Item 1 of this report, the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of this report and similar discussions in our other filings with the Securities and Exchange Commission (“SEC”) discuss some of the important risk factors that may affect our business, results of operations and financial condition. You should carefully consider those risks in addition to the other information in this report and in our other filings with the SEC before deciding to invest in our company or to maintain or increase your investment. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.
PART I
ITEM 1. BUSINESS
OVERVIEW
We are a music entertainment company that combines an online music network and two record labels to provide an integrated offering for music fans, artists and marketing partners. The ARTISTdirect Network (www.artistdirect.com) is a network of Web sites offering multi-media content, music news and information, community around shared music interests, music-related commerce and digital music services. Through our co-venture record label, ARTISTdirect Records, we develop new musical artists and produce and distribute their recordings as an independent label utilizing traditional channels of distribution. Through our iMusic record label we sign established artists with an existing fan base and release their recordings through traditional channels and emerging Internet distribution channels.
The ARTISTdirect Network features our music search engine and database containing information on more than 100,000 artists, retail e-commerce offering a wide selection of artist merchandise and music, our proprietary music guide that enables users to browse music by artist, genre or time period, a music-oriented online community and the ability for users to download and listen to music and view music videos.
•
The Ultimate Band List (“UBL”) - a comprehensive online music search engine and resource for music information. The UBL provides information on more than 100,000 artists across numerous musical genres, featuring news, concert information, artist biographies, album reviews, contests, promotions, music samples and downloads. The UBL also offers links to numerous other Web sites in the online music community;
•
Community - a music-oriented online community providing message boards relating to specific artists and general music topics. The Community area allows fans to communicate with others around the world to share interests and commentary about their favorite music and artists;
•
The ARTISTdirect Shopping area - a retail site offering a wide selection of music titles and artist and lifestyle merchandise;
•
Downloads - a feature that enables users to download and listen to music from a variety of artists. In addition, users can view a variety of current music videos featuring popular and emerging artists.
•
Music Guide - a feature that allows users to navigate a large catalog of music by artist, genre or time period (e.g. 60’s Rock), facilitating both quick access to music known to the user and the discovery of music that may be new to the user. The music guide is designed to function with either short music clips or with full song files at such time as we are able to enter into music licensing agreements on terms acceptable to us;
During 2001, we formed a new record label company, ARTISTdirect Records, LLC, as a co-venture between our wholly owned subsidiary, ARTISTdirect Recordings, Inc., and Radar Records Holdings, LLC, an entity wholly owned by our Chief Executive Officer, Frederick W. (Ted) Field. Mr. Field also serves as the Chief Executive Officer of ARTISTdirect Records. ARTISTdirect Records develops new musical artists, and produces and distributes their recordings as an independent label utilizing traditional channels of distribution. ARTISTdirect Records generates revenue primarily from the sale of compact discs by artists signed to the label. The objective of ARTISTdirect Records is to develop proprietary content that we can exploit to create value for our shareholders.
During 2002, our wholly owned subsidiary ARTISTdirect Digital, Inc. began operating a record label under the brand name iMusic. iMusic focuses on the signing of established artists with a proven sales base and an ability to generally make records less expensively than developing artists. We utilize both traditional channels of distribution and emerging Internet distribution channels, and we generally spend substantially less on marketing and promotion of these releases than would be spent to develop an audience for new artists.
In December 2001, we decided to exit the music talent agency business because we believed that our prospects for increasing the value of this business were limited and that there were potential conflicts of interests with our new co-venture record label. As a result, we have classified this segment of our business as a discontinued operation in our consolidated statement of operations for all periods presented. We wound up operations of the agency business in 2002.
INDUSTRY BACKGROUND
THE MUSIC INDUSTRY
Music is one of the most popular forms of entertainment worldwide and a multi-billion dollar consumer industry. In addition, the music industry generates substantial revenue from advertising, sponsorship, promotions and merchandise related to music events and individual artists. The music industry identifies artists and develops, promotes and distributes their content. The high cost associated with development, promotion and distribution has led artists to rely on third parties such as record labels, merchandisers and talent agents to represent their interests. The experience of the typical music consumer has been fragmented and inefficient. Music consumers have had to search a variety of media to find music news and information and have had to purchase compact discs, tickets and merchandise through different retail channels. Until recently, consumers were unable to legitimately purchase digital music online, and recently introduced services provide restricted access to limited catalogs of music. Goods, such as apparel and other artist merchandise, have been difficult to find and frequently available only at concerts or selected retail outlets. For music fans, opportunities to interact with their favorite artists and fellow enthusiasts have been limited.
INTERNET OPPORTUNITY
The Internet has emerged as a platform that allows millions of people worldwide to deliver and receive information rapidly, create virtual communities around shared interests and engage in electronic commerce. This has made the Internet an important new medium for music, dramatically altering the way consumers search for, discover, listen to and purchase music. The Internet offers:
•
efficient reach to a growing worldwide audience;
•
convenient access to a vast offering of musical content and services;
•
flexibility to tailor products and services to consumer interests and market dynamics;
•
a market for the digital distribution of music;
•
the potential for consumer personalization of the music experience; and
•
timely collection of customer preferences and demographics for targeted advertising and promotion.
Artists have begun to view the Internet as a platform to gain greater control over the programming, promotion and distribution of their music and related merchandise and to communicate directly with their fans. Many consumers have adopted the Internet to locate music information, share interests and discover and buy music. We believe that the features of the Internet and the common demographics of music consumers and Internet users represent an opportunity for the music industry to develop new digital music services that meet consumer demand in new and different ways. Artists will have the opportunity to exert greater control over the programming, promotion and distribution of their music and consumers will be able to search for, discover and purchase music and related merchandise and content at a single destination.
RECORD LABEL OPPORTUNITY
Consolidation of the music industry has resulted in significant concentration of music sales among five major music companies: BMG, EMI, Sony Music (a division of Sony Corporation), Universal Music Group (a division of Vivendi Universal), and Warner Music Group (a division of AOL Time Warner). While these companies have extensive resources to develop, market and distribute an artist’s music, some artists prefer to provide their services to smaller labels where they may represent a more significant portion of the label’s business and, therefore, be afforded more attention and focused resources. We also believe that artists are attracted to a label that has significant, integrated online resources to directly assist the artist in exploiting opportunities to reach consumers outside the traditional channels of retail distribution.
OUR SOLUTION
BENEFITS TO ARTISTS
By operating both an online music network and two independent record labels, we are able to work with artists to develop, produce and distribute their music and provide them with a platform to develop their presence on the Web. Our benefits to artists include:
Full-Service Record Label. We are able to develop, produce and distribute an artist’s recorded music through our labels, ARTISTdirect Records and iMusic. By focusing our resources on artists and repertoire (A&R), marketing and promotion, we are able to assist an artist in the critical elements of finding and developing an audience for their music. By distributing our releases through BMG, we provide broad reach to retail distribution channels both domestically and globally.
Online Media Network. We are able to offer artists access to an online media platform to create, present, promote and distribute their content. Features include auto-publishing tools, content management, and capabilities for advertising and direct marketing and electronic commerce. With continuing advances in broadband technology and standards for digital music distribution, we believe our Online Network could become a significant platform for the full range of artists’ content, commerce, digital distribution and community activities on the Internet.
Closer Relationships with Fans. Artist-specific Web sites promote greater fan affinity and loyalty by directly linking artists and fans. Artists can use these Web sites to provide content and products to fans, including artist news, concert information, music and video programming, exclusive chats, ticket giveaways and fan club activities. Artists can also solicit the views of fans on new music, live performances and music videos. A better understanding of their fans enables artists to develop relevant content, promote their music more effectively and create new revenue opportunities.
New Revenue Opportunities. We provide artists with an opportunity through our online network to sell directly to consumers their merchandise that was previously generally available only at concert venues or selected
retail locations. We also are able to assist artists in the development of a database of their fans that can be used for direct marketing opportunities.
New Platform for Digital Distribution. The Internet represents an important new platform for digital music distribution. As the music industry develops new services that provide secure digital distribution and meet the demands of consumers, we intend to make such services available through the ARTISTdirect Network. In addition, we intend to provide artists signed to ARTISTdirect Records with the opportunity to generate incremental revenue from digital music distribution.
BENEFITS TO CONSUMERS
Our ARTISTdirect Network offers an extensive destination for the music consumer. Our benefits to consumers include:
Comprehensive Music Resource. The ARTISTdirect Network includes comprehensive resources for searching, discovering and enjoying music content. These resources include a search engine and database of more than 100,000 artists covering a wide variety of musical genres, organized links to other Internet music resources, news, concert information, artist biographies, album reviews, contests and promotions, music samples and downloads. Our music guide is designed to provide access to a complete catalog of music that can be searched by artist, genre or time period.
Rich Community Features. Our community area features message boards relating to both specific artists and more general music topics. Our site enables fans around the world to share interests and commentary about their favorite music and artists and facilitates their discovery of new music.
Comprehensive Shopping Destination. The ARTISTdirect Network brings together many of the disparate elements of the music shopping experience. Music consumers can purchase and pre-order a full range of recorded music and shop for artist-related merchandise, including some items available only through ARTISTdirect. In addition, our content, downloadable music, and special promotions enhance the consumer experience.
BUSINESS STRATEGY
Our objective is to be a leading music entertainment company, producing and distributing new music, providing artist services and reaching music fans through a comprehensive online music network. Our strategy is to:
Build Our Record Label. We believe that there is a significant opportunity to establish ARTISTdirect Records as an important independent record label. We intend to sign quality artists capable of delivering commercially successful new music releases in the near term. We also intend to effectively market and promote our releases to create consumer demand and to achieve broad retail distribution in both domestic and international markets through our agreement with BMG Entertainment, one of the five major music companies.
Build Brand Awareness. We intend to continue to try to establish ARTISTdirect as a leading brand for music entertainment using primarily online marketing channels to reach consumers and promote the ARTISTdirect brand name. We believe that the establishment of ARTISTdirect Records will provide a significant new platform for branding as we begin to issue new releases under the ARTISTdirect Records name.
Exploit Our Unique Assets. We intend to exploit our uniquely integrated assets, broad reach and experienced, artist-oriented management team to differentiate ourselves from companies with less comprehensive offerings. For example, we aim to:
•
offer selected artists a range of services, including development, marketing and promotion through our record label; online programming, promotion and distribution through the ARTISTdirect Network; and inclusion in our entertainment marketing initiatives;
•
develop branded live events and tours sponsored by advertisers and merchants; and
•
enable advertisers and merchants to deliver their messages to the audience of the entire ARTISTdirect Network or to targeted audiences within the ARTISTdirect Network.
ARTISTdirect BUSINESS SEGMENTS
ARTISTdirect NETWORK. The ARTISTdirect Network is comprised of our Media and E-commerce operations. Our Media operations include our content-oriented web sites and our entertainment marketing initiatives. Revenue from Media operations is generated from the sale of online advertising and integrated marketing solutions. E-commerce operations include our ARTISTdirect Shopping area, offering a comprehensive selection of music CDs and broad range of artist and lifestyle merchandise. Revenue from E-commerce operations is generated primarily from the sale of music CDs and artist and lifestyle merchandise.
iMusic Record Label. In 2002, our wholly owned subsidiary ARTISTdirect Digital, Inc. began operating a record label under the iMusic brand name. The iMusic record label focuses on the signing of established artists with a proven sales base and an ability to generally make records less expensively than developing artists. We utilize both traditional channels of distribution and emerging Internet distribution channels and generally spend substantially less on marketing and promotion of these releases than on those of new artists. We believe that iMusic can establish a new business model for the record industry and provides a complement to ARTISTdirect Records whose focus is on the development of new artists with a significant sales potential. As of December 31, 2002, iMusic had signed distribution agreements with 21 artists and had released 7 albums.
ARTISTdirect Records. In 2001, we formed a new record label company, ARTISTdirect Records, LLC, as a co-venture between our wholly owned subsidiary, ARTISTdirect Recordings, Inc., and Radar Records Holdings, LLC, an entity wholly owned by our Chief Executive Officer, Mr. Field. Mr. Field serves as the Chief Executive Officer of ARTISTdirect Records. ARTISTdirect Records develops new musical artists, and produces and distributes their recordings as an independent label utilizing traditional distribution channels.
In November 2001, ARTISTdirect Records agreed in principle to enter into a preliminary North America distribution agreement and worldwide license agreement with BMG, the global music division of Bertelsmann AG. Under the terms of the agreement, BMG Distribution distributes the label’s releases in North America, and BMG licenses ARTISTdirect Records repertoire in territories throughout the world. In April 2002, the agreements with BMG were finalized, including BMG’s purchase of 5% of the equity of ARTISTdirect Records from the Company. As part of this transaction, BMG agreed to assume $5.0 million of the Company’s $50 million funding commitment to ARTISTdirect Records.
As of December 31, 2002, ARTISTdirect Records had signed recording agreements with 17 artists and had 48 full-time employees.
INFRASTRUCTURE AND OPERATIONS
TECHNOLOGY
Our infrastructure is designed to be integrated, scalable, reliable and secure. The software that we use supports the acquisition, management and publication of content on our Web sites. During 2002, the management of our Web sites and servers for content, applications, database and electronic commerce was taken over internally from CNP, Inc., a third party vendor that ceased operations. Our servers are maintained at IX2 Networks, LLC, a co-location facility in Los Angeles, California. Our operations depend on our and IX2’s ability to protect our systems against fire, power loss, telecommunications failure, break-ins and other events. All Web sites, servers, and systems are monitored and periodic backups are stored at a remote location
Our current e-commerce system is based on SAP software with certain enhancements provided to us by Pandesic, LLC, a joint venture between Intel and SAP that wound up operations in January 2001. Upon Pandesic’s cessation of operations, we received the source code and executables for the e-commerce system that had been provided previously by Pandesic, implemented SAP’s software in house under a two-year license from SAP. In December 2002, our two-year license expired and we entered into a perpetual license agreement with SAP.
ORDER PROCESSING AND FULFILLMENT
Our Web sites include an ordering system that is designed to facilitate convenient online purchasing of pre-recorded music and merchandise. Customers can add items to their “shopping cart” while surfing our Web sites. At any time they can securely “checkout”, at which time they need to register (if they are new customers), or enter a username and password to retrieve previously saved billing, shipping and credit card information. We verify orders submitted for credit card payment for fraud detection and sufficient funds before we release them for fulfillment. We also accept alternative modes of payment, such as checks and money orders. Credit card numbers are encrypted, and all customer, commerce and transactional data are stored in secure databases protected by firewalls. The transmission of information over the Internet uses Secure Socket Layer security technology verified by VeriSign.
Alliance Entertainment. In August 1998, we entered into a five-year agreement with Alliance Entertainment Corp. to be our primary supplier of music and music-related information for our ARTISTdirect Superstore. Alliance owns the All Music Guide, a comprehensive source of artist and album information that is supplied to our users primarily through its integration into the UBL. Alliance fulfills compact discs ordered by our customers and we pay Alliance the wholesale cost plus a fulfillment fee. In addition, Alliance provides warehouse space and fulfillment services pursuant to an oral agreement that Alliance may terminate at any time for a majority of the music-related merchandise that we offer which allows the consolidated shipping of customer orders for both music and merchandise. We have integrated our order processing system with Alliance’s information systems to assist in fulfillment tracking, inventory management and customer service. We purchase almost all of the music titles available for sale on our Web sites from inventory held by Alliance.
Benn Co. (formerly Old Glory). In November 2001, we entered into a six-month agreement with Old Glory Boutique Distributing Inc. (“Old Glory”) to be a wholesale supplier of music-related merchandise and provide fulfillment services for the products for which it sells to us. The agreement was renewed for a one-year period in May 2002 and shall automatically renew for an additional year in May 2003 unless either party gives notice of its intent not to renew no less than 90 days before the end of the annual term. In December 2002, this agreement was assigned from Old Glory to Benn Co., LLC.
If we are unable to renew our agreements with these suppliers when they expire, on favorable terms or at all, or if Alliance ceases to provide fulfillment services for merchandise, our business could be adversely affected.
CUSTOMER SERVICE
In June 2001, we entered into a two-year agreement with AEC One-Stop Group, Inc. (“Alliance Entertainment”) to provide customer support services for our Web sites’ consumers and respond to customer inquiries, orders and other requests made by phone, fax, e-mail and regular mail. Prior to entering into the agreement with Alliance, we provided customer service with an internal staff of customer service representatives.
SALES AND MARKETING
ADVERTISING SALES
We sell entertainment marketing solutions, including advertising and sponsorships, to advertisers seeking to reach one or more of the distinct demographic audiences viewing content in the ARTISTdirect Network or attending a live event that we organize. Components of an entertainment marketing solution may include, among other things, title sponsorship of an event or concert tour, promotion in marketing materials for an event or tour, signage and presence at live events, contests to promote consumer registration for sponsor services, and banner ads or content sponsorship on the ARTISTdirect Network. In addition, 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, the number of elements involved, and payments to third parties, such as artists, to secure their services. For the years ended December 31, 2002 and 2001, advertising represented 15% and 28%, respectively, of our revenue. AT&T Wireless accounted for 14% and 20% of our advertising revenues for the year ended December 31, 2002 and 2001, respectively. During the same periods, Universal Music Group accounted for 0% and 17% of our advertising revenue.
MARKETING AND PROMOTION
We use a number of methods to create awareness of the ARTISTdirect Network and drive traffic to our Web sites. We have focused much of our marketing activity on e-mail direct marketing to communicate with registered users of specific artists and the ARTISTdirect Network. Campaigns have included direct notification of special merchandise offers, contests, promotions, music downloads and non-scheduled live performances. In addition, we participate in live music and other industry events that provide prominent visibility for ARTISTdirect and maintain a public relations program to facilitate communication with music industry and consumer-oriented press.
COMPETITION
The market for the online promotion and distribution of music and music-related products and services is relatively new, highly competitive and rapidly changing. There are a large number of Web sites competing for the attention and spending of consumers and advertisers, and we expect that number to increase, because there are few barriers to entry to Internet commerce. In addition, the competition for advertising revenue, both on Web sites and in more traditional media, is intense. We compete as follows:
•
for music consumers and advertisers with providers of music information, community and content such as MTV, America Online, MSN, Yahoo!, Listen.com and various other companies;
•
with major online music retailers such as Amazon.com and CDnow in selling music and merchandise;
•
for music consumers and artist relationships with traditional music industry companies, including BMG Entertainment, a unit of Bertelsmann AG, EMI Music, a unit of EMI Group, Sony Music Entertainment, a unit of Sony Corporation, Warner Music Group, a unit of AOL Time Warner, and Universal Music Group, a unit of Vivendi Universal. Some of these companies have recently 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 Tower Records and Virgin Megastore and their Internet affiliates, in selling music and merchandise.
Some of our competitors have agreed to work together to offer music over the Internet, and we may face increased competitive pressures as a result. For example, Universal Music Group and Sony Music have formed a joint venture to operate pressplay, a subscription music service that offers consumers both downloads and on-demand streaming. In addition, RealNetworks, AOL Time Warner, Bertelsmann AG and EMI Group formed MusicNet, a digital music subscription platform featuring on-demand downloads and streaming.
We believe that we are able to compete primarily on the bases of:
•
our integrated offering of both online and offline assets, including the ARTISTdirect Network, iMusic record label and ARTISTdirect Records;
•
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;
•
the ease of use and consumer acceptance of the ARTISTdirect Network; and
•
the ability to effectively promote our brands.
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:
These competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements and to devote greater resources to the development, promotion and sale of their products or services than we can. Web sites maintained by our existing and potential competitors may be perceived by consumers, artists, talent management companies and other music-related vendors or advertisers as being superior to ours. In addition, we may not be able to maintain or increase our Web site traffic levels, purchase inquiries and number of click-thrus on our online advertisements. Further, our competitors may experience greater growth in these areas than we do. Increased competition could result in advertising price reduction, reduced margins or loss of market share, any of which could harm our business.
GOVERNMENTAL REGULATION
The laws and regulations that govern our business change rapidly. Although our operations are currently based in California, the United States government and the governments of other states and foreign countries have attempted to regulate activities on the Internet. The following are some of the evolving areas of law that are relevant to our business:
CONTENT REGULATION
Federal, state and foreign governments have adopted and proposed laws governing the content of material transmitted over the Internet. These include laws relating to obscenity, indecency, libel and defamation. For example, the Child Online Protection Act, or COPA, prohibits and imposes criminal penalties and civil liability on anyone communicating material harmful to minors through the Internet for commercial purposes, unless access to such material is blocked to minors under age 17. The Third U.S. Circuit Court of Appeals has upheld a preliminary injunction precluding enforcement of COPA. In November 2001, the U.S. Supreme Court heard an appeal but no decision has been issued yet. We could be liable if the injunction against COPA is lifted and if content delivered by us or placed on our Web sites violates COPA. On March 6, 2003, the Third U.S. Circuit Court of Appeals issued a ruling that COPA restricts free speech because it is not narrowly focused is enough to only target pornography, and is therefore unconstitutional. The Department of Justice could appeal this ruling to the U.S. Supreme Court.
PRIVACY LAW
The state of privacy law is unsettled, and rapidly changing. Current and proposed federal, state and foreign privacy regulations and other laws restricting the collection, use and disclosure of personal information could limit our ability to use the information in our databases to generate revenues. In late 1998, the Children’s Online Privacy Protection Act, or COPPA, was enacted, mandating that measures be taken to safeguard minors under the age of 13. The FTC promulgated regulations implementing COPPA on October 21, 1999, which became effective on April 21, 2000. The principal COPPA requirement is that individually identifiable information about minors under the age of 13 not be collected, used or displayed without first obtaining informed parental consent that is verifiable in light of present technology. The FTC final regulations create a “sliding scale” of permissible methods for obtaining such consent. Consent for internal use of the individually
identifiable information of children under the age of 13 can be obtained through e-mail plus an additional safeguard, such as confirming consent with a delayed e-mail, telephone call, or letter. Obtaining verifiable consent from a child’s parent to share that child’s information with a third party or enable the child to publicly distribute the information by, for example, allowing unrestricted access to a chat room or message board is significantly more burdensome. While the temporary “sliding scale implementation was due to expire on April 21, 2002, on October 31, 2001, the FTC extended the implementation period through April 21, 2005.
The FTC has required that parental consent for such higher risk activities be verified by more secure methods than e-mail, such as a credit card in connection with a transaction, print-and-sign forms, toll-free numbers staffed by trained operators, or digital signatures. Complying with the new requirements is costly and will likely dissuade some of our customers. While we are attempting to be fully compliant with the FTC requirements, our efforts may not be entirely successful. In addition, at times we rely upon outside vendors to maintain data-collection software, and there can be no assurance that they will at all times comply with our instructions to comply with COPPA. If our methods of complying with COPPA are inadequate, we may face litigation with the FTC or individuals, which would adversely affect our business.
Moreover, we have posted a Private Policy pertaining to all users and visitors to our Web site. By doing so, we have subjected ourselves to the jurisdiction of the FTC. Should any of our business practices be found to differ from our Private Policy, we could be subject to sanctions and penalties from the FTC. It is also possible that users or visitors could try to recover damages in a civil action as well.
LAWS GOVERNING SENDING OF UNSOLICITED COMMERCIAL E-MAIL
We typically provide our customers and other visitors to our Web sites with an opportunity to “opt-in,” or agree to receive e-mailings from us. While there is no federal regulation yet, 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 state laws regarding these types of e-mails could result in significant fines, actual or statutory damages, and injunctive actions.
CONFORMANCE TO E-COMMERCE STATUTORY REQUIREMENTS FOR FORMATION OF CONTRACTS
We conduct e-commerce on our Web sites, and through affiliated Web sites. The applicable law on online formation of contracts has been unsettled and is evolving. On June 30, 2000, the federal government enacted the “E-Sign” statute, which in limited cases permits online formation of contracts. Similarly, on January 1, 2000, California adopted a standard version of the Uniform Electronic Transactions Act (“UETA”), which also permits electronic signatures and record-keeping for certain types of contracts. We attempt to comply with these laws, but there is no guarantee that we will be successful. Judicial interpretation of their application could result in customer contracts being set aside or modified. In that case, our e-commerce revenue could be materially adversely affected.
SALES TAX
The tax treatment of goods sold over the Internet is currently unsettled. We collect sales taxes for goods shipped to California and Florida, where we have a physical presence. A number of proposals have been made at the state and local level that would impose additional taxes on the sale of goods through the Internet. Such proposals, if adopted, could substantially impair the growth of electronic commerce and could adversely affect our opportunity to derive financial benefit from electronic commerce. While the Internet Tax Freedom Act has placed a moratorium on new state and local taxes on Internet commerce, the tax moratorium will expire on November 1, 2003 and may not continue. Failure to renew this legislation in the future would allow various states to impose taxes on Internet-based commerce, which could adversely affect our business.
ONLINE CONTESTS AND SWEEPSTAKES
We conduct online promotional contests and sweepstakes. No purchase is necessary to participate. Our official rules, with all material terms, conditions of eligibility, dates of participation, methods of entry and limitations, if any, along with the odds and prize offerings, are posted on our Web sites. In order to comply with New York and Florida state law, our prizes are limited in value to less than $5,000, or we must comply with those states’ registration and bonding requirements. While we attempt to comply with the law of all fifty state jurisdictions, we may not be uniformly successful, and foreign jurisdictions may attempt to regulate or ban our promotional contests. In that event, we could lose an effective tool for increasing and keeping visitors to our Web site, and our business could be adversely affected.
INTELLECTUAL PROPERTY
OUR PROPRIETARY RIGHTS
Copyrighted material that we develop, as well as our service marks and domain names relating to the ARTISTdirect, UBL or iMusic brands, and other proprietary rights are important to our business prospects. We seek to protect our common-law trademarks through federal registration, but these actions may be inadequate. Where consultants develop copyrighted content for us, our general policy is to use written agreements prior to content creation to obtain ownership of that content. In addition, we principally rely upon trademark, copyright, trade secret and contract law to protect our proprietary rights. We generally enter into confidentiality agreements, “work-made-for-hire” contracts and intellectual property licenses with our employees, consultants and corporate partners, respectively, as part of our efforts to control access to and distribution of our technologies, content and other proprietary information.
Despite our efforts to protect our proprietary rights from unauthorized use or disclosure, parties may attempt to disclose or use our customer lists, Web site content, service marks, domain names or confidential commercial data. The steps that we have taken may not prevent misappropriation of our proprietary rights, particularly in foreign countries where laws or law enforcement practices may not protect our proprietary rights at all, or as fully as in the United States. If third parties were to use or otherwise misappropriate our copyrighted materials, trademarks or other proprietary rights without our consent or approval, our competitive position could be harmed, or we could become involved in costly and distracting litigation to enforce our rights.
OUR WEB SITES FEATURE CONTENT THAT IS COPYRIGHTED BY MULTIPLE THIRD-PARTIES
A copyright gives the owner divisible rights, including those of performance, reproduction and distribution. The music featured by us is typically comprised of copyrighted works owned, controlled or administered by multiple third parties, including record labels, artists, songwriters, music publishers and performance rights and licensing organizations such as The Harry Fox Agency, Broadcast Music Inc. and the American Society of Composers, Authors and Publishers. Each song often has multiple copyright owners, who control rights which may include performance, reproduction and distribution rights in the “musical composition” comprised of the lyrics and music, as well as with the “sound recording” of the artist’s interpretation of the “musical composition.” In the case of music videos, there are separate copyrights to the visual content, as well as “synchronization rights” for integrating the music and video. We, or our artists, may have different licensing arrangements with some or all of these parties to perform, reproduce and distribute works depending upon how the song or music video is used by us.
Our Web sites, depending upon the specific musical work, may offer audio streaming of part or all of an entire song or “Web casting,” or the downloading of an entire song in MP3 or other compressed audio formats. Full-length streaming only occurs in special instances after obtaining an oral license from the record label or band manager for the “sound recording.” In that case, an ASCAP or BMI blanket music license is also obtained by us or by our artists for rights to perform the associated underlying “musical composition.” Where we offer full-length downloads of songs in MP3 or other compressed audio formats, we seek to obtain the rights to transmit, reproduce and perform the “sound recording” in writing from the person or entity owning or controlling copyrights in such “sound recording.” With respect to rights in the “musical compositions” embodied in such “sound recordings” offered for download, we seek to clear rights in musical composition in one of the following three ways:
•
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; 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.
There are other situations, such as a limited 30-second sample of a song that is “streamed,” where we use content relying upon a sub-license from an artist’s record label. However, the laws in this area are uncertain, and we may be forced to obtain additional licenses or may be prevented from third party content use, and may further be liable to pay actual or statutory damages, profits attributable to any alleged infringement, as well as attorneys’ fees. Our licensing arrangements for third-party content vary from formal contracts to informal agreements based on the promotional nature of the content. In some cases we pay a fee to the licensor for use of the “sound recording,” “musical composition” or music video and in other cases the use is free. We also use other third-party content, including photographs, artist names, likenesses and concert reviews. While it is our general policy to obtain a written release or license for such use, in many instances we rely only upon an oral license for such use. We rely upon our positive working relationships with copyright owners to obtain licenses on favorable terms. Any changes in the nature or terms of these arrangements, including any requirement that we pay significant fees for the use of the content, could have a negative impact on the availability of content or our business.
For example, the Copyright Office recently opined that additional royalties, besides those collected for musical compositions by ASCAP or BMI, are due for Webcasted music that is selected by or on behalf of the recipient pursuant to 17 U.S.C. sec. 114(j)(7). If upheld, that ruling would prevent us from expanding our service to permit users to play a requested song via our Web site without paying additional royalties.
LINKING AND FRAMING OF THIRD-PARTY WEB SITES
We link to and “frame” third-party Web sites of our artists without express written permission to do so. In addition, in the past we have provided a search feature to allow users to find music residing elsewhere on the Internet. Those practices are controversial, and have, in instances not involving us, resulted in litigation. Various claims, including trademark and copyright infringement, unfair competition, and commercial misappropriation, as well as infringement of the right of publicity may be asserted against us as a result of these practices. The law regarding linking and framing remains unsettled; it is uncertain as to how existing laws, especially trademark and copyright law, will be applied by the judiciary to the Internet. Also, Congress is increasingly active in passing new laws related to the Internet, and there is uncertainty as to the impact of future potential laws, especially those involving domain names, databases and privacy.
DEFAMATION OR CONTRIBUTORY INFRINGEMENT
Our Web site features a community area where visitors can post comments We do not censor such comments and it is possible that a customer could use our Web sites as a forum to make false, misleading or disparaging remarks about others. Such on-line comments could lead to claims for defamation or infringement. As to libel claims brought in the United States, we believe that we qualify for safe harbor protection for third-party postings under 47 U.S.C. sec. 230(c)(1). However, other countries, notably the United Kingdom, may impose such liability, and it is possible we could be sued there for third-party postings. Separately, our Web sites allow consumers to use our personal Web publishing tools to post samples of their works. Such postings could be misused to post unlicensed copyrighted content of others. We have obtained limited safe-harbor protection under the recently enacted Digital Millennium Copyright Act against liability for infringing material of which we do not have control and knowledge.
EMPLOYEES
As of December 31, 2002, we had 38 full-time employees. None of our employees is represented by a labor union. We have not experienced any work stoppages and consider our employee relations to be good.
RISK FACTORS
Before investing in our company or deciding to maintain or increase your investment, you should carefully consider the risks described below, in addition to the other information contained in this report and in our other filings with the Securities and Exchange Commission. The risks and uncertainties described below are not the only ones facing our company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business operations. If any of these risks actually occur, our business, financial condition or results of operations could be seriously harmed. In that event, the market price for our common stock could decline and you may lose all or part of your investment.
We Face Substantial Doubt About Our Ability to Continue as a Going Concern Without Further Substantial Cost Reductions and/or Additional Financing
The report from our Independent Auditors includes an explanatory paragraph that describes substantial doubt concerning our ability to continue as a going concern given our current available cash resources. In order to address this concern, we are implementing substantial cost reductions and exploring the disposition of one or more business units such that we may be able to operate as a going concern. However, there can be no assurance that these efforts will be sufficient to enable us to operate as a going concern on a sustained basis. In addition, we are pursuing alternatives to raise additional capital both at ARTISTdirect and ARTISTdirect Records in order to continue the operations of both entities. We do not have any formal commitments at this time and there can be no assurance that additional capital can be obtained either by ARTISTdirect or by ARTISTdirect Records on reasonable terms, in a timely manner or at all. If additional funds are raised through the issuance of equity securities of either ARTISTdirect or ARTISTdirect Records, the percentage ownership of current stockholders in ARTISTdirect and/or ARTISTdirect Records will be reduced. If we raise additional funds by issuing debt, we may be subject to limitations on our operations, including limitations on the payment of dividends, and any debt issued by ARTISTdirect Records may be senior to the obligations of ARTISTdirect Records to ARTISTdirect. Failure to raise additional capital could seriously harm or result in the cessation of the business of ARTISTdirect Records and ARTISTdirect, and impair the value of our investment in ARTISTdirect Records. Cessation of the business of ARTISTdirect Records or ARTISTdirect could result in bankruptcy or liquidation, in either case potentially resulting in a total loss for stockholders of ARTISTdirect.
It Is Difficult To Evaluate Our Business And Prospects Because We Have A Limited Operating History And Rapidly Evolving Business
Our limited operating history and rapidly evolving business make it difficult to evaluate our prospects or to accurately predict our future revenue or results of operations. Our revenue and income potential are unproven, and our business model is constantly and rapidly evolving. In particular, the Internet is constantly changing and we may need to modify our business model to adapt to these changes. In addition, our decision to focus a substantial portion of both our human and capital resources on our record label businesses, ARTISTdirect Records and iMusic, represents entry into a business new to us that entails significant uncertainty.
Our Business Model Is New And Unproven, And We May Not Be Able To Generate Sufficient Revenue To Operate Our Business Successfully
Our model for conducting business and generating revenue is new and unproven. Our success will depend primarily on our ability to generate revenue and income from ARTISTdirect Records and our iMusic record label and from multiple sources through the ARTISTdirect Network, including:
•
online sales of music and related merchandise;
•
sales of advertising and sponsorships;
•
marketing our database of consumer information and preferences;
•
sales of, or subscription fees for, digitally distributed music; and
•
sales of music CDs by the ARTISTdirect Records and iMusic record labels.
It is uncertain whether a music-related Web site that relies on attracting people to learn about, listen to and purchase music and related merchandise can generate sufficient revenue from electronic commerce, advertising, sales of database information and sales of, or fees for, digital downloads of music, to become a viable business. We provide many of our online features without charge, and we may not be able to generate sufficient revenue to pay for these features. In addition, it may take a significant amount of time for us to develop ARTISTdirect Records with Ted Field and our iMusic record label. Accordingly, we are not certain that our business model will be successful or that we can sustain revenue growth or be profitable. If our markets develop more slowly than expected or become saturated with competitors, or our products and services do not achieve or sustain market acceptance, we may not be able to successfully operate our business.
We Have A History Of Operating Losses And Anticipate Losses And Negative Cash Flow For The Foreseeable Future
To date, we have not been profitable on an annual or quarterly basis and have incurred accumulated losses of approximately $242.0 million as of December 31, 2002. For the years ended December 31, 2002 and 2001, we incurred net losses of approximately $48.2 million and $69.9 million, respectively, which represented approximately 771% and 671%, respectively, of our revenue for those periods. We expect our operating losses and negative cash flow to continue for at least the near future. We will need to generate significant additional revenue to achieve profitability. Consequently, it is possible that we may never achieve profitability, and even if we do achieve profitability, we may not sustain or increase profitability on a quarterly or annual basis in the future. If we do not achieve or sustain profitability in the future, then we will likely be unable to continue our operations.
Our Operating Results Will Likely Be Unpredictable
Our operating results are likely to fluctuate significantly in the future due to a variety of factors, many of which are outside of our control. Because our operating results are volatile and difficult to predict, our operating results have in the past, and in the future may, fall below the expectations of securities analysts and investors. In this event, the trading price of our common stock may fall significantly.
Global Sales of Recorded Music Have Recently Declined and This Trend May Continue in the Future
Based on data compiled by the International Federation of the Phonographic Industry (IFPI), global sales of recorded music declined 1.3% in value and 1.2% in units from 1999 to 2000, declined 5.0% in value and 6.5% in units from 2000 to 2001, and declined 9.2% in value and 11.2% in units in the first half of 2002 compared with the first half of 2001. The IFPI attributes this decline, in part, to widespread copying and illegal Internet downloading of music. This trend of declining sales of recorded music may continue in the future and could have a detrimental impact on revenue at our iMusic and ARTISTdirect Records labels.
If We Are Not Successful In Generating Revenue From The ARTISTdirect Records Co-Venture With Ted Field, Our Business And Financial Condition May Be Materially Adversely Affected
In 2001, we decided to invest a significant amount of our resources in offline activities and in May 2001, we entered into an agreement with music and entertainment veteran, Ted Field, to develop and operate our record label co-venture, ARTISTdirect Records, and to hire Mr. Field as our Chairman of the Board and Chief Executive Officer. ARTISTdirect Records is a relatively new enterprise and faces significant challenges in developing and operating its planned business, including but not limited to the following:
•
identifying and entering into recording agreements with artists for ARTISTdirect Records;
•
hiring and retaining personnel for ARTISTdirect Records;
•
producing and promoting new music recordings for artists signed to ARTISTdirect Records ;
•
developing a recognized brand name in the music industry;
•
developing distribution channels for ARTISTdirect Records;
•
integrating the ARTISTdirect Records operations with our existing operations;
•
obtaining the capital necessary to sustain the ARTISTdirect Records operations; and
•
generating ARTISTdirect Records revenue and achieving profitability.
ARTISTdirect Records has a very limited operating history upon which to assess whether it will be able to meet all of the challenges required to successfully develop and operate its business. Accordingly, there can be no assurance that Mr. Field will be able to successfully operate ARTISTdirect Records. ARTISTdirect Records may be forced to curtail or cease operations if it is not able to obtain the capital necessary to sustain its operations, in which events the value of our investment in ARTISTdirect Records may be seriously impaired. If ARTISTdirect Records is not able to develop a successful business with revenue and profits, we will not receive the anticipated benefits of our investment in ARTISTdirect Records and our business, financial condition and results of operations would be materially and adversely affected.
There May Be A Significant Conflict Of Interest As A Result Of Ted Field’s Separate Ownership Interest In ARTISTdirect Records And His Dual Roles As Chief Executive Officer Of Both ARTISTdirect Records And The Company
As of December 31, 2002, Mr. Field held options to purchase approximately 12.8% of the currently outstanding voting interests in the Company and also held 30% of the outstanding ownership interests in ARTISTdirect Records, the Company’s record label co-venture. By virtue of the difference in his ownership interests, Mr. Field would likely gain a greater personal benefit if opportunities were realized by ARTISTdirect Records rather than by the Company. Accordingly, there are potential conflicts of interest between the Company and Mr. Field. Although our employment agreement with Mr. Field precludes him from voting on behalf of the Company on matters concerning ARTISTdirect Records, Mr. Field will, by virtue of his authority as Chief Executive Officer of both the Company and ARTISTdirect Records, have substantial influence over the execution of any decisions made by the Company’s management and Board of Directors.
As a result, Mr. Field could, through his day-to-day managerial decisions, take actions that are detrimental to the Company and favorable to ARTISTdirect Records. For instance, Mr. Field could decide to sign a particular artist to the ARTISTdirect Records record label instead of the iMusic record label. In addition, Mr. Field’s concurrent service as the Chief Executive Officer of both the Company and ARTISTdirect Records could allow Mr. Field to devote more time to ARTISTdirect Records than to the Company. Under the terms of the employment agreement with each entity, Mr. Field is required to devote at least 80% of his business time exclusively to the Company and ARTISTdirect Records. However, Mr. Field is allowed to devote all of that business time exclusively to ARTISTdirect Records as long as it does not adversely affect his performance under the terms of his employment agreement with the Company. While the Company does not expect that any of the foregoing events will occur, there can be no assurance that Mr. Field will always act in the best interests of the Company and its stockholders.
We Have Committed A Substantial Amount Of Our Available Cash To The ARTISTdirect Records Co-Venture With Ted Field And, As A Result, The Amount Of Cash That We Will Have Available To Operate Our Other Businesses Has Been Substantially Reduced
The ARTISTdirect Records co-venture with Mr. Field represented a significant shift in the planned use of our cash resources. As of December 31, 2002, we had provided $30.25 million to ARTISTdirect Records, are obligated to provide an additional $2.75 million in 2003 and an additional $12.0 million from 2004 through July 2006. As of December 31, 2002, we had unrestricted cash and short-term investments totaling $8.0 million. Our commitment to fund ARTISTdirect Records is subject to a guaranty for the benefit of BMG. Should we fail to meet our
commitment, BMG may choose to enforce the guaranty or provide substitute financing that could result in dilution of our interest in ARTISTdirect Records.
Assuming payment of the $2.75 million advance to ARTISTdirect Records in 2003, we currently anticipate that available cash resources, including short-term investments, may not be sufficient to meet anticipated needs for working capital and capital expenditures for at least twelve months without additional capital. Furthermore, to continue its operations ARTISTdirect Records will require additional capital in 2003 beyond that to be provided by us.
We are currently pursuing alternatives to raise additional capital in order to continue the operations of ARTISTdirect and ARTISTdirect Records. There can be no assurance that additional capital can be obtained by either ARTISTdirect or by ARTISTdirect Records on reasonable terms, in a timely manner or at all. If additional funds are raised through the issuance of equity securities of either ARTISTdirect or ARTISTdirect Records, the percentage ownership of current stockholders in ARTISTdirect and/or ARTISTdirect Records will be reduced. If we raise additional funds by issuing debt, we may be subject to limitations on our operations, including limitations on the payment of dividends, and any debt issued by ARTISTdirect Records may be senior to the obligations of ARTISTdirect Records to ARTISTdirect. Failure to raise additional capital could seriously harm or result in the cessation of the business of ARTISTdirect Records and ARTISTdirect, and impair the value of our investment in ARTISTdirect Records. Cessation of the business of ARTISTdirect Records or ARTISTdirect could result in bankruptcy or liquidation, in either case potentially resulting in a total loss for stockholders of ARTISTdirect.
See “Liquidity and Capital Resources” on pages 26-28 for more information on our liquidity and capital resources.
Our Equity Interest In ARTISTdirect Records May Be Significantly Diluted If We Are Unable To Meet Our Financing Commitment
In the event that we fail to provide funding to ARTISTdirect Records as required under the terms of the operating agreement governing the co-venture, ARTISTdirect Records then has the right to secure substitute financing. Among other things, any advances made by us that are outstanding at the time will become subordinated to repayment of the substitute financing and we can be forced to divest certain of our equity interest in ARTISTdirect Records should the issuance of an equity interest to the substitute financier be required as a condition of the substitute financing.
If We Are Not Successful In Generating and Increasing Revenue From Our iMusic Record Label, Our Business And Financial Condition May Be Materially Adversely Affected
During 2002, through our wholly owned subsidiary ARTISTdirect Digital, Inc., we launched a second record label, under the brand-name iMusic. The iMusic record label is a new operation and we will face significant challenges in developing and growing this operation, including but not limited to the following:
•
identifying and entering into recording agreements with artists for the iMusic record label;
•
producing and promoting music recordings for artists signed to the iMusic record label;
•
developing a recognized brand name in the music industry;
•
developing distribution channels for the iMusic record label; and
•
generating iMusic record label revenue and achieving profitability.
The iMusic record label has a very limited operating history upon which to assess whether it will be able to meet all of the challenges required to successfully operate and generate and increase revenues. If we are not able to generate and increase revenue and profits from the iMusic record label, our business, financial condition and results of operations would be materially and adversely affected. Furthermore, we may be forced to curtail or cease the
operations of iMusic, or seek to divest iMusic, if we are unable to obtain financing for the operations of ARTISTdirect, in which event we may be unable to recover the value of our investment to date.
We Do Not Currently Expect Online Advertising To Grow Significantly In The Near Future And As A Result, Our Business May Be Adversely Affected
If we do not increase advertising revenue, our business will be adversely affected. Increasing our advertising revenue depends upon many factors, including our ability to:
•
respond to and anticipate fluctuations in the demand for, and pricing of, online advertising;
•
develop and maintain key advertising relationships and compete for advertisers with Internet and traditional media companies;
•
conduct successful selling and marketing efforts aimed at advertisers;
•
successfully develop, sell and execute entertainment marketing solutions;
•
increase the size of our audience and the amount of time that our audience spends on our Web sites;
•
accurately measure the size and demographic characteristics of our audience;
•
offer advertisers the means to effectively target their advertisements to our audience; and
•
increase the amount of revenue per advertisement.
Our failure to achieve one or more of these objectives could impair our ability to increase advertising revenue, which could adversely affect our business. In addition to the above factors, general economic conditions, as well as economic conditions specific to online advertising, electronic commerce and the music industry, could affect our ability to increase our advertising revenue. In particular, the growth of online advertising has declined since 2000, which has had, and in the future may continue to have, a significant adverse effect on our revenue from online advertising. We do not currently expect online advertising to grow significantly in the near future. In the past, we have traditionally relied on a limited number of customers for our advertising revenue. For instance, during the year ended December 31, 2002, AT&T Wireless accounted for 14% and Miller Brewing accounted for 12% respectively, of our total media revenue. The loss of these customers could have a significant adverse effect on our media revenue.
The Effectiveness Of The Internet For Advertising Is Unproven, Which May Discourage Some Advertisers From Advertising On Our Sites
Our future depends in part on an increase in the use of the Internet and other forms of digital media for advertising. The Internet advertising market is relatively new and rapidly evolving, and we cannot yet gauge the effectiveness of advertising on the Internet as compared to traditional media. As a result, demand for Internet advertising is uncertain. Many advertisers have little or no experience using the Internet for advertising purposes. The adoption of Internet advertising, particularly by companies that have historically relied upon traditional media for advertising, requires the acceptance of a new way of conducting business, exchanging information and advertising products and services. Such customers may find advertising on the Internet to be undesirable or less effective than traditional advertising media for promoting their products and services. In particular, online advertising revenue has significantly decreased. If the Internet advertising market fails to grow, our business could be adversely affected. In addition, the market for advertising on other forms of digital media, such as broadband distribution, is even less developed than Internet advertising, and if that market does not develop, our growth may be limited.
We Depend Upon Artists To Generate Electronic Commerce Revenue And Traffic To Our Web Sites
We believe that the future success of our online e-commerce business depends in part on our ability to maintain our existing artist relationships and to establish additional relationships with artists. During 2001, we modified the agreements with many of our artists to simplify the relationship between the artists and us. Our business would be adversely affected by any of the following:
•
our inability to establish relationships with new artists and offer their music and merchandise for sale to our customers;
•
the loss of popularity of artists for whom we sell music and merchandise;
•
increased competition to maintain existing relationships with artists; and
•
non-renewals or non-conversions of certain of our current agreements with artists.
If we are not able to provide valuable services or incentives to artists, or if we otherwise fail to maintain good relations with our artists, they may lose interest in providing content and merchandise and otherwise promoting the ARTISTdirect Network. The artists own the domain names for their Web sites and some of the intellectual property rights with respect to content developed for the Web sites. As a result, we may lose the rights to operate artists’ official online stores if our agreements with these artists terminate and are not renewed or converted. Most of our current artist contracts have a term of three years, and most of these agreements expire in 2002. Upon expiration, artists may decide not to renew these contracts on reasonable terms, if at all. We plan to negotiate new agreements with some of our existing artists and terminate existing agreements with some of our other artists. Our inability to negotiate new agreements or to terminate existing agreements may have an adverse impact on our business. In the past, we have offered our artists options to purchase our common stock. Options were intended to provide artists with an additional incentive to actively promote their Web sites and the ARTISTdirect Network. We do not currently intend to offer artists options or other equity incentives in the future and this may impair our efforts to sign new artists. If we cannot maintain our current relationships with artists or sign agreements with new artists, our user base would likely diminish and our ability to generate revenues from electronic commerce would be seriously harmed.
We May Not Be Able To Develop Or Obtain Sufficiently Compelling Content To Attract And Retain Our Target Audience
For our business to be successful, we must provide content and services that attract consumers who will purchase music and related merchandise online. We may not be able to provide consumers with an acceptable mix of products, services, information and community to attract them to our Web sites or to encourage them to remain on our Web sites for an extended period of time. If our audience determines that our content does not reflect its tastes, then our audience size could decrease or the demographic characteristics of our audience could change and we may be unable to react to those changes effectively or in a timely manner. Any of these results would adversely affect our ability to attract advertisers and sell music and other related merchandise. Our ability to provide compelling content could be impaired by any of the following:
•
reduced access to content controlled by record labels, music publishers and artists;
•
diminished technical expertise and creativity of our production staff; and
•
inability to anticipate and capitalize on trends in music.
If We Do Not Build And Maintain Strong Brands, We May Not Be Able To Attract A Significant Number Of Users To Our Web Sites
To attract users we must develop a brand identity for ARTISTdirect and increase public awareness of the ARTISTdirect Network; however to conserve cash, we have significantly decreased the amounts we have spent and plan to spend on our offline and online advertising and promotional efforts to increase brand awareness, traffic and revenue. Accordingly, our marketing activities may not result in increased revenue and, even if they do, any increased revenue may not offset the expenses we incur in building our brands. Moreover, despite these efforts we may be unable to increase public awareness of our brands, which would have an adverse effect on our results of operations.
Our Online Store Agreements With Artists Do Not Preclude Our Artists From Selling Music And Related Merchandise On Other Web Sites
Our online store agreements with artists do not preclude them from selling merchandise and compact discs or offering music downloads on other Web sites. If we are unable to attract sufficient traffic to the ARTISTdirect Network, consumers may purchase the products that we offer on other Web sites. If we are unable to generate revenue from the sale of music and related merchandise, our results of operations will be adversely affected.
Our Market Is Highly Competitive And We May Not Be Able To Compete Successfully Against Our Current And Future Competitors
The market for the online promotion and distribution of music and related merchandise is highly competitive and rapidly changing. There are a significant number of Web sites promoting and distributing music and related merchandise that compete for the attention and spending of consumers, advertisers and users. We face competitive pressures from numerous actual and potential competitors. Our competitors include America Online, MSN, Yahoo!, Listen.com, Amazon.com, CDnow, MTV, other web sites and traditional music companies.
Competition is likely to increase significantly as new companies enter the market and current competitors expand their services. Some of our competitors have announced agreements to work together to offer music over the Internet, and we may face increased competitive pressures as a result. Many of our current and potential competitors in the Internet and music entertainment businesses may have substantial competitive advantages relative to us, including:
These competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements and devote greater resources to develop, promote and sell their products or services than we can. Consumers, artists, talent management companies and other music-related vendors or advertisers may perceive Web sites maintained by our existing and potential competitors as being superior to ours. In addition, increased competition could result in reduced advertising rates and margins and loss of market share, any of which could harm our business.
We Depend On A Limited Number Of Suppliers For Music Merchandise, Fulfillment And Distribution and If We Cannot Secure Alternate Suppliers, Our Business May Be Harmed
We rely to a large extent on timely distribution by third parties. During 2002, we relied on two vendors, Alliance Entertainment, and Benn Co. (formerly Old Glory Boutique Distributing, Inc.) to fulfill and distribute our orders for music and related merchandise. During the year ended December 31, 2002, approximately 85% and 15%, respectively, of our total customer orders were fulfilled by Alliance and Benn Co., respectively. We purchase a significant portion of our artist-licensed merchandise from Benn Co. and most all of our compact discs from Alliance Our contracts with Alliance and Benn Co. expire in August 2003 and April 2003, respectively. Our business could be significantly disrupted if Alliance or Benn Co. were to terminate, fail to renew or breach their agreements or suffer adverse developments that affect their ability to supply products to us. If, for any reason, Alliance, Benn Co. or other vendors are unable or unwilling to supply products to us in sufficient quantities and in a timely manner, we may not be able to secure alternative suppliers, on acceptable terms, in a timely manner or at all.
We Depend On Third Party Inventory And Financial Systems And Carrier Services
Because we rely on third parties to fulfill orders, we depend on their systems for tracking inventory and financial data. If our distributors’ systems fail or are unable to scale or adapt to changing needs, or if we cannot integrate our information systems with the systems of any new distributors, we may not have adequate, accurate or timely inventory or financial information. We also rely on third-party carriers for shipments to and from distribution facilities. We are therefore subject to the risks, including employee strikes and inclement weather, associated with our carriers’ ability to provide delivery services to meet our distribution and shipping needs. In the past, both Alliance and we have occasionally experienced an unusually high volume of orders, which resulted in shipping delays to our customers. These delays did not have a material adverse effect, however, our failure to deliver products to our customers in a timely and accurate manner in the future could harm our reputation, our relationship with customers, the ARTISTdirect brand and our results of operations.
Our Business Is Subject To Seasonality, Which Could Adversely Affect Our Operating Results
We have experienced and expect to continue to experience seasonal fluctuations in our online sales. These seasonal patterns will cause quarterly fluctuations in our operating results. In particular, a disproportionate amount of our online sales have been realized during the fourth calendar quarter and during the summer months, traditionally when artists go on tour. Due to our limited operating history, it is difficult to predict the seasonal pattern of our online sales and the impact of such seasonality on our business and operating results. Our seasonal online sales patterns may become more pronounced, strain our personnel, warehousing, and order shipment activities and cause our operating results to be significantly less than expected for any given period. This would likely cause our stock price to fall.
Our Record Label Businesses Are Subject To Unpredictable Fluctuations, Which Could Adversely Affect Our Operating Results
We expect that the ARTISTdirect Records and iMusic record labels will experience significant fluctuations in revenue and income based, in part, on the release schedule for artists signed to the label and the subsequent sales of the released compact discs. It is inherently difficult to predict the sales for any particular compact disc and, therefore, operating results for any given period may be significantly higher or lower than another given period. To the extent that the record labels’ results are significantly lower than expected for any given period, this could adversely affect our overall operating results and would likely cause our stock price to fall.
We May Be Subject To System Disruptions, Which Could Reduce Our Revenue
Our ability to attract and retain artists, users, advertisers and merchants for our online network depends on the performance, reliability and availability of our Web sites and network infrastructure. Our own staff performs the maintenance and operation of substantially all of our Internet communications hardware and servers. We have periodic maintenance windows, and we experience outages from time to time caused by temporary problems in our own systems or software. While we have implemented procedures to improve the reliability of our systems, these interruptions may continue to occur from time to time. Our users also depend on third party Internet service providers and Web site operators for access to our Web sites. These entities have experienced significant outages in the past, and could experience outages, delays and other difficulties due to system failures in the future which are unrelated to our systems, but which could nonetheless adversely affect our business.
Computer Viruses, Electronic Break-Ins Or Similar Disruptive Events Could Disrupt Our Online Services
Computer viruses, electronic break-ins or similar disruptive events could disrupt our online services. System disruptions could result in the unavailability or slower response times of our Web sites, which would reduce the number of advertisements delivered or commerce conducted on our Web sites and lower the quality of our users’ experience. Service disruptions could adversely affect our revenue and, if they were prolonged, would seriously harm our business and reputation. Our business interruption insurance may not be sufficient to compensate us for losses that may occur as a result of these interruptions.
If We Do Not Successfully Manage Our Operations, We May Not Be Able To Operate Our Business Effectively
Since our inception in August 1996, we have rapidly and significantly expanded and changed our operations. We expect further significant changes, particularly as a result of the ARTISTdirect Records and iMusic record labels and other potential opportunities. This process has strained, and we expect that it will continue to strain, our management, operations, systems and financial resources. In 2001 and 2002, we reduced our headcount to conserve cash and expect to further reduce headcount in the future. At the same time, we have expanded staff associated with ARTISTdirect Records. Accordingly, to manage our operations and personnel, we must improve and effectively utilize our existing operational, management, marketing and financial systems and maintain close coordination among our technical, finance, marketing, sales and production staffs. In addition, we may also need to increase the capacity of our software, hardware and telecommunications systems on short notice. We also will need to manage an increasing number of complex relationships with users, strategic partners, advertisers and other third parties, especially in light of certain functions being outsourced. Our failure to manage growth could disrupt our operations and ultimately prevent us from generating the revenue we expect.
The Loss Of Key Personnel, Including Ted Field, Marc Geiger, Or Keith Yokomoto, Could Adversely Affect Our Business Because These Individuals Are Important To Our Continued Growth
Our future success depends to a significant extent on the continued services of our senior management, particularly Ted Field, Marc Geiger, and Keith Yokomoto. The loss of any of these individuals would likely have an adverse effect on our business. Competition for personnel throughout our industry is intense and we may be unable to retain these key employees or attract, integrate or retain other highly qualified employees in the future. We have in the past experienced, and we expect to continue to experience, difficulty in hiring and retaining highly skilled employees with appropriate qualifications. If we do not succeed in attracting new personnel or retaining and motivating our current personnel, our business could be adversely affected. Recently enacted and proposed changes in corporate governance and securities laws and regulations, such as the Sarbanes-Oxley Act of 2002, could make it more difficult for us to attract and retain qualified executive officers or qualified members of our Board of Directors, particularly to serve on our audit committee.
If We Are Unable To Protect Our Intellectual Property Rights, Our Competitive Position Could Be Harmed Or We Could Be Required To Incur Expenses To Enforce Our Rights
We rely upon registered trademark rights in the United States for our commercial use of the ARTISTdirect, UBL, Ultimate Band List, and iMusic brand names and their respective associated domain names, and the ARTISTdirect logo. We seek to protect our trademarks, copyrights and other proprietary rights by registration and other means, but these actions may be inadequate. We have trademark applications pending in several jurisdictions, but our registrations may not be accepted or may be preempted by third parties and/or we may not be able to register our trademarks in all jurisdictions in which we intend to do business. We generally enter into confidentiality or license agreements with our employees, consultants and corporate partners, and generally control access to and distribution of our proprietary information. The steps we have taken may not prevent misappropriation of our proprietary rights, particularly in foreign countries where laws or law enforcement practices may not protect our proprietary rights as fully as in the United States. If third parties were to use or otherwise misappropriate our copyrighted materials, trademarks or other proprietary rights without our consent or approval, our competitive position could be harmed, or we could become involved in litigation to enforce our rights. In addition, policing unauthorized use of our content, trademarks and other proprietary rights could be very expensive, difficult or impossible, particularly given the global nature of the Internet.
Our Access To Copyrighted Content Depends Upon The Willingness Of Content Owners To Make Their Content Available
The music content available on the ARTISTdirect Network is typically comprised of copyrighted works owned or controlled by multiple third parties. Most of the content on our artist-specific Web sites is either owned or licensed by the artist. On other parts of the ARTISTdirect Network, depending on the nature of the content and how we use the music content, we typically license such rights from publishers, record labels, performing rights societies or artists. We frequently either do not have written contracts or have short-term contracts with copyright owners, and, accordingly, our access to copyrighted content depends upon the willingness of such parties to continue to make their content available. If the fees for music content increase substantially or if significant music content becomes unavailable, our ability to offer music content could be materially limited. We have not obtained a license
for some of the content offered on the ARTISTdirect Network, including links to other music-related sites and thirty-second streamed song samples, because we believe that a license is not required under existing law. However, this area of law remains uncertain and may not be resolved for a number of years. When this area of law is resolved, we may be required to obtain licenses for such content, alter or remove the content from our Web sites and be forced to pay potentially significant financial damages for past conduct.
Intellectual Property Claims Against Us Could Be Costly And Could Result In The Loss Of Significant Rights
Third parties may assert trademark, copyright, patent and other types of infringement or unfair competition claims against us. If we are forced to defend against any such claims, whether they are with or without merit or are determined in our favor, we may face costly litigation, loss of access to, and use of, content, diversion of technical and management personnel, or product shipment delays. As a result of such a dispute, we may have to develop non-infringing technology or enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may be unavailable on terms acceptable to us, or at all. While we have resolved all such disputes in the past, we may not be able to do so in the future. If there is a successful claim of infringement against us and we are unable to develop non-infringing technology or license the infringed or similar technology or content on a timely basis, it could harm our business. In addition, we rely on third parties to provide services enabling our online product sales transactions, including credit card processing, order fulfillment, shipping and customer service. We could become subject to infringement actions by third parties based upon our use of intellectual property provided by our third-party providers. It is also possible that we could become subject to infringement actions based upon the content licensed from third parties. Any such claims or disputes could subject us to costly litigation and the diversion of our financial resources and technical and management personnel. Further, if our efforts to enforce our intellectual property rights are unsuccessful or if claims by third parties against ARTISTdirect, the UBL and iMusic are successful, we may be required to change our trademarks, alter or remove content, pay financial damages, or alter our business practices. These changes of trademarks, alteration of content, payment of financial damages or alteration of practices may adversely affect our business.
We May Be Unable To Acquire Necessary Web Domain Names
We may be unable to acquire or maintain Web domain names relating to our brand or to artist-specific Web sites in the United States and other countries in which we may conduct business. We currently hold various relevant domain names, including the “artistdirect.com,” “ubl.com,” and “imusic.com” domain names. The acquisition and maintenance of domain names generally is regulated by governmental agencies and their designees and is subject to change. The relationship between regulations governing domain names and laws protecting trademarks and similar proprietary rights is unclear. Therefore, we could be unable to prevent third parties from acquiring or using domain names that infringe or otherwise decrease the value of our brand name, trademarks and other proprietary rights.
If Our Online Security Measures Fail, We Could Lose Visitors To Our Sites And Could Be Subject To Claims For Damage From Our Users, Content Providers, Advertisers And Merchants
Our relationships with consumers would be adversely affected and we may be subject to claims for damage if the security measures that we use to protect their personal information, especially credit card numbers, are ineffective. We rely on security and authentication technology that we license from third parties to perform real-time credit card authorization and verification with our bank. We cannot predict whether events or developments will result in a compromise or breach of the technology we use to protect a customer’s personal information. Our infrastructure may be vulnerable to unauthorized access, physical or electronic computer break-ins, computer viruses and other disruptive problems. Internet service providers have experienced, and may continue to experience, interruptions in service as a result of the accidental or intentional actions of Internet users, current and former employees and others. Anyone who is able to circumvent our security measures could misappropriate proprietary information or cause interruptions in our operations. Security breaches relating to our activities or the activities of third-party contractors that involve the storage and transmission of proprietary information could damage our reputation and our relationships with our content providers, advertisers and merchants. We also could be liable to our content providers, advertisers and merchants for the damages caused by such breaches or we could incur substantial costs as a result of defending claims for those damages. We may need to expend significant capital and other resources to protect against such security breaches or to address problems caused by such breaches. Our security measures may not prevent disruptions or security breaches.
We May Be Subject To Liability If Private Information Provided By Our Users Were Misused
Our privacy policy discloses how we use individually identifiable information that we collect. This policy is displayed and accessible throughout the ARTISTdirect Network. Despite this policy, however, if third persons were able to penetrate our network security or otherwise misappropriate our users’ personal information or credit card information, we could be subject to liability. We could also be subject to liability for claims for unauthorized purchases with credit card information, impersonation or other similar fraud claims, or other misuses of personal information, such as for unauthorized marketing purposes. These claims could result in costly and time-consuming litigation.
Laws Or Regulations May Adversely Affect Our Ability To Collect Demographic And Personal Information From Users, Or To Display Certain Content On Our Sites, And Could Affect Our Ability To Attract Advertisers
Legislatures and government agencies have adopted and are considering adopting additional laws and regulations regarding the collection, use and disclosure of personal information obtained from individuals when accessing Web sites. For example, the Children’s Online Privacy Protection Act restricts the ability of Internet companies to collect information from children under the age of 13 without their parents’ consent. In addition, the Federal Trade Commission and state and local authorities have been investigating Internet companies regarding their use of personal information. Our privacy programs may not conform with laws or regulations that are adopted. In addition, these legislative and regulatory initiatives may adversely affect our ability to collect demographic and personal information from users, which could have an adverse effect on our ability to provide advertisers with demographic information. These initiatives may also affect our ability to conduct electronic commerce.
The European Union has adopted a directive that imposes restrictions on the collection and use of personal data. The directive imposes restrictions that are more stringent than current Internet privacy standards in the United States. If this directive were enforced against us, it could prevent us from collecting data from users in European Union member countries or subject us to liability for use of information in contravention of the directive. Other countries have adopted or may adopt similar legislation. We could incur additional expenses if new regulations regarding the use of personal information are introduced or if government authorities choose to investigate our privacy practices.
In addition, legislatures and government agencies have adopted and are considering adopting additional laws and regulations governing the content of material transmitted over the Internet. These include laws relating to obscenity, indecency, libel and defamation. For example, the Child Online Protection Act, or COPA, prohibits and imposes criminal penalties and civil liability on anyone communicating material harmful to minors through the Internet for commercial purposes, unless access to such material is blocked to minors under age 17. The U.S. Supreme Court has maintained a preliminary injunction precluding enforcement of COPA, pending the decision on questions of COPA’s constitutionality that the U.S. Supreme Court remanded to the Third U.S. Circuit Court of Appeals. We could be liable if the injunction against COPA is lifted and if content delivered by us or placed on our Web sites violates COPA. Such a result may adversely affect our ability to attract users under age 17 and, consequently, may adversely affect our ability to attract advertisers.
We May Continue To Have Contingent Liability Due To Our Issuances Of Certain Unregistered Securities
Prior to our initial public offering, we issued a number of shares and options to purchase shares of our common stock to our employees and to artists and their managers and advisors. Due to the nature of the persons who received these shares and options in addition to our employees and the total number of shares and options issued to them and our employees, the issuance of some of these shares and options did not comply with the requirements of Rule 701 under the Securities Act of 1933, as amended, or any other available exemptions from the registration requirements of Section 5 of the Securities Act, and may not have qualified for any exemption from qualification or registration under applicable state securities laws either.
As a result, in November 2001,we made a rescission offer to all these persons pursuant to a registration statement filed under the Securities Act and pursuant to applicable state securities law. In the rescission offer, we offered to repurchase from these persons all shares purchased by them pursuant to option exercises before the expiration of the
rescission offer for an amount equal to the purchase or exercise price paid for these purchased shares, plus interest from the date of purchase until the expiration of the rescission offer, at the current statutory rate per year mandated by the state in which the shares were purchased, or at 7% per year if a “private placement” exemption was available in a particular state or if the shares were otherwise issued in compliance with state law (less any amounts received by those persons who had already sold their shares). We also offered to repurchase all unexercised options granted to these persons at 20% of the option exercise price times the number of option shares, plus interest from the date the options were granted until the rescission offer expires, at the current statutory rate per year mandated by the state in which the options were granted, or at 7% per year if a “private placement” exemption was available in a particular state or if the options were otherwise granted in compliance with state law. The rescission offer was completed in December 2001. 83,403 shares and 636,740 options were tendered in the rescission offer and the cost to us of repurchasing such shares and options was approximately $10.2 million.
The Securities Act does not expressly provide that a rescission offer will terminate a purchaser’s right to rescind a sale of stock that was not registered under the Securities Act as required. Accordingly, we may continue to be contingently liable under the Securities Act to any offerees that rejected the rescission offer. In addition, it is possible that offerees may claim that the consideration offered to them in the rescission offer was insufficient, in which case we may have additional liability.
Our Common Stock Price Has Been Volatile, Which Could Result In Substantial Losses For Individual Stockholders
The market prices of Internet-related stocks, including our common stock, have been volatile and we expect that they will continue to be volatile. In particular, our common stock may be subject to significant fluctuations in response to a variety of factors, including but not limited to:
•
general economic conditions;
•
actual or anticipated variations in quarterly operating results;
•
changes in financial estimates by securities analysts;
•
failure to meet analyst predictions and projections;
•
changes in market valuations of media and online e-commerce companies;
•
new products or services offered by us or our competitors;
•
announcements of significant acquisitions, strategic partnerships, joint ventures or capital commitments by us or our competitors;
•
additions or departures of key personnel;
•
our sales of common stock or other securities in the future; and
•
other events or factors, many of which are beyond our control.
In addition, the average trading volume of our common stock has been extremely low in the past. As a result, our stock price may be susceptible to significant volatility on a day-to-day basis, depending on the number of shares traded on any given day. Due to these factors, you may not be able to sell your stock at or above the price you paid for it, which could result in substantial losses.
We May Be Sued For Content Available Or Posted On Our Website Or Products Through Our Web Sites Or For Linking And Framing Of Third-Party Web Sites
We may be liable to third parties for content published on our Web sites and other Web sites where our syndicated content appears if the music, artwork, text or other content available violates their copyright, trademark or other intellectual property rights or if the available content is defamatory, obscene or pornographic. Similar claims have been brought, sometimes successfully, against Web site operators in the past. We also may be liable for content uploaded or posted by our users on our Web sites, such as digitally distributed music files, postings on our message boards, chat room discussions and copyrightable works. In addition, we could have liability to some of our
content licensors for claims made against them for content available on our Web sites. We also could be exposed to these types of claims for content that may be accessed from our Web sites or via links to other Web sites or for products sold through our Web site. While we have resolved all of these types of claims made against us in the past, we may not be able to do so in the future. We intend to implement measures to reduce exposure to these types of claims, but such measures may not be successful and may require us to expend significant resources. Any litigation as a result of defending these types of claims could result in substantial costs and damages. Our insurance may not adequately protect us against these types of claims or the costs of their defense or payment of damages. We link to and “frame” third-party Web sites of our artists without express written permission to do so. In addition, in the past we have provided a search feature to allow users to find music residing elsewhere on the Internet. Those practices are controversial, and have, in instances not involving us, resulted in litigation. Various claims, including trademark and copyright infringement, unfair competition, and commercial misappropriation, as well as infringement of the right of publicity may be asserted against us as a result. The law regarding linking and framing remains unsettled; it is uncertain as to how existing laws, especially trademark and copyright law, will be applied by the judiciary to the Internet. Also, Congress is increasingly active in passing new laws related to the Internet, and there is uncertainty as to the impact of future potential laws, especially those involving domain names, databases and privacy.
Software Programs That Prevent Or Limit The Delivery Of Advertising May Seriously Damage Our Ability To Attract And Retain Advertisers
A number of “filter” software programs have been developed which limit or prevent advertising from being delivered to an Internet user’s computer. This software could adversely affect the commercial viability of Internet advertising. These programs attempt to blank out, or block, banner and other advertisements. To date, such programs have not had a material adverse impact on our ability to attract and retain advertisers or caused us to fail to meet the terms of our advertising agreements. These programs may, however, have these effects on us in the future. Widespread adoption of this type of software would seriously damage our ability to attract and retain advertisers.
We May Need To Change The Manner In Which We Conduct Our Business If Government Regulation Increases
There are currently few laws or regulations that specifically regulate communications or commerce on the Internet. Laws and regulations may be adopted in the future, however, that address issues such as user privacy, pricing, taxation, content, copyrights, distribution, security, and the quality of products and services. Several telecommunications companies have petitioned the Federal Communications Commission to regulate Internet service providers and online services providers in a manner similar to long distance telephone carriers and to impose access fees on these companies. Any imposition of access fees could increase the cost of transmitting data over the Internet. In addition, the growth and development of the market for online commerce may lead to more stringent consumer protection laws, both in the United States and abroad, that may impose additional burdens on us. The United States Congress has enacted Internet laws regarding children’s privacy, copyrights, taxation and the transmission of sexually explicit material. The law of the Internet, however, remains largely unsettled, even in areas where there has been some legislative action. Moreover, it may take years to determine the extent to which existing laws relating to issues such as property ownership, libel and personal privacy are applicable to the Web. Any new, or modifications to existing, laws or regulations relating to the Web could adversely affect our business. Prohibition and restriction of Internet content and commerce could reduce or slow Internet use, decrease the acceptance of the Internet as a communications and commercial medium and expose us to liability. Any of these outcomes could have a material adverse effect on our business, results of operations and financial condition. The growth and development of the market for Internet commerce may prompt calls for more stringent consumer protection laws, both in the United States and abroad, that may impose additional burdens on companies conducting business over the Internet.
The Internet Is Subject To Rapid Changes, Which Could Result In Significant Additional Costs
The market for Internet products and services is characterized by rapid change, evolving industry standards and frequent introductions of new technological developments. These new standards and developments could make our existing or future products or services obsolete. Keeping pace with the introduction of new standards and technological developments could result in significant additional costs or prove difficult or impossible for us. The failure to keep pace with these changes and to continue to enhance and improve the responsiveness, functionality and features of our Web sites could harm our ability to attract and retain users. Among other things, we will need to
license or develop leading technologies, enhance our existing services and develop new services and technologies that address the varied needs of our users.
Our Net Sales Could Be Adversely Affected If We Become Subject To Sales And Other Taxes
If one or more states or any foreign country successfully asserts that we should collect sales or other taxes on our sale of products over the Internet, our net sales and results of operations could be harmed. We do not currently collect sales or other similar taxes for physical shipments of goods into states other than California and Florida. However, one or more states may seek to impose sales tax collection obligations on companies, such as ARTISTdirect, which engage in or facilitate online commerce. A number of proposals have been made at the state and local level that would impose additional taxes on the sale of goods and services through the Internet. Such proposals, if adopted, could substantially impair the growth of electronic commerce and could adversely affect our opportunity to derive financial benefit from electronic commerce. Moreover, if any state or foreign country were to successfully assert that we should collect sales or other taxes on the exchange of merchandise on its system, our results of operations could be adversely affected. In addition, any operations in states outside California and Florida could subject our shipments in such states to state sales taxes under current or future laws. Congress has enacted legislation limiting the ability of the states to impose taxes on Internet-based transactions. This legislation, known as the Internet Tax Freedom Act, imposes a moratorium ending on November 1, 2003 on state and local taxes on electronic commerce where such taxes are discriminatory and on Internet access unless such taxes were generally imposed and actually enforced before October 1, 1998. Failure to renew this legislation in the future would allow various states to impose taxes on Internet-based commerce.
Our Success Depends On The Continued Development And Maintenance Of The Internet And The Availability Of Increased Bandwidth To Consumers
The success of our business will rely on the continued improvement of the Internet as a convenient means of consumer interaction and commerce, as well as an efficient medium for the delivery and distribution of music. Our business will depend on the ability of our artists and consumers to conduct commercial transactions with us, as well as to continue to upload and download music files, without significant delays or aggravation that may be associated with decreased availability of Internet bandwidth and access to our Web site. This will depend upon the maintenance of a reliable network with the necessary speed, data capacity and security, as well as timely development of complementary products, such as high-speed modems, for providing reliable Internet access and services. The failure of the Internet to achieve these goals will reduce our ability to generate significant revenue.
Our penetration of a broader consumer market will likely depend, in part, on continued proliferation of high speed Internet access. The Internet has experienced, and is likely to continue to experience, significant growth in the numbers of users and amount of traffic. As the Internet continues to experience increased numbers of users, increased frequency of use and increased bandwidth requirements, the Internet infrastructure may be unable to support the demands placed on it. In addition, increased users or bandwidth requirements may harm the performance of the Internet. The Internet has experienced a variety of outages and other delays and it could face outages and delays in the future. These outages and delays could reduce the level of Internet usage as well as the level of traffic, and could result in the Internet becoming an inconvenient or uneconomical source of music and related products and merchandise which would cause our revenue to decrease. The infrastructure and complementary products or services necessary to make the Internet a viable commercial marketplace for the long term may not be developed successfully or in a timely manner. Even if these products or services are developed, the Internet may not become a viable commercial marketplace for the products or services that we offer.
ITEM 2.
ITEM 2. PROPERTIES
Our principal corporate offices are located in Los Angeles, California where we lease approximately 64,000 square feet under a lease that expires in 2010. We have sub-leased approximately 30,000 square feet of our space to a third party under a sub-lease agreement that is subject to a termination option anytime after April 30, 2004. We expect that our current space will accommodate our needs for the foreseeable future
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
From time to time, we may be involved in litigation relating to claims arising out of our ordinary course of business. We are not presently involved in any material legal proceedings.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
ARTISTdirect’s common stock is listed for quotation on the Nasdaq National Market under the symbol “ARTD.” The following table sets forth, for the two most recent fiscal years, the high and low closing sale prices for our common stock as reported by Nasdaq:
On March 17, 2003, the closing sale price for our common stock as reported by Nasdaq was $2.01 per share.
HOLDERS
As of March 17, 2003, there were 269 holders of record of our common stock.
DIVIDENDS
We have never paid any cash dividends on our common stock and we have no current plans to do so.
SALES OF UNREGISTERED SECURITIES
None.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data with respect to ARTISTdirect’s consolidated statements of operations for the years ended and consolidated balance sheets as of December 31, 1998, 1999, 2000, 2001 and 2002, are derived from the audited Consolidated Financial Statements of the company. The following information should be read in conjunction with the Consolidated Financial Statements of the company and the related notes thereto and
“Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Annual Report on Form 10-K.
TABLE OF SELECTED FINANCIAL DATA
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
The following discussion should be read in conjunction with our consolidated financial statements and the notes to those financial statements included elsewhere in this Annual Report. The following discussion contains forward-looking statements based on our current expectations, estimates and projections about our industry, management’s beliefs and certain assumptions made by us. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “may,” “will” or similar expressions are intended to identify forward-looking statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Such statements include, but are not limited to, statements concerning our unproven business model, increased competition in its industry, our ability to generate revenues from our record label, online product sales, advertising and other revenue streams, ability to increase visits to our site, ability to attract and retain artists, ability to adequately fund our operations and financial commitments, ability to offer compelling content, ability to fulfill on-line music and merchandise orders in a timely manner, ability to build brand recognition, ability to integrate acquisitions of technology and other businesses, ability to protect and/or obtain intellectual property rights, and ability to manage growth. Such statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. Factors that could cause or contribute to the differences are discussed in “Risk Factors” and elsewhere in this Annual Report on Form 10-K. You should carefully consider those risks, in addition to the other information in this Annual Report and in our other filings with the SEC, before deciding whether or not to increase or maintain your investment in ARTISTdirect. We undertake no obligation to revise or update publicly any forward-looking statements for any reason. The information contained in this Annual Report is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this Annual Report and in our other filings with the SEC that discuss our business in greater detail.
OVERVIEW
We are a music entertainment company that combines an online music network and two record labels to provide an integrated offering for music fans, artists and marketing partners. The ARTISTdirect Network (www.artistdirect.com) is a network of Web sites offering multi-media content, music news and information,
community around shared music interests, music- related commerce and digital music services. We previously operated a record label, Kneeling Elephant Records, which ceased operations in June 2000. In May 2001, we entered into an agreement with veteran entertainment executive Ted Field to become our Chairman and Chief Executive Officer and form a new record label in partnership with us. On June 29, 2001, our stockholders approved the employment of Mr. Field and the formation of the record label, ARTISTdirect Records, LLC, as a 50/50 co-venture between ARTISTdirect and Mr. Field where we agreed to provide a significant financial commitment. Through our co-venture record label, we develop new musical artists and produce and distribute their recordings as an independent label utilizing traditional distribution channels. In addition to the formation of the record label and our financial commitment, we entered into a five-year employment agreement with Mr. Field and he joined our Board of Directors. Mr. Field also serves as the Chief Executive Officer of the record label.
In November 2001, ARTISTdirect Records agreed in principle to enter into a preliminary North America distribution agreement and worldwide license agreement with BMG, the global music division of Bertelsmann AG. Under the terms of the agreement, BMG Distribution distributes the label’s releases in North America, and BMG licenses ARTISTdirect Records repertoire in territories throughout the world. In April 2002, the agreements with BMG were finalized, including BMG’s purchase of 5% of the equity of ARTISTdirect Records from the Company. As part of this transaction, BMG agreed to assume $5.0 million of the Company’s funding commitment to ARTISTdirect Records. The Company recorded 100% of the losses attributable to ARTISTdirect Records from inception to April 30, 2002. From May 1, 2002, the Company has recorded only its proportionate share, on the basis of relative funding commitments, of any future losses of ARTISTdirect Records.
During 2002, the Company advanced to ARTISTdirect Records $25.0 million under its funding commitment and has advanced a total of $30.25 million as of December 31, 2002. As part of an agreement to accelerate additional funding of $10 million in 2002, the Company’s ownership interest in ARTISTdirect Records increased from 45% to 65% and the ownership interest of Ted Field decreased from 50% to 30%.
In 2002, our wholly owned subsidiary ARTISTdirect Digital, Inc. began operating a record label under the brand name iMusic. iMusic focuses on the signing of established artists with a proven sales base and an ability to generally make records less expensively than developing artists. We utilize both traditional channels of distribution and emerging Internet distribution channels and generally spend substantially less on marketing and promotion of these releases than on those of new artists.
Based upon our available cash resources and our anticipated requirements for working capital to continue our online operations, pursue our plan for the iMusic record label and meet our funding commitment to ARTISTdirect Records, we face substantial doubt about our ability to continue as a going concern. In order to address this concern, we intend to implement substantial cost reductions and have also been pursuing alternatives to raise additional capital both at ARTISTdirect and ARTISTdirect Records in order to continue the operations of both entities. See Liquidity and Capital Resources section for more detail.
In December 2001, we decided to exit the talent agency business because we believed that our prospects for increasing the value of this business were limited and that there were potential conflicts of interests with our new co-venture record label. As a result, we have recorded the net results of this business segment as a discontinued operation in the consolidated statement of operations for all years presented. We completed the wind down of the agency business during 2002.
The Company has significantly reduced its operating costs over the past two years including a reduction in staffing. We expect this to help us reduce our net loss going forward and conserve our cash resources given prevailing market conditions. We have incurred cumulative net losses of $242.0 million from inception to December 31, 2002, of which approximately $74.3 million represented stock-based compensation expense. While we have significantly reduced our operating expenses, especially those related to our online operations, technology infrastructure and marketing, we expect our net losses to continue and to remain significant for the foreseeable future.
We are committed to advance to ARTISTdirect Records an additional $2.75 million in 2003 and $12.0 million through 2006. The Company’s commitment to fund ARTISTdirect Records is subject to a guaranty for the
benefit of BMG. Should the Company fail to meet its commitment, BMG may choose to enforce the guaranty or provide substitute financing that could result in dilution of the Company’s interest in ARTISTdirect Records.
We have a limited operating history on which to base an evaluation of our business and prospects. Our prospects must be considered in light of the risks, expenses, and difficulties encountered by companies in their early stage of development, particularly companies in new and rapidly evolving markets. See “Risk Factors” for a more complete description of the many risks we face. Our business is evolving rapidly, and therefore we believe that period-to-period comparisons of our operating results may not be meaningful and may not be accurate indicators of future performance.
We have identified the following as critical accounting policies: revenue recognition, impairment of long-lived assets and equity grants to employees and non-employees. See discussion of these critical accounting policies beginning on page 41.
RESCISSION OFFER
In December 2001, we completed a rescission offer in which we rescinded the purchase of 83,403 shares of our common stock purchased upon the exercise of options and the issuance of vested and unvested unexercised options to purchase 636,740 shares of our common stock. The shares of stock were repurchased at prices ranging from $12.40 to $40.00 per share and the unexercised options that were rescinded had exercise prices ranging from $12.40 to $140.00 per share. In aggregate, we paid $10.2 million, which we funded from our available cash balances. As a result of the rescission offer, the number of our fully diluted shares was reduced to 3,460,608.
REVENUE
We currently generate revenues from three sources: E-Commerce, Media and iMusic record label. Prior to our decision to exit the Agency business in December 2001, we also generated revenues from the music talent agency business that wound up operations in 2002. Therefore, the results of the Agency business have been shown in our financial statements as a discontinued operation. Prior to June 30, 2000, we generated revenue from our Kneeling Elephant Record Label. This revenue is shown in our financial statements under the iMusic record label line in 2002. Substantially all of our revenue is generated in cash. For the years ended December 31, 2002 and 2001, there was no barter revenue and only approximately 1% of our revenue for the year ended December 31, 2000 was barter revenue.
E-Commerce Revenue. E-Commerce revenue includes the sale of music and related merchandise, such as apparel, collectibles and accessories, through the ARTISTdirect shopping mall of our network. We recognize the gross amount of product sales and shipping revenue upon shipment of the item and record appropriate reserves for product returns. We have experienced seasonality with respect to our online product sales. In particular, our e-commerce sales in the fourth quarter have, on average, been higher than in other quarters. We believe that this trend may continue for the foreseeable future. For the years ended December 31, 2002 and 2001, e-commerce revenue was $4.7 million and $7.5 million, respectively, which constituted approximately 75% and 72%, respectively, of our total net revenue from continuing operations for those periods.
Media Revenue. Media revenue consists primarily of sales of banner advertisements and sponsorships. In sales of banner advertisements, we principally earn revenue based on the number of impressions or times an advertisement appears on pages viewed within our Web sites. Our banner advertising commitments generally range from one to six months. Banner advertising revenue is generally recognized as the impressions are served during the period in which the advertisement is displayed, provided that no significant obligations of ARTISTdirect remain and collection of the resulting receivable is probable. We typically guarantee a minimum number of impressions to the advertiser. To the extent that minimum guaranteed page deliveries are not met, we defer recognition of the corresponding revenue until the guaranteed impressions are delivered. We also sell to advertisers sponsorship of a Web page or event for a specified period of time. We recognize sponsorship revenue over the period in which the sponsored page or event is displayed. To the extent that committed obligations under sponsorship agreements are not met, revenue recognition is deferred until the obligations are met. For the years ended December 31, 2002 and December 31, 2001, media revenue was $924,000 and $2.9 million, respectively, which constituted approximately 15% and 28%, respectively, of our total net revenue from continuing operations for those periods. Since most of our
sponsorship and advertising contracts are short-term in nature, our advertising revenue is susceptible to significant fluctuation. In particular, our net revenue from advertising revenue has significantly decreased since the third quarter of 2000. This decrease is primarily due to advertisers spending less money on banner advertising. Due to the continued weak demand for online advertising, we do not expect our advertising revenues to increase significantly in the near future. During the years ended December 31, 2002 and 2001, AT&T Wireless accounted for 12% and 20%, respectively, Miller Brewing accounted for 12% and 0%, and Universal Music Group accounted for 0% and 17%, respectively, of our total media revenue. No other advertiser accounted for more than 10% of our media revenue for these periods.
Agency Revenue. Revenue from the ARTISTdirect Agency, which we decided to dispose of in December 2001 and is shown as a discontinued operation in our financial statements, consisted primarily of commissions generated on tour and event bookings of artists represented by the agency. Agency revenue was recognized at the time the artist was paid. Agency revenue fluctuated depending on touring schedules of major artists represented by the agency. For the years ended December 31, 2002 and December 31, 2001, agency revenue was $259,000 and $1.0 million, respectively.
iMusic Record Label Revenue. iMusic record label revenue consists primarily of the sale of compact discs by artists signed to the iMusic record label. The Company recognizes revenues upon the shipment of compact discs to retailers and independent wholesalers and records appropriate reserves for product returns. iMusic is the brand name used by the Company for the record label operated by its wholly owned subsidiary ARTISTdirect Digital, Inc. Prior to June 30, 2000, the Company operated its Kneeling Elephant Records label and generated revenues from overhead advances from RCA. We discontinued our Kneeling Elephant Records operation after June 30, 2000.
ARTISTdirect Records. ARTISTdirect Records generates revenue primarily from the sale of compact discs by artists signed to the record label. Since the Company is not deemed to have voting or operating control of ARTISTdirect Records, the Company accounts for this investment under the equity method of accounting as loss from equity investments in the consolidated statements of operations.
COST OF REVENUE
Direct cost of product sales consists of the cost of merchandise sold, the amounts payable to artists for their share of net proceeds, online transaction costs, including credit card fees, warehousing and fulfillment charges and shipping costs. Direct cost of product sales also includes manufacturing costs and distribution fees payable related to the sales of the iMusic record label. Other cost of revenue consists primarily of Web site hosting and maintenance costs, online content programming costs, online advertising serving costs, record royalties payable to iMusic artists and payroll and related expenses for staff involved with the Website. Stock-based compensation included in cost of revenue represents the amortization of non-cash compensation expense related to vendor warrants and stock options granted to artists and their advisors in connection with entering into contractual commitments to operate their online commerce activities. In connection with the amortization of vendor warrants and artist stock options granted through December 31, 2002, we recorded non-cash compensation expense of approximately $3.1 million for the year ended December 31, 2002 and approximately $8.4 million for the year ended December 31, 2001. We currently do not intend to grant additional equity interests in the future related to obtaining e-commerce rights from artists. Historically, our cost of revenue has generally exceeded our net revenue primarily as a result of the non-cash stock based compensation expense and also due to other cost of revenue exceeding media revenues.
OPERATING EXPENSE
Web Site Development. Web site development expense consists primarily of expenses incurred to update the content and design of our Web sites and underlying technology infrastructure. These expenses primarily include payments to third-party service vendors and personnel costs. The implementation of Emerging Issues Task Force No. 00-02, “Accounting for Website Development Costs,” effective July 1, 2000, did not have a material impact on our consolidated financial statements.
Sales and Marketing. Sales and marketing expense consists primarily of advertising, marketing and promotion expenses incurred to promote our Web sites, plus payroll and related expenses for personnel engaged in marketing and advertising sales activities.
General and Administrative. General and administrative expense consists of payroll and related expenses for executive and administrative personnel, professional services expenses, facilities expenses, travel and other general corporate expenses.
Provision for Doubtful Accounts. Provision for doubtful accounts consists of provisions related to un-collectable receivables.
Stock-based Compensation. We recorded a total of $53.5 million of stock-based compensation expense (exclusive of amounts recorded within cost of revenue) for the period from inception through December 31, 2002 in connection with equity granted to employees, directors, professional firms, artists and artist advisors during this period. We recorded amortization of stock-based compensation expense of approximately $1.9 million during the year ended December 31, 2002 and approximately $12.4 million during the year ended December 31, 2001. We may grant additional equity securities in the future to employees, directors, and others. In December 2001, we completed a rescission offer to certain holders of stock options and shares purchased pursuant to stock options and recorded stock based compensation expense of approximately $6.9 million. The compensation expense recorded for the repurchase of unexercised stock options (vested and unvested) from employees was the sum of the intrinsic value at the original measurement date (less any expense related to the intrinsic value recorded up to the acceptance of the rescission offer) and the amount of cash paid to the holder that exceeded the lesser of the intrinsic value at the original measurement date or immediately prior to settlement (the settlement date being the closing date of the 30-day period for the rescission offer). Approximately $4.6 million was recorded as stock based compensation expense immediately upon the closing date of the rescission offer in December 2001, and an additional $900,000 was recognized in 2002. The compensation that was recorded for the repurchase of unexercised non-employee options (vested and unvested) was calculated as the difference between the amount of cash paid for the repurchase of the options and the fair value of the options on the closing date of the rescission offer. The fair value of the options was determined using the Black-Scholes option-pricing model over the remaining life of the options.
The unamortized portion of stock based compensation expense at the time of repurchase related to the initial grant of the options to the non-employees continued to be amortized over the remaining service period related to the original option grants. In 2001, $10.6 million of such expense was recognized in stock based compensation. Of this amount, $1.8 million related to services to be performed in 2002 but the compensation expense was recognized in 2001 as a result of the related service agreement being cancelled in 2001. The remaining unamortized balance at December 31, 2001 of $2.7 million was reclassified from unearned compensation to prepaid expenses (as the equity instruments were no longer outstanding) in the balance sheet and were recorded as expense in 2002, which was the remaining service period related to the original option grants. The key assumptions used in the Black Scholes option pricing model for the purpose of the calculation were: a risk free rate of 6%; a volatility factor of 95% in December 2001; no expected dividends; and an expected life which is equal to the remaining contractual life of the options as of December 2001.
The compensation charge for the repurchase of shares issued pursuant to the exercise of options (by employees and non-employees) was calculated as the difference between the amount of cash paid for the repurchase of the shares (which includes the exercise proceeds and accrued interest) and the fair value of the shares on the date the repurchase was accepted. The compensation charge related to shares repurchased from employees was $195,000 and was recorded as stock based compensation in 2001. The compensation related to the non-employee shares repurchased was $2.1 million in 2001 of which $1.1 million was recorded in 2001, and $1.0 million was recorded in 2002.
We did not record any compensation expense related to the shares and options of those holders who chose not to accept the rescission offer. The staff of the Securities and Exchange Commission has taken the position that a person’s federal right of rescission may survive the rescission offer. However, federal courts in the past have ruled that a person who rejects or fails to accept a rescission offer is precluded from later seeking similar relief. We believe that subsequent to the rescission offer, any rights to rescind will be contingent upon legal rulings, the outcome of which are not currently determinable. Accordingly, we will account for shares and options that were not
rescinded in the rescission offer as if there is no right of rescission. In the event any rescissions occur subsequent to the expiration of the rescission offer in December 2001, we will account for those rescissions, if any, in the manner described above at the time those rescissions are completed.
We record stock compensation for employee option grants equal to the excess of the fair value of our common stock over the exercise price on the grant date. We record the compensation over the vesting period. For options/warrants granted to non-employees, we record as stock compensation the fair value of the options/warrants (using the Black Scholes option pricing model) amortized over the related period of service.
Depreciation and Amortization. Depreciation and amortization expense consists of the depreciation of fixed assets and the amortization of acquired intangible assets. The acquisitions of iMusic, Mjuice and the minority interest of the UBL were accounted for using the purchase method of accounting and, accordingly, the purchase prices were allocated to the tangible and intangible assets acquired and liabilities assumed on the basis of their fair value on the acquisition dates. Substantially the entire purchase price of these transactions is attributable to the acquired intangible assets. As a result, the aggregate excess purchase price over the net tangible assets allocated to goodwill was $20.6 million and was being amortized over five years, the expected estimated average useful life of these assets. We recorded write-downs of $11.4 million and $788,000 of goodwill during the years ended December 31, 2001 and 2002, respectively. No goodwill remains on the balance sheet as of December 31, 2002. The non-cash charges relating to depreciation of our fixed assets will continue to affect our reported operating results in the future periods.
We evaluate impairment of long-lived assets (which consist primarily of fixed assets) and goodwill (prior to January 1, 2002) comparing the projected future cash flows at the lowest level of discrete financial information, by our operating segments, to the carrying amount of the assets. In the event that projected future cash flows do not appear to be sufficient to recover the carrying amounts of the assets, we record an impairment charge to record the assets at their fair value. The fair value represents the discounted projected future cash flows.
Effective January 1, 2002, we evaluate impairment of goodwill by comparing the fair value of the goodwill to its carrying amount. In the event the carrying amount of the goodwill exceeds its fair value, the carrying amount is adjusted to its fair value.
INTEREST INCOME AND EXPENSE
Interest income consists of earnings on our cash and cash equivalents, and interest expense consists of interest associated with capital lease agreements.
RESULTS OF OPERATIONS - ARTISTdirect, Inc.
YEARS ENDED DECEMBER 31, 2002 AND 2001
NET REVENUE
Net revenue from continuing operations for the year ended December 31, 2002 decreased to $6.3 million from $10.4 million for the year ended December 31, 2001, which represented a decrease of 40%. The decrease was due to decreases in e-commerce and media that were partially offset by increase in iMusic record label revenues.
E-commerce revenue for the year ended December 31, 2002 decreased to $4.7 million from $7.5 million for the year ended December 31, 2001, a decrease of 38% primarily as a result of lower traffic to the site, fewer sales orders and a continued weak sales environment for music and licensed artist merchandise.
Advertising and other revenue decreased to $924,000 for the year ended December 31, 2002 from $2.9 million for the year ended December 31, 2001, a decrease of 68% as a result of a decrease in the number of online advertisers and a reduction in the sales of non-impression based advertising and offline sponsorships. The decrease in advertising revenues is attributed to general weakness in the U.S. economy, overall softness in the advertising market and a specific decline in the demand for online advertising.
iMusic record label revenue increased to $613,000 for the year ended December 31, 2000 from $0 for the year ended December 31, 2001, an increase of 100% as a result of the launch of the iMusic record label in the third quarter of 2002.
COST OF REVENUE
Direct cost of product sales. Direct cost of product sales decreased to $4.0 million for the year ended December 31, 2002 from $6.1 million for the year ended December 31, 2001, which represented a decrease of 35%. This $2.1 million decrease corresponded with the decrease in online product sales revenue and was primarily attributable to a $2.0 million decrease in product costs and a $.6 million decrease in transaction costs partially offset by iMusic record label cost of sales of $.4 million.
Other cost of revenue. Other cost of revenue decreased to $3.7 million for the year ended December 31, 2002, from $5.7 million for the year ended December 31, 2001, which represented a decrease of 36%. This $2.0 million decrease was due primarily to an approximate $900,000 decrease in decrease in network payroll costs due to a reduction in headcount, an approximate $900,000 decrease in web site hosting and maintenance costs due to a restructuring of our third party service provider agreements, and an approximate $800,000 decrease in entertainment marketing costs due to a reduction in event costs in connection with a decrease in related advertising revenue offset partially by approximately $400,000 of iMusic record label distribution fees and royalty costs.
Stock-based compensation. For the year ended December 31, 2002, we recorded non-cash stock-based compensation charges of $3.1 million compared to $8.4 million for the year ended December 31, 2001, which represented a decrease of 63%. The stock-based compensation expense relates primarily to the amortization of the estimated value of the options, using the Black-Scholes option pricing model, given to artists and their advisors in connection with the operation of their stores and is amortized over the life of the associated contracts. The decrease in stock-based compensation is primarily due to the expense of approximately $900,000 in 2001 related to the rescission offer and the completion of the terms of artist agreements during 2002. The $3.1 million in expense in 2002 consists of $2.1 million related to option grants to artists and advisors, $900,000 in compensation expense related to the rescission for which services were being provided by artists and advisors in 2002, and $79,000 of expense related to warrants granted to suppliers.
OPERATING EXPENSE
Web Site Development. Web site development expense decreased to $53,000 for the year ended December 31, 2002, from $3.7 million for the year ended December 31, 2001, which represented a decrease of 99%. This decrease was primarily attributable to a $2.1 million decrease in payroll and related costs in 2002 from the elimination of our information technology development staff and an approximate $1.6 million decrease in fees paid to third party service vendors relating to the development and internal transition of our E-commerce system incurred in 2001.
Sales and Marketing. Sales and marketing expense decreased to $2.2 million for the year ended December 31, 2002 from $5.7 million for the year ended December 31, 2001, which represented a decrease of 61%. The $3.5 million decrease was primarily attributable to a $1.0 million decrease in our online advertising expenditures resulting from the restructuring of our agreement with Ticketmaster, a $1.1 million reduction in payroll and related costs and an approximate $700,000 reduction in e-mail marketing expenses, publicity costs and other promotional expenses.
General and Administrative. General and administrative expense decreased to $7.6 million for the year ended December 31, 2002 from $13.3 million for the year ended December 31, 2001, which represented a decrease of 44%. The $5.8 million decrease was primarily attributable to a $1.7 million decrease in payroll costs associated with reduced headcount in staff in 2001, $1.6 million decrease in outside services due in part to the rescission in 2001, $1.0 million decrease in facilities expenses, and $1.3 million decrease in travel and entertainment, communications and other general and administrative expenses.
Provision for Doubtful Accounts. Bad debt expense decreased to $42,000 for the year ended December 31, 2002 from $1.5 million for the year ended December 31, 2001 due to the write-off of a $1.5 million receivable due from one of the major records labels related to advertising and promotion services provided.
Stock-based Compensation. We recorded stock-based compensation expense of $1.9 million for the year ended December 31, 2002 in connection with stock issuances to employees, directors, professional firms, artists and advisors for promotional services, which represented a decrease of 85% from the $12.4 million expense for the comparable period in 2001. Stock-based compensation in 2002 represented the remaining amortization of prepaid compensation paid in 2001 related to the value of options granted to artists and advisors. The decrease is primarily due to the expense recorded in 2001 of $6.1 million related to the rescission of options granted to employees, professional firms, artists and advisors, and due to the completion of promotion agreements with artists in 2002.
Depreciation and Amortization. Depreciation and amortization expense decreased to $2.8 million for the year ended December 31, 2002 from $6.5 million for the year ended December 31, 2001, which represented a decrease of 57%. This $3.7 million decrease was primarily due to a decrease in the amortization of intangible assets as a result of the $11.4 write-off of goodwill in 2001 and goodwill no longer being amortized effective January 1, 2002.
Loss from Impairment of Goodwill. During the year ended December 31, 2002 we recorded a loss on impairment of goodwill related to the write-off of the remaining goodwill associated with the Company’s online operations in the amount of $788,000. During the year ended December 31, 2001 we recorded a loss on impairment of goodwill related to our acquisitions of Mjuice, iMusic and the UBL in the amount of $11.4 million. These write-downs were recorded due to declines in advertising revenue on the Network and the determination that there was insufficient basis to support the carrying amounts of goodwill based upon the projected undiscounted future cash flows related to the underlying Network assets.
INTEREST INCOME AND EXPENSE
Interest income decreased to $748,000 for the year ended December 31, 2002 from $3.6 million for the year ended December 31, 2001, which represented a decrease of 79%. This $2.9 million decrease is primarily due to lower average cash balances held during 2002 compared with 2001 and lower interest rates.
LOSS FROM EQUITY INVESTMENTS
Loss from equity investments increased to $29.3 million for the year ended December 31, 2002 from $9.0 million for the year ended December 31, 2001. The increase is due to an increase in the loss of ARTISTdirect Records. The Company recorded 100% of the venture’s loss through April 30, 2002 due to its commitment to fund 100% of its operations. As of May 1, 2002, the Company began recording approximately 83% of the venture’s loss based on its relative share of the remaining funding commitment to the venture.
DISCONTINUED OPERATIONS
Income from discontinued operations increased to $147,000 for the year ended December 31, 2002 from $47,000 for the year ended December 31, 2001. The increase is due to the timing of touring activity and a reduction of expenses in 2002 during the wind-down of operations.
NET LOSS
Net loss decreased to $48.2 million for the year ended December 31, 2002, compared to $69.9 million for the year ended December 31, 2001, which represented a decrease of $21.7 million or 31%. This decrease is primarily attributable to a $5.4 million decrease in the gross loss, a $10.7 million decrease in the loss from impairment of goodwill, a $10.5 million decrease in stock-based compensation, a $5.8 million decrease in general and administrative, a $3.7 million decrease in depreciation and amortization, a $3.7 million decrease in website development, a $3.5 million decrease in sales and marketing, and a $1.4 million decrease in provision for doubtful
accounts partially offset by a $20.3 million increase in the loss from equity investments and a $2.8 million decrease in interest income.
YEARS ENDED DECEMBER 31, 2001 AND 2000
NET REVENUE
Net revenue from continuing operations for the year ended December 31, 2001 decreased to $10.4 million from $18.7 million for the year ended December 31, 2000, which represented a decrease of 44%. The decrease was due to decreases in e-commerce, media and other revenue.
E-commerce revenue for the year ended December 31, 2001 decreased to $7.5 million from $12.2 million for the year ended December 31, 2000, a decrease of 38% primarily as a result of fewer sales orders, decreased interest in certain of our top-selling artists and an overall weaker retail environment.
Advertising and other revenue decreased to $2.9 million for the year ended December 31, 2001 from $6.3 million for the year ended December 31, 2000, a decrease of 54% primarily as a result of a decrease in the number of online advertisers, and a reduction in the sales of non-impression based sponsorships. The decrease in advertising revenues is attributed to general weakness in the U.S. economy, overall softness in the advertising market and a specific decline in the demand for online advertising.
COST OF REVENUE
Direct cost of product sales. Direct cost of product sales decreased to $6.1 million for the year ended December 31, 2001 from $10.4 million for the year ended December 31, 2000, which represented a decrease of 41%. This $4.3 million decrease corresponded with the decrease in online product sales revenue and was primarily attributable to a $2.9 million decrease in product costs and a $1.4 million decrease in transaction costs.
Other cost of revenue. Other cost of revenue decreased to $5.7 million for the year ended December 31, 2001, from $8.1 million for the year ended December 31, 2000, which represented a decrease of 29%. This $2.4 million decrease was due to a $1.4 million decrease in payroll costs due to a reduction in headcount and a $1.0 million decrease in content programming and related costs due to the termination of our efforts to create broadband programming.
Stock-based compensation. For the year ended December 31, 2001, we recorded non-cash stock-based compensation charges of $8.4 million compared to $7.5 million for the year ended December 31, 2000, which represented an increase of 11%. The stock-based compensation expense relates primarily to the amortization of the estimated value of the options, using the Black-Scholes option pricing model, given to artists in connection with the operation of their stores and is amortized over the life of the associated contracts. During 2001, $1.5 million of the expense related to the early closure of certain of the artist stores and approximately $900,000 related to the rescission offer completed in December 2001. In 2001, we reclassified the remaining amount of unearned compensation from the equity section to an asset, as the equity instruments were no longer outstanding after the rescission offer was completed. As of December 31, 2001, $2.9 million of prepaid compensation expense remains to be amortized, all of which will be recorded as stock-based compensation expense in 2002. The $8.4 million of expense in 2001 consists of $7.2 million related to option grants to artist and advisors, $859,000 related to the rescission offer and $322,000 related to warrants granted to suppliers.
OPERATING EXPENSE
Web Site Development. Web site development expense decreased to $3.7 million for the year ended December 31, 2001, from $5.4 million for the year ended December 31, 2000, which represented a decrease of 31%. This decrease was primarily attributable to a $2.1 million decrease in fees paid to third party service vendors relating to the development of our Web site and an approximate $600,000 decrease in programming development costs offset by an increase of $1.0 million in internal payroll and related costs.
Sales and Marketing. Sales and marketing expense decreased to $5.7 million for the year ended December 31, 2001 from $25.6 million for the year ended December 31, 2000, which represented a decrease of 78%. The decrease was primarily attributable to a significant decrease in our online advertising expenditures, as well as lower payroll and related costs.
General and Administrative. General and administrative expense decreased to $13.3 million for the year ended December 31, 2001 from $17.0 million for the year ended December 31, 2000, which represented a decrease of 21%. This decrease was primarily attributable to salary and benefit savings associated with the reduction in staff in 2001 and overall cost savings in travel and entertainment, communications, computer supplies and outside services.
Provision for Doubtful Accounts. Bad debt expense increased to $1.5 million for the year ended December 31, 2001 from $653,000 for the year ended December 31, 2000, which represented a 145% increase. This increase was primarily due to a $1.5 million provision recorded against a receivable from one of the major record labels, to be settled in the form of cash or content, that was determined to be impaired as of 12/31/01.
Stock-based Compensation. We recorded stock-based compensation expense of $12.4 million for the year ended December 31, 2001 in connection with stock issuances to employees, directors, professional firms, artists and advisors for promotional services, which represented an increase of 145% from the $5.1 million expense for the comparable period in 2000. Stock-based compensation in 2001 included $6.1 million of expense related to the rescission offer completed in December 2001, as well as $300,000 for the early closure of artists’ stores and termination of the related promotion agreements. The expense during the year ended December 31, 2000 reflected a credit to stock-based compensation of $6.6 million related to stock appreciation rights granted to certain executives of the Company as a result of a reduction in the valuation of the Company’s underlying common stock as compared with December 31, 1999. This credit was offset by $11.7 million of stock-based compensation expense related to options granted to employees, professional firms, artists and advisors. As of December 31, 2001, $1.7 million of prepaid compensation expense remains to be amortized, all of which will be recorded as stock-based compensation expense in 2002.
Depreciation and Amortization. Depreciation and amortization expense increased to $6.5 million for the year ended December 31, 2001 from $6.2 million for the year ended December 31, 2000, which represented an increase of 4%. This increase was primarily due to an increase in depreciation of fixed assets and leasehold improvements offset by a decrease in the amortization of intangible assets as a result of the write-off in 2001 of goodwill associated with the acquisitions of iMusic, Mjuice and the minority interest in UBL.
INTEREST INCOME AND EXPENSE
Interest income decreased to $3.6 million for the year ended December 31, 2001 from $6.0 million for the year ended December 31, 2000, which represented a decrease of 40%. The decrease is due to lower average cash balances held during 2001 compared with 2000 and lower average interest rates.
LOSS FROM EQUITY INVESTMENTS
Loss from equity investments increased to $9.0 million for the year ended December 31, 2001 from $235,000 for the year ended December 31, 2000. The increase is due primarily to the $8.6 million equity loss recognized from ARTISTdirect Records, the Company’s record label co-venture. Included in the equity loss were $3.2 million of advances paid to artists, which are recoupable from future royalties earned on record sales. However, given that the artists signed by the venture have no previous track record, the venture has provided for 100% of the advances made. The Company recognized 100% of the venture’s loss due to its commitment to fund 100% of its operations as of December 31, 2001.
DISCONTINUED OPERATIONS
Income from discontinued operations decreased to $47,000 for the year ended December 31, 2001 from $2.2 million for the year ended December 31, 2000, which represented a decrease of 98%. The decrease is due to a
decline in touring activity in 2001 among the Agency’s most popular touring artists resulting in a $1.9 million decline in tour commission revenues in 2001 compared with the prior year.
NET LOSS
Net loss increased to $69.9 million for the year ended December 31, 2001, compared to $59.3 million for the year ended December 31, 2000, which represented an increase of $10.6 million or 14%. The increase in the net loss is primarily attributable to a $2.5 million increase in gross loss, primarily as a result of lower Media revenues, a $7.3 million increase in stock-based compensation, an $11.4 million loss from the impairment of goodwill, an $8.8 million increase in loss from equity investments, a $2.4 million decrease in interest income and a $2.1 million decrease in income from discontinued operations partially offset by a $1.6 million decrease in website development, a $19.9 million decrease in sales and marketing expenses, a $3.6 million decrease in general and administrative expenses, and an $947,000 increase in provision for doubtful accounts.
LIQUIDITY AND CAPITAL RESOURCES - ARTISTdirect, Inc.
On March 31, 2000, we completed our IPO and raised net proceeds of approximately $52.4 million through the sale of 500,000 (after giving effect to our reverse stock split in July 2001) common shares. In addition, we raised an aggregate of $97.5 million of gross proceeds through the sale of 700,029 shares of Series C preferred stock in December 1999 and January 2000. In May 1999, we issued 375,000 shares of Series B preferred securities in exchange for an aggregate purchase price of $15.0 million. In April 2001, we completed a partial self-tender offer for 200,000 of our outstanding shares at a price per share of $12.50. Our out-of-pocket costs, including expenses associated with the tender offer, were approximately $2.7 million, which we funded from our existing cash and cash equivalents. During the second half of 2001, we also purchased approximately 40,000 shares for a total of $234,000 under an open market share repurchase program. As of December 31, 2002, we had $1.9 million of unrestricted cash and cash equivalents and held $6.1 million in short-term investments.
Net cash used in operating activities was $11.2 million for the year ended December 31, 2002, and $22.2 million and $35.1 million for the years ended December 31, 2001 and 2000, respectively. Net cash used in operating activities for each of these periods primarily consisted of net losses partially offset by non-cash items such as stock-based compensation and depreciation and amortization.
Net cash used in investing activities was $12.8 million for the year ended December 31, 2002, which consisted primarily of $25.0 million of investment in ARTISTdirect Records offset partially by $12.3 million of proceeds from the maturity/sale of short-term investments. Net cash provided by investing activities was $11.6 million for the year ended December 31, 2001, which consisted primarily of $18.0 million of proceeds from the maturity/sale of short-term investments partially offset by $5.3 million of investment in ARTISTdirect Records. Net cash used in investing activities was $46.3 million for the year ended December 31, 2000, and consisted primarily of the purchase of short-term investments of $36.4 million, fixed asset purchases and leasehold improvements to our corporate offices of $7.5 million and $2.0 million relating to the acquisition of Mjuice.com, Inc.
Net cash provided by financing activities was $855,000 for the year ended December 31, 2002 which was primarily a result of the release of restricted cash related to two letters of credit held by third parties related to our office lease and e-commerce credit card processor. Net cash used in financing activities was $15.9 million for the year ended December 31, 2001 and consisted of payments made for the rescission of certain shares and options issued to employees, artists, advisors and professional firms of $10.2 million, the repurchase of common stock of $2.7 million and approximately $3.0 million held as restricted cash related to our lease agreement for our Los Angeles office and our E-Commerce business. Net cash provided by financing activities was $63.7 million for the year ended December 31, 2000 which was principally attributable to the proceeds of our initial public offering in March 2000 in which we raised approximately $52.4 million, net of underwriters’ discounts and offering costs, and $10.4 million raised from the sale of Series C preferred stock in January 2000, net of offering costs.
As of December 31, 2002 our principal commitments consisted of our obligation to fund ARTISTdirect Records of approximately $14.75 million ($45 million commitment less $30.25 million funded as of December 31,
2002) and obligations outstanding under operating leases, primarily for office space, and employment contracts. A summary of our contractual cash obligations, excluding the record label funding commitment, as of December 31, 2002 is as follows:
We currently anticipate that available cash resources, including short-term investments, may likely not be sufficient to meet anticipated needs for working capital and capital expenditures for the next twelve months without additional capital or a significant reduction of operating expenses that would likely include a shut-down or disposition of operations. Furthermore, ARTISTdirect Records will require capital in addition to that to be provided by us to continue its operations. We are in the process of implementing substantial cost reductions and exploring the disposition of one or more business units such that we may be able to operate as a going concern. However, there can be no assurance that these efforts will be sufficient to enable us to operate as a going concern on a sustained basis. We are also pursuing alternatives to raise additional capital in order to continue funding of ARTISTdirect and ARTISTdirect Records. There can be no assurance that additional capital can be obtained by either ARTISTdirect or by ARTISTdirect Records on reasonable terms, in a timely manner or at all. If additional funds are raised through the issuance of equity securities of either ARTISTdirect or ARTISTdirect Records, the percentage ownership of current stockholders in ARTISTdirect and/or ARTISTdirect Records will be reduced. If we raise additional funds by issuing debt, we may be subject to limitations on our operations, including limitations on the payment of dividends, and any debt issued by ARTISTdirect Records may be senior to the obligations of ARTISTdirect Records to ARTISTdirect. Failure to raise additional capital could seriously harm the business of ARTISTdirect Records and ARTISTdirect, and impair the value of our investment in ARTISTdirect Records. In such event, we may seek to divest all or certain of our assets or the entire company in order to raise the capital necessary to sustain business operations. Should this fail, we may be forced to cease operations and seek bankruptcy protection or undertake liquidation, potentially resulting in a total loss for stockholders.
RESULTS OF OPERATIONS - ARTISTdirect Records, LLC
YEAR ENDED DECEMBER 31, 2002 AND PERIOD FROM MAY 31, 2001(INCEPTION) TO DECEMBER 31, 2001
NET REVENUE
Net revenue increased to $3.7 million for the year ended December 31, 2002 from $0 for the period from May 31, 2001 (inception) to December 31, 2001. During 2002, ARTISTdirect Records released seven albums, Custom’s Fast in March 2002, Badly Drawn Boy’s About a Boy soundtrack in April 2002, Mad At Gravity’s Resonance and Smilez and Southstar’s Crash the Party in July 2002, and No Good’s Game Day, PBB and Naam Brigade’s Early In The Game in September 2002 and Badly Drawn Boy’s Have You Fed The Fish. Net revenues in 2002 are reflected
net of a provision for actual and estimated future returns of $1.7 million. During 2001, the Company did not release any albums.
COST OF REVENUE
Direct cost of product revenue includes manufacturing costs and distribution fees payable to BMG and the provision for artist advances and royalty expense. Manufacturing and distribution expenses for the year ended December 31, 2002 was $1.3 million compared with $0 in the period ending December 31, 2001. Artist advances and recording costs relate to signed artists as well as an advance against future royalties paid to a producer. The provision for advances and royalties for the year ended December 31, 2002 was $8.8 million compared with $3.2 million for the period ending December 31, 2001. The increase was due to an increase in the number of artists signed in 2002 and the level of recording activity compared with the prior year.
OPERATING EXPENSE
Sales and Marketing. Sales and marketing expense represents costs of sales, marketing, promotion, publicity and video production related to ARTISTdirect Records’ albums released during the period as well as the related costs for additional expected releases being set up for release during 2003. Sales and marketing expense for the year ended December 31, 2002 was $12.0 million compared with $799,000 for 2001.
General and Administrative. General and administrative expense represents payroll and related expenses, costs for travel & entertainment, outside legal fees and general office and communication expenses. General and administrative expense for the year ended December 31, 2002 was $14.4 million compared with $4.5 million for 2001. The increase is due primarily to a full year’s amount of expense in 2002 and an increase in headcount and related activity to support the first releases of the label during 2002.
INTEREST EXPENSE
Interest Expense. Interest expense represents the accrual of interest on loan advances made to ARTISTdirect Records from ARTISTdirect, Inc. and BMG. Interest expense for the year ended December 31, 2002 was $1.1 million compared with $126,000 in 2001. The increase is due to an increase in the level of advances made during 2002 and the accrual of a full year of interest in comparison with the prior year.
NET LOSS
Net loss was $34.0 million for the year ended December 31, 2002 and was comprised of a gross loss of $6.3 million, total operating expenses of $26.4 million and interest expense of $1.1 million. Net loss for the period ended December 31, 2001, was $8.7 million and was comprised of a gross loss of $3.2 million, total operating expenses of $5.4 million and interest expense of $126,000.
LIQUIDITY AND CAPITAL RESOURCES - ARTISTdirect Records, LLC
As of December 31, 2002, ARTISTdirect Records had $0 of cash. During the year ended December 31, 2002, ARTISTdirect made loan advances to ARTISTdirect Records of $25.0 million. These loan advances were made under ARTISTdirect’s $15 million funding commitment for 2002 and a Bridge Loan facility that accelerated $10 million of funding that otherwise would have been due in 2003. In addition, during the year ended December 31, 2002, BMG made loan advances of $4.75 million as well as certain recoupable distribution advances in conjunction with its North American distribution agreement and worldwide license agreement.
In order to continue its operations, ARTISTdirect Records will require capital within the next twelve months in addition to the $2.75 million that is to be provided by ARTISTdirect in 2003 under its overall funding commitment to ARTISTdirect Records. We are currently pursuing alternatives to raise additional capital in order to continue operations of ARTISTdirect Records. There can be no assurance that additional capital can be obtained by the Company on reasonable terms or at all. Failure to raise additional capital could seriously harm the business of
ARTISTdirect Records. In such event, we may seek to divest our interest in ARTISTdirect Records in order to raise the capital necessary to sustain business operations. Should this fail, we may be forced to cease operations and seek bankruptcy protection or undertake liquidation, potentially resulting in a total loss for equity holders. If additional funds were raised through the issuance of equity securities, the percentage ownership of the Company’s current equity holders would be reduced.
CRITICAL ACCOUNTING POLICIES
The Company’s discussion and analysis of its financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, intangible assets, income taxes, and contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The Company believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.
Revenue Recognition
E-commerce revenue consist primarily of the gross amount of sales revenue paid by the customer for recorded music and merchandise sold via the Internet, including shipping fees, and is recognized when the products are shipped. The Company records e-commerce revenue on a gross basis as the Company enters into the sale transactions with customers, establishes the prices of the products, chooses the suppliers of the products, assumes the risk of inventory loss and collects all amounts from the customers and assumes the credit risk. E-commerce revenue is subject to amounts due to the respective artists based on their contracts, and such expense is recorded as part of direct cost of product sales.
The Company records amounts charged to customers for shipping and handling in accordance with Emerging Issues Task Force 00-10, “Accounting for Shipping and Handling Fees and Costs.” 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 consolidated statements of operations. For the years ended December 31, 2000, 2001 and 2002, the Company recorded $1.9 million, $1.5 million and $1.0 million, respectively, as revenue for shipping and handling fees charged to customers. For the years ended December 31, 2000, 2001 and 2002, the Company recorded $1.6 million, $1.1 million and $736,000, respectively, of shipping and handling costs as direct cost of product sales in the consolidated statements of operations.
Media revenue consists primarily of the sale of advertisements and sponsorships, both online and offline, under short-term contracts. To date, the duration of the Company’s advertising and sponsorship commitments has generally averaged from one to three months with certain programs lasting up to six months. The Company’s online obligations typically include the guarantee of a minimum number of “impressions” or times 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.
The Company recognizes revenue for sponsorship arrangements, both online and offline, over the period during which the advertising is provided, generally on a straight-line basis. If the sponsorship arrangement is for the sponsorship of a specific event, the Company recognizes revenue when the event occurs. The Company recognizes revenue separately for each element of integrated entertainment marketing packages that offer advertisers a combination of off-line concert and tour sponsorships that are supported by on-line banner advertising, web page sponsorships, emails to the Company’s customers and custom content. The Company determines the fair value of
each deliverable based on the fair value of the different deliverables when sold on a stand-alone basis. The Company recognizes revenue for each deliverable as the services are provided. The Company recognizes revenue for the banner impression deliverable as the banner impressions are delivered. The Company recognizes revenue for the customer emails when the emails are sent. The Company recognizes revenue for web page sponsorships on a straight-line basis over the term of the sponsorship. The Company recognizes revenue for the custom content when the content is provided to the customer. The Company recognizes revenue for event sponsorships when the event has occurred.
iMusic record label revenue consists primarily of the sale of compact discs by artists signed to iMusic, which is the brand name used by the Company for the record label operated by its wholly-owned subsidiary ARTISTdirect Digital, Inc. The Company recognizes revenues upon the shipment of compact discs from its distributor to retailers and independent wholesalers and records appropriate reserves for product returns. At the time of the shipment of the product, the following criterion under Statement of Financial Accounting Standards (SFAS) No. 48, “Revenue Recognition When Right of Return Exists,” have been met: the seller’s price to the buyer is substantially fixed or determinable at the date of sale; the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product; the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product; the buyer acquiring the product for resale has economic substance apart from that provided by the seller; the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer; the amount of future returns can be reasonably estimated.
Stock Based Compensation
The Company accounts for stock-based employee compensation in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25 and FASB Interpretation No. 44 (FIN 44), “Accounting for Certain Transactions Involving Stock Compensation,” and complies with the disclosure requirements of SFAS No. 123, “Accounting for Stock-Based Compensation.” Under APB No. 25, compensation expense is recorded based on the difference, if any, between the fair value of the Company’s stock and the exercise price on the measurement date. The Company accounts for stock issued to non-employees in accordance with SFAS No. 123, which requires entities to recognize as expense over the service period the fair value of all stock-based awards on the date of grant and EITF 96-18, “Accounting for Equity Investments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services”, which addresses the measurement date and recognition approach for such transactions.
The Company recognizes compensation expense related to variable awards in accordance with FIN 28. For fixed awards, the Company recognizes expense over the vesting period or the period of service.
Stock-based compensation included in cost of revenue represents the amortization of non-cash compensation expense related to vendor warrants and stock options granted to artists and their advisors in connection with entering into contractual commitments to operate their online commerce activities. We record the fair value of options/warrants granted to non-employees as compensation expense over the period of service. We determine the fair value of the options/warrants based on the Black-Scholes option-pricing model.
Stock-based compensation included in operating expenses represents the amortization of non-cash compensation expense related to equity instruments granted to employees, directors, professional firms, artists and artist advisors. Compensation for equity grants to non-employees is recorded in the same manner as described above. We record stock compensation for employee option grants equal to the excess of the fair value of our common stock over the exercise price on the grant date. We record the compensation over the vesting period.
Impairment of Long-Lived Assets and Goodwill
Prior to January 1, 2002, the Company periodically reviewed the carrying amount of long-lived assets and goodwill to determine whether current events or circumstances warranted adjustments to such carrying amounts. An impairment adjustment was necessary in the event the net book value of such long-lived assets and goodwill exceeded the future undiscounted cash flows attributable to such assets. In such an event, the loss would be
measured by the amount that the carrying value of such assets exceeded their fair value, as determined based on estimated discounted cash flows.
Effective January 1, 2002, the Company evaluates the impairment of goodwill by comparing the carrying amount of the goodwill at the reporting unit level to the fair value of the goodwill. The carrying amount of the goodwill is adjusted to its fair value in the event the fair value exceeds the carrying amount.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In July 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and Other Intangible Assets”. SFAS No. 141 requires that all business combinations be accounted for under the purchase method. The statement further requires separate recognition of intangible assets that meet one of two criteria. The statement applies to all business combinations initiated after June 30, 2001.
SFAS No. 142 requires that an intangible asset that is acquired shall be initially recognized and measured based on its fair value. The statement also provides that goodwill should not be amortized, but shall be tested for impairment annually, or more frequently if circumstances indicate potential impairment, through a comparison of fair value to its carrying amount. SFAS No. 142 is generally effective for fiscal periods beginning after December 15, 2001 and the amortization provisions of SFAS No. 142 are effective for acquisitions subsequent to June 30, 2001. The Company adopted SFAS No. 142 effective January 1, 2002 (See Note 2 and 8).
In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment of Long-Lived Assets” which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. While SFAS No. 144 supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,” it retains many of the fundamental provisions of that statement. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. The adoption of SFAS No. 144 did not have a material impact on the Company’s financial position, result of operation and cash flow.
In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections (SFAS 145).” SFAS 145 rescinds SFAS 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. Upon adoption of SFAS 145, we will be required to apply the criteria in APB Opinion No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions (Opinion No. 30), in determining the classification of gains and losses resulting from the extinguishment of debt. Additionally, SFAS 145 amends SFAS 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions to be accounted for in the same manner as sale-leaseback transactions. SFAS 145 will be effective for fiscal years beginning after May 15, 2002 with early adoption of the provisions related to the rescission of SFAS 4 encouraged. Upon adoption, companies must reclassify prior period items that do not meet the extraordinary item classification criteria in Opinion No. 30. The adoption of SFAS 145 for long-lived assets held for use did not have a material impact on the Company’s consolidated financial statements.
In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit and Disposal Activities.” SFAS 146 nullifies Emerging Issues Task Force (EITF) issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). Under EITF issue 94-3, a liability for an exit cost is recognized at the date of an entity’s commitment to an exit plan. Under SFAS 146, the liabilities associated with an exit or disposal activity will be measured at fair value and recognized when the liability is incurred and meets the definition of a liability in the FASB’s conceptual framework. This statement is effective for exit or disposal activities initiated after December 31, 2002. The Company believes that the adoption of SFAS 146 will not have a material impact on its consolidated financial statements.
In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others” (“FIN 45”), an interpretation of FASB Statements Nos. 5, 57 and 107 and a rescission of FASB Interpretation No. 34. FIN 45
elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees issued. FIN 45 also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken. The initial recognition and measurement provisions of FIN 45 are applicable to guarantees issued or modified after December 31, 2002 and the Company believes the adoption of FIN 45 will not have a material effect on its consolidated financial statements. The disclosure requirements are effective for financial statements of interim and annual periods ended after December 15, 2002.
In November 2002, the FASB’s Emerging Issues Task Force (EITF) issued EITF 00-21 “Revenue Arrangements with Multiple Deliverables.” EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. Specifically, EITF 00-21 addresses how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. In applying EITF 00-21, separate contracts with the same entity or related parties that are entered into at or near the same time are presumed to have been negotiated as a package and should, therefore, be evaluated as a single arrangement in considering whether there are one or more units of accounting. That presumption may be overcome if there is sufficient evidence to the contrary. EITF 00-21 also addresses how arrangement consideration should be measured and allocated to the separate units of accounting in the arrangement. The guidance in this Issue is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. Alternatively, companies may elect to report the change in accounting as a cumulative-effect adjustment. Early application of this consensus is permitted. The adoption of this accounting pronouncement may have a significant impact on the Company’s financial statements.
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure-an amendment of SFAS No. 123”. This statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. This statement also amends the disclosure requirements of SFAS No. 123 and APB Opinion No. 28, “Interim Financial Reporting,” to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. Certain of the disclosure modifications are required for fiscal years ending after December 15, 2002 and are included in the Notes to these Consolidated Financial Statements. The Company will implement SFAS No. 148 effective January 1, 2003 regarding disclosure requirements for condensed financial statements for interim periods. The Company’s management has determined that they will continue to account for stock-based employee compensation in accordance with APB No. 25.
In February 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46”), which addresses the consolidation by business enterprises of variable interest entities, which have one or both of the following characteristics: (1) the equity investment at risk is not sufficient to permit the entity to finance its activities without additional financial support from other parties, or (2) the equity investors lack one or more of the following essential characteristics of a controlling financial interest: (a) the direct or indirect ability to make decisions about the entity’s activities through voting or similar rights, (b) the obligation to absorb the expected losses of the entity if they occur, or (c) the right to receive the expected residual returns of the entity if they occur. FIN 46 will have a significant effect on existing practice because it requires existing variable interest entities to be consolidated if those entities do not effectively disburse risks among parties involved. In addition, FIN 46 contains detailed disclosure requirements. FIN 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. This Interpretation may be applied prospectively with a cumulative-effect adjustment as of the date on which it is first applied or by restating previously issued financial statements for one or more years with a cumulative-effect adjustment as of the beginning of the first year restated. The adoption of the pronouncement may have a significant impact on the Company's consolidated financial statements.
ITEM 7A.
ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market rate risk for changes in interest rates is related primarily to our investment portfolio. We have not used derivative financial instruments in our investment portfolio. Our short-term investments are comprised of U.S. Government obligations and public corporate debt securities. Interest rate fluctuations impact the carrying value of the portfolio. We do not believe that the future market risks related to the above securities will have material adverse impact on our financial position, results of operations or liquidity.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our consolidated financial statements and schedule, as listed under Item 14, appear in a separate section of this Annual Report on Form 10-K beginning on page.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information in the sections titled “Proposal One: Election of Directors,” “Directors, Executive Officers and Key Employees of the Company” and “Compliance with Section 16(a) of the Exchange Act” appearing in our definitive proxy statement for the 2003 Annual Meeting of Stockholders is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information in the section titled “Executive Compensation and Related Information” appearing in our definitive proxy statement for the 2003 Annual Meeting of Stockholders is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information in the section titled “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” appearing in our definitive proxy statement for the 2003 Annual Meeting of Stockholders is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information in the section titled “Certain Relationships and Related Transactions” appearing in our definitive proxy statement for the 2003 Annual Meeting of Stockholders is incorporated herein by reference.
ITEM 14.
ITEM 14. CONTROLS AND PROCEDURES
Based on their evaluation as of a date within 90 days of the filing date of this Report, ARTISTdirect’s principal executive officer and principal financial officer have concluded that ARTISTdirect’s disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934) are effective to ensure that information required to be disclosed by ARTISTdirect in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.
There have been no significant changes in our internal controls or in other factors that could significantly affect our internal controls subsequent to the date that our principal executive officer and principal financial officer carried out their evaluation.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1). FINANCIAL STATEMENTS
ARTISTdirect financial statements appear in a separate section of this Annual Report on Form 10-K beginning on the pages referenced below:
ARTISTdirect, Inc. and Subsidiaries Consolidated Financial Statements
ARTISTdirect Records, LLC financial statements appear in a separate section of this Annual Report on Form 10-K beginning on the pages referenced below:
ARTISTdirect Records, LLC Financial Statements
(2) FINANCIAL STATEMENT SCHEDULE
ARTISTdirect financial statement schedule appears in a separate section of this Annual Report on Form 10-K on the pages referenced below. All other schedules have been omitted as they are not applicable, not required or the information is included in the consolidated financial statements or the notes thereto.
(3) EXHIBITS
3.1
Amended and Restated Certificate of Incorporation of the Registrant. Incorporated by reference to Exhibit 3.1 in the Registrant’s Registration Statement on Form S-1 initially filed on September 22, 1999 (Registration No. 333-87547), as amended by Amendment No.’s 1 - 7 thereto.
3.2
Amended and Restated Bylaws of the Registrant. Incorporated by reference to Exhibit 3.2 in the Registrant’s Registration Statement on Form S-1 initially filed on September 22, 1999 (Registration No. 333-87547), as amended by Amendment No.’s 1 - 7 thereto.
3.3
Certificate of Amendment of the Third Amended and Restated Certificate of Incorporation. Incorporated by reference to Exhibit 3.3 in the Registrant’s Quarterly Report on Form 10-Q filed on August 14, 2001.
3.4
Certificate of Amendment, dated June 3, 2002, of the Third Amended and Restated Certificate of Incorporation. Incorporated by reference to Exhibit 3.4 in the Registrant’s Quarterly Report on Form 10-Q filed on August 14, 2002.
4.1
See Exhibits 3.1 and 3.2 for provisions of the Registrant’s Certificate of Incorporation and Bylaws determining the rights of holders of the Registrant’s common stock.

Confidential treatment was requested for certain confidential portions of this exhibit pursuant to Rule 24b-2 under the Securities Exchange Act of 1934. In accordance with Rule 24b-2, these confidential portions were omitted from this exhibit and filed separately with the Securities and Exchange Commission.
(b) REPORTS ON FORM 8-K
On December 23, 2002, we filed a report on Form 8-K relating to the election by our Vice Chairman of the Board and President of Artist Services, Marc Geiger, to defer 50% of his salary that he was due to receive under his employment agreement with ARTISTdirect.
On December 13, 2002, we filed a report on Form 8-K relating to the election by our Chairman of the Board and Chief Executive Officer, Frederick Field, to defer salary that he was due to receive under his employment agreements with ARTISTdirect and with ARTISTdirect Records, L.L.C.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
We, the undersigned officers and directors of ARTISTdirect, Inc., do hereby constitute and appoint Frederick W. Field and James B. Carroll, and each of them, our true and lawful attorneys-in-fact and agents, each with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Report, and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that each of said attorneys-in-fact and agents, or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
CERTIFICATIONS OF THE CHIEF EXECUTIVE OFFICER
UNDER SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, Frederick W. Field, Chief Executive Officer of ARTISTdirect, Inc., certify that:
1. I have reviewed this annual report on Form 10-K of ARTISTdirect, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and
c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
6. The registrant’s other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 28, 2003
/s/ FREDERICK W. FIELD
Frederick W. Field
Chief Executive Officer
CERTIFICATIONS OF THE CHIEF FINANCIAL OFFICER
UNDER SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, James B. Carroll, Chief Financial Officer of ARTISTdirect, Inc., certify that:
1. I have reviewed this annual report on Form 10-K of ARTISTdirect, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and
c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
6. The registrant’s other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 28, 2003
/s/ JAMES B. CARROLL
James B. Carroll
Chief Financial Officer
CERTIFICATIONS OF THE CHIEF EXECUTIVE OFFICER
UNDER SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Annual Report of ARTISTdirect, Inc. (the “Registrant”) on Form 10-K for the period ending December 31, 2002 as filed with the Securities and Exchange Commission on the date hereof (the “Annual Report”), I, Frederick W. Field, Chief Executive Officer of the Registrant, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to my best knowledge:
(1) the Annual Report fully complies with the requirements of Section 13(a) or 15 (d) of the Securities Exchange Act of 1934; and
(2) the information contained in the Annual Report fairly presents, in all material respects, the financial condition and results of operations of the Registrant.
Date: March 28, 2003
/s/ FREDERICK W. FIELD
Frederick W. Field
Chief Executive Officer
CERTIFICATIONS OF THE CHIEF FINANCIAL OFFICER
UNDER SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Annual Report of ARTISTdirect, Inc. (the “Registrant”) on Form 10-K for the period ending December 31, 2002 as filed with the Securities and Exchange Commission on the date hereof (the “Annual Report”), I, James B. Carroll, Chief Financial Officer of the Registrant, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to my best knowledge:
(1) the Annual Report fully complies with the requirements of Section 13(a) or 15 (d) of the Securities Exchange Act of 1934; and
(2) the information contained in the Annual Report fairly presents, in all material respects, the financial condition and results of operations of the Registrant.
Date: March 28, 2003
/s/ JAMES B. CARROLL
James B. Carroll
Chief Financial Officer
ARTISTDIRECT, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
INDEPENDENT AUDITORS’ REPORT
To the Board of Directors
ARTISTdirect, Inc.
We have audited the accompanying consolidated balance sheets of ARTISTdirect, Inc. and subsidiaries (the Company) as of December 31, 2001 and 2002 and the related consolidated statements of operations, stockholders’ equity (deficit) and cash flows for each of the years in the three year period ended December 31, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of ARTISTdirect, Inc. and subsidiaries as of December 31, 2001 and 2002 and the results of its operations and its cash flows for each of the years in the three year period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 3 to the consolidated financial statements in 2002 the Company changed its method of accounting for the amortization of goodwill.
The accompanying financial statements have been prepared assuming that ARTISTdirect, Inc. and subsidiaries will continue as a going concern. As more fully described in note 1, the Company has incurred substantial operating losses and negative cash flows from operations to date and has funding commitments related to its record label joint venture. The Company needs additional capital to fund its operations and the operations of the record label joint venture. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ KPMG LLP
Los Angeles, CA
February 14, 2003
ARTISTDIRECT, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
See accompanying notes to consolidated financial statements.
ARTISTDIRECT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT FOR SHARE DATA)
See accompanying notes to consolidated financial statements
ARTISTDIRECT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY (DEFICIT)
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
See accompanying notes to consolidated financial statements.
ARTISTDIRECT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(IN THOUSANDS)
ARTISTDIRECT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS (continued)
(IN THOUSANDS)
See accompanying notes to consolidated financial statements.
1. BASIS OF PRESENTATION
ORGANIZATION
ARTISTdirect, Inc. (the “Company”) was formed on October 6, 1999 upon its merger with ARTISTdirect, LLC (the “Capital Reorganization”). The Capital Reorganization was only a change in the form of ownership of the Company. ARTISTdirect, LLC was organized as a California limited liability company and commenced operations on August 8, 1996. ARTISTdirect, LLC had a 99% ownership interest in ARTISTdirect Agency LLC, Kneeling Elephant Records, LLC and ARTISTdirect New Media, LLC (“Affiliated Companies”) and has consolidated their results since inception. On May 31, 2001, the Company, through its wholly-owned subsidiary, ARTISTdirect Recordings, Inc., agreed to acquire a 50% equity interest in a joint venture with Frederick W. (Ted) Field to form a new record label, ARTISTdirect Records, LLC (“ARTISTdirect Records”). This transaction became effective as of June 29, 2001. In April 2002, the Company’s ownership position in ARTISTdirect Records decreased to 45% as a result of a sale of a 5% interest to BMG Music. However, the Company’s ownership position increased to 65% as of December 31, 2002, as a result of the Company’s agreement to accelerate its funding commitment to ARTISTdirect Records (see Note 9).
PRINCIPLES OF CONSOLIDATION
The accompanying financial statements include the consolidated accounts of the Company and its subsidiaries in which it has controlling interests in the form of voting and operating control. All significant intercompany accounts and transactions have been eliminated for all periods presented. With respect to ARTISTdirect Records, the Company has recorded 100% of the losses attributable to that venture through April 30, 2002 based on the Company’s commitment to fund 100% of its operations up to that time. As of May 1, 2002, the Company began to record approximately 83% of ARTISTdirect Records’ losses as a result of BMG’s equity purchase from and assumption of a portion of the Company’s funding commitment to the label. However, given that the Company does not have voting or operating control, even with its majority ownership position, the Company accounts for this investment under the equity method of accounting as income (loss) from equity investments in the consolidated statements of operations.
GOING CONCERN
The Company has incurred losses and negative cash flows from operations in every fiscal period since inception and has an accumulated deficit of $201 million as of December 31, 2002. For the year ended December 31, 2002, the Company incurred a net loss of $48.2 million and negative operating cash flows of $11.2 million. Additionally, the Company has been funding substantially all of the operations of ARTISTdirect Records, LLC, its record label joint venture. The Company’s operations to date and loans to ARTISTdirect Records, LLC have been funded by sales of its preferred and common stock. Management expects its operating losses and the operating losses of ARTISTdirect Records, LLC to continue for the foreseeable future. The Company currently anticipates that available cash reserves may likely not be sufficient to meet anticipated needs for working capital and capital expenditures over the next twelve months without additional capital. The Company is attempting to raise additional funding, but does not have any formal commitments as of the date of these financial statements. If such funding is not available, then the Company may not be able to fund its own operations or the operations of ARTISTdirect Records, LLC. The conditions described above raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
2. REVERSE STOCK SPLITS
On March 21, 2000, and July 5, 2001, the Company effected a 1 for 4 reverse stock split and a 1 for 10 reverse stock split (the “Reverse Stock Splits”), respectively. The outstanding common securities, options and warrants have been retroactively adjusted to reflect the Reverse Stock Splits. All discussion of equity amounts in the following footnotes reflects the effect of the Reverse Stock Splits.
3. SIGNIFICANT ACCOUNTING POLICIES
CASH EQUIVALENTS
Cash equivalents consist of investments, which are readily convertible into cash and have maturities of three months or less at the time of purchase.
RESTRICTED CASH
Restricted cash consists of a letter of credit posted for the benefit of the Company’s landlord in the amount of approximately $1.8 million and a letter of credit posted for the benefit of the Company’s e-commerce credit card processor in the amount of $350,000.
SHORT-TERM INVESTMENTS
The Company classifies its short-term investments as available-for-sale and has recorded the investments at fair value, with the difference between amortized cost and fair value being recorded as a component of stockholders’ equity. Prior to December 31, 2001, the Company’s short-term investments were classified as held-to-maturity as the Company had the intent and ability to hold the securities to maturity. The securities were stated at amortized cost, adjusted for amortization of premiums and accretion discounts to maturity. The Company invests primarily in fixed income securities with maturities of one year or less at the time of purchase.
DEPRECIATION
Depreciation is provided using the straight-line method over the following estimated useful lives:
REVENUE RECOGNITION
E-commerce revenue consist primarily of the gross amount of sales revenue paid by the customer for recorded music and merchandise sold via the Internet, including shipping fees, and is recognized when the products are shipped. The Company records e-commerce revenue on a gross basis as the Company enters into the sale transactions with customers, establishes the prices of the products, chooses the suppliers of the products, assumes the risk of inventory loss and collects all amounts from the customers and assumes the credit risk. E-commerce revenue is subject to amounts due to the respective artists based on their contracts, and such expense is recorded as part of direct cost of product sales.
The Company records amounts charged to customers for shipping and handling in accordance with Emerging Issues Task Force 00-10, “Accounting for Shipping and Handling Fees and Costs.” 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 consolidated statements of operations. For the years ended December 31, 2000, 2001 and 2002, the Company recorded $1.9 million, $1.5 million and $1.0 million, respectively, as revenue for shipping and handling fees charged to customers. For the years ended December 31, 2000, 2001 and 2002, the Company recorded $1.6 million, $1.1 million and $736,000, respectively, of shipping and handling costs as direct cost of product sales in the consolidated statements of operations.
Media revenue consists primarily of the sale of advertisements and sponsorships, both online and offline, under short-term contracts. To date, the duration of the Company’s advertising and sponsorship commitments has generally averaged from one to three months with certain programs lasting up to six months. The Company’s online obligations typically include the guarantee of a minimum number of “impressions” or times 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.
The Company recognizes revenue for sponsorship arrangements, both online and offline, over the period during which the advertising is provided, generally on a straight-line basis. If the sponsorship arrangement is for the sponsorship of a specific event, the Company recognizes revenue when the event occurs. The Company recognizes revenue separately for each element of integrated entertainment marketing packages that offer advertisers a combination of off-line concert and tour sponsorships that are supported by on-line banner advertising, web page sponsorships, emails to the Company’s customers and custom content. The Company determines the fair value of each deliverable based on the fair value of the different deliverables when sold on a stand-alone basis. The Company recognizes revenue for each deliverable as the services are provided. The Company recognizes revenue for the banner impression deliverable as the banner impressions are delivered. The Company recognizes revenue for the customer emails when the emails are sent. The Company recognizes revenue for web page sponsorships on a straight-line basis over the term of the sponsorship. The Company recognizes revenue for the custom content when the content is provided to the customer. The Company recognizes revenue for event sponsorships when the event has occurred.
The Company in the past has entered into several contracts with advertisers whereby the parties exchanged online and offline advertising. This revenue was recognized as trade and barter. Trade and barter is valued based upon similar cash transactions, which have been entered into within six months prior to the respective trade and barter agreement. Trade and barter revenue was $309,000, $0 and $0 for years ended December 31, 2000, 2001 and 2002, respectively.
iMusic record label revenue consists primarily of the sale of compact discs by artists signed to iMusic, the brand name used by the Company for the record label operated by its wholly owned subsidiary ARTISTdirect Digital, Inc. The Company recognizes revenues upon the shipment of compact discs from its distributor to retailers and independent wholesalers and records appropriate reserves for product returns. At the time of the shipment of the product, the following criterion under Statement of Financial Accounting Standards (SFAS) No. 48, “Revenue Recognition When Right of Return Exists,” have been met: the seller’s price to the buyer is substantially fixed or determinable at the date of sale; the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product; the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product; the buyer acquiring the product for resale has economic substance apart from that provided by the seller; the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer; the amount of future returns can be reasonably estimated.
The Company estimates the provision for returns on a quarterly basis by album based on the amount of time since the initial album release, the actual returns to date, the trend of sales activity (sales by the retailers and wholesalers) and the number of unsold units at retailers and wholesalers. Returns to the Company’s distributor are deemed to be returns to the Company. The iMusic record label revenues recorded for the year ended December 31, 2002 are net of a provision for returns of $265,000.
COST OF REVENUE
Direct cost of product sales consists of amounts payable to artists related to e-commerce sales, which includes the cost of merchandise sold and the artists’ share of net proceeds, and online commerce transaction costs, including credit card fees, fulfillment charges and shipping costs. Direct cost of product sales also includes manufacturing costs and distribution fees payable related to the sales of the iMusic record label. Other cost of revenue consists primarily of Web site hosting and maintenance costs, online content programming costs, online advertising serving costs, record royalties payable to iMusic artists and payroll and related expenses for staff involved with the Website. Stock-based compensation expense relates to non-cash charges in connection with options issued to artists and their advisors for the right to operate their stores and warrants issued to vendors. Amounts payable to artists and transaction costs are recognized upon shipment. Website-related costs are recognized immediately when incurred.
Payroll and related expenses are recognized in the period incurred. Non-cash stock-based compensation charges are recognized over the period of the related agreements.
DISCONTINUED OPERATIONS
The Company has accounted for its Agency division as a discontinued operation in accordance with Accounting Principles Board (APB) No. 30, Accounting for Discontinued Operations, and recorded the net results of this business segment in a single line entitled “Income from discontinued operations” in the Statement of Operations for the years ended December 31, 2000, 2001 and 2002. The classification of the Agency division as a discontinued operation was made prior to the initial application of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Agency commission revenue is recognized in accordance with the terms of the representation agreements between the Company and its clients. Revenue is generally recorded upon payment for the performance of services or delivery of materials created by the artists represented.
INVENTORIES
Inventories, included in prepaid expenses and other current assets, consist of music-related merchandise, amounts advanced for inventory on behalf of artists, and unsold finished goods for the iMusic record label, and are stated at the lower of cost or net realizable value. Cost is determined using the first-in, first-out method.
INCOME TAXES
The Company accounts for income taxes under the asset and liability method whereby deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
WEB SITE DEVELOPMENT COSTS
Web site development costs consist primarily of third-party development costs and payroll and related expenses for in-house Web site development costs incurred in the start-up and production of the Company’s content and services. These costs are expensed as incurred. The implementation of Emerging Issues Task Force No. 00-02 “Accounting for Web site Development Costs,” effective July 1, 2000, did not have a material impact on the consolidated financial statements.
ADVERTISING COSTS
Advertising costs are expensed as incurred and totaled $14.7 million, $2.7 million and $1.0 million during the years ended December 31, 2000, 2001 and 2002, respectively.
IMPAIRMENT OF LONG-LIVED ASSETS AND GOODWILL
Prior to January 1, 2002, the Company periodically reviewed the carrying amount of long-lived assets and goodwill to determine whether current events or circumstances warranted adjustments to such carrying amounts. An impairment adjustment was necessary in the event the net book value of such long-lived assets and goodwill exceeded the future undiscounted cash flows attributable to such assets. In such an event, the loss would be measured by the amount that the carrying value of such assets exceeded their fair value, as determined based on estimated discounted cash flows.
In 2001, the Company determined that the remaining goodwill associated with the acquisition of Mjuice was fully impaired due to the Company’s decision to wind down the related operation and recorded a loss from impairment of $4.5 million. In addition, due to the decline in advertising revenues, the Company determined that there was insufficient basis to support the entire carrying amount of goodwill associated with the 1999 acquisitions
of iMusic and UBL based upon the projected undiscounted future cash flows related to the underlying assets of these goodwill amounts and recorded a loss from impairment of $7.0 million based on the estimated discounted cash flows. For the year ended December 31, 2001, the Company recorded an aggregate $11.4 million loss from impairment of goodwill. Both of these write-downs were reflected in the Media segment operations.
Prior to January 1, 2002, the Company amortized goodwill, which represents the excess of the purchase price over the net assets acquired in business acquisitions, over 5 years. In January 2002, the Company adopted SFAS No. 142, “Goodwill and Other Intangible Assets” and as a result, has ceased to amortize goodwill. Instead, the Company was required to perform a transitional impairment review of its goodwill as of January 1, 2002 and an annual impairment review thereafter. The Company evaluated the impact of the adoption of SFAS No. 142 and determined that no impairment charge was required upon adoption of this standard. Its impairment test was performed through comparison of the fair value of the reporting units with the carrying value of their assets. In the second quarter of 2002, the Company determined the remaining goodwill associated with the iMusic and UBL acquisitions of $788,000 was impaired due to a continuing decline in e-commerce and advertising revenues, and recorded a loss from impairment of that amount. This write-down was reflected in the Media segment operations. The fair value of the reporting unit to which the goodwill impairment related was determined based on the discounted estimated future cash flows. The discount rate used in the discounted cash flow analysis was determined based on the estimated cost of capital in the industry in which the Media segment operates. As of December 31, 2002, no goodwill or intangible assets remain on the Company’s balance sheet.
Impairment of long-lived assets is monitored on a continuing basis, and is assessed based on the undiscounted cash flows generated by the underlying assets. In the event the carrying amount of long-lived assets exceed the undiscounted future cash flows, then the carrying amount of such assets is adjusted to their fair value. There was no impairment of long-lived assets as of December 31, 2002.
CONCENTRATION OF CREDIT RISK AND SUPPLIER RISK
Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash, short-term investments and trade accounts receivable. The Company places its cash and short-term investments in high credit quality instruments. Cash balances at certain financial institutions may exceed the FDIC insurance limits. The Company performs ongoing credit evaluations of its customers but does not require collateral. Exposure to losses on receivables is principally dependent on each customer’s financial condition. The Company monitors its exposure to credit losses and maintains allowances for anticipated losses.
The Company purchases a large percentage of its music-related merchandise inventory from a limited number of suppliers. The Company is subject to risk in the event that any of the suppliers is unable to fulfill their orders.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts of financial instruments, which include cash and cash equivalents, short-term investments, accounts receivable, accounts payable and accrued expenses, approximate fair value because of the short maturity of these instruments.
LIABILITY ASSOCIATED WITH INVESTMENTS IN AFFILIATED COMPANIES
Investments in affiliated companies in which the Company’s voting interest is greater than 20% and does not have a controlling financial interest, or in which the Company is able to exert significant influence in instances where the voting interest is less than 20%, are accounted for under the equity method of accounting. Under this method, the investment, originally recorded at cost, is adjusted to recognize the Company’s share of the net earnings or losses of the affiliates as they occur rather than as dividends or other distributions received. The Company’s share of losses is generally limited to the extent of the Company’s investment in and advances to the investee. However, the Company records losses in excess of its investment when funding commitments exist. The Company is accounting for its investment in ARTISTdirect Records, a limited liability company with Ted Field that was formed in July 2001, on the equity method of accounting since the Company does not have voting or operational control of the investee. The Company had committed to fund 100% of the operations of ARTISTdirect Records and
has recorded 100% of the losses attributable to that venture from inception to April 30, 2002. From May 1, 2002, the Company’s funding commitment was reduced by the sale of 5% of ARTISTdirect Records’ equity to BMG and therefore the Company has recorded only its proportionate share, on the basis of relative funding commitments, of any future losses of ARTISTdirect Records. The Company has recorded a liability related to this investment as of December 31, 2001 and 2002 as the Company’s share of losses exceeded their advances in 2001 and 2002.
The Company records a valuation allowance on loans to AD Records in the period in which it appears that the loan is no longer collectible. To date, the Company has not recorded a valuation allowance on its loans to AD Records as the carrying amount of the loans has been reduced to zero as a result of the Company recording its share of losses of AD Records as of December 31, 2001 and 2002.
LOSS PER COMMON SHARE
The Company computes net loss per share in accordance with SFAS No. 128, “Earnings per Share” and Securities and Exchange Commission Staff Accounting Bulletin No. 98 (SAB 98). SFAS No. 128 requires companies with complex capital structures to present basic and diluted EPS. Basic EPS is measured as the income or loss available to common shareholders divided by the weighted average outstanding common shares for the period. Diluted EPS is similar to basic EPS but presents the dilutive effect on a per share basis of potential common shares (e.g. convertible securities, options, etc.) as if they had been converted at the beginning of the periods presented. Potential common shares that have an anti-dilutive effect (i.e., those that increase income per share or decrease loss per share) are excluded from diluted EPS. Dividends to preferred shareholders and interest on the rescission offer balance have been added to the net loss in determining the net loss attributable to common shareholders.
Included in net loss attributable to common shareholders for the year ended December 31, 2000 is the effect of the beneficial conversion feature of the Series C redeemable preferred stock that converted into common shares as of March 31, 2000 in connection with the initial public offering. The value of the beneficial conversion feature was calculated based on the $24.00 per share difference between the initial public offering price of $120.00 and the effective conversion price of $96.00 multiplied by the 1,015,625 shares of common stock issued to the Series C shareholders.
The diluted loss per share excludes approximately 980,000, 820,000 and 780,000 securities as of December 31, 2000, 2001 and 2002, respectively, since the impact would be anti-dilutive.
STOCK-BASED COMPENSATION
The Company accounts for stock-based employee compensation in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25 and FASB Interpretation No. 44 (FIN 44), “Accounting for Certain Transactions Involving Stock Compensation,” and complies with the disclosure requirements of SFAS No. 123, “Accounting for Stock-Based Compensation.” Under APB No. 25, compensation expense is recorded based on the difference, if any, between the fair value of the Company’s stock and the exercise price on the measurement date. The Company accounts for stock issued to non-employees in accordance with SFAS No. 123, which requires entities to recognize as expense over the service period the fair value of all stock-based awards on the date of grant and EITF 96-18, “Accounting for Equity Investments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services”, which addresses the measurement date and recognition approach for such transactions.
The Company recognizes compensation expense related to variable awards in accordance with FIN 28. For fixed awards, the Company recognizes expense over the vesting period or the period of service.
Stock-based compensation is comprised of sales and marketing expense of $2.2 million, $6.3 million and $1.9 million for the years ended December 31, 2000, 2001 and 2002, respectively, and general and administrative expense of $2.9 million, $6.1 million and $31,000 for the years ended December 31, 2000, 2001 and 2002, respectively.
Prior to the Company’s initial public offering in March 2000, the Company issued shares or options to purchase shares to employees, artists and advisors. The issuance of these shares or options did not fully comply with certain requirements under the Securities Act, or available exemptions there under, and as a result the Company made a rescission offer to all these persons pursuant to a registration statement filed under the Securities Act and pursuant to California securities law.
As a result of completing the rescission offer in December 2001, the Company incurred stock based compensation expense for the repurchase of unexercised stock options held by employees and non-employees and shares of common stock held by employees and non-employees pursuant to the exercise of stock options. The compensation expense recorded for the repurchase of unexercised stock options (vested and unvested) from employees was the sum of the intrinsic value at the original measurement date (less any expense related to the intrinsic value recorded up to the acceptance of the rescission offer) and the amount of cash paid to the holder that exceeds the lesser of the intrinsic value at the original measurement date or upon the completion of the rescission offer. Such amount was recorded as expense immediately upon the completion of the rescission offer.
The compensation expense recorded for the repurchase of unexercised non-employee options (vested and unvested) was calculated as the difference between the amount of cash paid for the repurchase of the options and the fair value of the options on the closing date of the rescission offer. This compensation expense was recorded over the period over which the non-employee provided services to the Company pursuant to a contract. The fair value of the options was determined using the Black-Scholes option-pricing model over the remaining life of the options. Any unamortized expense at the time of repurchase related to the initial grant of the options to the non-employees continued to be amortized over the remaining service period related to the original option grants. The key assumptions used in the Black Scholes model for the purpose of the calculation were: a risk free rate of 6%; a volatility factor of 98%; no expected dividends; and an expected life which was equal to the remaining contractual life of the options as of December 31, 2001.
The compensation expense for the repurchase of shares issued pursuant to the exercise of options (by employees and non-employees) was calculated as the difference between the amount of cash paid for the repurchase of the shares and the fair value of the shares on the date the repurchase. The compensation expense related to the repurchase of shares from employees was recorded at the time of repurchase, and the compensation expense related to the repurchase of shares from non-employees was recorded over the period over which services were being provided.
Pro forma information regarding net loss per share is required by SFAS 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of such statement. The fair value for these options was estimated at the date of grant using the Black-Scholes option-pricing model. The assumptions used in the model and the weighted average fair value of each option granted for 2000, 2001 and 2002 are as follows:
For purpose of pro forma disclosures, the estimated fair value of the options is amortized into expense over the options’ vesting period. The Company’s pro forma information follows (in thousands, except per share amount):
COMPREHENSIVE LOSS
The Company’s only component of other comprehensive income is the unrealized gain (loss) on available for sale securities, which was a gain of $146,000 and $78,000 as of December 31, 2001 and 2002, respectively. These amounts have been recorded as a separate component of stockholders’ equity.
ESTIMATES
In preparing financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Some of the more significant estimates include allowances for bad debt, impairment of long-lived assets and goodwill, stock based compensation and the valuation allowance on deferred tax assets. Actual results could differ from those estimates.
RECLASSIFICATIONS
Certain reclassifications have been made to the 2000 and 2001 financial statements to conform to the 2002 presentation.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In July 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and Other Intangible Assets”. SFAS No. 141 requires that all business combinations be accounted for under the purchase method. The statement further requires separate recognition of intangible assets that meet one of two criteria. The statement applies to all business combinations initiated after June 30, 2001.
SFAS No. 142 requires that an intangible asset that is acquired shall be initially recognized and measured based on its fair value. The statement also provides that goodwill should not be amortized, but shall be tested for impairment annually, or more frequently if circumstances indicate potential impairment, through a comparison of fair value to its carrying amount. SFAS No. 142 is generally effective for fiscal periods beginning after December 15, 2001 and the amortization provisions of SFAS No. 142 are effective for acquisitions subsequent to June 30, 2001. The Company adopted SFAS No. 142 effective January 1, 2002 (See Notes 2 and 8).
In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. While SFAS No. 144 supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,” it retains many of the fundamental provisions of that statement. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. The adoption of SFAS No. 144 did not have a material impact on the Company’s financial position, result of operation and cash flow.
In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections (SFAS 145).” SFAS 145 rescinds SFAS 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. Upon adoption of SFAS 145, we will be required to apply the criteria in APB Opinion No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions (Opinion No. 30), in determining the classification of gains and losses resulting from the extinguishment of debt. Additionally, SFAS 145 amends SFAS 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions to be accounted for in the same manner as sale-leaseback transactions. SFAS 145 will be effective for fiscal years beginning after May 15, 2002 with early adoption of the provisions related to the rescission of SFAS 4 encouraged. Upon adoption, companies must reclassify prior period items that do not meet the extraordinary item classification criteria in Opinion No. 30. The adoption of SFAS 145 for long-lived assets held for use did not have a material impact on the Company’s consolidated financial statements.
In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit and Disposal Activities.” SFAS 146 nullifies Emerging Issues Task Force (EITF) issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). Under EITF issue 94-3, a liability for an exit cost is recognized at the date of an entity’s commitment to an exit plan. Under SFAS 146, the liabilities associated with an exit or disposal activity will be measured at fair value and recognized when the liability is incurred and meets the definition of a liability in the FASB’s conceptual framework. This statement is effective for exit or disposal activities initiated after December 31, 2002. The Company believes that the adoption of SFAS 146 will not have a material impact on its consolidated financial statements.
In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others” (“FIN 45”), an interpretation of FASB Statements Nos. 5, 57 and 107 and a rescission of FASB Interpretation No. 34. FIN 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees issued. FIN 45 also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken. The initial recognition and measurement provisions of FIN 45 are applicable to guarantees issued or modified after December 31, 2002 and are not expected to have a material effect on the Company’s financial position, result of operation and cash flow. The disclosure requirements are effective for financial statements of interim and annual periods ended after December 15, 2002.
In November 2002, the FASB’s Emerging Issues Task Force (EITF) issued EITF 00-21 “Revenue Arrangements with Multiple Deliverables.” EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. Specifically, EITF 00-21 addresses how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. In applying EITF 00-21, separate contracts with the same entity or related parties that are entered into at or near the same time are presumed to have been negotiated as a package and should, therefore, be evaluated as a single arrangement in considering whether there are one or more units of accounting. That presumption may be overcome if there is sufficient evidence to the contrary. EITF 00-21 also addresses how arrangement consideration should be measured and allocated to the separate units of accounting in the arrangement. The guidance in this Issue is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. Alternatively, companies may elect to report the change in accounting as a cumulative-effect adjustment. Early application of this consensus is permitted. The adoption of this accounting pronouncement may have a significant impact on the Company’s financial statements.
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure-an amendment of SFAS No. 123”. This statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. This statement also amends the disclosure requirements of SFAS No. 123 and APB Opinion No. 28, “Interim Financial Reporting,” to require prominent disclosures in both annual and interim financial statements about the method of
accounting for stock-based employee compensation and the effect of the method used on reported results. Certain of the disclosure modifications are required for fiscal years ending after December 15, 2002 and are included in the Notes to these Consolidated Financial Statements. The Company will implement SFAS No. 148 effective January 1, 2003 regarding disclosure requirements for condensed financial statements for interim periods. The Company’s management has determined that they will continue to account for stock-based employee compensation in accordance with APB No. 25.
In February 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46”), which addresses the consolidation by business enterprises of variable interest entities, which have one or both of the following characteristics: (1) the equity investment at risk is not sufficient to permit the entity to finance its activities without additional financial support from other parties, or (2) the equity investors lack one or more of the following essential characteristics of a controlling financial interest: (a) the direct or indirect ability to make decisions about the entity’s activities through voting or similar rights, (b) the obligation to absorb the expected losses of the entity if they occur, or (c) the right to receive the expected residual returns of the entity if they occur. FIN 46 will have a significant effect on existing practice because it requires existing variable interest entities to be consolidated if those entities do not effectively disburse risks among parties involved. In addition, FIN 46 contains detailed disclosure requirements. FIN 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. This Interpretation may be applied prospectively with a cumulative-effect adjustment as of the date on which it is first applied or by restating previously issued financial statements for one or more years with a cumulative-effect adjustment as of the beginning of the first year restated. The adoption of this pronouncement may have a significant impact on the Company’s consolidated financial statements.
4. SUPPLEMENTAL DISCLOSURES TO CONSOLIDATED STATEMENTS OF CASH FLOWS
Significant non-cash investing and financing activities are reflected in the following table:
5. SHORT-TERM INVESTMENTS
The Company’s short-term investments consist of the following:
6. PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost and consist of the following:
7. ALLOWANCES FOR DOUBTFUL ACCOUNTS AND SALES RETURN RESERVE
A summary of the activity of the allowance for doubtful accounts for the periods indicated is reflected in the following table:
A summary of the activity of the reserve for sales returns for the periods indicated is reflected in the following table:
8. GOODWILL
As described in Note 3, the Company adopted SFAS No. 142 in January 2002. The following table reconciles the reported net loss for the years ended December 31, 2000, 2001, and 2002 to their adjusted amounts, excluding
previously reported goodwill amortization expense, which is no longer recorded under the provisions of SFAS No. 142:
While not contemplated by the disclosure requirements of SFAS No. 142, the elimination of goodwill amortization in 2000 and 2001 would have increased the related recorded balances of goodwill in these periods and accordingly would have increased the loss from impairment of goodwill in 2001 and 2002 by aggregate amounts equal to the eliminated goodwill amortization.
9. ACCRUED EXPENSES
Accrued expenses are comprised of the following:
10. INVESTMENT IN ARTISTDIRECT RECORDS, LLC
In May 2001, the Company entered into an agreement with Frederick W. “Ted” Field to become Chairman and Chief Executive Officer of ARTISTdirect and form a new record label ARTISTdirect Records, LLC, in partnership with ARTISTdirect. On June 29, 2001, ARTISTdirect stockholders approved the employment of Mr. Field and the formation of the ARTISTdirect Records record label. ARTISTdirect Records was formed as a 50/50 co-venture between ARTISTdirect and Mr. Field, with the Company providing a $50 million financial commitment.
In November 2001, ARTISTdirect Records agreed in principle to enter into a preliminary North America distribution agreement and worldwide license agreement with BMG, the global music division of Bertelsmann AG. Under the terms of the agreement, BMG Distribution will distribute the label’s releases in North America, and BMG will license ARTISTdirect Records repertoire in territories throughout the world. In April 2002, the agreements
with BMG were finalized, including BMG’s purchase of 5% of the equity of ARTISTdirect Records from the Company. As part of this transaction, BMG agreed to assume $5.0 million of the Company’s funding commitment to ARTISTdirect Records. The Company initially committed to ARTISTdirect Records a total of $50 million over five years with the Company committing to fund up to $15.0 million per year, subject to a limit of $33 million in any three year period. Any funding in excess of these amounts would require the approval of the Company’s Board of Directors. As a result of the BMG equity purchase, the Company’s funding commitment was reduced to $45 million.
In August 2002, the Company’s Board of Directors approved an agreement (the “Bridge Loan Agreement”) to accelerate up to $10 million of its funding commitment to ARTISTdirect Records. This funding was in addition to the $15 million that the Company was obligated to advance to ARTISTdirect Records in 2002 as part of the initial $50 million funding commitment. During 2002, the Company funded its $15 million commitment plus the additional $10 million bridge loan for total advances to the record label of $25.0 million in 2002 and $30.25 million from the inception of the record label through December 31, 2002. The $10 million of accelerated funding was credited toward the satisfaction of the Company’s overall funding commitment and funding obligation for 2003 resulting in a remaining funding commitment of $2.75 million for 2003 and $12.0 million for 2004. The Company’s commitment to fund ARTISTdirect Records is subject to a guaranty for the benefit of BMG. Should the Company fail to meet its commitment, BMG may choose to enforce the guaranty or provide substitute financing that could result in dilution of the Company’s interest in ARTISTdirect Records.
As consideration for entering into the Bridge Loan Agreement and funding the additional $10 million, the Company received an additional 20% interest in ARTISTdirect Records from Radar Records Holdings, L.L.C. (“FieldCo,” the entity through which Mr. Field owns his interest in ARTISTdirect Records) which resulted in an increase in the Company’s ownership share of ARTISTdirect Records to 65% from 45% and a decrease in Mr. Field’s ownership share to 30% from 50%. The Bridge Loan Agreement also provides that any dilution from the issuance of equity interests in ARTISTdirect Records that would have been borne solely by the Company will be borne both by FieldCo and the Company pro rata with their then respective ownership interests. Furthermore, the Bridge Loan Agreement provides for FieldCo to guarantee a 25% minimum annual compounded return to be realized from the Company's advances and equity interests in ARTISTdirect Records, however, there can be no assurance that such rate of return will be realized. Consequently, the Company has not recorded any amounts related to the 25% minimum annual compounded return.
ARTISTdirect Records will require capital in 2003 in addition to the $2.75 million commitment from the Company. As a result, the Company is pursuing alternatives to raise additional capital for both itself and for ARTISTdirect Records. However, there can be no assurance that additional capital can be obtained by either the Company or by ARTISTdirect Records on reasonable terms or at all. If additional funds were raised through the issuance of equity securities of either the Company or ARTISTdirect Records, the percentage ownership of the Company’s current stockholders in the Company and/or ARTISTdirect Records would be reduced. Failure to raise additional capital could seriously harm the business of ARTISTdirect Records and impair the value of the Company’s investment in ARTISTdirect Records. In such event, we may seek to divest all or certain of our assets or the entire company in order to raise the capital necessary to sustain business operations. Should this fail we may be forced to cease operations and seek bankruptcy protection or undertake liquidation, potentially resulting in a total loss for stockholders.
Because the Company does not have voting or operating control of ARTISTdirect Records, even with its majority ownership position, it does not consolidate the results of ARTISTdirect Records and it records its share of losses based on the equity method of accounting as loss from equity investments in its consolidated statements of operations. Prior to the completion of BMG’s purchase of a 5% interest in ARTISTdirect Records in April 2002 and BMG’s assumption of 10% of the Company’s total funding commitment, the Company had committed to fund 100% of the operations of ARTISTdirect Records and has recorded 100% of the losses attributable to that venture from inception of ARTISTdirect Records to April 30, 2002. From May 1, 2002, the Company has recorded only its proportionate share, on the basis of remaining relative funding commitments, of any future losses of ARTISTdirect Records. The Company recognized $8.6 million and $29.3 million of equity loss from the record label for the years ended December 31, 2001 and 2002, respectively.
The Company charged ARTISTdirect Records $200,000 and $1.35 million in 2001 and 2002, respectively, for the reimbursement of overhead costs including rent and other occupancy costs and shared personnel. These amounts are reflected as a reduction in general and administrative expense in the Company’s consolidated statements of operations.
The carrying amount of the Company’s investment in ARTISTdirect Records represents the difference between the Company’s investment and advances and the Company’s share of losses from ARTISTdirect Records. The Company continues to record the losses of ARTISTdirect Records to the extent it has additional funding commitments. The Company records its loan advances to ARTISTdirect Records as additional equity investments. As of December 31, 2001 and 2002, the Company’s share of losses exceeded the amount of the Company’s investment and advances to those dates, resulting in a credit balance of approximately $3.0 million and $7.7 million, respectively. Therefore, the carrying amounts have been classified as a liability on the Company’s balance sheet.
The Company has no recorded investment in the loans to ARTISTdirect Records, as the carrying amount of the loans have been reduced to zero as a result of the Company recording its share of losses of ARTISTdirect Records as of December 31, 2001 and 2002. The Company does not record interest income on the loans to ARTISTdirect Records.
A rollforward of the Company’s net investment balance for the periods indicated is as follows:
See the separate financial statements for ARTISTdirect Records, LLC as an exhibit to this Form 10-K.
11. INVESTMENTS IN OTHER AFFILIATED COMPANIES
The Company has a 45% ownership in SnoCore, LLC and accounts for the investment under the equity method. The Company recorded equity income of $15,000 and $48,000 for this investment for the years ended December 31, 2000 and 2001, respectively, and an equity loss of $16,000 for the year ended December 31, 2002. The Company received distributions of $0, $5,000 and $0 from the investee during the years ended December 31, 2000, 2001 and 2002, respectively.
During the year ended December 31, 2000, the Company entered into a joint venture, ARTISTdirect Latin America, LLC in which the Company held a 50% ownership interest. The Company made investments of $250,000 and $395,000 during the years ended December 31, 2000 and 2001, respectively, and recorded these amounts as its share of losses under the equity method. During 2002, the venture ceased operations and no additional investment was made or loss recognized by the Company during 2002.
12. DISCONTINUED OPERATIONS
In December 2001, the Company made the decision to exit the music talent agency business and as a result this segment has been classified as a discontinued operation in the consolidated statement of operations for years ended December 31, 2000, 2001 and 2002 and its net results are reflected as “Income from discontinued operations.” The Agency business did not have any significant assets or liabilities associated with it and no gain or loss has been
recognized related to its disposal. The wind up of operations of the Agency business was completed during 2002. A summary of the income statements of the Agency business segment is as follows:
13. INCOME TAXES
Income taxes differ from the amount computed using a tax rate of 35% as a result of the following:
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and (liabilities) at December 31, 2001 and 2002 are presented below:
At December 31, 2002, the Company had net operating loss carryforwards totaling approximately $131.3 million for Federal income tax purposes expiring beginning in 2019 and California state net operating loss carryforwards of $130.3 million expiring beginning in 2007. Due to the uncertainty surrounding the realization of the benefits of its tax attributes, including net operating loss carryforwards in future tax returns, the Company has recorded a valuation allowance against its deferred tax assets as of December 31, 2001 and 2002 of $64.6 million and $81.4 million, respectively.
In assessing the potential realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the Company attaining future taxable income during the periods in which those temporary differences become deductible. In addition, Internal Revenue Code Section 382 substantially restricts the ability of a Corporation to utilize existing net operating losses in the event of an “ownership change.” Therefore, the Company’s net operating losses for Federal income tax purposes may be limited due to changes in ownership.
14. SIGNIFICANT CONTRACTS
In February 2002, the Company amended an existing agreement with Ticketmaster pursuant to which the Company agreed to purchase online advertising totaling $2.0 million from Ticketmaster and in conjunction became entitled to certain non-exclusive opportunities to “pre-sell” tickets on the ARTISTdirect website. The Company recognized as sales and marketing expense the amount paid on straight-line basis, which approximates how the services were received, over the amended term of the agreement. The term of the amended agreement expires in April 2003.
In connection with the issuance of Series C Preferred shares in 1999 and 2000, the Company entered into strategic relationships with four record labels. Under the terms of these agreements, the Company has the right to purchase certain content related to each of the respective companies’ artists on terms generally made available to other online music companies. Under one of the agreements, the Company provided marketing and promotional services on its network and recognized advertising and sponsorship revenues of $1.0 million and $500,000 in the years ended December 31, 2000 and 2001, respectively. The Company never received any content as expected under the agreement and during 2001 determined that the collectibility of this receivable either in the form of cash or acceptable content was impaired under this agreement. Consequently, a provision for doubtful accounts of $1.5 million was recorded in the consolidated statement of operations. The Company did not provide or receive any services or benefits from any of the other labels and did not record any revenues or expenses related to these other agreements.
In December 1999, the Company entered into an advertising and promotion agreement with Yahoo! pursuant to which the Company purchased media placement on Yahoo! in return for cash and warrants in the Company (see Note 16 regarding treatment of warrants).. The Company recorded as sales and marketing the expense related to the amounts paid in cash to Yahoo! for advertising and promotion services over the term of the agreement on a straight-line basis that approximates how the promotions were received. On November 7, 2000, the Company amended this agreement such that it was terminated as of December 31, 2000. Yahoo! delivered certain additional page views containing the Company’s banners on various Yahoo! properties through June 30, 2001.
In April 2000, the Company entered into an agreement with a landlord for office space for a term of ten years. In connection with the agreement, the Company issued warrants to purchase 6,250 shares of common stock at $139.30 per share. The expense related to the warrants is being amortized over the term of the agreement.
For the years ended December 31, 2000, 2001 and 2002, the Company incurred legal expenses of approximately $464,000, $364,000 and $260,000, respectively, for legal services provided by Lenard & Gonzalez LLP and its successor firm, Lenard, Brisbin & Klotz LLP. Allen Lenard, one of the Company’s former directors who resigned from the board in September 2002, was Managing Partner of Lenard & Gonzalez LLP and is managing partner of Lenard, Brisbin & Klotz LLP.
The Company entered into a settlement agreement with an employee in connection with the termination of his employment in October 1997. Pursuant to this agreement, the employee received a severance payment of $175,000 that was paid in full in 1999. As part of the settlement agreement, the individual received an option to purchase the lesser of 10,000 securities or 2.5% of the shares offered to the public upon an initial public offering at an exercise price that will be set at the completion of the initial public offering pursuant to the provision defined in the settlement agreement. The employee exercised the purchase option of 10,000 shares. The Company recorded compensation expense of $1,025,000 for the year ended December 31, 2000, which represented the difference between the fair value of the common stock and the amount paid.
15. RESCISSION OFFER
In December 2001, the Company completed a rescission offer in which it rescinded the purchase of 83,403 shares of its common stock purchased upon the exercise of options and the issuance of vested and unvested unexercised options to purchase 636,740 shares of common stock. The shares of stock were repurchased at prices ranging from $12.40 to $40.00 per share and the unexercised options that were rescinded had exercise prices ranging from $12.40 to $140.00 per share. In aggregate, the Company paid $10.2 million to rescind the shares and options.
As a result of the completion of the rescission offer, the Company recorded stock compensation expense of $6.9 million and $1.9 million in 2001 and 2002, respectively. The $6.9 million of compensation expense recognized in 2001 consisted of $859,000 reflected in cost of revenues and $6.1 million included in operating expenses as stock-based compensation. The $1.9 million of compensation expense recognized in 2002 consisted of $900,000 reflected in cost of revenues and $1.0 million reflected in operating expenses. No additional compensation expense related to the rescission offer is expected in 2003.
As of December 31, 2001, the Company reclassified $2.7 million of unearned compensation (related to the original option grants subject to the rescission offer) to prepaid stock-based compensation in the balance sheet, as the underlying equity instruments were no longer outstanding as a result of the rescission of the instruments in December 2001.
The Company did not record any compensation expense related to the shares and options of those holders who chose not to accept the rescission offer. The staff of the Securities and Exchange Commission has taken the position that a person’s federal right of rescission may survive the rescission offer. However, federal courts in the past have ruled that a person who rejects or fails to accept a rescission offer is precluded from later seeking similar relief. The Company believes that subsequent to the rescission offer, any rights to rescind will be contingent upon legal rulings, the outcome of which are not currently determinable. Accordingly, the Company will account for shares and options that were not rescinded in the rescission offer as if there is no right of rescission. In the event any rescissions occur subsequent to the expiration of the rescission offer in December 2001, the Company will account for those rescissions, if any, in the manner described above at the time those rescissions are completed.
16. STOCKHOLDERS’ EQUITY
COMMON STOCK
In March 2000, the Company completed an initial public offering in which it sold 500,000 shares for total proceeds, net of offering costs, of $52.4 million.
In April 2001, the Company completed a tender offer in which it repurchased 200,000 shares of common stock for a total cost of $2.5 million. The repurchased shares are reflected as treasury stock in the balance sheet as of December 31, 2001.
In May 2001, the Company authorized the purchase of up to $2 million worth of the Company’s common stock. During 2001, the Company repurchased in the open market or in privately negotiated transactions 39,499 shares of common stock for an aggregate purchase price of approximately $234,000. This repurchase was separate from the Company’s tender offer described above, and is reflected as treasury stock in the balance sheet as of December 31, 2001. No shares were repurchased by the Company in 2002.
VARIABLE EQUITY INTERESTS
During 1998, the Company issued common units, which were converted to common shares upon the conversion of the Company to a C Corporation in October 1999, to certain executive employees and its outside legal counsel in connection with services rendered and to be rendered. These units were accounted for as stock appreciation rights (Appreciation Rights), and as a result of these transactions, the Company recorded a credit to stock based compensation expense in the amount of $6.6 million for the year ended December 31, 2000 as a result of the decline
in the value of the Company’s common shares from December 31, 1999 to March 31, 2000, the date on which the Appreciation Rights were settled.
WARRANTS
During 1999, the Company issued warrants, which were immediately exercisable, to purchase 35,967 shares of common stock at $40.00 per share to two vendors from whom it purchased merchandise. None of the warrants have been exercised as of December 31, 2002. The value of the warrants was $864,000, of which $262,000, $322,000 and $79,000 was recognized as stock based compensation in cost of revenues for the years ended December 31, 2000, 2001 and 2002, respectively. The remaining unamortized value of the warrants of $32,000 will be amortized in 2003 over the remaining agreement term.
In December 1999, the Company issued warrants to purchase 33,926 shares of common stock at $120 per share in connection with an advertising and promotion agreement. The warrants vested in December 2001. The value of the warrants upon issuance was $2.0 million. These warrants are being accounted for as variable instruments under EITF 96-18 up through June 30, 2001, when performance under the agreement was completed and a measurement date was reached. Due to the decrease in fair value of the Company’s common stock, the value of the warrants was reduced to $66,000 as of June 30, 2001. The related expense for the years ended December 31, 2000, 2001 and 2002 was $28,000, $20,000 and $0, respectively. The warrants expired unexercised in December 2002.
In January 2000, the Company issued warrants to purchase 6,250 shares of common stock at $139.28 per share in connection with an office lease. The warrants, which expire in January 2005, were exercisable upon grant, and none have been exercised as of December 31, 2002. The warrants were valued at $568,000 and are being amortized over the term of the related lease. During the years ended December 31, 2000, 2001 and 2002, $47,000, $57,000 and $57,000, respectively, has been recorded as stock based compensation expense.
EQUITY TRANSFER
In March 2000, the founders of the Company entered into a series of transactions whereby two employees and an outside legal counsel would receive the appreciation on the Company’s common stock above $139.28 per share through the third day of trading after the initial public offering. Additionally, the two employees and outside legal counsel received stock options on the third day of trading after the initial public offering with an exercise price of $139.28. There was no expense charge for the appreciation rights and stock options granted to the two employees, as the stock price was below $139.28 per share on the third day of trading and the exercise price on the stock options was greater than the fair value of the Company’s common stock on the date of grant. The fair value of the appreciation rights and stock options granted to the outside legal counsel was $2,029,000 and was recorded as expense for the year ended December 31, 2000, as the grants related to past services. The stock option grants to the outside legal counsel are reflected as option grants under the Advisor Plan (see discussion in Note 17).
17. STOCK OPTIONS
EMPLOYEE OPTION PLAN
In October 1999, the Company implemented the 1999 Employee Stock Option Plan that replaced the 1998 Unit Option Plan. The plan has currently reserved 801,185 shares of the Company’s common stock for issuance to employees, non-employee members of the board of directors and consultants. This share reserve automatically increases on the first trading day in January each calendar year by an amount equal to two percent (2%) of the total number of shares of our common stock outstanding on the last trading day of December in the prior calendar year, but in no event will this annual increase exceed 87,500 shares. No option may have a term in excess of 10 years. The options generally vest within three years. As of December 31, 2002, 553,179 shares remained available for future option grant.
The Company accounts for its employee stock option plan in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” Interpretation No. 44, and
other related interpretations. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price.
Summary stock option activity for 1999 Employee Stock Option Plan during the years ended December 31, 2000, 2001 and 2002 is as follows:
The Company recorded stock-based compensation of $4.7 million, $2.7 million and $31,000 related to stock options granted to employees under the 1999 Employee Stock Option Plan during the years ended December 31, 2000, 2001 and 2002, respectively.
In February 2000, the Company accelerated the vesting of 11,480 stock options granted to an executive of the Company. The resulting compensation expense of $964,000, which represented the difference between the fair value of the Company’s common stock on the date of modification and the exercise price, was recorded during the year ended December 31, 2000.
In May 2001, the Company granted an officer non-qualified stock options, which are not part of any stock option plan maintained by the Company, to purchase 444,480 shares of common stock at an exercise price of $7.50 per share. Of the 444,480 option shares, 302,370 are exercisable immediately (the underlying shares pursuant to the exercise of this portion of the options vest over five years from the date of the option grant), 75,588 are exercisable in the event the 30-day average closing price of the Company’s common stock on NASDAQ equals or exceeds $35.00 per share within three years from the grant date, and 66,522 are exercisable in the event the 30-day average closing price of the Company’s common stock on NASDAQ equals or exceeds $70.00 per share within three years of the grant date. The two options that are not exercisable upon grant shall also become exercisable in the event of a de-listing of the Company’s common stock from NASDAQ and a subsequent re-listing, a change in control of the Company or an involuntary termination of the officer (within three years of the date of grant). These stock option grants were non-compensatory as the exercise price exceeded the fair value of the common stock on the date of grant.
In September 2001, the Company granted options to purchase 35,687 shares of its common stock at an exercise price of $7.50 per share to outside legal counsel. The fair value of the stock options granted to the outside legal counsel was $171,000 and was recorded as stock based compensation during 2001 as the grant related to past services.
The following table summarizes information regarding options outstanding and options exercisable at December 31, 2002:
ADVISOR OPTION PLAN
In June 1999 and as amended in October 1999 and March 2000 the Company adopted the 1999 Artist and Artist Advisor Stock Option Plan (the Advisor Plan). The Advisor Plan has currently reserved 260,000 shares of common stock for issuance to artists for whom the Company entered into agreements related to online and e-commerce activities and their agents, business managers, attorneys and other advisors. This share reserve automatically increases on the first trading day in January each calendar year by an amount equal to one percent (1%) of the total number of shares of our common stock outstanding on the last trading day of December in the prior calendar year, but in no event will this annual increase exceed 37,500 shares. As of December 31, 2002, 224,464 shares remained available for future option grants. The options expire seven years from the date of grant and vesting generally varies between one to three years. In December 2001, a majority of the outstanding options under the Advisor plan were rescinded and cancelled. No new option grants under this plan were made during 2001 or 2002.
Summary stock option activity for the Advisor Plan options during the years ended December 31, 2000, 2001 and 2002 is as follows:
The weighted average fair value of options granted under the Advisor Plan was $66.50 per option in 2000 resulting in a total value for options granted of $2.1 million. Of the $2.1 million, $1.8 million was expensed in 2000 and $300,000 was expensed in 2001.
The following table summarizes information regarding options outstanding and options exercisable at December 31, 2002:
ARTIST OPTION PLAN
In June 1999 and as amended in October 1999, the Company adopted the 1999 Artist Stock Plan (the Artist Plan). The Artist Plan currently has reserved 551,185 shares of common stock for issuance to artists for whom the Company entered into agreements related to their online and e-commerce activities. This share reserve automatically increases on the first trading day in January each calendar year by an amount equal to two percent (2%) of the total number of shares of our common stock outstanding on the last trading day of December in the prior calendar year, but in no event will this annual increase exceed 87,500 shares. As of December 31, 2002, 527,311 shares remained available for future option grants. The options expire seven years from the date of grant and vesting generally varies between one to three years. In December 2001, a majority of the outstanding options under the Advisor plan were rescinded and cancelled. No new option grants under this plan were made during 2001 or 2002.
Summary stock option activity for the Artist Option Plan during the years ended December 31, 2000, 2001 and 2002 is as follows:
The weighted average fair value of the options granted under the Artist Option Plan in 2000 was $99.70 per option resulting in a total value for options granted of $4.7 million that has been recorded as unearned compensation in the statement of stockholders’ equity, and is being amortized over the service period of the related artist agreements.
The following table summarizes information regarding options outstanding and options exercisable at December 31, 2002:
Total compensation expense related to the Advisor Plan and the Artist Option Plan (excluding the impact of the rescission offer) was $10.2 million, $10.6 million and $2.9 million for the years ended December 31, 2000, 2001 and 2002, respectively, of which $7.3 million, $7.2 million and $2.1 million, respectively, was included in cost of revenue, and $2.9 million, $3.4 million and $800,000, respectively, was included in operating expenses.
The estimated fair values of the options granted under the Advisor Plan and the Artist Option Plan was determined using the Black-Scholes option-pricing model. The key assumptions used in the model for the purpose of the calculation were a risk free rate of 6.4%, a volatility factor ranging from 80% to 150%, no expected dividends and an expected life of seven years (the contractual term of the options) for options granted in 2000.
For the year ended December 31, 2000, the decrease to unearned compensation of $1.4 million was comprised of additions of $5.7 million, which were offset by reductions of $7.1 million. The additions were a result of the grant of options under the Artist Option Plan and Advisor Plan with a fair value of $4.9 million; warrants granted to the landlord with a fair value of $568,000; and the issuance of compensatory options under the 1999 Employee Stock Option Plan with a fair value of $210,000. The reductions were a result of the cancellation of options under the Artist Option Plan and Advisor Plan with an unamortized balance of $1.3 million on the cancellation date; a decrease in the value of the unamortized portion of the variable equity interest of $600,000; a decrease in the value of warrants accounted for as variable instruments of $1.9 million; and the cancellation of unvested compensatory employee options with a remaining unamortized value of $3.3 million as a result of terminations in 2000.
For the year ended December 31, 2001, the decrease in unearned compensation of $2.4 million was a result of the cancellation of unvested compensatory employee options.
EMPLOYEE STOCK PURCHASE PLAN
In October 1999, the Company adopted the 1999 Employee Stock Purchase Plan that has reserved 100,000 shares of common stock for issuance under this plan. This share reserve automatically increases on the first trading day in January each calendar year, by an amount equal to one percent (1%) of the total number of our common stock
outstanding on the last trading day of December in the prior calendar year, but in no event will this annual increase exceed 25,000 shares. Terms of the plan permit eligible employees to purchase common stock through payroll deduction of up to 15% of each employee’s compensation. The accumulated deductions will be applied to the purchase of shares on each semi-annual purchase date at a purchase price per share equal to 85% of the fair market value per share on the participant’s entry date into the offering period or the semi-annual purchase date, whichever is lower. Pursuant to the provisions of APB No. 25, shares issued to employees under this plan are considered noncompensatory. During the years ended December 31, 2000, 2001 and 2002, 6,758 shares, 3,902 shares and 1,134 shares, respectively, were issued under this plan for total proceeds of $40,000, $17,000 and $4,000, respectively.
18. 401(K) PLAN
In February 1999 and as amended in January 2000, the Company adopted the Cash or Deferred Profit Sharing Plan and Trust under Section 401(k) of the Internal Revenue Code (the 401(k) Plan). Under the 401(k) Plan, participating employees may defer a percentage (not to exceed 15%) of their eligible pretax earnings up to the Internal Revenue Service’s annual contribution limit. All employees of the Company age 21 years or older who complete three months of service are eligible to participate in the 401(k) Plan. The Company does not match participants’ contributions to the 401(k) Plan. Accordingly, there is no expense for the years ended December 31, 2000, 2001 and 2002.
19. COMMITMENTS AND CONTINGENCIES
LEASE COMMITMENTS
Future minimum lease payments under operating leases for facilities and certain equipment are as follows as of the years ended December 31:
In conjunction with our office space lease, the Company has posted a letter of credit for the benefit of the landlord in the amount of approximately $1,806,000. If the Company is not in default of its lease obligations, the amount of the letter of credit reduces annually by $451,627 (20% of the original amount) in May of each year beginning in 2002.
Rent expense under operating leases for the years ended December 31, 2000, 2001 and 2002 for the Company was $1,735,000, $1,961,000 and $1,806,000, respectively.
The Company has entered into a sublease with a third party for a portion of its main facility. The sublease provides for monthly payments of approximately $55,000 through April 2004 and is recorded as a reduction to general and administrative expense.
EMPLOYMENT CONTRACTS
Future payments under employment contracts are as follows for the years ended December 31:
During 2002, certain employment agreements were amended whereby certain executives agreed to defer all or a portion of their future salaries until the Company raised new debt or equity financing of at least $20 million. The future payments under employment contracts as of December 31, 2002 shown above do not take into account these contractual deferrals. If these deferrals do not become payable, the Company’s future payment obligations under employment agreements as shown above would decrease by $1.0 million annually during 2003, 2004 and 2005 and by $500,000 during 2006.
LITIGATION
The Company is subject to various pending and threatened legal actions, which arise in the normal course of business. The Company’s management believes that the impact of such litigation will not have a material adverse impact on its financial position or results of operations.
20. REPORTABLE SEGMENTS
As of December 31, 2002, the Company operates primarily through three reportable segments: E-commerce operations (“E-commerce”), Media Operations (“Media”) and Record Label operations through its iMusic record label and its 65% equity interest in ARTISTdirect Records LLC, its co-venture with Ted Field. However, since the Company does not exert voting and operating control over ARTISTdirect Records, its results are not consolidated. Prior to June 2000, the Company operated its Kneeling Elephant record label venture and its results are reflected in the record label segment.
In prior years, the Company also considered its Talent Agency business to be a segment, but the Company decided in December 2001 to exit this business and as a result it has been shown as a discontinued operation in the Consolidated Statement of Operations. The Company also previously considered Digital Music to be a separate segment; however, this business has not developed as quickly as initially anticipated and is currently no longer considered a separate reportable segment. The segment data below has been restated for all periods to reflect the current segment structure.
E-commerce revenue is generated from the sale of recorded music and music-related merchandise. Media revenue is generated from the sale of advertising and sponsorships, both online and offline. Record label revenue is generated from the sale of recorded music performed by artists signed to the Company’s wholly owned iMusic record label.
The factors for determining reportable segments were based on service and products. Each segment is responsible for executing a unique marketing and business strategy. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on EBITDA (earnings or loss before interest, taxes, depreciation and amortization, including stock based compensation, and loss from impairment of goodwill). Included in EBITDA are direct operating expenses for the segment. The following table summarizes the revenue and EBITDA by segment for the years ended December 31, 2000, 2001 and 2002. Corporate expenses consist of general operating expenses that are not directly related to the operations of the segments.
The following table summarizes assets as of December 31, 2001 and 2002.
Assets by segment are those assets used in the Company operations in each segment. Corporate assets are principally made up of cash and cash equivalents, short-term investments, prepaid expenses, computer equipment, leasehold improvements and other assets.
As of December 31, 2002, the Company had advanced $30.25 million to its record label venture, ARTISTdirect Records and recorded losses of approximately $8.6 million and $29.3 million for the years ended December 31, 2001 and 2002, respectively. See Note 10 for further discussion.
21. QUARTERLY RESULTS OF OPERATIONS
The following table sets forth unaudited quarterly results of operations for the eight most recent quarters ended December 31, 2002. This unaudited quarterly information has been derived from the Company’s unaudited financial statements and, in the Company’s opinion, includes all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the information for the periods covered. The operating results for any quarter are not necessarily indicative of the operating results for any future period.
ARTISTDIRECT RECORDS, LLC
INDEPENDENT AUDITORS’ REPORT
The Members
ARTISTdirect Records, LLC
We have audited the accompanying balance sheets of ARTISTdirect Records, LLC (the Company) as of December 31, 2001 and 2002 and the related statements of operations, changes in members’ deficit and cash flows for the period from May 31, 2001 (inception) through December 31, 2001 and for the year ended December 31, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of ARTISTdirect Records, LLC as of December 31, 2001 and 2002 and the results of its operations and its cash flows for the period from May 31, 2001 (inception) through December 31, 2001 and for the year ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.
The accompanying financial statements have been prepared assuming that ARTISTdirect Records, LLC will continue as a going concern. As more fully described in note 1, the Company has incurred substantial operating losses and negative cash flows from operations to date. The Company needs additional capital to fund its operations. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ KPMG LLP
Los Angeles, CA
February 14, 2003
ARTISTDIRECT RECORDS, LLC
BALANCE SHEETS
(IN THOUSANDS)
See accompanying notes to financial statements.
ARTISTDIRECT RECORDS, LLC
STATEMENTS OF OPERATIONS
(IN THOUSANDS)
See accompanying notes to financial statements
ARTISTDIRECT RECORDS, LLC
STATEMENT OF CHANGES IN MEMBERS’ EQUITY (DEFICIT)
(IN THOUSANDS)
See accompanying notes to financial statements.
ARTISTDIRECT RECORDS, LLC
STATEMENT OF CASH FLOWS
(IN THOUSANDS)
See accompanying notes to financial statements.
ARTISTDIRECT RECORDS, LLC
NOTES TO FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
ORGANIZATION
ARTISTdirect Records, LLC (the “Company”) was formed in May 2001 as a 50/50 owned record company between ARTISTdirect, Inc.(“ARTISTdirect”) and Radar Records Holdings, LLC (“Radar Records”), an entity owned and controlled by Ted Field, Chairman and Chief Executive Officer of ARTISTdirect. The Company commenced operations in July 2001. At the time of formation of the Company, ARTISTdirect committed to provide funding of up to $50 million over five years, funding up to $15 million per year. In November 2001, ARTISTdirect agreed to sell a 5% equity interest in the Company to BMG Music, a wholly-owned partnership of Bertelsmann Music Group, Inc., the global music division of Bertelsmann AG (“BMG”), in connection with entering into a North American distribution agreement and a worldwide licensing agreement. In April 2002, these agreements were formally executed. As part of these transactions, BMG agreed to advance certain monies against net sales proceeds under the agreements and also assumed $5.0 million of ARTISTdirect’s funding commitment to the operations of the Company.
In August 2002, ARTISTdirect agreed to accelerate up to $10 million of its funding commitment to the Company under a bridge loan agreement. As part of the consideration for the accelerated funding, the full $10 million having been advanced during 2002, ARTISTdirect’s ownership percentage in the Company increased from 45% to 65% and Radar Record’s ownership percentage decreased to 30%. BMG’s ownership percentage remained at 5%.
GOING CONCERN
The Company has incurred losses and negative cash flows from operations since inception in 2001 and has an accumulated deficit of $42.5 million as of December 31, 2002. For the year ended December 31, 2002, the Company incurred a net loss of $34.0 million and negative operating cash flows of $31.0 million. The Company has relied on loan and distribution advances to fund its operations to date. During 2002, the Company received loan advances of $29.75 million from ARTISTdirect and BMG and has received $35.0 million of loan advances through December 31, 2002. Management expects its operating losses to continue for the foreseeable future. The Company will require additional advances or equity funding in order to meet anticipated needs for working capital and capital expenditures during the next twelve months. The Company is attempting to raise additional funding through the sale of its equity, but does not have any formal commitments as of the date of these financial statements. If such funding is not available, then the Company may be forced to cease operations and seek bankruptcy protection or undertake liquidation, potentially resulting in a total loss for equity holders. The conditions described above raise substantial doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
2. SIGNIFICANT ACCOUNTING POLICIES
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include deposits in a money-market account that are readily convertible into cash and have an original maturity date of 90 days or less.
REVENUE RECOGNITION
Revenue consists primarily of the sale of compact discs by artists signed under contract with the Company. The Company recognizes revenues upon the shipment of compact discs from its distributor to retailers and independent wholesalers and records appropriate reserves for product returns. At the time of the shipment of the product, the
following criterion under Statement of Financial Accounting Standards (SFAS) No. 48, “Revenue Recognition When Right of Return Exists,” have been met: the seller’s price to the buyer is substantially fixed or determinable at the date of sale; the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product; the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product; the buyer acquiring the product for resale has economic substance apart from that provided by the seller; the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer; the amount of future returns can be reasonably estimated.
The Company estimates the provision for returns on a quarterly basis by album based on the amount of time since the initial album release, the actual returns to date, the trend of sales activity (sales by the retailers and wholesalers) and the number of unsold units at retailers and wholesalers. Returns to the Company’s distributor are deemed to be returns to the Company. Revenues recorded for the year ended December 31, 2002 are net of a provision for actual and estimated future returns of $1.7 million.
COST OF REVENUE
Manufacturing expenses consists of the cost of pressing compact discs, manufacturing printed booklets and packaging materials and a provision for the obsolescence of finished goods and components. Distribution expenses consist of the distribution fee payable to BMG and other distribution expenses including the cost of processing returns and warehousing inventory. Artist advances and royalty expenses consist of payments made to artists and others in connection with the recording of an album.
ARTIST ADVANCES
Artist advances consists of the amounts advanced to artists in connection with the recording of their albums. In addition, included in artist advances are costs expended for producer fees, musician fees, engineering and studio costs, equipment costs, mastering and remix costs, sample clearances and artist living expenses during recording. Artist advances are typically recoupable from artist royalties earned from the sale of compact discs. The Company expenses these advances when incurred as the Company’s artists have limited or no history of album sales.
INVENTORY
Inventory, net of a provision for obsolescence, consists of finished albums maintained in the warehouse of the Company’s distributor and is stated at the lower of cost or net realizable value.
DEPRECIATION
Depreciation is provided using the straight-line method over the following estimated useful lives:
INCOME TAXES
The Company is treated as a limited liability company for federal and state income tax reporting purposes whereby income (or losses) of the Company is reported in the individual income tax returns of the Company’s members.
STOCK-BASED COMPENSATION
The Company accounts for stock-based employee compensation in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25 and FASB Interpretation No. 44 (FIN 44), “Accounting for Certain Transactions Involving Stock Compensation,” and complies with the disclosure requirements of SFAS No.
123, “Accounting for Stock-Based Compensation.” Under APB No. 25, compensation expense is recorded based on the difference, if any, between the fair value of the Company’s stock and the exercise price on the measurement date. The Company accounts for stock issued to non-employees in accordance with SFAS No. 123, which requires entities to recognize as expense over the service period the fair value of all stock-based awards on the date of grant and EITF 96-18, “Accounting for Equity Investments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services”, which addresses the measurement date and recognition approach for such transactions. The Company recognizes compensation expense related to variable awards in accordance with FIN 28. For fixed awards, the Company recognizes expense over the vesting period or the period of service
The Company has not recorded any stock-based compensation expense for the periods ended December 31, 2001 and 2002.
CONCENTRATION OF CREDIT RISK AND SUPPLIER RISK
Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash and cash equivalents and trade accounts receivable. The Company places its cash and cash equivalents in high credit quality instruments. Cash balances at certain financial institutions may exceed the FDIC insurance limits. The Company’s exposure to losses on receivables is dependent upon the financial condition of its distributor, BMG, who is responsible for credit losses from retail or wholesale customers.
The Company purchases its inventory from a limited number of suppliers. However, there are a number of alternative suppliers who can provide manufacturing services for the Company.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts of financial instruments, which include cash and cash equivalents, accounts receivable, accounts payable and accrued expenses, approximate fair value because of the short maturity of these instruments.
ESTIMATES
In preparing financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Some of the more significant estimates are the allowance for sales returns and inventory obsolescence. Actual results could differ from those estimates.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In July 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and Other Intangible Assets”. SFAS No. 141 requires that all business combinations be accounted for under the purchase method. The statement further requires separate recognition of intangible assets that meet one of two criteria. The statement applies to all business combinations initiated after June 30, 2001.
SFAS No. 142 requires that an intangible asset that is acquired shall be initially recognized and measured based on its fair value. The statement also provides that goodwill should not be amortized, but shall be tested for impairment annually, or more frequently if circumstances indicate potential impairment, through a comparison of fair value to its carrying amount. SFAS No. 142 is generally effective for fiscal periods beginning after December 15, 2001 and the amortization provisions of SFAS No. 142 are effective for acquisitions subsequent to June 30, 2001. The Company adopted SFAS No. 142 effective January 1, 2002 (See Note 2 and 8).
In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment of Long-Lived Assets” which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. While SFAS No. 144 supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,” it retains many of the fundamental provisions of that statement. SFAS No. 144 is
effective for fiscal years beginning after December 15, 2001. The adoption of SFAS No. 144 did not have a material impact on the Company’s financial position, result of operation and cash flow.
In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections (SFAS 145).” SFAS 145 rescinds SFAS 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. Upon adoption of SFAS 145, we will be required to apply the criteria in APB Opinion No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions (Opinion No. 30), in determining the classification of gains and losses resulting from the extinguishment of debt. Additionally, SFAS 145 amends SFAS 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions to be accounted for in the same manner as sale-leaseback transactions. SFAS 145 will be effective for fiscal years beginning after May 15, 2002 with early adoption of the provisions related to the rescission of SFAS 4 encouraged. Upon adoption, companies must reclassify prior period items that do not meet the extraordinary item classification criteria in Opinion No. 30. The adoption of SFAS 145 for long-lived assets held for use did not have a material impact on the Company’s consolidated financial statements.
In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit and Disposal Activities.” SFAS 146 nullifies Emerging Issues Task Force (EITF) issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). Under EITF issue 94-3, a liability for an exit cost is recognized at the date of an entity’s commitment to an exit plan. Under SFAS 146, the liabilities associated with an exit or disposal activity will be measured at fair value and recognized when the liability is incurred and meets the definition of a liability in the FASB’s conceptual framework. This statement is effective for exit or disposal activities initiated after December 31, 2002. The Company believes that the adoption of SFAS 146 will not have a material impact on its consolidated financial statements.
In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others” (“FIN 45”), an interpretation of FASB Statements Nos. 5, 57 and 107 and a rescission of FASB Interpretation No. 34. FIN 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees issued. FIN 45 also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken. The initial recognition and measurement provisions of FIN 45 are applicable to guarantees issued or modified after December 31, 2002 and are not expected to have a material effect on the Company’s financial position, result of operation and cash flow. The disclosure requirements are effective for financial statements of interim and annual periods ended after December 15, 2002.
In November 2002, the FASB’s Emerging Issues Task Force (EITF) issued EITF 00-21 “Revenue Arrangements with Multiple Deliverables.” EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. Specifically, EITF 00-21 addresses how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. In applying EITF 00-21, separate contracts with the same entity or related parties that are entered into at or near the same time are presumed to have been negotiated as a package and should, therefore, be evaluated as a single arrangement in considering whether there are one or more units of accounting. That presumption may be overcome if there is sufficient evidence to the contrary. EITF 00-21 also addresses how arrangement consideration should be measured and allocated to the separate units of accounting in the arrangement. The guidance in this Issue is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. Alternatively, companies may elect to report the change in accounting as a cumulative-effect adjustment. Early application of this consensus is permitted. The adoption of this accounting pronouncement is not expected to have a significant impact on the Company’s financial statements.
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure-an amendment of SFAS No. 123”. This statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. This statement also amends the disclosure requirements of SFAS No. 123 and APB Opinion No. 28, “Interim Financial
Reporting,” to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. Certain of the disclosure modifications are required for fiscal years ending after December 15, 2002 and are included in the Notes to these Consolidated Financial Statements. The Company will implement SFAS No. 148 effective January 1, 2003 regarding disclosure requirements for condensed financial statements for interim periods. The Company’s management has determined that they will continue to account for stock-based employee compensation in accordance with APB No. 25.
In February 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46”), which addresses the consolidation by business enterprises of variable interest entities, which have one or both of the following characteristics: (1) the equity investment at risk is not sufficient to permit the entity to finance its activities without additional financial support from other parties, or (2) the equity investors lack one or more of the following essential characteristics of a controlling financial interest: (a) the direct or indirect ability to make decisions about the entity’s activities through voting or similar rights, (b) the obligation to absorb the expected losses of the entity if they occur, or (c) the right to receive the expected residual returns of the entity if they occur. FIN 46 will have a significant effect on existing practice because it requires existing variable interest entities to be consolidated if those entities do not effectively disburse risks among parties involved. In addition, FIN 46 contains detailed disclosure requirements. FIN 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. This Interpretation may be applied prospectively with a cumulative-effect adjustment as of the date on which it is first applied or by restating previously issued financial statements for one or more years with a cumulative-effect adjustment as of the beginning of the first year restated. The adoption of this pronouncement may have a significant impact on the Company’s consolidated financial statements.
3. ARTIST ADVANCES
As of December 31, 2002, ARTISTdirect Records had signed recording agreements with 17 artists and advanced a total of $11.3 million in artist advances and recording costs. As of December 31, 2001, the Company had signed seven artists and advanced a total of $3.2 million. The amount of these advances is recoupable against royalties to be earned by the artists based on sales. However, given that most of the artists signed by the label have no previous track record, the venture has expensed the advances as incurred. As of December 31, 2002, ARTISTdirect Records is contractually committed to additional minimum artist advances of approximately $2.0 million. This advance commitment could increase by an additional approximate $2.0 million depending upon the sales performance of certain initial releases and excludes approximately $30 million that could be advanced under the exercise of options for additional albums at the Company’s sole discretion. In January 2003, the Company signed an additional artist and committed to additional advances of $2.0 million.
4. PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost and consist of the following:
5. ALLOWANCE FOR SALES RETURN RESERVE
A summary of the activity of the reserve for sales returns for the periods indicated is reflected in the following table:
6. ACCRUED EXPENSES
Accrued expenses are comprised of the following:
7. SIGNIFICANT CONTRACTS
In November 2001, ARTISTdirect Records agreed in principle to enter into a preliminary North American distribution agreement and worldwide license agreement with BMG Music ("BMG"), the global music division of Bertelsmann AG. Under the terms of the agreement, BMG distributes ARTISTdirect Records’ releases in North America, and BMG licenses ARTISTdirect Records’ repertoire in territories throughout the world. In April 2002, the agreements with BMG were finalized including BMG’s purchase of 5% of the equity of ARTISTdirect Records from ARTISTdirect, Inc. In connection with the purchase of equity, BMG agreed to assume $5.0 million of ARTISTdirect’s funding commitment to ARTISTdirect Records that it advanced during 2002. This loan advance bears interest at a rate of LIBOR plus four percent and the principal and interest are not repayable until December 31, 2015 or upon such time as the Company achieves certain defined levels of excess cash flow and available cash.
Under the distribution and license agreements, BMG has made non-returnable advances to the Company of $2.5 million in 2001, $2.5 million in 2002 and $2.0 million in January 2003 that are recoupable from net sales proceeds from the Company’s artist repertoire. The advances are to be recouped on a monthly basis based on a defined calculation. As of December 31, 2001 and 2002, the unrecouped balance related to distribution advances from BMG was $2.5 million and $4.1 million, respectively.
8. RELATED PARTY TRANSACTIONS
In connection with the formation of the Company, ARTISTdirect, Inc. which initially owned 50% of the membership units of the Company, committed to fund 100% of the Company’s operations up to a total of $50 million over 5 years. ARTISTdirect, Inc.’s funding commitment was reduced to $45 million in connection with its sale of 5% of the equity of ARTISTdirect Records to BMG who assumed $5 million of the funding commitment. The loan advances provided to the Company by ARTISTdirect and BMG bear interest at a rate of LIBOR plus four percent and the principal and interest are not repayable until December 31, 2015 or upon such time as the Company achieves certain defined levels of excess cash flow and available cash. As of December 31, 2001 and 2002, the Company had loans payable to ARTISTdirect, Inc. of $30.25 million and to BMG of $4.75 million, respectively. In addition, as of December 31, 2001 and 2002, the Company had accrued interest payable to ARTISTdirect, Inc. of $135,000 and $1.1 million, respectively, and to BMG of $0 and $189,000, respectively.
ARTISTdirect, Inc. provides certain services to the Company under a shared services agreement. These services include the providing of office space, internet and telephone services and the services of certain ARTISTdirect, Inc. personnel primarily in the areas of accounting, legal, information technology, human resources and administration. During the period from May 31 to December 31, 2001 and the year ended December 31, 2002, the Company reimbursed ARTISTdirect, Inc. $1.35 million and $200,000, respectively.
9. MEMBERS’ EQUITY
Upon its formation in May 2001, the Company issued 10,000,000 membership units for total proceeds of $100,000.
A member has entered into contingent compensation agreements whereby certain employees and non-employees would receive a portion of the proceeds received by one of the members of the Company upon a sale event as defined in the contingent compensation agreements. The percentage of the sale proceeds that these individuals shall receive is subject to vesting provisions of up to 5 years. As of December 31, 2002, the Company had entered into contingent compensation agreements that would result in the payment of up to approximately 11.8% of the sale proceeds received by the member of the Company that is a party to these agreements. As of December 31, 2002, approximately 42% of the 11.8%, or a total of approximately 5.0% of the sale proceeds subject to payment under these agreements, is vested. The Company shall recognized compensation expense for any payments made under these arrangements upon the occurrence of a sale event as defined in the contingent compensation agreements. No such event has occurred as of December 31, 2002.
10. 401(K) PLAN
In 2001, the Company adopted ARTISTdirect, Inc.’s Cash or Deferred Profit Sharing Plan and Trust under Section 401(k) of the Internal Revenue Code (the 401(k) Plan). Under the 401(k) Plan, participating employees may defer a percentage (not to exceed 15%) of their eligible pretax earnings up to the Internal Revenue Service’s annual contribution limit. All employees of the Company age 21 years or older who complete three months of service are eligible to participate in the 401(k) Plan. The Company does not match participants’ contributions to the 401(k) Plan. Accordingly, there is no expense for the year ended December 31, 2002 and the period from May 31, 2001 (inception) and December 31, 2001.
11. COMMITMENTS AND CONTINGENCIES
Future minimum lease payments under operating leases for certain equipment are as follows for of the years ended December 31:
Future payments under employment contracts are as follows:
During 2002, the employment agreement of the Company’s chief executive was amended whereby the executive agreed to defer all of his future salary until the Company raised new debt or equity financing of at least $20 million. The future payments under employment contracts as of December 31, 2002 shown above do not take into account this contractual deferral. If this deferral does not become payable, the Company’s future payment obligations under employment agreements as shown above would decrease by $1.0 million annually during 2003, 2004 and 2005 and by $500,000 during 2006.
LITIGATION
The Company is subject to various pending and threatened legal actions, which arise in the normal course of business. The Company’s management believes that the impact of such litigation will not have a material adverse impact on its financial position or results of operations.
EXHIBIT INDEX

Confidential treatment was requested for certain confidential portions of this exhibit pursuant to Rule 24b-2 under the Securities Exchange Act of 1934. In accordance with Rule 24b-2, these confidential portions were omitted from this exhibit and filed separately with the Securities and Exchange Commission.