called “uber.”  Uber-level solutions allow MediaDefender to provide an approximate 95 percent effectiveness in preventing unauthorized downloads of customer-specified content. MediaDefender’s development team is constantly monitoring advances in peer-to-peer networking and developing solutions to target new networks.

Advertising. During 2007 MediaDefender worked with several advertising agencies and their clients to launch trial programs which distributed branded content on P2P networks.  The Company was paid on a typical ad impression, cost per thousand (CPM) basis per delivered files.  These programs, while limited in quantity, were successful and the Company anticipates to significantly increase the volume of such programs during 2008 and beyond which would serve to reduce the potential negative impact of a reduction in the growth of its IPP solutions services in the recorded  music and television area.

Patent Pending Technology. MediaDefender’s IPP solutions utilize proprietary software and a robust, scalable IT platform . This patent-pending combination of software and IT was created over time and based upon the successes and failures of real-world trials. Computer equipment and software is monitored and maintained on a 24/7 basis. The use of back-up and redundant systems, combined with constant monitoring, allows MediaDefender to provide continuous coverage and rapidly address potential technical problems.

Intellectual Property. In December 2002, MediaDefender filed an umbrella patent application that covers a variety of its concept and back-end technologies, which is still pending. Due to the evolving nature of P2P networks, these technologies are not based on any one service, but rather have the fluidity to be transferred to any P2P network. The claims in the patent filing are predominantly methods for managing a large array of computers for the purpose of preventing piracy on P2P networks.

Sales and Marketing. MediaDefender’s sales process is relationship-based with a relatively long sales cycle. Initial customer relationships were with music and movie industry clients, targeted due to the impact of piracy on these businesses, and has since expanded to software and gaming clients. MediaDefender management has invested significant time in building relationships with its clients, which has resulted in word-of-mouth referrals.

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Customers . MediaDefender’s current principal customers include four major record labels and four major movie studios.  Approximately 68% of MediaDefender’s consolidated revenues were from four customers.  Of those four customers, two customers accounted for 21%  and 18%, respectfully, of MediaDefender’s revenues during the year ended December 31, 2007.

Market Share and Competition. Management believes that MediaDefender has a majority of the  IPP solution market. Its major existing competitor, Safenet, Inc.  has  been in the IPP market for seven years  without gaining significant market share and  Macrovison, a firm which had been competing in the IPP business, recently stopped offering the service due to a lack of performance in the market.

ARTISTdirect Overview – Media and E-Commerce Segments

The ARTISTdirect network (www.artistdirect.com) is a network of web-sites offering multi-media content, music news and information, community around shared music interests, advertising sponsorships, music-related specialty commerce and digital music services.

Our network consists of our music search engine and database containing information on more than 100,000 artists, retail goods, e-commerce offering a wide selection of artist merchandise and music, our proprietary music guide that enables users to browse music by artist, genre or time period, a music-oriented online community and the ability for users to download and listen to music and view music videos.

Technology. Our infrastructure is designed to be integrated, scalable, reliable and secure. The software that we use supports the acquisition, management and publication of content on our web-sites. During fiscal 2007, the management of our web-sites and servers for content, applications, database and electronic commerce was handled internally. Our servers are maintained at three co-location facilities in El Segundo and Los Angeles, California. Our operations depend on the ability to protect our systems against fire, power loss, telecommunications failure, break-ins and other events. All web-sites, servers, and systems are monitored and periodic backups are stored at our data center.

Order Processing and Fulfillment. Our web-sites include an ordering system that is designed to facilitate convenient online purchasing of pre-recorded music and merchandise.  We utilize an outside fulfillment house to verify orders submitted for credit card payment for fraud detection and sufficient funds before we release the order for shipment.  The fulfillment house insures that the credit card numbers are encrypted, and all customer, commerce and transactional data are stored in secure databases protected by firewalls. The transmission of information over the Internet uses Secure Socket Layer security technology verified by VeriSign, an industry leader in online security.

We have an agreement with Alliance Entertainment Corp. (“Alliance”) to be the primary supplier of our music and movie-related merchandise.  Alliance processes and fulfills the orders by our customers and we pay Alliance the wholesale costs of the merchandise plus transaction fees.  Alliance also provides customer service and shipping services.  Alliance provides a complete one stop fulfillment service pursuant to a contract which expires in July of 2008.  If we are unable to continue our agreement with Alliance or identify a suitable alternative fulfillment house, our E-commerce business could be adversely affected.

Sales and Marketing. We sell advertising and sponsorships to companies seeking to reach one or more of the distinct demographic audiences viewing content in the ARTISTdirect network. Advertisers may choose single elements such as targeted or run-of-network banners or sponsorship of fixed placement on our web-sites. Pricing is negotiated based upon the size of the target audience, the duration and intensity of the campaign and the size and placement of the advertisement.

We use a number of methods to create awareness of the ARTISTdirect network designed to drive traffic to our web-sites. We have focused much of our marketing activity on e-mail direct marketing to communicate with registered users about specific artists and the ARTISTdirect network. Campaigns have included direct notification of special merchandise offers, contests, promotions and available music downloads. To the extent our registered users in the future opt out of e-mails or use technology to block marketing e-mails, our operating results could be adversely affected. Ad-blocking technologies may be used to limit the effectiveness of web advertising.

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Customers. During the year ended December 31, 2007, one customer accounted for $1.2 million or 16% of total media revenue.  During the year ended December 31, 2006, one customer accounted for  13% of total media revenue. No other customer accounted for more than 10.0% of our media or e-commerce revenue during those years.

Competition. The market for the online promotion and distribution of music and music-related products and services is highly competitive and rapidly changing. There are a large number of web-sites competing for the attention and spending of consumers and advertisers, and we expect that number to increase, because there are few barriers to entry to Internet commerce. In addition, the competition for advertising revenue, both on web-sites and in more traditional media, is intense. We compete as follows:

·                  for music consumers and advertisers with providers of music information, community and content such as MTV, America Online, MSN, Yahoo!, Listen.com, myspace.com, mp3.com, billboard.com and various other companies;

·                  with major online music retailers such as Amazon.com and iTunes Music Store in selling music and merchandise;

·                  for music consumers and artist relationships with traditional music industry companies, including Sony BMG Music Entertainment, EMI Music, a unit of EMI Group, Warner Music Group, and Universal Music Group, a unit of Vivendi. Some of these companies have established online presences to promote and distribute the music and tours of their respective artists;

·                  for music consumers and advertisers with publishers and distributors of traditional media, such as television, radio and print, including MTV, CMT, Rolling Stone and Spin and their Internet affiliates; and

·                  with traditional retailers targeting music consumers, including Wal-Mart and Virgin Megastore and their Internet affiliates, in selling music and merchandise.

Our competitors have worked together to offer music over the Internet, and we may face increased competitive pressures as a result. We believe that we are able to compete effectively on the basis of:

·                  the breadth and quality of our search, database and the community features of our site;

·                  the variety, availability and price of music-related merchandise on our sites; and

·                  the ease of use and consumer acceptance of the ARTISTdirect network.

Competition is likely to increase significantly as new companies enter the market and current competitors expand their services. Many of our current and potential competitors in the Internet and music entertainment businesses may have substantial competitive advantages over us, including:

·                  longer operating histories;

·                  significantly greater financial, technical, management capital and marketing resources;

·                  greater brand name recognition;

·                  larger existing customer bases; and

·                  more popular content or artists.

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These competitors may be able to respond more quickly to new or emerging technologies, regulatory developments and changes in customer requirements and to devote greater resources to the development, promotion and sale of their products or services than we can. Web-sites maintained by our existing and potential competitors may be perceived by consumers, artists, talent management companies and other music-related vendors or advertisers as being superior to ours. In addition, we may not be able to maintain or increase our web-site traffic levels, purchase inquiries and number of click-through on our online advertisements. Further, our competitors may experience greater growth in these areas than we do. Increased competition could result in advertising price reduction, reduced margins or loss of market share, any of which could materially harm our business.

Governmental Regulation. The laws and regulations that govern our business change rapidly. Although our operations are currently based in California, the United States government and the governments of other states and foreign jurisdictions have attempted to regulate activities on the Internet. The following is a general discussion of some of the evolving areas of law that are relevant to our business:

Content Regulation. Federal, state and foreign governments have adopted and proposed laws governing the content of material transmitted over the Internet. These include laws relating to obscenity, indecency, libel and defamation. For example, the Child Online Protection Act, or “COPA,” prohibits and imposes criminal penalties and civil liability on anyone communicating material harmful to minors through the Internet for commercial purposes, unless access to such material is blocked to minors under age 17. The Third U.S. Circuit Court of Appeals has upheld a preliminary injunction precluding enforcement of COPA. In June 2004, the U.S. Supreme Court upheld the injunction and remanded the case to the District Court. We could be liable if the injunction against COPA is lifted and if content delivered by us or placed on our web-sites violates COPA.

Privacy Law. The state of privacy law is unsettled, and rapidly changing. Current and proposed federal, state and foreign privacy regulations and other laws restricting the collection, use and disclosure of personal information could limit our ability to use the information in our databases to generate revenues. In late 1998, the Children’s Online Privacy Protection Act, or “COPPA,” was enacted, mandating that measures be taken to safeguard minors under the age of 13. The Federal Trade Commission (“FTC”) promulgated regulations implementing COPPA on October 21, 1999, which became effective on April 21, 2000.

The principal COPPA requirement is that individually identifiable information about minors under the age of 13 not be collected, used, displayed or otherwise collected without first obtaining informed parental consent that is verifiable in light of present technology. The FTC final regulations create a “sliding scale” of permissible methods for obtaining such consent based on how the information will be used. Consent for internal use of the individually identifiable information of children under the age of 13 can be obtained through e-mail plus an additional safeguard, such as confirming consent with a delayed e-mail, telephone call, or letter.

We comply with the COPPA requirements by not collecting or displaying the individually identifying information of users who, when attempting to register on the web-sites, enter their birth date indicating they are under the age of 13. Complying with the COPPA requirements is costly and may dissuade some of our potential customers.

Because we have posted a privacy policy pertaining to all users and visitors to our web-site, we are subject the jurisdiction of the FTC.  We may also be subject to the laws and regulations of other states, for example we are aware that California passed the California Online Privacy Protection Act, which took effect July 1, 2004 and mandates content and posting requirements for web-sites privacy policies of web-sites that collect personal information from California residents. While we are attempting to be fully compliant with the FTC and California requirements, our efforts may not be entirely successful. In addition, at times we rely upon outside vendors to maintain data-collection software, and there can be no assurance that they will at all times comply with our instructions to comply with COPPA, our Privacy Policy and FTC and California or other state requirements. If our methods of complying with these requirements are inadequate, we may face litigation with the FTC, California governmental authorities or individuals, which would adversely affect our business. Should any of our business practices be found to differ from our privacy policy, we could be subject to sanctions and penalties from the FTC or injunctions and penalties from California governmental authorities. It is also possible that users or visitors could try to recover damages in a civil action as well. Attorney Generals in various States also have in the past sought to enforce posted privacy policies and may continue to do so in the future.

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Laws Governing Sending of Unsolicited Commercial E-mail. We typically provide our customers and other visitors to our web-sites with an opportunity to “opt-in,” or agree to receive e-mail from us. The federal government signed the Controlling the Assault of Non-Solicited Pornography and Marketing Act of 2003 (CAN-SPAM) designed to limit unsolicited commercial e-mail commonly referred to as “spam.” In addition, California and a number of other states regulate the sending of e-mails for commercial purposes to third parties where there is no preexisting business relationship. Further, several states give Internet service providers (“ISPs”) a private right of action against those who send large e-mailings across their servers in contravention of the ISP’s posted policy. There is no guarantee that we will always be fully compliant in all of our communications at all times. Our failure to comply with applicable laws regarding these types of e-mails could result in significant fines, actual or statutory damages, and injunctive actions.

Conformance to E-Commerce Statutory Requirements for Formation of Contracts. We conduct e-commerce on our web-sites, and through affiliated web-sites. The applicable law on online formation of contracts is evolving. On June 30, 2000, the federal government enacted the Electronic Signatures in Global and National Commerce Act (“E-SIGN”), which provides that certain electronic signatures and electronic contracts with consumers, of the type that we enter into, are not unenforceable solely because they are electronic.  E-SIGN also specifies requirements for electronic record retention.  On January 1, 2000, California adopted a version of the Uniform Electronic Transactions Act (“UETA”), which also permits electronic signatures and record-keeping for certain types of contracts.  Forty-six states have adopted a version of UETA.  Because all state-UETA laws are not identical, there are potentially conflicting requirements applicable to electronic signatures and electronic contracts.  We attempt to comply with these laws, but there is no guarantee that we will be successful.   Judicial interpretation or issuance of governmental regulations interpreting E-SIGN and potentially conflicting State UETA laws with regard to contracts of the type entered into by our customers through out web-sites and affiliated web-sites could result in customer contracts being set aside or modified. In that case, our e-commerce revenue could be materially adversely affected.

Sales Tax. The tax treatment of goods sold over the Internet is currently unsettled. We collect sales taxes for goods shipped to California and Florida, where we have a physical presence (i.e., a “nexus”). A number of proposals have been made at the state and local level that would impose additional taxes on the sale of goods through the Internet. Such proposals, if adopted, could substantially impair the growth of electronic commerce and could adversely affect our opportunity to derive financial benefit from electronic commerce.

Online Contests and Sweepstakes. We occasionally conduct online promotional contests and sweepstakes. No purchase is necessary to participate. Our official rules, with material terms and conditions, eligibility restrictions, dates of participation, methods of entry, prize descriptions and restrictions, and odds of winning, are posted on our web-sites. To avoid having to register and bond our online promotions in the states of New York and Florida, the approximate retail value of the prizes we offer is generally less than $5,000 for a single promotion. Although we structure our promotions in a way that attempts to comply with applicable statutes as we believe they are currently interpreted and enforced in all fifty states, many of those statutes were drafted long before the advent of promotions over the Internet, and different states have interpreted substantially similar statutes differently. Thus, our ability to conduct online promotions is subject to the broad discretionary enforcement powers vested in various authorities. Further, our ability to conduct online promotions may be affected in whole or in part by various business method patents that may have been issued. In addition, foreign jurisdictions may attempt to regulate or ban our promotional contests. Under any of those three scenarios, we could face fines or possible exposure to liability or lose an effective tool for increasing traffic to and keeping visitors at our web-sites, and our business could be adversely affected.

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Intellectual Property. Software, content and other material that we develop, as well as our service marks and domain names relating to the ARTISTdirect or UBL brands, and other proprietary rights are important to our business prospects. Significant impairment of our intellectual property rights could harm our business. We seek to protect certain of our common-law trademarks through Federal registration in the United States of America and State registrations in Puerto Rico. We also have trademark registrations in Argentina, Australia, Brazil, Canada, Chile, Costa Rica, the European Union, Japan, Mexico, Panama, Peru, the United Kingdom and Venezuela. Given the cost of filing, maintaining and protecting federal registrations, we may choose not to register or enforce certain of our trademarks that later turn out to be important. Despite our efforts, it is possible that the scope of protection gained from seeking trademark registration will be insufficient or that the registration may be deemed invalid or unenforceable.

We seek to protect many of our innovations as trade secrets and principally rely upon trade secret and contract law in the Unites States to protect our proprietary rights. We generally enter into confidentiality agreements, “work-made-for-hire” contracts and intellectual property licenses with our employees, consultants and corporate partners, respectively, as part of our efforts to control access to and distribution of our technologies, content and other proprietary information. For example, where consultants develop copyrighted content for us, our general policy is to use written agreements prior to content creation to obtain ownership of that content.

The following sets forth a schedule of our active trademarks:

Federal Trademark Filings

State Trademark Filings

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International Filings

11

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* Indicates that application is pending and not yet registered.

Despite our efforts to protect our proprietary rights from unauthorized use or disclosure, our efforts may not be sufficient or successful. It may be possible that some of our innovations may not be protectable. The steps that we have taken may not prevent misappropriation of our proprietary rights, particularly in foreign countries where laws or law enforcement practices may not protect our proprietary rights at all, or as fully as in the United States. Confidentiality may be compromised intentionally or accidentally by contractors, customers, other third parties or our employees. If third parties were to use or otherwise misappropriate our web-site content, source code, other copyright materials, trademarks, service marks or other proprietary rights without our consent or approval, our competitive position could be harmed, or we could become involved in costly and distracting litigation to enforce our rights.

A copyright gives the owner divisible rights, including those of performance, reproduction and distribution. The music featured by us is typically comprised of copyrighted works owned, controlled or administered by multiple third parties, including record labels, artists, songwriters, music publishers and performance rights and licensing organizations such as (but not limited to) The Harry Fox Agency, Broadcast Music Inc. (“BMI”) and the American Society of Composers, Authors and Publishers (“ASCAP”). Each song often has multiple copyright owners, who control rights which may include performance, reproduction and distribution rights in the “musical composition” comprised of the lyrics and music, as well as with the “sound recording” of the artist’s interpretation of the “musical composition.” In the case of music videos, there are separate copyrights to the visual content, as well as “synchronization rights” for integrating the music and video. We, or our artists, may have different licensing arrangements with some or all of these parties to perform, reproduce and distribute works depending upon how the song or music video is used by us.

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Our web-sites, depending upon the specific musical work, may offer audio streaming of part or all of an entire song or “Web casting,” or the downloading of an entire song in MP3 or other compressed audio formats. Full-length streaming only occurs in special instances after obtaining a license from the record label or band manager for the “sound recording.” In that case, an ASCAP or BMI blanket music license is also obtained by us or by our artists for rights to perform the associated underlying “musical composition.” Where we offer full-length downloads of songs in MP3 or other compressed audio formats, we seek to obtain the rights to transmit, reproduce and perform the “sound recording” in writing from the person or entity owning or controlling copyrights in such “sound recording.” With respect to rights in the “musical compositions” embodied in such “sound recordings” offered for download, we seek to clear rights in musical composition in one or more of the following three ways:

·                  a license agreement with the publisher, writer or other owner of such copyright in the “musical composition”.

·                  a waiver of any fees or royalties that would otherwise be required for such use; and/or;

·                 a representation and warranty from the owner of the copyrights in the “sound recording” that no mechanical royalties are owed to any third parties.

In the event that the foregoing steps are insufficient to clear rights, or we otherwise fail to obtain rights, we could be exposed to claims of copyright infringement, with attendant disruption to our operations and liability including potential statutory or actual damages and loss of profits attributable to infringement, plus payment of attorneys’ fees to the claimant and entry of an injunction against us.

There are other situations, such as a limited 30-second sample of a song that is “streamed,” where we use content relying upon a sub-license from an artist’s record label. However, the laws in this area are uncertain, and we may be obligated to obtain additional licenses or may be prevented from third party content use, and may, in the event proper licenses and clearances have not been secured, further be liable to pay actual or statutory damages, profits attributable to any alleged infringement, as well as attorneys’ fees. Our licensing arrangements for third-party content vary from formal contracts to informal agreements based on the promotional nature of the content. In some cases we pay a fee to the licensor for use of the “sound recording,” “musical composition” or music video and in other cases the use is free. We also use other third-party content, including photographs, artist names, likenesses and concert reviews. While it is our general policy to obtain a written release or license for such use, in many instances we rely only upon an oral license for such use. We rely upon our positive working relationships with copyright owners to obtain licenses on favorable terms. Any changes in the nature or terms of these arrangements, including any requirement that we pay significant fees for the use of the content, could have a negative impact on the availability of content or our business.

Linking and Framing of Third-Party web-sites. We link to and “frame” third-party web-sites of our artists without express written permission to do so. In addition, in the past we have provided a search feature to allow users to find music residing elsewhere on the Internet. Those practices are controversial, and have, in instances not involving us, resulted in litigation. Various claims, including trademark and copyright infringement, unfair competition, and commercial misappropriation, as well as infringement of the right of publicity may be asserted against us as a result of these practices. The law regarding linking and framing remains unsettled; it is uncertain as to how existing laws, especially trademark and copyright law, will be applied by the judiciary to the Internet. Also, Congress is increasingly active in passing new laws related to the Internet, and there is uncertainty as to the impact of future potential laws, especially those involving domain names, databases and privacy.

Defamation or Contributory Infringement. Our web-site features a community area where visitors can post comments. We do not censor such comments and it is possible that a customer could use our web-sites as a forum to make false, misleading or disparaging remarks about others. Such on-line comments could lead to claims for defamation or infringement. As to libel claims brought in the United States, we believe that we qualify for safe harbor protection for third-party postings under 47 U.S.C. Section 230(c)(1). However, other countries, notably the United Kingdom, may impose such liability, and it is possible we could be sued there for third-party postings. Separately, our web-sites allow consumers to use our personal web publishing tools to post samples of their works. Such postings could be misused to post unlicensed copyrighted content of others. We have obtained limited safe-harbor protection under the Digital Millennium Copyright Act against liability for infringing material of which we do not have control and knowledge.

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Seasonality. The seasonality of our e-commerce segment affects our revenue. Our CDs and other online goods are most often purchased during the winter holiday season and also during the summer months, traditionally when artists go on concert tour.

ITEM 2.                             DESCRIPTION OF PROPERTY

The following table provides a schedule of corporate offices and facilities leased by us:

We believe that all real property and facilities leased by us are in good repair and adequate for our purposes for the next 12 months.

ITEM 3.                             LEGAL PROCEEDINGS

We are periodically subject to various pending and threatened legal actions, which arise in the normal course of business. Our management currently believes that the impact of any such litigation will not have a material adverse impact on our financial position or results of operations.

As a result of the restatement of our financial statements and the other events described elsewhere in this Annual Report on Form 10-KSB, we have triggered various events of default under our senior debt and subordinated debt financing documents.  We could be subject to future claims under our financing documents, see “Item 6. Management’s Discussion and Analysis — Going Concern”.

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ITEM 4.                                                     SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters submitted to a vote of our stockholders during the fourth quarter of the fiscal year ended December 31, 2007.

PART II

ITEM 5.                       MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS ISSUERS PURCHASES OF EQUITY SECURITIES

Market Information

Our common stock has been listed for quotation on the Over-the-Counter Bulletin Board under the symbol “ARTD.OB” since May 9, 2003.  The following table sets forth the high and low sales prices for our common stock, as reported by the Over-the-Counter Bulletin Board for fiscal 2007 and 2006, respectively:

The closing price of our common stock on March 24, 2008 was $0.41 per share, as reported on the Over-The-Counter Bulletin Board.  The Over-the-Counter quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not represent actual transactions.

Holders of Record

As of March 24, 2008, we had 265 holders of record of our common stock, excluding shares held in “street name” by brokerage firms and other nominees who hold shares for multiple investors.

Dividends

The Company has not declared or paid any cash dividends on our common stock since its inception.  The Company’s various senior and subordinated financing documents prevent the Company from paying any cash dividends on account of our common stock.  Subject to the Company’s obligations to our senior and subordinated lenders, the Company intends to retain any future earnings, if any, to finance the Company’s business, and we do not expect to declare or pay any cash dividends in the foreseeable future.

Equity Compensation Plan Information

Refer to Item 11 “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” below for information with respect to our equity compensation plans.

Additional Information

Copies of our prior Annual Reports on Form 10-KSB, Quarterly Reports on Form 10-QSB, Current Reports on Form 8-K, and any amendments to those reports, are available free of charge on the Internet at www.sec.gov. All statements made in any of our filings, including all forward-looking statements, are made as of the date of the document in which the statement is included, and we do not assume or undertake any obligation to update any of those statements unless we are required to do so by law.

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ITEM 6.  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.

On July 28, 2005, the Company completed the acquisition of MediaDefender, Inc., a privately-held Delaware corporation, (“MediaDefender”).  The stockholders of MediaDefender received aggregate consideration of $42,500,000 in cash, subject to certain holdbacks and adjustments described in the Merger Agreement.

The acquisition of MediaDefender 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.  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 reduced 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.

MediaDefender is the leading provider of anti-piracy solutions in the Internet-piracy-protection (“IPP”) industry.  It should be noted that revenue related to anti-piracy activities declined in 2007 from 2006 and management anticipates a further decline in 2008.  The largest source of this decline is reduced spending on the part of the major music labels due to a significant reduction in their sales and profitability.  See additional details and discussion in the Net Revenue section below.

During 2007, MediaDefender began offering advertisers specific programs to download branded content on file-sharing networks.  While such advertising based programs provided approximately $560,000 of revenue during 2007, management believes such activities could be a significant factor in 2008 and beyond as advertisers become more familiar with branded promotion activities on peer-to-peer networks, which currently carry the majority of internet traffic.  Advertising related revenue will be needed to offset anticipated declines in revenues from anti-piracy programs, especially those related to music.

During 2006, MediaDefender offered file-sharing marketing services, wherein MediaDefender receives a fee for redirecting specific peer-to-peer traffic on the Internet to designated client destinations.  This type of redirect program activity was not significant during 2007 and management does not anticipate this to be a major source of revenue going forward.

In order to fund the acquisition of MediaDefender, the Company completed a $15,000,000 senior secured debt transaction and a $30,000,000 convertible subordinated debt transaction, as described below at “Financing Transactions with Respect to MediaDefender, Inc. Acquisition”.

Going Concern:

As a result of communications with the Staff of the Securities and Exchange Commission 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, on December 20, 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 December 20, 2006, 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.  On July 6, 2007, the Company’s registration statement was declared effective by the SEC, thus making it available to the investors in the Senior Financing and Sub-Debt Financing.

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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.  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 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 December 31, 2007 and 2006.  Notwithstanding such developments, the Company believes that it would have been out of compliance with certain of its financial covenants at December 31, 2007.

During 2007 and 2006, 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.  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 payments due on the outstanding senior indebtedness during 2007 were timely paid.  Pursuant to the terms of the Subordination Agreement, interest on the outstanding subordinated convertible notes payable cannot be paid as a result of the existence of the events of default described herein.

As of December 31, 2007 and 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 December 31, 2007, approximately $410,000 and $1,972,000 was outstanding with respect to accrued registration delay penalties to the holders of the Senior Financing and the Sub-Debt Financing, respectively, and approximately $146,000 and $3,206,000 was outstanding with respect to accrued interest payable to the holders of the Senior Financing and the Sub-Debt Financing, respectively.  Through December 31, 2007, the Company had not paid the registration delay penalties to Sub-Debt Notes, although it had made advance payments to the holders of the Senior Notes aggregating $1,000,000 in exchange for multiple forbearance agreements.

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. 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.

Pursuant to a series of Forbearance and Consent Agreements with the investors in the Senior Financing, such investors agreed to forbear from the exercise of their rights and remedies under the Senior Financing documents as a result of the events of default with respect to the unavailability of the Company’s registration statement, as well as certain other events of default that existed or that could come into existence during the forbearance period, from April 17, 2007 through February 20, 2008, in exchange for aggregate cash payments of $1,000,000 in 2007 and $494,446 in February 2008.  The payments made by the Company under the Forbearance and Consent Agreements were credited against the registration delay cash penalties and interest on the penalties resulting from the Company’s default under the various agreements between the Company and the Senior Financing investors.  On March 17, 2008, the Company entered into a Forbearance and Consent Agreement with the investors in the Company’s Senior Debt Financing, which was effective as of February 20, 2008, whereby the investors  agreed to forbear from exercising any of their rights and remedies under the Senior Financing transaction documents through December 31, 2008 in exchange for an adjustment in the interest rate associated with the Senior Notes from 11.25% to 15%, provided the loan is repaid prior to September 30, 2008 or 16%, if the loan remains outstanding subsequent to that date.

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The registration delay penalties and ongoing default interest charges are continuing to have a significant and material negative impact on the Company’s operations and cash flows.  The Company and its representatives and advisors are in ongoing discussions with the holders of its senior and subordinated debt obligations to obtain a waiver of and amendment to certain of the financing documents with respect to the events of default, the impact of the restatements, the payment of cash penalties and default interest, and various related matters.  The Company is exploring various alternatives to resolve the defaults under its senior and secured debt obligations, but is unable to predict the outcome of such negotiations.  On February 7, 2008 the Company retained the services of Salem Partners, LLC, to serve as a financial advisor to the Company in connection with the sale, merger, consolidation, reorganization or other business combination and the restructuring of the material terms of the Company’s senior notes and/or subordinated convertible notes.  To the extent that the Company is unable to complete a sale or merger, or restructure its senior and subordinated debt obligations in a satisfactory manner and/or the lenders begin to exercise additional remedies to enforce their rights, the Company will not have sufficient cash resources to maintain its operations.  In such event, the Company may be required to consider a formal or informal restructuring or reorganization, including a filing under Chapter 11 of the United States Bankruptcy Code.

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 foregoing, the Company’s independent registered public accounting firm, in its report on the Company’s 2007 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.

Critical Accounting Policies:

The discussion and analysis of the Company’s financial condition and results of operations is based upon its consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America.  The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities.  On an ongoing basis, the Company evaluates its estimates, including those related to accounts receivable, tangible and intangible assets, warrant and derivative liabilities, income taxes, and contingencies and litigation, among others.  The Company bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions.  The Company believes that the following critical accounting policies affect the more significant judgments and estimates used in the preparation of its consolidated financial statements:   revenue recognition, stock-based compensation, goodwill, intangible assets and long-lived assets, derivative instruments, income taxes and accounts receivable.

Revenue Recognition.  The Company complies with the provisions of Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements”, as amended by SAB No. 104, and recognizes revenue when all four of the following criteria are met:  (i) persuasive evidence that an arrangement exists; (ii) delivery of the products and/or services has occurred; (iii) the selling price is both fixed and determinable; and (iv) colectability is reasonably assured.

E-commerce revenue consists primarily of the gross amount of sales revenue paid by the customer for recorded music and merchandise sold via the Internet, including shipping fees, and is recognized when the products are shipped.  The Company has a contract with a fulfillment house to service its music-related e-commerce activity.  The Company records e-commerce revenue on a gross basis as the Company enters into the sale transactions with customers, establishes the prices of the products, chooses the suppliers of the products, assumes the risk of inventory loss and collects all amounts from the customers and assumes the credit risk.  In certain circumstances, e-commerce revenue is subject to royalties, and such expense is recorded as part of cost of e-commerce revenue.

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The Company records amounts charged to customers for shipping and handling in accordance with EITF 00-10, “Accounting for Shipping and Handling Fees and Costs” (“EITF 00-10”).  Pursuant to EITF 00-10, the Company records amounts charged to customers for shipping and handling as revenue, and records the related costs incurred for shipping and handling to direct cost of product sales in the statement of operations.

Media revenue consists primarily of the sale of advertisements and sponsorships under short-term contracts.  To date, the duration of the Company’s advertising commitments has generally averaged from one to three months, although certain programs can last up to one year.  The Company’s online obligations typically include the guarantee of a minimum number of times (“impressions”) that an advertisement appears in pages viewed by the users of the Company’s online properties.  Online advertising revenue is generally recognized as the impressions are served during the period in which the advertisement is displayed, provided that no significant obligations of the Company remain and collection of the resulting receivable is reasonably assured.  To the extent that minimum guaranteed page deliveries are not met, recognition of the corresponding revenue is deferred until the guaranteed impressions are delivered.

The Company recognizes revenue for sponsorship arrangements over the period during which the advertising is provided, generally on a straight-line basis.  The Company recognizes revenue for a banner impression deliverable as the banner impressions are delivered.  The Company recognizes revenue for web-page sponsorships on a straight-line basis over the term of the sponsorship.  The Company recognizes revenue for custom content when the content is provided to the customer.

Anti-piracy and file-sharing marketing services revenue is recognized on a monthly basis as services are provided to customers.  Deferred revenue is recorded for customers who prepay the full, or any portion, of their respective contracts.

Stock-Based Compensation.  Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standard No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”), a revision to SFAS No. 123, “Accounting for Stock-Based Compensation”.  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.  Accordingly, the Company recognizes compensation cost for equity-based compensation for all new or modified grants issued after December 31, 2005.  In addition, commencing January 1, 2006, the Company recognized the unvested portion of the grant date fair value of awards issued prior to 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.

The Company accounts for stock option and warrant grants issued and vesting to non-employees in accordance with EITF No. 96-18, “Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services”, and EITF 00-18, “Accounting Recognition for Certain Transactions involving Equity Instruments Granted to Other Than Employees”, whereas the value of the stock compensation is based upon the measurement date as determined at either (a) the date at which a performance commitment is reached or (b) at the date at which the necessary performance to earn the equity instrument is complete.

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Goodwill, Intangible Assets and Long-Lived Assets.  Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”), requires purchased intangible assets other than goodwill to be amortized over their useful lives unless these lives are determined to be indefinite.

SFAS No. 142 requires goodwill to be tested for impairment at least on an annual basis and more often under certain circumstances, and written down when impaired.  An interim impairment test is required if an event occurs or conditions change that would more likely than not reduce the fair value of the reporting unit below the carrying value.

We completed a goodwill impairment test during the Third Quarter of 2007 and found no need for an adjustment.  Due to the reduced sales activity in our anti-piracy business for the year 2007 and our internal projections for 2008, we again revisited the impairment work during our year end review for 2007 and noted that while the test thresholds were narrower, an adjustment was still not required.  We plan to closely monitor the sales activity within this segment during each fiscal quarter of 2008 and, if warranted, will record an impairment loss to adjust downward the carrying value of the segment at that time.

Impairment losses are limited to the carrying value of the goodwill, which represents the excess of the carrying amount of a reporting unit’s goodwill over the implied fair value of that goodwill.  In determining the estimated future cash flows, the Company considers current and projected future levels of income based on management’s plans for that business, as well as business trends, prospects and market and economic conditions.

Derivative Instruments. Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”), requires all derivatives to be recorded on the balance sheet at fair value.  When multiple derivatives (both assets and liabilities) exist within a financial instrument, they are bundled together as a single hybrid compound instrument in accordance with SFAS No. 133 Implementation Issue No. B15, “Embedded Derivatives:  Separate Accounting for Multiple Derivative Features Embedded in a Single Hybrid Instrument”.  The calculation of the fair value of derivatives utilizes highly subjective and theoretical assumptions that can materially affect fair values from period to period.  The change in the fair value of the derivatives from period to period is recorded in other income (expense) in the statement of operations.  As a result, the Company’s financial statements are impacted quarterly based on factors such as the price of the Company’s common stock and the principal amount of Sub-Debt Notes converted into common stock.  Consequently, the Company’s results of operations and financial position may vary from quarter to quarter based on factors other than those directly associated with the Company’s operating revenues and expenses.  The recognition of these derivative amounts does not have any impact on cash flows.

EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock (“EITF 00-19”), requires freestanding contracts that are settled in a company’s own stock, including common stock warrants, to be designated as an equity instrument, an asset or a liability.  When the ability to physically or net-share settle a conversion option or the exercise of freestanding options or warrants is deemed to be not within the control of the Company, the embedded conversion option or freestanding options or warrants may be required to be accounted for as a derivative liability.  Under the provisions of EITF 00-19, a contract designated as an asset or a liability must be carried at fair value on a company’s balance sheet, with any changes in fair value recorded in a company’s results of operations.

The Company has accounted for registration rights penalties in accordance with EITF 00-19-2, “Accounting for Registration Payment Arrangements”, which the Company adopted as of December 31, 2006, and Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies”.  Since the registration rights component of the derivative liabilities was not material through September 30, 2006, there was no cumulative-effect adjustment recorded as a result of the transition rules with respect to the adoption of EITF-00-19-2 at December 31, 2006.

The Company accounts for derivatives, including the embedded derivatives associated with the Sub-Debt Notes and the warrants issued in conjunction with the Senior Financing and the Sub-Debt Financing, at fair value, adjusted at the end of each reporting period to reflect any material changes, with any such changes included in other income (expense) in the statement of operations.

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At the date of the conversion of Sub-Debt Notes into common stock or the principal repayment of Senior Notes, the pro rata portion of the related unamortized discount on debt and deferred financing costs is charged to operations and included in other income (expense).  At the date of exercise of any of the warrants, or the conversion of Sub-Debt Notes into common stock, the pro rata portion of the fair value of the related warrant liability and/or embedded derivative liability is transferred to additional paid-in capital.

Income Taxes.  The Company accounts for income taxes under Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS No. 109”).  SFAS No. 109 requires recognition of deferred tax assets and liabilities for the expected future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the statement of operations in the period that includes the enactment date.  A valuation allowance is established, when necessary, to reduce deferred tax assets to the amount expected to be realized.

Accounts Receivable.  The Company grants credit to its customers generally in the form of short-term trade accounts receivable.  Accounts receivable are stated at the amount that management expects to collect from outstanding balances.  When appropriate, management provides for probable uncollectible amounts through a provision for doubtful accounts and an adjustment to a valuation allowance.  Management primarily determines the allowance based on the aging of accounts receivable balances, historical write-off experience, customer concentrations, customer creditworthiness and current industry and economic trends.  Balances that are still outstanding after management has used reasonable collection efforts are written off through a charge to the valuation allowance and a credit to accounts receivable.  Concentrations of credit risk with respect to trade receivables generated by the Company’s operations are generally limited.  However, MediaDefender’s customers consist primarily of large reputable companies in the music and entertainment industries.

Adoption of New Accounting Policies:

In June 2006, the Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue 06-3, “How Taxes Collected From Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)” (“EITF 06-3”).  The scope of EITF 06-3 includes any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer, and provides that a company may adopt a policy of presenting taxes either on a gross basis - that is, including the taxes within revenue - or on a net basis.  For any such taxes that are reported on a gross basis, a company should disclose the amounts of those taxes for each period for which an income statement is presented if those amounts are significant.  The Company collects various state sales taxes that fall under the scope of EITF 06-3 on goods that it sells in its e-commerce business segment and is accounting for and reporting such taxes on a net basis.  EITF 06-3 is effective for financial reports for interim periods and annual reporting periods beginning after December 15, 2006.  The Company adopted EITF 06-3 effective January 1, 2007.  The adoption of EITF 06-3 did not have a material effect on the Company’s financial statements.

In December 2006, the Financial Accounting Standards Board (“FASB”) issued FSP EITF 00-19-2, “Accounting for Registration Payment Arrangements” (“EITF 00-19-2”), which addresses an issuer’s accounting for registration payment arrangements.  EITF 00-19-2 specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with SFAS No. 5, “Accounting for Contingencies”.  EITF 00-19-2 further clarifies that a financial instrument subject to a registration payment arrangement should be accounted for in accordance with other applicable generally accepted accounting principles without regard to the contingent obligation to transfer consideration pursuant to the registration payment arrangement.  EITF 00-19-2 is effective immediately for registration payment arrangements and the financial instruments subject to those arrangements that are entered into or modified subsequent to the date of issuance of EITF 00-19-2.  For registration payment arrangements and financial instruments subject to those arrangements that were entered into prior to the issuance of EITF 00-19-2, EITF 00-19-2 is effective for financial statements issued for fiscal years beginning after December 15, 2006, and interim periods within those fiscal years.  Early adoption of EITF 00-19-2 for interim or annual periods for which financial statements or interim reports have not been issued is permitted.  The Company chose to early adopt EITF 00-19-2 effective December 31, 2006.

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Effective January 1, 2007, the Company adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, Accounting for Income Taxes” (“FIN 48”).  FIN 48 addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements.  Under FIN 48, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position.  The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement.  FIN 48 also provides guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures.  The adoption of the provisions of FIN 48 did not have a material effect on the Company’s financial statements.  As of December 31, 2007, no liability for unrecognized tax benefits was required to be recorded.

The Company files income tax returns in the U.S. federal jurisdiction and various states.  The Company is subject to U.S. federal or state income tax examinations by tax authorities for years after 2003 (see Note 11).

The Company’s policy is to record interest and penalties on uncertain tax provisions as income tax expense

Recent Accounting Pronouncements:

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”), which establishes a formal framework for measuring fair value under Generally Accepted Accounting Principles (“GAAP”). SFAS No. 157 defines and codifies the many definitions of fair value included among various other authoritative literature, clarifies and, in some instances, expands on the guidance for implementing fair value measurements, and increases the level of disclosure required for fair value measurements. Although SFAS No. 157 applies to and amends the provisions of existing FASB and American Institute of Certified Public Accountants (“AICPA”) pronouncements, it does not, of itself, require any new fair value measurements, nor does it establish valuation standards. SFAS No. 157 applies to all other accounting pronouncements requiring or permitting fair value measurements, except for: SFAS No. 123R, share-based payment and related pronouncements, the practicability exceptions to fair value determinations allowed by various other authoritative pronouncements, and AICPA Statements of Position 97-2 and 98-9 that deal with software revenue recognition. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is currently assessing the potential effect of SFAS No. 157 on its financial statements.

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”), which provides companies with an option to report selected financial assets and liabilities at fair value. SFAS No. 159’s objective is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. Generally accepted account principles have required different measurement attributes for different assets and liabilities that can create artificial volatility in earnings. SFAS No. 159 helps to mitigate this type of accounting-induced volatility by enabling companies to report related assets and liabilities at fair value, which would likely reduce the need for companies to comply with detailed rules for hedge accounting. SFAS No. 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 requires companies to provide additional information that will help investors and other users of financial statements to more easily understand the effect of the company’s choice to use fair value on its earnings. SFAS No. 159 also requires companies to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet. SFAS No. 159 does not eliminate disclosure requirements included in other accounting standards, including requirements for disclosures about fair value measurements included in SFAS No. 157 and SFAS No. 107. SFAS No. 159 is effective as of the beginning of a company’s first fiscal year beginning after November 15, 2007. Early adoption is permitted as of the beginning of the previous fiscal year provided the company makes that choice in the first 120 days of that fiscal year and also elects to apply the provisions of SFAS No. 157. The Company is currently assessing the potential effect of SFAS No. 159 on its financial statements.

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In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS No. 141(R)”), which requires an acquirer to recognize in its financial statements as of the acquisition date (i) the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree, measured at their fair values on the acquisition date, and (ii) goodwill as the excess of the consideration transferred plus the fair value of any noncontrolling interest in the acquiree at the acquisition date over the fair values of the identifiable net assets acquired.  Acquisition-related costs, which are the costs an acquirer incurs to effect a business combination, will be accounted for as expenses in the periods in which the costs are incurred and the services are received, except that costs to issue debt or equity securities will be recognized in accordance with other applicable GAAP.  SFAS No. 141(R) makes significant amendments to other Statements and other authoritative guidance to provide additional guidance or to conform the guidance in that literature to that provided in SFAS No. 141(R).  SFAS No. 141(R) also provides guidance as to what information is to be disclosed to enable users of financial statements to evaluate the nature and financial effects of a business combination.  SFAS No. 141(R) is effective for financial statements issued for fiscal years beginning on or after December 15, 2008. Early adoption is prohibited. The Company has not yet determined the effect on its consolidated financial statements, if any, upon adoption of SFAS No. 141(R).

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51” (“SFAS No. 160”), which revises the relevance, comparability, and transparency of the financial information that a reporting entity provides in its consolidated financial statements by establishing accounting and reporting standards that require (i) the ownership interests in subsidiaries held by parties other than the parent be clearly identified, labeled, and presented in the consolidated statement of financial position within equity, but separate from the parent’s equity, (ii) the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of income, (iii) changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary be accounted for consistently as equity transactions, (iv) when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary be initially measured at fair value, with the gain or loss on the deconsolidation of the subsidiary being measured using the fair value of any noncontrolling equity investment rather than the carrying amount of that retained investment, and (v) entities provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS No. 160 amends FASB No. 128 to provide that the calculation of earnings per share amounts in the consolidated financial statements will continue to be based on the amounts attributable to the parent. SFAS No. 160 is effective for financial statements issued for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Early adoption is prohibited. SFAS No. 160 shall be applied prospectively as of the beginning of the fiscal year in which it is initially applied, except for the presentation and disclosure requirements, which shall be applied retrospectively for all periods presented. The requirements of SFAS No. 160 does not apply to the Company as it is currently structured.

On March 19, 2008—The Financial Accounting Standards Board (FASB) issued FASB Statement No. 161, Disclosures about Derivative Instruments and Hedging Activities. The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged.  The Company is currently assessing the potential effect of FASB No. 161 on its financial statements.

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Results of Operations - Years Ended December 31, 2007 and 2006:

The table shown below presents information with respect to the Company’s consolidated statements of operations as to actual amounts and as a percentage of total net revenue, for the years ended December 31, 2007 and 2006.

The Company evaluates performance based on, among other factors, earnings or loss before interest, taxes, depreciation and amortization (“Adjusted EBITDA”), which is a non-GAAP financial measure.  Adjusted EBITDA also excludes stock-based compensation, changes in the fair value of warrant liability and derivative liability, and other non-cash write-offs and charges.  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.

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Management believes that Adjusted EBITDA enhances an overall understanding of the Company’s financial performance by investors because it is frequently used by securities analysts and other interested parties in evaluating companies in its industry segment.  In addition, management believes that Adjusted EBITDA is useful in evaluating the Company’s operating performance compared to that of other companies in its industry segment because the calculation of Adjusted EBITDA eliminates the accounting effects of financing costs, income taxes and capital spending, which items may vary for different companies for reasons unrelated to overall operating performance.

However, Adjusted EBITDA has certain limitations.  Adjusted EBITDA is not a recognized measurement under GAAP, and when analyzing the Company’s operating performance, investors should use Adjusted EBITDA in addition to, and not as an alternative for, standard GAAP financial measures such as net income (loss) or cash flow from operations, or any other measure utilized in determining the Company’s operating performance that is calculated in accordance with GAAP.  Because Adjusted EBITDA is not calculated in accordance with GAAP, it may not be comparable to similarly-titled measures utilized by other companies.  Adjusted EBITDA eliminates certain substantial recurring items from net income (loss), such as depreciation, amortization, interest expense and income taxes, among others.  Each of these items has been incurred in the past, will continue to be incurred in the future, and should be considered in the overall evaluation of the Company’s operating performance.  The Company compensates for these limitations by providing the relevant disclosure of the items excluded in the calculation of Adjusted EBITDA, both in the reconciliation to the GAAP financial measure of net income (loss) and in the consolidated financial statements and footnotes, all of which should be considered when evaluating the Company’s operating performance.  Furthermore, Adjusted EBITDA is not intended to be a measure of the Company’s free cash flow or liquidity in general, as it does not consider certain ongoing cash requirements, such as a required debt service payments and income taxes.

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 table shown below summarizes net revenue and Adjusted EBITDA by operating segment for the years ended December 31, 2007 and 2006, respectively.  A reconciliation of Net Income (Loss) to Adjusted EBITDA is also provided.

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