10-Q 1 d10q.txt FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ___________________________ FORM 10-Q Quarterly Report Pursuant To Section 13 or 15(d) of the Securities Exchange Act Of 1934 March 31, 2001 Commission File No. 0-24671 EMUSIC.COM INC. (Exact Name of small business issuer as specified in its charter) Delaware 94-3290594 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 1991 Broadway, 2/nd/ Floor 94063 Redwood City, California (Zip Code) (Address of principal executive offices) Registrant's telephone number, including area code: (650) 216-0200 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No_________ ----- Indicate the number of shares outstanding of each of the issuer's classes of Common Stock, as of the latest practicable date: Common Stock, $0.001 Par Value 43,202,000 shares (Class) (Outstanding at April 18, 2001) EMUSIC.COM INC. FORM 10-Q INDEX

2 -------------------------------------------------------------------------------- PART I: FINANCIAL INFORMATION ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -------------------------------------------------------------------------------- EMUSIC.COM INC. CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands) (Unaudited)

The accompanying notes are an integral part of these financial statements. 3 EMUSIC.COM INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) (Unaudited)

The accompanying notes are an integral part of these financial statements. 4 EMUSIC.COM INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (Unaudited)

The accompanying notes are an integral part of these financial statements. 5 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Note 1--The Company and Summary of Significant Accounting Policies The Company EMusic.com Inc. ("EMusic" or the "Company") sells downloadable music over the Internet and operates a network of music-oriented Web sites, including RollingStone.com, EMusic.com and other sites, that generates revenue from the sale of advertising. The Company also generates revenue from the licensing of its acquired music catalogs. EMusic, a Delaware corporation, is based in Redwood City, California, with regional offices in New York, Los Angeles and Chicago. Basis of Presentation These consolidated financial statements contemplate the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has incurred losses in each fiscal year since inception as a result of incurring costs to establish its business, which were significantly in excess of revenues. The Company has also used its cash resources to make substantial investments in music content for its websites. As described in "Subsequent Events" below, the Company announced a signed definitive merger agreement with Universal Music Group on April 9, 2001. In the absence of the proposed acquisition of the Company by Universal, management would need to undertake additional cost reduction efforts or obtain additional working capital from external sources or convert other assets in order to maintain current operations. If the acquisition is not completed, no additional cost reductions were undertaken and no additional working capital was raised, the Company projects that its cash would run out during the fourth calendar quarter of 2001. If the acquisition is not completed, there can be no assurance that the Company will be able to obtain additional financing on acceptable terms, or at all. In the opinion of management, the unaudited consolidated condensed financial statements included herein have been prepared on a basis consistent with prior periods reported consolidated financial statements and include all material adjustments, consisting of normal recurring adjustments, necessary to fairly present the information set forth therein. All significant inter-company balances and transactions have been eliminated. Certain information and footnote disclosures normally included in the financial statements have been condensed or omitted pursuant to rules and regulations of the Securities and Exchange Commission ("SEC"), although we believe that the disclosures in the unaudited interim financial statements are adequate to ensure that the information presented is not misleading. The results of operations for the interim reporting periods presented herein are not necessarily indicative of any future operating results. The financial information as of June 30, 2000, is derived from our Annual Report on Form 10-K for the Fiscal Year Ended June 30, 2000, as filed with the SEC. The interim financial statements presented herein should be read in conjunction with the financial statements and the notes thereto included in the Form 10-K. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reported period. Actual results could differ materially from those estimates. 6 Net Loss per Common Share The weighted average shares used to compute basic net loss per share include outstanding shares of Common Stock from the date of issuance, and exclude shares of Common Stock subject to our right of repurchase. The calculation of diluted net loss per share for all periods presented excludes shares of Common Stock issuable upon exercise of employee stock options and outstanding warrants, as their effect would be antidilutive. Therefore, the weighted average number of shares used in the calculation of basic and dilutive net loss per Common share is the same. The following table summarizes the computation of basic and diluted net loss per share (in thousands, except per share data):

Comprehensive Net Loss There are no differences between our net loss as reported for any of the periods reported herein and our comprehensive loss, as defined by Statement of Financial Accounting Standards No. 130, for each of these respective periods. Segment information During all periods presented, the Company operated in a single business segment, an online music network of websites (including EMusic.com, RollingStone.com and other sites) that sells downloadable music and advertising. All long-lived assets and all revenues were located or generated in the United States of America. Concentrations One customer accounted for more than 10% of total revenues for the three months ended March 31, 2001 and two customers accounted for more than 10% of total revenue for the nine months ended March 31, 2001. No customer accounted for more than 10% of revenues for the three months or nine months ended March 31, 2000. 7 Web site development costs Costs incurred in the design, creation and maintenance of content, graphics and user interface of the Company's Web site are expensed as incurred in accordance with SOP 98-1, and Emerging Issues Task Force ("EITF") 00-02 "Accounting for Web Site Development Costs." Costs incurred in the development of application and infrastructure of the Company's web site are capitalized and amortized over their useful life, which is estimated to be two years. Recent Accounting Pronouncements The Company adopted Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended by SFAS 137 and SFAS 138. SFAS 133 establishes methods of accounting for derivative financial instruments and hedging activities related to those instruments as well as other hedging activities, and was effective for all fiscal quarters of all fiscal years beginning after June 15, 2000. The Company's adoption of this pronouncement did not have a material impact on the Company's financial position and results of operations. In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101 (SAB 101), "Revenue Recognition in Financial Statements." In addition the SEC released, in October 2000 interpretative guidance on SAB 101 in the form of frequently asked questions and responses thereto. SAB 101 and the frequently asked questions and responses provide guidance for revenue recognition under certain circumstances. The Company is currently evaluating the impact of SAB 101 on its financial statements and related disclosures, but does not expect that such impact, if any, will be material. The accounting and disclosures prescribed by SAB 101 will be effective for the fourth quarter of the Company's fiscal year ending June 30, 2001. In March 2000, the FASB issued FASB Interpretation No. 44 (FIN44), "Accounting for Certain Transactions Involving Stock Compensation, an interpretation of APB Opinion No. 25" ("Interpretation"). The Interpretation is intended to clarify certain problems that have arisen in practice since the issuance of APB 25. The Interpretation provides guidance, some of which is a significant departure from current practice. The Interpretation generally provides for prospective application for grants or modifications to existing stock options or awards made after June 30, 2000. However, for certain transactions the guidance is effective after December 15, 1998 and January 12, 2000. The adoption of this pronouncement did not have an effect on the current financial statements, but may impact the Company's future accounting regarding stock option transactions. At the September and November 2000 EITF meetings, the EITF reached a consensus on EITF 00-19, "Determination of Whether Share Settlement Is within the Control of the Issuer for Purposes of Applying Issue No. 96-13". This EITF provides guidance on the accounting for derivative financial instruments indexed to, and potentially settled in, a company's own stock. Generally, EITF 00-19 requires all warrants and equity derivative contracts issued which could require or force cash settlement by the issuer to be classified as an asset or liability and not permanent equity. EITF 00-19 also requires other significant additional requirements in order to achieve equity classification. EITF 00-19 is effective for all new contracts and contract modifications entered into after September 20, 2000. Contracts that were entered into prior to or on September 20, 2000, would not be required to follow EITF 00-19 unless they remain outstanding at June 30, 2001. The Company does not expect the adoption of EITF No. 00-19 to have a material impact on the Company's financial position or results of operations. 8 Impairment, Restructuring and Other Charges Restructuring Charges In January 2001, EMusic announced a corporate reorganization aimed at reducing expenses and focusing the Company on its two core sources of revenue -- advertising and promotional revenue through RollingStone.com, and downloadable music sales through EMusic.com. As a result of these actions the Company recorded a restructuring charge in the quarter ended March 31, 2001, of approximately $1,349,000 that primarily included charges related to severance, lease terminations and other contract cancellations. The severance charges include the reduction of 66 positions, or approximately 36% of the Company's workforce. Restructuring charges for the quarter ended March 31, 2001 consist of the following (in thousands):

Impairment and Other Charges Impairment and other charges for the nine months ended March 31, 2001 consisted of the following: Impairment of goodwill and intangibles............. $ 148,349 Impairment and write-down of music-related assets.. 20,806 Uncollectible notes receivable .................... 2,496 Settlement of contract dispute..................... 1,410 ---------- $ 173,061 ========== As a result of the downturn in the online music and advertising markets during the quarter ended December 31, 2000, as well as the decline in the market capitalization of companies in this sector, the Company assessed the recoverability of its long-lived assets in accordance with SFAS 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." The Company compared the carrying value of its recorded fixed assets, goodwill and intangible assets to the estimated future undiscounted operating cash flows identified with these assets. Where the carrying value of such assets exceeded the undiscounted cash flows a non-cash write-down of goodwill and intangibles equivalent to the extent that the carrying value of the long-lived assets exceeded the related estimated discounted cash flows was recorded. This impairment charge was recorded firstly as a reduction in the carrying value of goodwill and then as a reduction in the carrying value of other intangibles. 15 The Company evaluated the recoverability of its advance royalties and music catalog assets in accordance with SFAS 50, "Financial Reporting in the Record and Music Industry," as well as assessed its cost method investments in other music companies for potential impairment. The write-down of advanced royalties and the related warrants was determined based on the extent that estimated future royalties to be earned by each label for the remaining life of the respective digital rights agreement exceeded the net unearned advance and unamortized warrant balance at December 31, 2000. The write-down of music catalogs was determined based on the amount that the carrying value exceeded the estimated sale price for the physical rights and the future estimated digital revenues associated with the digital rights of these catalogs. The Company's investments in private music companies were written down if the carrying value of the investment was not justified by the ability of the investee company to sustain an earnings capacity to ensure recoverability of the Company's investment. During 2000, the Company loaned a total of $5,500,000 to two independent music labels from which the Company licenses music content. Both labels were delinquent in repaying the principal and interest payments due. Based on the financial condition of these labels, management did not believe that the total outstanding balance of $5,526,000 at December 31, 2000, to be fully recoverable, and accordingly a valuation reserve of $2,496,000 was recorded at December 31, 2000. During the quarter ended March 31, 2001, a payment of $3,030,000 was received from one of the music labels in full settlement of the note. In January 2001, the Company settled a contract dispute with a music label. As part of the settlement the Company returned its common stock investment in the label, which had a carrying value of $1,000,000 at December 31, 2000. In addition the Company paid a cash settlement of $410,000, which was accrued at December 31, 2000 and paid in January 2001. The impairment charges are based on estimates and, therefore, are subject to risks and uncertainties related to the Company's ability to generate cash flows from operations and to collect amounts due from business partners. Sale of IUMA On March 22, 2001, the Company sold its trademarks, domains, and certain other assets associated with the operations of its IUMA.com website to Vitaminic S.p.A., based in Milan, Italy, for $400,000 in cash and $500,000 in Vitaminic common stock, resulting in a pre-tax gain of $751,000. The Company received $200,000 in March 2001 and is to be paid an additional $200,000 on or before June 30, 2001. The number of Vitaminic shares the Company will receive will be determined based on the average market price of Vitaminic stock traded on the Nuovo Mercato stock exchange during the five business days preceding the date on which the shares are issued. Such shares are expected to be freely tradeable within 180 days from issuance. Subsequent Events On April 9, 2001, the Company announced a signed definitive merger agreement with Universal Music Group. Under the agreement, Universal Music Group has commenced a cash tender offer to acquire all of EMusic's outstanding shares at a price of $0.57 per share. Any shares not purchased in the tender offer will be converted into the same cash price in a subsequent merger. The tender offer was made by an offer to purchase and other offering and solicitation documents, copies of which were filed with the Securities and Exchange Commission (SEC) and mailed to EMusic stockholders. The obligation of Universal to complete the tender offer is conditioned on a minimum tender of shares representing a majority of EMusic's fully diluted shares. In addition, the offer is conditioned on EMusic having cash and marketable securities (after deduction for estimated transaction costs) of a minimum of $5,000,000 on April 30, 2001, reducing by no more than approximately $48,000 for each day thereafter until the offer closes. Either party can terminate the agreement if the offer is not completed by June 25, 2001. 16 The transaction is subject to other customary conditions. It is not subject to the waiting period requirements of the Hart-Scott-Rodino Antitrust Improvement Act of 1976. Availability of SEC Tender Offer and Other Information EMusic security holders and any potential investors in EMusic securities are advised to carefully read the tender offer statement on Schedule TO filed by Universal with the SEC, the solicitation/recommendation statement on Schedule 14D-9 filed by EMusic with the SEC and all other documents filed by either company with the SEC in connection with the proposed tender offer and/or mergerThose documents will contain important information about the proposed transaction. Security holders and potential investors may obtain free copies of those documents, as well as other documents filed by EMusic at the SEC's website at http://www.sec.gov. These documents are also available to all stockholders of EMusic at no expense to them by submitting a request to Investor Relations at EMusic. Liquidity and Capital Resources At March 31, 2001, we had cash and cash equivalents totaling $10,888,000. Net cash of $22,300,000 was used for operating activities during the nine months ended March 31, 2001, principally as a result of net losses of $214,479,000 generated during the nine months partially offset by non-cash expenses, including amortization of $18,469,000, depreciation of $2,764,000, royalties earned of $972,000, stock compensation of $369,000 and impairment and other charges of $172,651,000. Additionally, cash was used for the pay-down of accounts payable and accrued compensation of $2,976,000 and $896,000, respectively, partially offset by the collection of accounts receivable of $875,000 and reduction of prepaid and other assets of $888,000. We expect to continue to incur negative cash flows from operations as the market continues to develop. Net cash provided by investing activities totaled $18,670,000 for the nine months ended March 31, 2001, resulting from net maturities of short-term investments of $19,669,000 and net decreases in notes receivable of $2,971,000, offset by $3,341,000 spent for royalty advances and purchases of $629,000 for capital equipment and software. Net cash used in financing activities totaled $73,000 for the nine months ended March 31, 2001, as we paid $138,000 on a capital lease, offset by proceeds of $65,000 received from the exercise of stock options and execution of the Employee Stock Purchase Plan. Under an agreement with Rolling Stone LLC we are required to purchase $1,100,000 of advertising and other services annually in Rolling Stone magazine until February 2011 and to pay Rolling Stone an annual license fee of $1,250,000, which increases to $1,500,000 in 2006. In April 1999, we entered into a five-year lease agreement for new office space. Under the terms of the agreement, we will make minimum monthly lease payments of approximately $67,000 for a period of 60 months, which began in April 1999. This monthly amount includes certain maintenance costs associated with the leased space, and is subject to annual increases based on the Consumer Price Index. We have incurred significant losses from operations during each fiscal year since inception and have been dependent upon raising money from issuances of our preferred stock and common stock in order to fund these losses and our investment in content and other assets needed to establish our business. In the absence of the proposed acquisition of the Company by Universal, we would need to undertake additional cost reduction efforts or obtain additional working capital from external sources or convert other assets in order to maintain our current operations. If the acquisition is not completed, no cost reductions were undertaken and no additional working capital was raised, we project that our cash would run out during the fourth calendar quarter of 2001. If the acquisition is not completed, there can be no assurance that additional financing will be available on terms acceptable to us, or at all. If additional funds are required and not available or are not available on acceptable terms, we may need to 17 curtail certain of our plans or discontinue certain of our operations. If we raise additional funds by issuing equity or convertible debt securities, the percentage ownership of our then existing stockholders will be reduced, and these securities may have rights, preferences or privileges senior to those of our stockholders. 18 FACTORS THAT MAY AFFECT OUR RESULTS Investing in our Common Stock involves a high degree of risk. You should carefully consider the following factors and other information contained in this Form 10-Q and the other filings, which we make with the SEC from time to time before deciding to invest in our stock. Any of the following risks, if they actually occur, could materially and adversely affect our business, financial condition or results of operations. In such event, the trading price of our common stock could decline, and stockholders could lose all or part of their investments. The acquisition of EMusic by Universal may not be completed Although we have entered into an agreement to be acquired by Universal Music Group, there can be no assurance that such acquisition will be completed. The obligation of Universal to complete the pending tender offer is conditioned on a minimum tender of shares representing a majority of EMusic's fully diluted shares and other customary conditions. In addition, the offer is conditioned on EMusic having cash and marketable securities (after deduction for estimated transaction costs) of a minimum of $5 million on April 30, 2001, reducing by no more than approximately $48,000 for each day thereafter until the offer closes. Either party can terminate the agreement if the offer is not completed by June 25, 2001. We have limited cash resources and may need to obtain additional funds to execute our business plan. If we are unable to obtain such funds, we will not be able to expand our business as planned or may need to curtail or discontinue certain operations. As of March 31, 2001, we had approximately $10.9 million in cash and cash equivalents. In the absence of the proposed acquisition of the Company by Universal, we would need to undertake additional cost reduction efforts or obtain additional working capital from external sources or conversion of other assets in order to maintain our current operations. If the acquisition is not completed, no cost reductions were undertaken and no additional working capital raised, we project that our cash would run out during the fourth calendar quarter of 2001. If the acquisition is not completed, there can be no assurance that additional financing will be available on terms favorable to us, or at all. If additional funds are required and not available or are not available on acceptable terms, we may need to curtail certain of our plans or discontinue certain of our operations. If we raise additional funds by issuing equity or convertible debt securities, the percentage ownership of our then existing stockholders will be reduced, and these securities may have rights, preferences or privileges senior to those of our stockholders. Our stock may be subject to de-listing and our stock price has been and may continue to be volatile. Our common stock is currently traded on the Nasdaq National Market under the ticker symbol "EMUS." We have received a notice of de-listing from the Nasdaq National Market. We have filed an appeal with respect to this notice. If our stock were de-listed from the Nasdaq National Market there would likely be a substantial reduction in the liquidity of any investment in our common stock. De-listing could also reduce the ability of holders of our common stock to purchase or sell shares as quickly and as inexpensively as they have done historically. This lack of liquidity also makes it more difficult for us to raise capital in the future. There can be no assurance that an active trading market will be sustained in the future. In addition to fluctuations in our operating results, the following factors could cause the price of our securities to be volatile: . development of the downloadable music market; . technological innovations; . legal development with respect to copyright law and downloadable music; 19 . new products; . acquisitions or strategic alliances entered into by us or our competitors; . failure to meet securities analysts' expectations; . government regulatory action; . patent or proprietary rights developments; and . market conditions for Internet and technology stocks in general. We have a new and unproven business model and it may not generate sufficient revenue for our business to survive or be successful. Our model for conducting business and generating revenues is new and unproven and if it fails to develop as we plan, our business may not succeed. Our business model depends upon our ability to generate revenue streams from multiple sources primarily through our websites, including: . online sales of downloadable music; . website advertising and sponsorship fees from third parties; and . licensing of musical recordings for use by others. It is uncertain whether a music-based website such as EMusic.com, that relies on attracting people to purchase and download music, mostly from lesser-known artists, can generate sufficient revenues to survive. This business model may not succeed or it may not be sustainable as our business grows. We are substantially dependent upon our EMusic Unlimited subscription service, which allows users to download substantially all of the music for sale at EMusic.com for a fixed monthly fee. If our subscription service is not accepted by users, our ability to increase our revenues will be adversely affected. Likewise, if users download greater numbers of albums or tracks than we currently expect, our operating results would be adversely affected. In order for our business to be successful, we must not only develop services that directly generate revenue, but also provide content and services that attract consumers to our websites on a regular basis. We will need to develop new offerings as consumer preferences change and new competitors emerge. We may not be able to provide consumers with an acceptable blend of products, services, and informational and community offerings that will attract consumers to our websites on a regular basis. We provide many of our products and services without charge, and we may not be able to generate sufficient revenue to pay for these products and services. Accordingly, we cannot be certain that our business model will be successful or that we will sustain revenue growth or be profitable. We are competing in a new market that may not develop sufficiently to support our business. The market for online music promotion and distribution is new and rapidly evolving. As a result, demand and market acceptance for our products and services are subject to a high degree of uncertainty and risk. In the early stages of this market, we are attempting to capitalize on a talent pool of artists underserved by the traditional recording industry. Consumers may not continue to be interested in listening to, or purchasing music from, these artists. If this new market fails to develop, develops more slowly than expected or becomes saturated with competitors, or our products and services do not achieve or sustain market acceptance, we may not generate sufficient revenues to become profitable. The future popularity of downloadable music will depend on consumer acceptance of downloading music generally. We believe that consumer acceptance is, in part, dependent on the availability of music from major record labels and portable devices to store and play this music. Although the major labels have announced plans to make music available 20 for download, to date they have only announced the availability of limited portions of their catalogs at prices, which are substantially higher than the prices which we have been charging for downloadable music. These actions may slow the overall consumer acceptance of downloadable music and adversely impact our ability to increase our revenues. Likewise, to the extent that new devices are not available at affordable prices, or consumer acceptance or distribution of these portable devices is delayed, our potential market, and thus our ability to increase our revenues, may be reduced. We have a limited operating history that makes an evaluation of our business difficult. Our limited operating history makes it difficult to evaluate our current business and prospects. As a result of our limited operating history, we do not have meaningful historical financial data upon which to forecast quarterly revenues and results of operations. Before investing in us, you should evaluate the risks, expenses and problems frequently encountered by companies such as ours that are in the early stages of development. We have incurred substantial losses to date and we expect net losses in the future. From inception through March 31, 2001, we had accumulated net losses of approximately $307 million. We expect substantial net losses for the foreseeable future and although we believe that we have a plan which can lead to positive cash flow from operations, there can be no assurance that our plan can be achieved. We believe it is critical to our long-term success that we continue to develop "EMusic" and "RollingStone.com" brand awareness and loyalty through marketing and promotion, expand our artist and consumer networks, develop our online content and expand our other services. We have recently reduced our operating expenses. If we determine that we need to increase operating expenses in order to achieve our goals, we will need to generate significant additional revenues to achieve profitability. As a result, we may never achieve profitability and, if we do achieve profitability in any period, we may not be able to sustain or increase profitability. Our revenues are adversely impacted by the availability of our music for free through Napster, and to a lesser extent other websites. Until or unless Napster ceases to operate in its current model, our downloadable music revenue growth will continue to be adversely affected. Our quarterly revenues and operating results are subject to fluctuation, which may result in volatility or a decline in the price of our stock. We believe that period-to-period comparisons of our operating results are not meaningful and should not be relied upon as indicators of future performance. Our quarterly operating results are likely to fluctuate significantly in the future as a result of a variety of factors, many of which are outside of our control, including: . the demand for downloadable music content and Internet advertising; . the application of revenue recognition policies to large contracts under generally accepted accounting principles; . the addition or loss of advertisers; . the level of traffic on our Internet sites; . amount and timing of capital expenditures and other costs relating to the expansion of our operations; . the introduction of new sites and services by us or our competitors; . seasonal trends in Internet use, purchases of downloadable music, and advertising placements; . price competition or pricing changes in the industry; 21 . technical difficulties or system downtime; and . general economic conditions, and economic conditions specific to the Internet and Internet media. In addition, while our revenues may vary significantly, a portion of our expenses are fixed. As a result, any decrease in revenues will not be accompanied by a decrease in our fixed operating expenses and our operating results will suffer. Our quarterly results may also be significantly impacted by the accounting treatment of acquisitions, financing transactions or other matters. Because of these and other factors it is likely that our operating results will fall below expectations in some future quarter and the trading price of our stock may drop. We depend significantly upon our relationship with the publisher and owner of Rolling Stone magazine, for editorial content, access to the archives of Rolling Stone and our use of the brand name "Rolling Stone," as well as for press coverage, business and marketing opportunities, strategic relationships and potential acquisitions. If we are unable to continue this relationship and to utilize the Rolling Stone brand name and content on our websites, or if the Rolling Stone content or brand name is made accessible to our competitors, we may generate less traffic, which would reduce our revenue. In addition, if Rolling Stone is not able to continue to obtain license rights for online distribution of its magazine content from third-party contributors, we would not be able to make this content available on our Web sites which could reduce the number of visitors to our websites. Our agreement with Rolling Stone will terminate in 2011 unless we have a market capitalization of at least $2 billion at that time, in which case it will terminate in 2016. The agreement may be terminated earlier if we fail to comply with our obligations under the agreement. Under our agreement with Rolling Stone, we obtained the right to use the "Rolling Stone," "RollingStone Online" and "RollingStone.com" trademarks and their derivatives in connection with the Internet and the right to use the RollingStone.com domain name. If our agreement terminates, we will not be entitled to use these trademarks or the RollingStone.com domain. The loss of our right to use the Rolling Stone trademarks, domain or content would damage our reputation and severely limit our ability to generate advertising, e- commerce and other revenue. Shares eligible for future sale in the open market may depress our stock price. As of March 31, 2001, there were approximately 43.2 million shares of common stock outstanding, substantially all of which were tradable without registration under the Securities Act or pursuant to currently effective registration statements or exemptions from registration requirements. If our brand names are not accepted, our ability to attract content and customers to our website will be harmed. We believe that establishing and maintaining the EMusic and RollingStone.com brands is a critical aspect of our efforts to attract and expand our Internet audience and acquire new content and that the importance of brand recognition will increase due to the growing number of Internet sites and the relatively low barriers to entry in providing Internet content. We intend to incur significant expenses in our brand building efforts. If these efforts do not generate increased revenues our operating results will suffer. If we are unable to provide high quality content or otherwise fail to promote and maintain our brand, our business will be harmed. If we are unable to maintain or expand our contracts for music content, or if the content we license does not sell, our popularity and business may suffer. We believe that a primary draw to our EMusic.com website is the ability to access music from known artists and independent record labels. Currently, we have exclusive multi-year contracts for much of our music library. However, if we are unable to sign contracts for new content, or if we are unable to extend the terms of existing contracts as they expire, our website may fail to attract new, or retain existing, customers which would harm our business. For much of the content we license, we pay advances against future royalties, which will be owed on the sale of the content. If the content we license does not sell in sufficient quantities, we may not be able to recover all or part of the advances we have paid and our business could be harmed. 22 We rely on third parties for the hosting of our websites and if these hosting services become unavailable, our customers will not be able to access our websites. We currently rely on third parties, which host our EMusic.com and RollingStone.com websites. We currently do not maintain redundant websites. If for any reason our current website hosting services become unavailable or if our hosting service experiences technical problems, customers will not be able to access our websites until these services are restored or until we are able to make arrangements with an alternate provider. If we fail to adequately manage our growth, we may not be successful as we may miss market opportunities. If our revenues grow rapidly, we will also need to expand the scope of our operations and the number of our employees rapidly. In particular, we will need to hire additional engineering, sales, marketing, content acquisition and administrative personnel. Additionally, we may complete additional acquisitions, which could increase our employee headcount and business activity substantially. Any such rapid growth would place significant stress on our technology, operations, management and employee base. Any failure to successfully address such issues would harm our business. Our technology systems must be expanded and enhanced for our business to grow. In order to support a growing business, we will need to continue to enhance and expand the technology infrastructure, which supports our business. As our business continues to grow, we will need to add additional servers and other hardware and software systems as well as additional sites for website hosting. If we fail to successfully implement these new and enhanced systems, our operations could be disrupted, we may become less competitive, our revenues could be reduced and we may need to incur additional costs to address these issues. We may have difficulty executing acquisitions and integrating the acquired companies into our business. Our business strategy includes entering into strategic alliances and acquiring complementary businesses, technologies, content or products. During the last two fiscal years, we completed the acquisitions of Creative Fulfillment, Inc., IUMA, Cductive and Tunes.com. These and any other future acquisitions involve risks commonly encountered in acquisitions of companies, including: . exposure to unknown liabilities of acquired companies; . incurring acquisition costs and expenses in excess of what we anticipated; . the occurrence of fluctuations in our quarterly and annual operating results due to the costs and expenses of acquiring and integrating new businesses or technologies; . experiencing difficulties and expenses in assimilating the operations and personnel of the acquired businesses; . disruption of our ongoing business and diversion of our management's time and attention; . a possible inability to integrate successfully or to complete the development and application of acquired technology and a possible failure to achieve the anticipated financial, operating, and strategic benefits from these acquisitions; . experiencing difficulties in establishing and maintaining uniform standards, controls, procedures, and policies; . impairment of our relationships with key employees and customers of acquired businesses or the loss of these key employees and customers as a result of changes in management and ownership of the acquired businesses. In addition, our stockholders may be diluted if the consideration for future acquisitions consists of equity securities. We may not overcome these risks or any other problems encountered in connection with acquisitions. If we are unsuccessful 23 in doing so, our business could be harmed. We expect competition to increase significantly in the future and we may not be able to compete successfully. The market for the online promotion and distribution of music and music-related products and services is new, highly competitive and rapidly changing. The number of websites on the Internet competing for the attention and spending of consumers, users and advertisers has increased, and we expect it to continue to increase, because there are few barriers to entry to Internet commerce. In addition, the competition for advertising revenues, both on Internet websites and in more traditional media, is intense. Currently, there are more than one hundred music retailing websites on the Internet. We face competitive pressures from numerous actual and potential competitors. All of the major record label companies have announced initiatives with respect to the sale of downloadable music. To date we have announced agreements pursuant to which we will sell music from the Universal Music Group, EMI and BMG. If we are unable to obtain licenses to sell or otherwise distribute content from all or most of the major record label companies, our ability to increase our sales will be limited to our ability to obtain licenses from the independent record label segment of the music market, which has historically represented approximately 20% of the total music market. To the extent that other companies are able to obtain rights to content from major record labels, such companies may have a significant competitive advantage over us. 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 relative to us, including: . longer operating histories; . significantly greater financial, technical and marketing resources; . greater brand name recognition; . larger existing customer bases; and . more popular content or artists. These competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements and devote greater resources to the development, promotion, and sale of their products or services than we can. Websites 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 website traffic levels, purchase inquiries and number of click-throughs on our online advertisement. 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. Our business is dependent on the continued development and maintenance of the Internet and the availability of increased bandwidth to consumers. The success of our business will depend largely on the development and maintenance of the Internet infrastructure. This includes 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. Because global commerce on the Internet and the online exchange of information is new and evolving, we cannot predict whether the Internet will prove to be a viable commercial marketplace in the long term. The success of our business will rely on the continued improvement of the Internet as a convenient means of consumer 24 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 continue to upload and download mp3 and other music file formats, as well as to conduct commercial transactions with us, without significant delays or aggravation that may be associated with decreased availability of Internet bandwidth and slower access to our websites. Our penetration of a broader consumer market will depend, in part, on continued proliferation of high speed Internet access. Even compressed in mp3 format, a typical three-minute song file can occupy more than three megabytes of storage space. This file could take approximately seven minutes to download over a conventional 56 kbps modem compared to less than one minute over an xDSL or cable modem. 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, increases in users or bandwidth requirements may harm the performance of the Internet. The Internet has experienced a variety of outages and other delays as a result of damage to portions of its infrastructure, and it could face outages and delays in the future. This might include outages and delays resulting from denial of service problems such as those experienced by some major Internet sites. 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 music-related products and services. 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. We must maintain and establish strategic alliances to increase our customer base and enhance our business. In an attempt to increase our customer base and traffic on our websites, build brand recognition, attract paid advertising and enhance content, distribution and commerce opportunities, we have entered into agreements with various media, hardware device and Internet-related companies such as America Online, RealNetworks, and Microsoft. Our failure to maintain or renew our existing strategic alliances or to establish and capitalize on new strategic alliances could harm our business. Our future success depends to a significant extent upon the success of such alliances. Moreover, we are substantially dependent on our ability to advertise on other Internet sites and the willingness of the owners of other sites to direct users to our Internet sites through hypertext links. We may not achieve the strategic objectives of these alliances, and parties to strategic alliance agreements with us may not perform their obligations as agreed upon. Such agreements also may not be specifically enforceable by us. In addition, some of our strategic alliances are short term in nature and may be terminated by either party on short notice. The termination or impairment of these strategic alliances could reduce our ability to attract new customers. Our success depends on our retention of key personnel. Our performance is substantially dependent on the services of Gene Hoffman, Jr., our chief executive officer, as well as on our ability to recruit, retain and motivate other officers and key employees. Competition for qualified personnel is intense and there are a limited number of persons with knowledge of and experience in the Internet and music entertainment industries. The loss of the services of any of our officers or senior managers could harm our business. We may not be able to hire and retain a sufficient number of qualified employees to grow our business as planned. Our future success will depend on our ability to attract, train, retain and motivate other highly skilled technical, managerial, marketing and customer support personnel. Competition for these personnel is intense, especially for engineers, web designers and advertising sales personnel, and we may be unable to successfully attract sufficiently qualified personnel. A large percentage of our employees have joined us within the last 12 months and if revenues grow rapidly, our rate of hiring will need to continue. To manage the expected growth of our operations, we will need to integrate these employees into our business. Our inability to hire, integrate and retain qualified personnel in sufficient numbers may reduce the quality of our programs, products and services, and could harm our business. In addition, companies in the Internet and music industries whose employees accept positions with competitive companies frequently 25 claim that their competitors have engaged in unfair hiring practices. We may be subject to claims in the future as we seek to hire qualified personnel and those claims may result in material litigation. Even if unsuccessful, these claims could harm our business by damaging our reputation, requiring us to incur legal costs and diverting management's attention away from our business. Security concerns regarding credit card or other confidential information transmitted over the web could limit our growth and subject us to liability. A significant barrier to e-commerce and communications over the Internet has been the need for secure transmission of confidential information over public networks. Internet usage may not increase at the rate we expect unless some of these concerns are adequately addressed and found acceptable by the market. Internet usage could also decline if any well-publicized compromise of security occurred. We may incur significant costs to protect against the threat of security breaches or to alleviate problems caused by such breaches. Protections against security breaches may not be available at a reasonable price or at all. If a third party were able to circumvent our security measures and misappropriate our users' personal information, it may cause interruptions to our retail website operation, damage our reputation or subject us to claims by users. Any compromise of confidential data during transmission over the Internet may harm our business. Any failure of our internal security measures could cause us to lose customers and subject us to liability. Our business is dependent on maintaining a database of confidential user information, including credit card numbers. If the security measures that we use to protect personal information are ineffective, we may lose customers and our business would be harmed. We rely on security and authentication technology licensed from third parties. With this technology, we perform real-time credit card authorization and verification. We cannot predict whether new technological developments could allow these security measures to be circumvented. In addition, our software, databases and servers may be vulnerable to computer viruses, physical or electronic break-ins and similar disruptions. We may need to spend significant resources to protect against security breaches or to alleviate problems caused by any breaches and we may not be able to prevent all security breaches. Our intellectual property protection may be inadequate, and any loss or reduction in intellectual property protection may harm our business. Our intellectual property includes our trademarks and copyrights, proprietary software, and other proprietary rights. We believe that our intellectual property is important to our success and our competitive position, and we try to protect it. However, our efforts to protect our intellectual property could be inadequate. Use of the "EMusic" name by others could dilute our brand identity and confuse the market. In addition, our ability to conduct our business may be harmed if others claim we violate their intellectual property rights. For example, Sightsound.com, Inc. has asserted that many online music providers, including us, violate patent rights that it allegedly owns covering the sale of music over the Internet through digital downloads. If successful, these claims, or similar claims by others, could seriously harm our business by forcing us to cease using intellectual property that we depend on to operate our business. Even if unsuccessful, these claims could harm our business by damaging our reputation, requiring us to incur legal costs and diverting management's attention away from our business. Government regulation may require us to change the way we do business. Laws and regulations directly applicable to Internet communications, commerce and advertising are becoming more prevalent. The United States Congress has enacted Internet laws regarding children's privacy, copyrights and taxation. Such legislation could dampen the growth in use of the Internet generally and decrease the acceptance of the Internet as a communications, commercial and advertising medium. Although our transmissions originate in California and New Jersey, the governments of other states or foreign countries might attempt to regulate our transmissions or levy sales or other taxes relating to our activities. The European Union has enacted its own privacy regulations that may result in limits on the collection and use of certain user information. The laws governing the Internet, however, remain largely unsettled, even in areas where there has been some legislative action. It may take years to determine whether and how existing laws such as those governing intellectual property, privacy, libel and taxation apply to the Internet and Internet 26 advertising. In addition, 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. Furthermore, the Federal Trade Commission has recently investigated the disclosure of personal identifying information obtained from individuals by Internet companies. Evolving areas of law that are relevant to our business include privacy law, proposed encryption laws, content regulation and sales and use tax. For example, changes in copyright law could require us to change the manner in which we conduct business or increase our costs of doing business. In addition, currently pending litigation involving copyright infringement claims brought against MP3.com and Napster may result in decisions, which have a significant impact on our business. If the unlicensed distribution of music is held to be lawful, our ability to sell music could be materially harmed. Because of this rapidly evolving and uncertain regulatory environment, we cannot predict how these laws and regulations might affect our business. In addition, these uncertainties make it difficult to ensure compliance with the laws and regulations governing the Internet. These laws and regulations could harm us by subjecting us to liability or forcing us to change how we do business. In the event the Federal Trade Commission or other governmental authorities adopt or modify laws or regulations applicable to our business, including those relating to the Internet and copyright matters, our business could be harmed. We may have liability for content on our website and liability for other materials, which we distribute. We may be liable to third parties for content on our website and any other materials we distribute if: . the music, text, graphics or other content on our website violates their copyright, trademark, or other intellectual property rights; . our artists or labels violate their contractual obligations to others by providing content on our website; or . content we distribute is deemed obscene, defamatory or excessively violent. We may also be subject to these types of liability for content that is accessible from our websites through links to other websites. Although we believe that we have valid licenses for the music that we sell, other artists or labels may challenge whether the party granting us the license had the right to do so. Even if we are entitled to indemnification, defending any such claim could be costly and damage our reputation and adversely affect revenues if we must remove content from our site completely or temporarily. Liability or alleged liability for content or other materials could harm our business by damaging our reputation, requiring us to incur legal costs in defense, exposing us to significant awards of damages, fines and costs and could divert management's attention away from our business. In particular, in addition to civil damages, liability for violations of copyright law currently can result in penalties of up to $10,000 per occurrence. Imposition of sales and other taxes on e-commerce transactions may impair our ability to derive financial benefits from e-commerce. Except for sales of tangible merchandise into certain states, we do not collect sales or other taxes on sales of our products through our websites. Although the Internet Tax Freedom Act precludes, for a period of three years ending October 2001, the imposition of state and local taxes that discriminate against or single out the Internet, it does not currently impact existing taxes. However, one or more states may seek to impose sales tax collection obligations on out- of-state companies such as us, 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, it could affect our cost of doing business. 27 Legislation limiting the ability of states to impose taxes on Internet based transactions has been proposed in the U.S. Congress. We cannot assure you that this legislation will ultimately become law or that the tax moratorium in the final version of this legislation will be ongoing. Failure to enact or renew this legislation, if enacted, could allow various states to impose taxes on Internet-based commerce, which could harm our business. We may have difficulty expanding into international markets, which could limit the growth of our business. Our future growth and success will depend in part on our ability to generate international sales. There can be no assurance, however, that we will be successful in generating international sales of our products. Sales to customers in certain international countries may be subject to a number of risks, including: currency exchange rate risk; the risks that agreements may be difficult or impossible to enforce and receivables difficult to collect through an international country's legal system; foreign customers may have longer payment cycles; or foreign countries could impose withholding taxes or otherwise tax our foreign income, impose tariffs, embargoes, or exchange controls, or adopt other restrictions on foreign trade. In addition, the laws of certain countries do not protect our offerings and intellectual property rights to the same extent as the laws of the United States. If we fail to compete successfully or to expand the distribution of our offerings in international markets the growth of our business could be limited. Development of new standards for the electronic delivery of music may threaten our business. We currently rely on mp3 technology as a delivery method for the digital distribution of music. Mp3 is an open standard adopted by the Moving Picture Experts Group for the compression of audio files. We do not own or control mp3 technology and are dependent upon a license to obtain rights to certain patents relating to the technology. The onset of competing industry standards for the electronic delivery of music could significantly affect the way we operate our business as well as the public's perception of EMusic as a company. For example, in December 1998, the major recording studios announced a plan to develop a universal standard for the electronic delivery of music, called the Secured Digital Music Initiative. If new standards are developed and adopted by consumers, we may not be able to obtain a license to such technology on favorable terms or at all and our business could be harmed. Even if new standards are not developed, delays with respect to proposed standards, such as those, which have occurred with respect to SDMI, can cause confusion in the marketplace, slow the development of the market for downloadable music and otherwise harm our business. Mp3 technology is controversial within certain segments of the traditional music industry and we may face continued opposition to our use of mp3, which may slow market development and harm our business. Certain segments of the traditional music industry have not embraced the development of the mp3 format to deliver music, in part because users of mp3 technology can download and distribute unauthorized or "pirated" copies of copyrighted recorded music over the Internet. We believe that our success is largely dependent upon the ease with which customers can download and play music. We may face opposition from a number of different music industry sources including record companies and studios, the Recording Industry Association of America and certain artists. The adoption of competing standards may slow the development of the market for downloadable music or result in increased costs of doing business, which could harm our business. Our executive officers and directors control approximately 19% of our Common Stock and have power to influence significant corporate matters, which may delay, deter or prevent transactions that could benefit our stockholders. Executive officers and directors, in the aggregate, beneficially own approximately 19% of our outstanding Common Stock. These stockholders are able to significantly influence all matters requiring approval by our stockholders, including the election of directors and the approval of significant corporate transactions. This concentration of ownership may also have the effect of delaying, deterring or preventing a change in control of EMusic and may make some transactions more difficult or impossible without the support of these stockholders. Anti-takeover provisions in our charter documents could negatively impact our stockholders. 28 Our Board of Directors has the authority to issue up to 20,000,000 shares of Preferred Stock without need for stockholder approval. The board may also determine the economic and voting rights, of this Preferred Stock. The holders of our Common Stock could be adversely affected by the issuance of Preferred Stock. Issuance of Preferred Stock could impede or prevent transactions that would cause a change in control of our company. This might discourage bids for our Common Stock as a premium over the market price of our Common Stock and adversely affect the trading price of our Common Stock. We have no current plans to issue shares of Preferred Stock. In addition, other provisions in our charter documents could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. Our data warehousing and web server systems are vulnerable to limitations on power availability, natural disasters, failure of third-party services and other unexpected problems. Since our data warehousing, web server and network facilities for EMusic.com are all located in California, we are potentially subject to the power shortages recently experienced in California. In addition, an earthquake or other natural disaster could affect all of our facilities simultaneously. An unexpected event such as a power or telecommunications failure, fire, flood or earthquake at our on-site data warehousing facility or at our Internet service providers' facilities could cause the loss of critical data and prevent us from offering our services to artists and consumers. Our business interruption insurance may not adequately compensate us for losses that may occur. In addition, we rely on third parties to securely store our archived data, house our web server and network systems, and connect us to the Internet. A failure by any of these third parties to provide these services satisfactorily could harm our business. 29 -------------------------------------------------------------------------------- ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK -------------------------------------------------------------------------------- Quantitative and Qualitative Disclosures About Market Risk We have considered the provisions of Financial Reporting Release No. 48 "Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments, and Disclosure of Quantitative and Qualitative Information about Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments and Derivative Commodity Instruments." We had no holdings of derivative financial or commodity instruments at March 31, 2001. However, we are exposed to financial market risks, including changes in interest rates. All of our revenue and capital spending is transacted in U.S. dollars. Our investments portfolio comprises amounts invested in short term cash deposits and therefore we believe that the fair value of our investment portfolio or related income would not be significantly impacted by increases or decreases in interest rates due mainly to the short-term nature of our investment portfolio. However, a sharp increase in interest rates could have a material adverse effect on the fair value of our investment portfolio. Conversely, sharp declines in interest rates could seriously harm interest earnings of our investment portfolio. Interest Rate Risk We do not hold derivative or speculative financial instruments and substantially all cash and cash equivalent balances are invested in money market accounts with floating interest rates, therefore we are not subject to significant interest rate risk. Currency Exchange Rate Risk During the period from inception through March 31, 2001, all of our revenues and expenses have been denominated in U.S. dollars. As a result, we have not incurred any realized or unrealized currency exchange rate gains or losses. We do not expect to incur any significant gains and losses during the next twelve months. We have not engaged in foreign currency hedging activities to date. 30 -------------------------------------------------------------------------------- PART II - OTHER INFORMATION -------------------------------------------------------------------------------- Item 2. Changes in Securities and Use of Proceeds During the quarter, we granted warrants for the purchase of 92,000 shares to advisors and in conjunction with the acquisition of musical content during quarter. All of such warrants were granted to accredited investors pursuant to Regulation D. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits None (b) Reports on Form 8-K None 31 -------------------------------------------------------------------------------- SIGNATURES -------------------------------------------------------------------------------- Pursuant to the requirements 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. Date: May 9, 2001 EMusic.com Inc. /s/ Emily Rupp ------------------------- Emily Rupp, Vice President and Chief Financial Officer 32

EMUSIC COM INC 10-Q