UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-K

 

 

Commission file number: 000-51761

 

 

 

 

The Orchard Enterprises, Inc.

(Exact name of registrant as specified in its charter)

 

100 Park Avenue, 2^nd Floor

New York, NY 10017

(Address of principal executive offices, including ZIP Code)

(212) 201-9280

 

(Registrant’s telephone number, including area code)

 

 

 

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

 

 

 

Indicate by check if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Act:  Yes o     No þ

 

Indicate by check if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act:  Yes o     No þ

 

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 þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

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

 

As of June 29, 2007, the aggregate market value of the registrant’s common stock held by non-affiliates was $26,899,624 based on the closing sales price for the registrant’s common stock, as reported on the NASDAQ Global Market System on such date.

 

As of March 31, 2008, the registrant had 6,155,127 shares of common stock outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s proxy statement for the 2008 Annual Meeting of Stockholders are incorporated by reference into Part II and Part III of this annual report on Form 10-K to the extent stated herein. The proxy statement will be filed within 120 days of the registrant’s fiscal year ended December 31, 2007.

 

 

THE ORCHARD ENTERPRISES, INC.

 

TABLE OF CONTENTS

 

 

Forward-Looking Statements

 

This annual report on Form 10-K contains forward-looking statements within the meaning of the federal securities laws. These statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from those expressed or implied by the forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “likely,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue” or the negative of these terms or other comparable terminology. These forward-looking statements are subject to a number of risks that could cause them to differ from our expectations. These include, but are not limited to, risks relating to:

 

 

You should not place undue reliance on these forward-looking statements, which are based on our current views and assumptions. In evaluating these statements, you should specifically consider various factors, including the foregoing risks and those outlined under “Risk Factors.” Many of these factors are beyond our control. Our forward-looking statements represent estimates and assumptions only as of the date of this annual report on Form 10-K. Except as required by law, we undertake no obligation to update any forward-looking statement to reflect events or circumstances occurring after the date of this annual report on Form 10-K.

 

 

Executive Summary

 

In this annual report on Form 10-K, all references to “we,” “us,” “our,” or the “Company” mean The Orchard Enterprises, Inc. and our consolidated subsidiaries, except where it is clear that the term means only The Orchard Enterprises, Inc., the stand-alone parent company formerly known as Digital Music Group, Inc., which we sometimes also refer to as “DMGI.” When we use the term “Orchard NY” we mean our principal operating subsidiary, Orchard Enterprises NY, Inc., and its consolidated subsidiaries that we acquired in the Merger.

 

The Merger

 

On November 13, 2007, we completed a business combination, sometimes referred to herein as the “Merger,” through the merger of our wholly-owned acquisition subsidiary with and into the former “The Orchard Enterprises Inc.” (a New York corporation now called “Orchard Enterprises NY, Inc.”). As a result of the Merger, the former shareholders of Orchard Enterprises NY, Inc. became the holders of a majority of the outstanding capital stock of our company and Orchard NY became our wholly-owned subsidiary. Although we were the acquiring entity for legal purposes, the Merger was accounted for as a “reverse acquisition” and for accounting purposes we were deemed to be the acquired entity in the Merger.

 

Accordingly, the historical financial results prior to the Merger are those of Orchard NY and its consolidated subsidiaries and replace the historical financial results of DMGI as it existed prior to the Merger. The results of operations for DMGI and its pre-Merger consolidated subsidiaries are included in the Company’s consolidated financial results beginning on November 13, 2007.

 

The presentation of Consolidated Statements of Stockholders’ Equity (Deficit) and Redeemable Preferred Stock reflects the historical stockholders’ equity of Orchard NY through November 12, 2007. The effect of the issuance of shares of DMGI common stock and DMGI Series A Preferred Stock in connection with the Merger and the inclusion of DMGI’s outstanding shares of common stock at the time of the Merger is reflected from November 13, 2007 through the year ended December 31, 2007.

 

In connection with the Merger, our board of directors declared a one for three reverse stock split of our common stock effective November 14, 2007, and we changed our trading symbol on the NASDAQ Global Market from “DMGI” to “ORCD.” We also began conducting our business under the trade name “The Orchard” and, on February 9, 2008, we officially changed our legal entity name from “Digital Music Group, Inc.,” to “The Orchard Enterprises, Inc.”

 

Business Overview

 

We are a global leader in digital media services, controlling and distributing more than 1,000,000 music and audio recordings and over 3,000 hours of video programming through hundreds of digital stores (e.g., iTunes, eMusic, Google, Netflix) and mobile carriers (e.g., Verizon, Vodafone, Bell Canada, Moderati, 3) worldwide. We generate income for our label, retailer, brand and agency clients by making these music and audio recordings, and videos available for purchase at the online stores and through innovative marketing and promotional campaigns; branded entertainment programs; film, advertising, gaming and television licensing; among other services.

 

Today, our core business is derived from the retail sale (through digital stores) and other forms of exploitation of our controlled, licensed music catalogue; this core business represents 88% of our total revenues for the year ended December 31, 2007. We believe we are differentiated and well positioned as a digital music marketer and distributor relative to our competition. It is generally accepted that digital music products will overtake and surpass physical music products (i.e., the “compact disc”) and become the primary means of retail music consumption. We believe that this trend away from physical music products will be sustained, long term, and irreversible, notably because the purchase of music content in digital format offers many advantages to consumers over physical form (such as larger selection, ability to sample prior to purchase, 24-hour accessibility, portable format, and single track availability as opposed to entire album). We expect to derive revenue growth as a result of this trend.

We believe we will achieve growth through:

 

 

We have developed an effective global organization of employees, consultants and companies operating in 28 countries worldwide that not only source local repertoire within their local territories for distribution by us, but also expand and service our network of digital entertainment service partners and provide our ancillary services and products within their local territories. We believe the combination of a functional organization and orientation with strong local delivery capabilities is a powerful and advantageous combination for us, and unique in the industry.

 

We believe that we have changed traditional notions of “distribution” by pioneering a broad suite of client services in addition to our primary music distribution and marketing business. These services range from placing a music recording for use in film, TV and advertising programming (referred to as “synchronization”), to co-marketing initiatives with leading consumer brands (for example, creating a digital music promotion that is redeemable by consumers who purchase an electronics item), to global publishing administration (whereby we research and administer the publishing copyright royalties on behalf of master recording owners). Historically, we have often been first to market these types of new, nontraditional services to our clients, and in making independent music available in new digital music retail services (whereby “independent” refers to master recordings not controlled or owned by the four major music companies, which are Sony/BMG, Universal Music Group, EMI and Warner Music Group). For example, we were the launch partner for Verizon, one of the largest U.S. mobile operators, for its VCAST music service (and represented the only independent music in the service when it first became available to end consumers). Further, we were among the first independent music providers to license the Hutchinson 3G (3) mobile services in the United Kingdom directly, without licensing the master recordings to an intermediary mobile technology company.

 

Our business requires limited capital expenditure, and is highly scalable in terms of operating expenses. We believe we are operating at scale in terms of our staffing, organization and technology and operations infrastructure, and can support substantial revenue growth with minimum incremental costs. We expect there to be a positive impact on our earnings over time as we participate in the strong market growth of the digital music sector, and the anticipated market growth in the video sector, and continue to improve our capabilities and win new clients.

 

We also believe that our technology platform, marketing expertise, and client services capabilities are directly applicable across a broad array of other entertainment media, such as video, or mobile casual gaming, and that we can capture material incremental growth by moving into additional digital entertainment licensing areas when and as those sectors emerge as attractive investment opportunities.

 

Market Context

 

The digital segment of the worldwide recorded music market, which includes use of the internet, wireless, cable and mobile networks to select and download purchased music, is growing rapidly. For 2007, the International Federation of the Phonographic Industry (IFPI), an industry trade organization, has estimated digital sales of recorded music at 15% of the total market. According to the PricewaterhouseCoopers’ Global Entertainment & Media Outlook: 2007-2011, global spending on digital recorded music will reach $22.8 billion in 2011, up from an estimated $7 billion in 2006, a 26.8% compound annual gain, and digital sales will overtake physical (i.e., compact disc) sales in 2010. The pervasive and steady consumer adoption of digital music as a widely accepted format has created new opportunities for both content owners and digital entertainment services.

 

The Apple iTunes Music Service, or iTunes, which was launched in 2003, remains the dominant internet-based digital music retailer, and offers consumers a pay-per-download service. However, other digital music retailers such as Verizon, Amazon, eMusic, RealNetworks, Napster, and others offer consumers additional choices, with some

offering broad access to content on various types of subscription bases. Consumers are also purchasing digital music in new ways; for example, via the purchase of full-track digital music downloads for music-enabled mobile phones.

 

The global television and film video industry, like the music industry in 2003, appears to be experiencing the early stages of a transition from sales and rentals in physical formats such as digital video discs (or DVDs), and consumption through subscription cable services and ad-supported broadcast television, to digital consumption through internet, mobile-based downloading and on-demand subscription services. Apple iTunes introduced television episode downloads in late 2005 and began offering feature-length film downloads in 2006. In addition to Apple, a number of other significant digital video retailers, including YouTube, Netflix, Joost and Amazon.com, have launched video download services. While the emergence of the digital video marketplace is nascent, we believe that it will offer us material revenue opportunities over time, in the form of permanent ownership downloads, subscription services providing access to large catalogues of video content, and advertising-supported free viewing.

 

Business Description

 

We perform four basic business activities:

 

 

License or acquire rights and service our supplier clients

 

We license or acquire the digital rights to music and video content from record labels, artists, television and film production companies, and other content owners. As of December 31, 2007, we had over 1,000,000 individual music and audio recordings (or “tracks”) for sale. Our music catalogue has been sourced from over 85 countries, encompasses thousands of labels, and covers a broad and deep array of music genres and historical eras. Additionally, we also have over 3,000 hours of video content for sale, as well as additional music and hundreds of hours of video content under license, which we have not yet made available for sale.

 

We acquire digital rights to music and video content as follows:

 

 

For the year ended December 31, 2007, we generated approximately 17% of our revenues from music content to which we have longer-term licenses (meaning a license with a duration of 5 years or more) (representing 28% of the total tracks we had for sale), and approximately 71% of our revenues from music content for which we have shorter-term distribution rights (representing 72% of the total number of tracks we had for sale).

 

We seek to obtain the broadest territorial distribution rights from our clients. From time to time, however, we enter into digital rights agreements with less than worldwide distribution rights (generally due to pre-existing rights restrictions on the part of the client), which we factor into the contractual terms that we negotiate with the content owner. Digital rights agreements for which we have exclusive worldwide rights represented approximately 66% of our revenues and 76% of the total tracks we had for sale for the year ended December 31, 2007.

 

We seek to maximize sales by meeting our record label clients’ product release dates (i.e., the date on which the client schedules to make the album available for sale physically or digitally, which is typically accompanied by an encompassing marketing and promotion plan developed and executed by the label and to an extent, their physical distributor) with wide availability and visibility across our global network of digital and mobile entertainment service partners. We maintain a company-wide release schedule that is reviewed on an ongoing basis to identify new priorities and targets, review the progress of previously identified priorities and targets (for example, SoundScan^tm data regarding total album/track sales and the ratio of physical to digital sales, placements and promotions achieved, online press coverage, and the like), and to make adjustments in our marketing and promotion programs as warranted. We also engage with our independent record label contacts to adequately manage time, resources and expectations with regard to the sales and performance of a given product, both internally and externally, and subject to the relevant label’s approval, we develop and manage a comprehensive digital marketing plan. We keep our clients informed of merchandising achieved on their behalf by way of screenshots of merchandising placements or promotions, and/or bi-weekly or monthly reports of online press, reviews, blog entries, stream and/or MP3 postings.

 

We also advise our independent record label clients on new digital and mobile outlets that we add to our distribution network, monitor delivery and availability status of their catalogue (i.e., “compliance checks”), and assist in analyzing digital sales data. The majority of this information is available to our label clients in an online account interface, a proprietary, sophisticated administration and analytical tool set branded as the Artist/Label Workstation^sm (or ALW^sm). The ALW^sm offers our artist and label clients with web-based administration and reporting tools, creatively deploying an array of Web 2.0 feature sets, and empowering a new level of control over catalogue and new release management, digital marketing reporting and analysis, accounting administration and royalty analysis. The ALW^sm offers a one-stop resource for our clients to manage their participation in the various services we offer, such as turn-key synchronization licensing support, automatic feeds for integrated marketing campaigns, and “demo builders” to enable us to easily support our and agency and brand clients’ non-traditional marketing campaigns. From within the ALW^sm, labels can order promotional and retail download cards through Drop Cards, as well as create viral fan widgets known as “gydgets,” among other features and functions.

 

We believe we provide a high level of personalized service and attention to our clients, and view this “service” orientation (as opposed to a “product” or “technology” provider orientation) as a major strategic advantage. We consider our focus on service to be a key factor behind our ability to achieve and maintain licensing terms that we believe may be materially higher than the industry average; and why, even when presented with terms that are more economically attractive, label clients nevertheless choose us over the competition.

 

Ingest, Manage and Deliver Our Assets To Our Revenue Channel Partners

 

We have developed a proprietary system to receive and process, store, manage and deliver content to digital music retailers and other digital entertainment services. This system is branded as V.E.C.T.O.R.^tm (Very Efficient Conduit To Our Retailers), and is used for content delivery to both internet-based and mobile-based retailers, among other clients. V.E.C.T.O.R.^tm enables the digital encoding of content into multiple formats for distribution to digital entertainment services operating over the internet, wireless, cable and mobile networks. End consumers can then listen, view and purchase the content for use on their personal computers, digital music and video players, and music and video-enabled mobile phones. We continue to work to improve and further develop V.E.C.T.O.R.^tm, and in the first quarter of 2008, we launched a proprietary video delivery component of V.E.C.T.O.R.^tm with the goal of managing all video deliveries internally without reliance on third-party technology providers (unlike, to our

knowledge, most of our competitors). We believe that this will provide a competitive advantage with respect to our exploiting our large video catalogue.

 

We believe that our proprietary V.E.C.T.O.R.^tm delivery system has had a positive impact on label relations with our content owners and the digital entertainment services we supply by reducing time to market considerably, which helps to ensure that new releases from labels are available on the Internet in conjunction with the physical and/or digital product release date. We believe, based upon historical data, that meeting this deadline (typically referred to as a music recording’s “release date”) has a positive impact on sales of those recordings.

 

As of December 31, 2007, V.E.C.T.O.R.^tm was integrated directly with content management systems of 55 internet retailers and 34 mobile operators, and these delivery points in turn powered a total of over 460 discrete retail storefronts in over 35 countries. We regularly add digital entertainment services and our current delivery capabilities, and believe that we will not be constrained with respect to the number and types of services we expect to add for at least the next two years.

 

During 2007, we transacted a total of approximately 16.2 million track deliveries via V.E.C.T.O.R.^tm, and V.E.C.T.O.R.^tm supported an average of approximately 248,000 daily deliveries during the month of December 2007. Even taking into account the full integration of all of our music, audio and video assets as part of integration activities after our Merger, we do not currently anticipate ingestion, storage or delivery constraints for at least the next two years.

 

Develop Global Sales Channels and Proactively Market To Them

 

After we distribute our music and video content to leading digital entertainment services worldwide, we then sell and promote our content to consumers. We design and execute global marketing and promotion programs locally, with experts in major music territories managing initiatives tailored to each country’s unique market characteristics and dynamics. We currently offer digital music and video for sale in over than 35 different countries, although the United States remains our largest market. For the year ended December 31, 2007, approximately 76% of our revenue was generated in the United States, with the remaining 24% coming from outside the United States.

 

Our digital entertainment service partners sell to end consumers via two primary business models: permanent copies of entire albums, individual recordings or mastertones on a pay-per-download basis; or broad access to a substantial quantity of content in various manners on a subscription basis. We receive revenue from the digital entertainment services based on the number of times our supplied content is downloaded or streamed by end consumers. Our digital entertainment service partners include: iTunes, Napster, RealNetworks, eMusic (which is controlled by our majority shareholder), Wal-Mart Music, MusicNet, Verizon, Sprint, Moderati, Zingy, 9 Squared, and many others.

 

In 2007, we began delivering certain video content to advertising-supported internet sites where the content will be available without charge to consumers. In these cases, we share in a percentage of the advertising revenue based on the number of times our supplied video content is viewed by end consumers. We expect to make more of our video content available during 2008 through existing contractual relationships with our existing video channel partners such as iTunes, YouTube, AOL/In2TV, Movielink, and BitTorrent, among other digital entertainment services.

 

We believe we have strong business relationships with iTunes and other digital entertainment services to which we provide content. Historically, we have been able to obtain premium placement for some of our distributed content on the digital entertainment services, and we intend to continue to work closely in partnership with our digital retail clients to achieve optimum placement and generate sales of our content.

 

Because of the flexibility of the digital format, we are able to market our music content in creative ways by mixing-and-matching our individual recordings to create new digital music albums. This permits us to target our music content to consumers of a particular lifestyle or age group or related to an event type, holiday or live music concert. We believe our expertise in this activity is a competitive advantage.

 

Our digital entertainment retailers operate across multiple business models, which continue to evolve as the market develops. We seek to maximize revenue across our digital entertainment service providers by working to

increase the availability and visibility of our distributed content across the principal models from which we generate revenues, including the following:

 

 

We also generate revenue via direct-to-consumer mastertone sales via SMS, a-la-carte mastertone sales via the Internet, streaming radio on the web and via mobile devices, and through advertising supported models, although these forms of monetization are at present not significant.

 

We also seek to work closely with certain content owners to market their music and video content directly to consumers, who will then be motivated to purchase this content at the various digital entertainment service providers. In such regard, we experiment with new ways to market our music catalogue directly to consumers. For example, we control the SMS short-code “INDIE” for the U.S. market and are beginning to develop programs to

monetize this short-code to deliver content directly to consumers via mobile devices. In addition, we intend to continue to market our services to content owners through strategic advertising and media releases, attendance at trade shows, event sponsorships and the like.

 

For our clients’ high priority releases, we coordinate online publicity and new media marketing and promotions to engage and capture consumers. While our goal is to boost digital sales by generating awareness for the digital music recordings we are marketing, we believe that all exposure for the artist benefits sales. Therefore, in certain cases, we expand our marketing efforts to include tour marketing, which can result in additional sales across concert tickets and physical recordings (compact discs) for our clients.

 

Our marketing programs include online publicity, communications tools and new media marketing and promotions:

 

 

Develop Value-Added Services To Drive Revenue and Margin

 

We provide a full array of non-retail services to our label clients as well as our digital entertainment service partners. We believe that these non-retail services not only maximize revenue through non-traditional models, but also provide key marketing exposure to artists and labels, simplify labels’ administrative tasks, increase our value to our clients and partners, and diversify revenue streams. Our non-retail services include:

 

 

 

Competition

 

We compete in three principal ways:

 

 

Numerous companies compete to acquire digital rights to music and video content, including, among others, Koch, Independent Online Distribution Alliance (IODA), ONEDigital/InGrooves, IRIS, PIAS, Believe, edelNet, and the independent label distribution subsidiaries of the four major record label groups (i.e., Sony BMG/RED, Universal Music Group/Fontana, EMI/Caroline and Warner Music Group/ADA). We also compete with these entities when our existing distribution agreements expire and are subject to renewal. We compete for distribution rights on the basis of payment terms, processing services, marketing ability, reporting services and other products and services we offer to content owners. We are unable to anticipate which other companies are, or are likely to be, seeking to secure digital distribution rights to the same music recordings we may seek to license.

We compete at Apple iTunes and other digital music services for consumers’ attention and download expenditures with the four major labels (which together represent approximately 72% of the current U.S. recorded music market), as well as independent labels that place their music recordings in digital music services either directly or through third party aggregators. The music recordings we distribute represents, to a large extent, back catalogue that are not current mainstream and popular hits, like those held and/or released by the major labels and certain independent labels. Many of these companies have significantly better brand recognition, longer operating histories and significantly greater financial, marketing and other resources than us, which may be competitively beneficial to them.

 

In some cases, the established physical distributors are attempting to leverage their physical distribution offering (which is still important to content owners, as physical formats still predominate) to entice content owners to also grant digital distribution rights to them. In the case of the major record label groups, which have always aggressively competed to provide physical distribution for independent labels, they now have become increasingly active in the digital market segment. These companies have the ability to offer the consolidation of both physical and digital distribution through a major record label, while we are focused only on the digital distribution of our content.

 

Intellectual Property

 

We rely on a combination of trade secret, copyright and trademark laws in the United States and other jurisdictions, as well as confidentiality provisions and contractual restrictions, to protect our proprietary rights, including our know-how.

 

“The Orchard,” “Flashlight” and The Orchard logo design are registered as Service Marks on the Principal Register of the U.S. Patent & Trademark Office. “The Orchard” is also a registered mark in Benelux. In addition, we use the following trademarks, which we have not yet attempted to register nor researched registrability: “Digital Wax,” “Trackdown,” “V.E.C.T.O.R.,” “Re:Live,” “OPP (Orchard Promo Program),” “ALW,” “Grab’M” and “Selector Series.”

 

Employees

 

As of March 28, 2008, we had 77 full time employees. Among these employees, 5 were senior management, 28 were in marketing and business development, 24 were in administration and 20 were in engineering and operations. None of these employees are covered by a collective bargaining agreement and we have never experienced a work stoppage. We consider our relations with our employees to be good.

 

Other Information

 

Our principal executive offices are located at 100 Park Avenue, 2nd Floor, New York, NY 10017 and our telephone number at that location is (212) 201-9280. Our website is located at www.theorchard.com.

 

In addition to the other information contained in this annual report on Form 10-K, we have identified the following risks and uncertainties that may have a material adverse effect on our business, financial condition or results of operations. Investors should carefully consider the risks described below before making an investment decision. The trading price of our common stock could decline due to any of these risks, and investors may lose all or part of their investment.

 

Risks Relating to Our Business

 

We have a limited operating history, have experienced net losses to date and may not be able to become profitable or generate positive cash flow in the future.

 

You should consider our business and prospects in light of the risks, expenses and difficulties encountered by companies in their early stage of development in a rapidly evolving industry. We did not begin to generate significant digital revenue until 2004, have experienced net losses since inception, had an accumulated deficit of approximately $24.1 million as of December 31, 2007, and have not yet been able to generate positive cash flow from operations. We cannot be certain that we will be able to generate net income and positive cash flow from operations in the future.

 

The failure to integrate our businesses and operations in a timely and efficient manner could adversely affect our business and our ability to realize expected synergies from the Merger.

 

The Merger involves risks related to the integration and management of technology, operations and personnel. The integration of our businesses has been and continues to be a complex and expensive process that may yet disrupt our business if not completed in a timely and efficient manner. Since the November 2007 Merger, we have strived to operate as a combined organization utilizing common information and communications systems, operating procedures, financial controls and human resources practices, although there is much work still to do.

 

We have encountered and may continue to encounter substantial difficulties, costs and delays in integrating operations, including relating to:

 

 

We will incur expenses to continue to remediate significant deficiencies that together constitute a material weakness in our present internal controls over financial reporting and in our ability to document, test and certify our system of internal controls. The inability to do so in a timely manner may result in the inability to detect or prevent material misstatements in our financial statements and could also result in the loss of investor confidence.

 

Although we have taken steps to remedy certain of the significant deficiencies that together constituted a material weakness in our internal controls over financial reporting as identified by our former independent auditors

in connection with the audit of our 2006 financial statements, we continue to have significant deficiencies that together constitute a material weakness in our internal controls over financial reporting. Notably, in connection with the audit of our 2007 consolidated financial statements, our independent auditors identified significant deficiencies regarding our overall lack of formalized written policies and procedures in the financial accounting area, our lack of appropriate resources to both manage the financial close process on a timely basis and handle the accounting for complex equity and other transactions, our lack of sophisticated financial reporting systems to allow the reporting of financial information on a timely basis, which is due in part to the small size of our company prior to the Merger, and our lack of a formalized disaster recovery plan in the information technology area. Because of this material weakness, we are not able to conclude that our disclosure controls and procedures were effective as of the end of the period covered by this annual report. Although we have developed a plan of action to correct these deficiencies, which we are currently implementing, there is no guarantee that our efforts will be successful. For further information regarding our internal controls over financial reporting, see Item 7 “Management’s Discussion and Analysis of Results of Operations and Financial Condition — Internal Controls Over Financial Reporting,” and Item 9A(T) “Controls and Procedures — Management’s report on internal controls over financial reporting.”

 

If we are not able to remediate our existing internal control deficiencies, we may not have adequate, accurate or timely financial information and our disclosure controls and procedures may not be effective. Further, material errors in our consolidated financial statements may go undetected and we may be unable to meet our reporting obligations or comply with the requirements of the SEC, which may subject us to sanctions or investigation by regulatory authorities, such as the SEC. If this occurs, there could be an adverse reaction in the financial markets due to a loss of confidence in the reliability of our financial statements.

 

In addition to continuing to remedy the significant deficiencies in our internal controls over financial reporting, we need to bring our financial reporting procedures up to public-company standards so as to allow management to report on, and, when required by Section 404 of the Sarbanes-Oxley Act of 2002, our independent registered public accountants to attest to, our internal controls over financial reporting. As a result, we will continue to incur additional expenses and diversion of management’s time in this area. We will be required to incur additional costs in documenting, evaluating, testing and remediating our internal control procedures and systems, including the hiring of consultants or additional personnel. Such actions, while necessary and beneficial, will adversely affect our financial results.

 

The loss of one or more of our key personnel, or our failure to recruit and retain other highly qualified personnel in the future, could cause a disruption in our relationships with digital entertainment services and content owners.

 

We depend on the continued services and performance of our key personnel. Although we have employment agreements with our executive officers, they may decide to terminate their employment or otherwise cease to be employed by us. We do not have key person life insurance for any of our personnel. As we grow, our business will be dependent on our ability to recruit, employ and retain additional management and skilled personnel. The loss of the services of any of our key personnel or the failure to attract other key personnel could disrupt and limit our ability to grow our business.

 

If the Internet and portable digital music and video players and mobile phones cease to be the medium accepted by the mass market for digital music and video content, our business could be affected adversely.

 

Our success depends to a substantial extent on the willingness of consumers to increase their use of digital entertainment services as a method of purchasing music and video content or viewing ad-supported content. The use of the internet, wireless, cable and mobile networks to select and download purchased music and video content is growing rapidly but is still evolving, and offering ad-supported video content is in its infancy. It is uncertain whether these markets will achieve and sustain high levels of demand and market acceptance. If the use of the internet, wireless, cable and mobile networks to select and purchase music and video content or view ad-supported content does not gain in popularity and market acceptance, our business could be adversely affected. Much of our revenue is currently tied to the popularity of portable digital music players like the iPod by Apple Inc. and other digital music listening and video viewing devices, including mobile phones. If the market penetration by these devices does not

continue to grow, the number of consumers purchasing digital music and video content may decrease or not grow, which could result in a reduction in our revenue.

 

The digital music industry is evolving and we are vulnerable to discounting, price-reductions, pricing structure and stocking changes that may evolve in the industry and, as a result, cause a reduction in our revenue.

 

We receive revenue based on the wholesale prices determined by the digital music retailers based, to a large extent, on the price they charge to consumers. We have limited ability to influence the pricing models of the digital entertainment services. While the major record labels were unsuccessful in their recent attempt to change the pricing structure, there is no assurance that they will not attempt to change the pricing structure in the future or that the digital music retailers will not initiate such a change that could result in lower pricing or tiered pricing that could reduce the amount of revenue we receive. In addition, the popularity of digital music retailers that offer digital music through subscription and other pricing models is increasing. For example, eMusic (which is controlled by our majority shareholder), a subscription-based music service, is now the second largest digital music retailer in the world. Currently, the revenue we earn per individual music recording is generally less under these subscription models than what we receive from iTunes, although we expect it will increase as more subscribers are added. Additionally, digital music services at present generally accept all the music content that we and other distributors deliver to them. However, to the extent the digital music services limit the types or amount of music recordings they will accept from content owners and distributors like us, or substantially limit the number of music recordings they will post for sale, or change their current stocking plans, for instance by removing music recordings that do not meet minimum sales thresholds or other criteria, our revenue could be significantly reduced.

 

Piracy is likely to continue to negatively impact our potential revenue.

 

Our revenue comes from the sale of our digital content over internet, wireless, cable and mobile networks, which is subject to unauthorized consumer copying and widespread dissemination on the Internet without an economic return to us. Global piracy is a significant threat to the entertainment industry generally and to us. Unauthorized copies and piracy have contributed to the decrease in the volume of legitimate sales of music and video content and have put pressure on the price of legitimate sales.

 

Because of our limited experience in the acquisition, processing and distribution of digital video content, we may not be able to earn an adequate return on our video content.

 

Our distribution approach may not work well for video content.

 

The approach we have taken to date in acquiring, processing and marketing music content may not work as well for video content. The distribution of digital video content through digital entertainment services is a relatively new extension of the digital entertainment marketplace. While we have entered into a variety of video distribution agreements and have distributed video content to the major video retailers, the resulting revenues have been limited. If we are unable to enter into additional video distribution agreements on commercially favorable terms, this could limit our future revenue. Additionally, some of our existing agreements with certain digital entertainment services are based on sharing advertising revenue associated with the video content it will make available through such partners. Advertising-supported revenue models associated with the distribution of video content are evolving, with many of our partners still in the test-marketing phase of developing their video distribution services. There can be no assurances as to the potential revenue that the combined company may generate under these models.

 

Our success depends on consumer demand for our content.

 

In addition, our success in digitally distributing video content depends on the market demand for digital video recordings and our ability to acquire and offer for purchase or advertising-supported viewing, video content that appeals to consumers’ tastes and preferences. Consumers’ tastes are subject to frequent, significant and sometimes unpredictable changes. We cannot accurately assess or control consumer demand for our digital video content.

 

Digital video distribution is in its infancy and technical requirements are evolving.

 

The process for digitally encoding video content and packaging it for delivery to meet the technical requirements of our digital entertainment service partners is more complex and time consuming than processing music content. The technical requirements continue to evolve and we may encounter unexpected difficulties in

adapting our processes or in meeting the technical requirements of the digital entertainment services as they continue to be refined. If this is the case, we may have to make significant investments in our technology and operating cost structure to meet evolving technical requirements. Any delay in processing and delivering video content to the digital entertainment services may cause delays in expected revenue growth and any significant changes to current processing requirements could increase our costs and delay or impede our ability to achieve a profit from the distribution of video content. Additionally, based on our experience to-date, a number of digital entertainment services providers have initially limited the amount and type of video content they will accept based on their capacity constraints and/or content selection criteria. If digital entertainment services continue to limit the types or amount of video content they will accept and we are unable to exploit all of the video content we have under contract, our revenue potential could be limited.

 

If the music content we provide to digital entertainment services does not appeal to consumers’ tastes and preferences, our revenue will decrease.

 

Our success depends on our ability to acquire or license digital rights and offer to consumers, digital music content that appeals to consumers’ tastes and preferences. Consumers’ tastes are subject to frequent, significant and sometimes unpredictable changes. We cannot accurately assess or control consumer demand for our music content. Our historical revenue is based on the number of music recordings available for purchase at digital entertainment services, which remained relatively small in numbers until late 2005. Seasonality and other trends in consumer demand for music have been difficult to assess from this limited historical data. In the future, our current music content and the additional music content we make available to consumers may not experience similar demand. Any reduction in the popularity of our music content with consumers will cause a reduction in our revenue.

 

Our business involves identifying and locating the holders of digital rights to additional music and video content, and failure to do so will limit our revenue growth.

 

Our ability to continue to increase our revenue depends on our ability to continue to acquire digital rights to music and video content. Ownership of music and video content is highly fragmented and not organized in a common marketplace. There is no central registry or directory of content owners and finding them can be difficult and time-consuming. We currently rely on our business development personnel, on networks of relationships and on market research to locate content owners, as well as our reputation in the industry and targeted advertising to attract content owners seeking to access the digital market. In the future, our ability to continue to identify, locate and attract such content owners will have a significant impact on the amount of content we are able to acquire.

 

Our inability to enter into agreements to acquire additional digital rights to music and video content on commercially favorable terms could impede our growth and increase our expenses.

 

The growth of our business is dependent, in large part, on our ability to acquire or license digital rights to additional music and video content. Even if we are able to locate additional content owners, they may not be willing to sell or license their digital rights or we may not be able to negotiate terms that are commercially favorable to us (particularly given the competitive environment of our industry). While we believe that our experience and knowledge in the music industry allows us to determine commercially reasonable prices for music and video content, we may be unable to objectively determine fair market value for the digital rights to the content that we acquire because of unknown consumer demand for such content, unknown number of additional owners of digital rights to such content in certain cases and absence of independent valuations for music and video content. If content owners are unwilling to sell or license their rights on terms that we have determined are commercially favorable to us, we will not be able to substantially increase our revenue.

 

We face competition from companies seeking to acquire the digital rights to music and video content, which could negatively impact our ability to acquire additional digital rights.

 

The market for acquiring digital rights from content owners is competitive, especially for the distribution of music catalogs owned by independent labels. The number of commercialized music and video recordings available for acquisition is large, but limited, and many of the more desirable music recordings are already subject to digital distribution agreements or have been directly placed with digital entertainment services. We face competition in our pursuit to acquire additional music and video content, which may limit the amount of available music and video content for sale or license and may lead to higher acquisition prices. Our competitors may from time to time offer

better terms of acquisition to content owners. Subsidiaries of the four major record labels, which have always aggressively competed to provide physical distribution for independent labels, have become increasingly active in the digital market segment. These companies have the ability to offer the consolidation of both physical and digital distribution through a major record label, can offer reduced physical distribution fees in order to gain the digital distribution rights from independent labels and other content owners and can condition an agreement to distribute physical content on the inclusion of digital rights, while we are focused only on the digital distribution of music and video content. Some of our competitors have adopted, and may continue to adopt, aggressive pricing policies and devote substantial resources to acquiring digital rights to music and video recordings. In addition, our competitors may form strategic alliances with record labels and digital entertainment services that could result in increased competition for the acquisition of music recordings, service offerings or favorable terms with the digital entertainment services. Increased competition for the acquisition of digital rights to music and video recordings may result in a reduction in our operating margins, market share and brand.

 

We are substantially dependent on a limited number of digital entertainment services, in particular iTunes, for the sale of our content.

 

We derive our revenue from a small number of leading digital entertainment services that make our content available to consumers. We generally deliver our music and video content to these digital entertainment services in priority of their significance to us. For the years ended December 31, 2007 and 2006, we received 54% and 51% of our revenue from iTunes, respectively. For the same periods, we received 11% and 12% of our revenue from eMusic (which is controlled by our majority shareholder), respectively. Our agreements with iTunes have terms of three years, some of which end in December 2008, some in October 2009, and some in April 2010. If we are not able to continue to renew our relationships with iTunes and other digital entertainment services that make our music and video content available to consumers on similar economic terms, our ability to generate revenue will be significantly reduced.

 

Our accounts receivable are concentrated with a limited number of digital entertainment services, particularly iTunes, which subjects us to substantial payment risk.

 

We rely on reports from digital entertainment services detailing download and other activity to determine our revenue, and such reports are typically provided to us within 30 to 45 days following the end of the reporting period, generally monthly. We receive payment at approximately the same time as we receive these detailed revenue reports. Our accounts receivable therefore consists of approximately one month’s revenue (or one quarter in the case of certain digital entertainment services that report quarterly). As of December 31, 2007, accounts receivable from iTunes represented 34% of total accounts receivable, compared to 35% of total accounts receivable as of December 31, 2006, and accounts receivable from eMusic (which is controlled by our majority shareholder), represented 14% and 15% of total accounts receivable at December 31, 2007 and 2006, respectively. The concentration of our accounts receivable among a small number of digital entertainment services is likely to continue and we expect our accounts receivable to become larger as we grow. We had a $427,000 allowance for doubtful accounts receivable as of December 31, 2007. However, if any significant digital entertainment services are unable to pay us as due each month (or quarter, as the case may be), it could disrupt our business and cause us to report a bad debt loss in excess of amounts provided for potential doubtful accounts.

 

We have entered into multi-year agreements for digital rights to music and video content and if we are unable to renew these agreements on commercially favorable terms as they expire, our revenue could materially decrease.

 

Our long-term success depends upon, among other things, our ability to renew our non-perpetual rights to music and video content once they expire. For the year ended December 31, 2007, approximately 71% of our revenue was derived from digital music distributed under short-term distribution agreements that expire in one to five years depending on certain factors. We are aware that our competitors have solicited a number of the record labels we have under short-term distribution agreements, just as we have solicited their record label clients in this highly competitive market. While we do not expect any net material decrease in revenue and gross profit from these activities, if our competition becomes increasingly aggressive or our level of service provided to our record label clients is not superior to our competition, we may experience a higher rate of non-renewal than we have in the past for our short-term digital distribution agreements. If any of our competitors offer better terms, it could cause us to

spend more money or grant better terms, or both, to renew the digital rights we currently hold. In addition, the larger and more prestigious independent record labels, which have traditionally accessed the digital music market through distribution companies like us, could seek direct distribution with digital music retailers when their agreements with us expire (or, in the alternative, choose to deliver directly to one or more of the largest digital music retailers, such as iTunes, and use distributors only for the lesser retailers). If we are unable to renew the non-perpetual rights to our music and video content on commercially favorable terms, our revenue could materially decrease.

 

Other parties may have digital rights, or claim to have such rights, to our music content, which may result in duplicates of the music recordings we sell to be available for purchase at the digital music services and cause a reduction in our revenue.

 

We generally acquire or license all of the digital rights that the owner of music content has available to grant; however, the holders of such rights may not possess exclusive rights to those music recordings. We are unable to determine the number of additional holders of rights to our music recordings. Aside from copyright law, the rights to music recordings are contractual in nature. There is no central registry or directory that evidences the chain of title to the rights of music recordings other than copyright registration, which is voluntary. Given the age of many of the music recordings we have acquired or licensed or may acquire or license in the future, there is often a lack of documentation to evidence the chain of title. In addition, there is a common practice in the music industry of licensing rights in various formats or in certain compilations and to grant the same rights to different parties for the same or different geographic regions. Our content acquisition and distribution agreements contain representations, warranties and indemnities only with respect to the digital rights granted to us and not with respect to the rights held by other parties. We are aware of numerous instances where other parties have legitimate digital rights to the same music recordings to which we have acquired or licensed the digital rights. If copies of our music recordings are available at the digital music services from alternative sources, our revenue will be reduced to the extent these copies are purchased instead of ours.

 

We may not receive legal title to the digital rights of music content that we have paid to acquire or license, and any determination that we don’t hold such rights may subject us to write-offs, claims for damages and lost profits.

 

Our acquisition and distribution agreements with content owners contain representations, warranties and indemnities with respect to the digital rights granted to us. In certain instances, we have purchased or licensed digital rights that were determined not to be held by the holder from whom we acquired or licensed those rights. If we were to acquire or make a cash advance for digital content and make available for purchase music recordings from a person who did not actually own such rights and we were unable to enforce or collect on the representations, warranties and indemnities made by such person, our business would be adversely affected. We would be required to write-off the cost of the acquisition or advance, lose the rights to sell such music and might be subject to copyright infringement lawsuits for selling such music recordings without the right to do so. Some of our largest label accounts have drawn multiple adverse claims of this kind. Such lawsuits are expensive to defend, regardless of the outcome, and could subject us to damages, which could be significant. Finally, these situations could adversely impact our reputation with content owners and our relationships with digital music services, which could adversely affect our business.

 

The declining market for physical recordings (such as albums or CDs) could affect the financial health our label client base, which could have a negative effect on our business.

 

Sales of physical recordings (albums and, primarily, CDs) are still the primary source of revenues for the recording industry generally. Recently, physical sales have been declining but the anticipated increase in digital revenue has not yet made up for the decline in physical revenues. The decline in revenues from physical sales could negatively affect the finances of our independent label clients, many of whom are thinly capitalized and/or suffer marginal cash flow. This decline in income could affect their ability to continue to sign new artists, market their current artists or even stay in business, which could have a negative effect on our business.

We could be liable for unpaid mechanical royalty obligations and bear liability for copyright infringement if our label clients fail to license and/or pay mechanical copyright royalties owed or if, where contractually obligated to do so, we fail to properly license and/or pay mechanical copyright royalties, which could have a negative effect on our business.

 

Mechanical royalties are the statutory or other payment due to the publisher of the underlying musical composition embodied in the master recording. We administer mechanical royalties for certain artists and record labels. All other artists and labels that we distribute represent and warrant to us that they will secure the appropriate licenses and pay any royalties due, and agree to indemnify us if they don’t. We believe this is common practice among digital distributors. As a result, in certain instances and under certain circumstances, if the required payments are not made, we could be liable for unpaid mechanical royalty obligations and bear liability for copyright infringement, which could have a negative effect on our business.

 

If content owners fail to deliver, or if there are long delays in the time it takes to receive the music and video content that we acquire rights to, our revenue growth will be negatively impacted and our cash flow will be affected adversely.

 

Implementation of our business plan and growth strategy depends on increasing the amount of music and video content we have available to consumers at digital entertainment services. Our purchase and long-term distribution agreements typically require the owners to deliver to us their music and video content under an agreement delivery timetable. Under our short-term distribution agreements, there is generally no specific delivery timetable, although the content owner is generally required to digitally distribute their entire catalogue to us and promptly provide all the master recordings and metadata to us for processing after execution of the agreement. Some of the content we acquire may be in older physical formats such as audio tape or vinyl records in the case of music recordings, or film, tape or other incompatible digital format in the case of video recordings, which requires processing onto compact disc or digital video disc prior to being delivered to us. In addition, our agreements require that certain descriptive information required by the digital entertainment services for each music and video be delivered with the content, such as recording title, album title, artist name, genre, copyright information, label name, unique product identifier, artwork, biographical information, sales information and date of release. Historically, it has at times taken several months or longer after we have entered into an agreement before we have received delivery of the music and video content acquired. In addition, in some cases the quality of the music and videos and metadata initially delivered is not sufficient or the data is not complete and follow-up work and effort is required to receive proper and complete delivery, although even with such extra efforts there are no assurances such problems can be cured. Although we generally specify delivery dates and make cash payments by us conditional upon delivery, we do not control the timing for complete receipt of the music and video content we have acquired. In addition, in certain cases, content owners have over delivered and in others have been unable to deliver all of the content specified in our agreements. We are typically not required to pay additional consideration for deliveries in excess of contract amounts and are not required to make cash payments for any content that is not delivered, or is defective or otherwise non-usable. However, our expected revenue growth rate is negatively impacted when we do not receive all the content we have contracted for. If there are long delays in the time it takes for the owners to deliver to us the music and video content in physical format or complete data format and the related complete descriptive information, it will delay our ability to begin the process of converting the content into the digital formats required by digital entertainment services. It could also cause inefficiencies in the utilization of our operations personnel who process these recordings. Any delay in making our music and video content available for purchase at the digital entertainment services will delay our revenue growth, and inefficiencies caused by such delays could cause a reduction in our cash flow in the interim.

 

Any extended delay by digital entertainment services in processing and making our music and video content available to consumers causes a delay in our ability to earn revenue from such content.

 

Following receipt of music and video content from the owners, we convert them into the specific digital formats required by digital entertainment services. We then deliver the music and video content in digital format, together with their associated descriptive information and artwork, to the digital entertainment services to be made available to consumers in the specific territories where we have acquired the digital rights. The digital entertainment services must then review our music and video content, descriptive information and artwork to ensure that they are in the proper format for their store or service. The content is only made available to consumers once the digital retailer or service has completed its review, encrypted the content with the particular retailer’s (if applicable) digital

rights management protection and other retailer or service-specific coding, and posted the digital files on the retailer’s or services’ computer servers. We are subject to the digital entertainment services’ internal processing timing and priorities. Our agreements with the digital entertainment services do not provide for a fixed processing time. Any extended delay in making our music and video content available to consumers causes a delay in when we can begin to earn revenue and return on investment from our content.

 

If we seek to acquire content through the acquisition of record labels or other companies that own master rights to music or video content, we may not be able to successfully integrate these companies.

 

We may attempt to acquire record labels or other companies that own master rights to music or video content for purposes of acquiring their digital rights. In the event we are able to acquire such record labels or other companies, we may be subject to a number of risks related to the integration and management of such companies, including failure to obtain valid consents to assignment of contracts, including contracts granting rights to music content, failure of the business of the acquired company to achieve expected results, diversion of our management’s attention, failure to retain key personnel of the acquired company, as well as the assumption of certain liabilities owed to such record labels’ and companies’ original grantors, artists, music publishers and other third parties. In addition, if we undertake an acquisition of a company that operates non-digital businesses or owns non-digital rights to music and video content, we may attempt to operate the non-digital businesses or sell the non-digital rights to another person or entity, and we may not be able to do so in a manner or on terms favorable to us.

 

If we are not able to integrate and scale our reporting and payment processes, we may experience delays providing reports to the content owners and paying required royalties that could have a negative effect on our brand identity.

 

We receive regular sales reports from digital entertainment services that contain sales information for our music and video content. Based on these reports, we provide summary reports to the content owners. When we acquire the perpetual digital rights to music content and in certain of our distribution agreements, we may assume the obligations of the content owner to pay any required royalty payments to the artists according to the terms of the existing agreements. In addition, we may be required to pay statutory publishing royalties on behalf of the content owner according to the terms of our agreements. As we integrate the extensive databases and information systems and acquire digital rights to additional music and video content, we may experience difficulties in preparing and distributing sales reports for the content owners or processing and paying artist and publishing royalties in a timely fashion, which could result in adverse claims by content owners. If we are not able to successfully expand our processing capability or introduce technology to allow us to determine and pay royalty amounts due and automate these tasks, we may experience delays as we increase the volume of our music and video content, which could have a negative effect on our relationships with content owners and brand identity.

 

We may need to raise additional capital to accomplish our objectives and, if we are unable to raise such funds as needed, our growth would be limited.

 

We may use our common stock in addition to our cash for the consideration for future acquisitions of digital rights to additional music and video content and/or for the acquisition of other businesses in the digital media industry. If our common stock does not maintain a sufficient market value or content and business owners are unwilling to accept common stock as part of the consideration for the sale of the digital rights to their music and video content or their businesses or as consideration for licensed rights to their music and video content, we may be required to utilize more of our cash resources, if available. We intend to be more aggressive in this area and may require additional financing in the future. If we do not have sufficient cash resources, our ability to acquire additional rights to music and video content and ancillary businesses could be limited unless we are able to obtain additional capital through future debt or equity financings. Our ability to obtain financing will depend, among other things, on our development efforts, business plans, operating performance and condition of the capital markets at the time we seek financing. Additional financing may not be available to us on favorable terms when required, or at all. Using cash to finance acquisitions could substantially limit our financial flexibility and using debt could result in financial covenants that limit our operations and financial flexibility. If we raise additional funds through the issuance of equity, equity-linked or debt securities, those securities may have rights, preferences or privileges senior to the rights of our common stock, and our common stockholders may experience dilution.

We face a potential loss of music content if it is determined that recording artists have a right to recapture rights in their content under the U.S. Copyright Act.

 

The U.S. Copyright Act provides authors and their heirs a right to terminate licenses or assignments of rights in their copyrighted works that were not “works made for hire.” If any of our music content were determined not to be “works made for hire,” then the recording artists or their heirs could have the right to terminate the rights we hold. These residual author rights generally survive for five years after the end of the 35-year period from the date of a post-1977 license or assignment, and in the case of a pre-1978 grant in a pre-1978 recording, five years after the end of the 56-year period from the date of creation or January 1, 1978, whichever is later. Any termination of our rights to our music content could result in a material reduction in our revenue.

 

Risks Relating to Our Common Stock

 

Dimensional Associates, LLC has significant influence on all stockholder votes and has effective control over the outcome of actions requiring the approval of our stockholders.

 

Dimensional Associates, LLC, or Dimensional, beneficially owns shares of our capital stock representing approximately 56% of the outstanding voting power of our capital stock. Dimensional thus has the ability to exert substantial influence or actual control over our management policies and strategic focus, could control the outcome of almost any matter submitted to our stockholders and has the ability to elect or remove all of our directors. There is a risk that the interests of Dimensional will not be consistent with the interests of other holders of our common stock.

 

Dimensional has significant control over our business and significant transactions. In addition to the effects described above, Dimensional’s control of our company could make it more difficult for us to raise capital by selling stock or for us to use our stock as consideration in acquisitions. This concentrated ownership also might delay or prevent a change in control and may impede or prevent transactions in which stockholders might otherwise receive a premium for their shares.

 

Sales of common stock by Dimensional could cause the trading price of our common stock to decline.

 

In connection with the Merger, we entered into a registration rights agreement with Dimensional and the other former stockholders of Orchard NY requiring us, under certain circumstances, to register all of the shares of common stock that will be beneficially owned by them as a result of the Merger. The exercise of these registration rights or sale by Dimensional in the public market pursuant to any such registration could cause the market price of our common stock to decline.

 

We do not intend to pay dividends.

 

We do not intend to pay dividends in the foreseeable future. We intend to retain future earnings, if any, to finance the expansion of our operations and for general corporate purposes, including future acquisitions. In addition, future financings may contain restrictions on our ability to pay dividends on our capital stock.

 

Provisions in our charter documents and under Delaware law could discourage a takeover that stockholders may consider favorable.

 

Our charter documents may discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable because they:

 

 

As a Delaware corporation, we are also subject to the Delaware anti-takeover provisions contained in Section 203 of the Delaware General Corporation Law. Under Delaware law, a corporation may not engage in a business combination with any holder of 15% or more of its capital stock unless the holder has held the stock for three years or, among other things, the board of directors has approved the transaction. Our board of directors could rely on this provision to prevent or delay an acquisition of our company.

Our stock price is subject to fluctuation and could decline and could result in our being delisted from trading on the NASDAQ Global Market.

 

The price at which our common stock has traded since its initial public offering in February 2006 has fluctuated significantly. The price is likely to continue to fluctuate significantly due to the following factors, some of which are beyond our control:

 

 

As a result of these and other factors, investors in our common stock may not be able to resell their shares at or above their purchase price or trade them on the NASDAQ Global Market if our stock price failed to meet the continued listing standards. In addition, sales of substantial amounts of our common stock by existing stockholders in the public market (such as Dimensional) may adversely affect the future market price of our common stock. Shares issued upon the exercise of outstanding options granted to our employees and directors also may be sold in the public market. Such sales could create the perception to the public of difficulties or problems with our business. As a result, these sales might make it more difficult for us to sell securities in the future at a time and price that we deem necessary or appropriate.

 

In the past, securities class action litigation often has been instituted against companies following periods of volatility in the market price of their securities. We maintain directors and officers’ liability insurance for this type of litigation. However, if such litigation is directed at us, it could result in substantial costs, including the deductible amount under our insurance policy and other indirect costs and a diversion of management’s attention and resources.

 

 

Not applicable.

 

 

We occupy approximately 13,600 square feet of office space at 100 Park Avenue in New York, New York, under a lease agreement that expires on January 30, 2009. We vacated our former headquarters in Sacramento and are endeavoring to negotiate early termination of the lease, which runs through May 31, 2009. We vacated our former space in San Francisco and exercised an early termination right to end the lease as of August 1, 2008. In addition, we maintain a small suite of offices at 25 Floral Street and Covent Garden, London, England pursuant to a license having an automatic renewal every two months, and lease office space in Paris, France, Berlin, Germany and Santa Monica, California. We anticipate the need to acquire additional office space in New York City in the near future and expect that our rental costs will increase substantially from the amounts historically paid in connection with the expiration of our lease in 2009.

 

 

We are involved in legal proceedings from time to time in the ordinary course of our business.

 

On March 11, 2008, we initiated suit in federal court in the Eastern District of California against TufAmerica, Inc. The complaint alleges fraud, breach of contract and various other wrongs in connection with a contract dispute with TufAmerica, Inc. concerning the number, nature and technical quality of master recordings the label was required to deliver to our company under the contract. We requested various forms of relief from the court, including the return of approximately $2.4 million in fees and advances already paid under the contract. TufAmerica, Inc. has not yet formally responded to these claims, although during the course of the dispute TufAmerica, Inc. had sent a letter to our company claiming damages in the amount of approximately $1.2 million. Because the litigation is in its early stages, we are unable to determine if the outcome of this case will be favorable to our company. While we believe we have meritorious claims and intend to pursue them vigorously, litigation is inherently uncertain and we can provide no assurance that the defendant will not pursue claims against our company in response to our action.

 

To our knowledge, other than the foregoing, there are no currently pending or threatened legal proceedings that could have a material effect on our business, financial condition or results of operations.

 

 

We held a Special Meeting of Stockholders on November 13, 2007 to: (1) approve the Agreement and Plan of Merger, dated as of July 10, 2007, as amended and restated on September 13, 2007 and as further amended and restated on October 5, 2007, by and among our company, our wholly-owned acquisition subsidiary DMGI New York, Inc. and Orchard NY, pursuant to which DMGI New York, Inc. would merge with and into Orchard NY, Orchard NY would become a wholly-owned subsidiary of our company and we would issue to Orchard NY stockholders and holders of Orchard NY deferred stock awards an aggregate 9,064,941 shares of our common stock and 448,833 shares of a new series of preferred stock; (2) approve a reverse stock split in a ratio from one-for-two to one-for-five of all issued and outstanding shares of our common stock, the final ratio to be determined within the discretion of our board of directors; (3) consider and vote upon an adjournment of the special meeting, if necessary, to solicit additional proxies if there are not sufficient votes in favor of the foregoing proposals; and (4) transact such other business as may properly come before the special meeting or any postponements or adjournments of the special meeting. The results of the special meeting on the above mentioned items were as follows:

 

Following the shareholder vote, the Merger was completed and our board of directors voted to effect a one for three reverse stock split effective on November 14, 2007.

 

Pursuant to the terms of the Merger, the Orchard NY stockholders were issued 2,862,910 shares of our common stock on a post-split basis (8,591,893 shares on a pre-split basis) and 446,918 shares of our Series A Convertible Preferred Stock and all of their outstanding shares in Orchard NY were cancelled. In addition, we assumed Orchard NY’s obligations under its outstanding deferred common and preferred stock awards, which, pursuant to the terms of the Merger, now represent the right to receive 157,683 shares of our common stock on a post-split basis (473,048 on a pre-split basis) and 1,915 shares of our Series A Preferred Stock for issuance pursuant to such awards.

 

Our Series A Preferred Stock is convertible into, and has voting rights equivalent to, 3.33 shares of common stock on a post split basis (ten shares on a pre-split basis) and is redeemable at the option of the board of directors after the fifth anniversary of its issuance at a price of $55.70 per share, subject to certain restrictions, plus any declared and unpaid dividends.

 

As a result of the Merger, Orchard NY became our wholly-owned subsidiary, with the former Orchard NY stockholders collectively owning common and preferred stock (including common and preferred stock subject to deferred stock awards) representing approximately 60% of the voting power of our outstanding capital stock.

 

 

Price Range of Common Stock

 

Our common stock is quoted on the NASDAQ Global Market under the symbol “ORCD.” Prior to November 14, 2007, our common stock was traded under the symbol “DMGI.” Our initial public offering took place on February 2, 2006 at $9.75 per share ($29.25 per share after adjusting for the November 14, 2007 one for three reverse stock split). Prior to February 2, 2006, there was no public trading market for our common stock. The following table presents the high and low closing prices for our common stock, as reported on the NASDAQ Global Market, and its predecessor, the NASDAQ National Market, for the periods indicated and as adjusted to give effect to the November 14, 2007 one for three reverse stock split.

 

 

 

Dividend Policy

 

We have never declared or paid any cash dividends on our common stock. We currently intend to retain our future earnings, if any, for future growth and development of our business and do not anticipate paying any cash dividends in the foreseeable future. Any future determination to pay dividends will be at the discretion of our board or directors and will depend on our results of operations, financial conditions, contractual and legal restrictions and other factors the board deems relevant.

 

Holders of Record

 

At March 28, 2008, the last reported sales price of our common stock on the NASDAQ Global Market was $5.92 per share, and at March 31, 2008, the number of holders of record was 133. Because many of our shares of common stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by those record holders.

 

Equity Compensation Plans

 

The information required by this item regarding equity compensation plans is incorporated by reference under the section entitled “Equity Compensation Plan Information” contained in our definitive proxy statement for our 2008 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission within 120 days after our fiscal year ended December 31, 2007, or our “2008 Proxy Statement.”

 

Issuer Purchases of Equity Securities

 

On November 13, 2007, we acquired a total of 11,111 shares of our common stock in a non-monetary exchange valued at an agreed price per share of $6.75 on a post-split basis (or 33,334 shares on a pre-split basis at a price per share of $2.25 per share). These shares were acquired from a former executive and director of our company prior to the Merger in exchange for certain music recordings and were not acquired as part of any publicly announced share repurchase plan or program. We acquired no other shares during the fourth quarter of 2007 and do not currently have in place any publicly announced share repurchase plan or program.

 

 

Intentionally omitted.

 

The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this annual report on Form 10-K. This discussion contains forward-looking statements, the accuracy of which involves risks and uncertainties. See “Forward-Looking Statements.” Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us described in “Risk Factors.”

 

Overview

 

Background and Basis of Presentation

 

On November 13, 2007, The Orchard Enterprises, Inc. (formerly known as Digital Music Group, Inc. or “DMGI”) consummated a business combination with Orchard Enterprises NY, Inc. (formerly known as The Orchard Enterprises Inc., which we refer to as “Orchard NY”) through a merger of a subsidiary of DMGI with and into Orchard NY pursuant to the terms of the Second Amended and Restated Merger Agreement dated October 5, 2007, as amended on November 7, 2007 (the “Merger”). Pursuant to the terms of the Merger, all of the outstanding common and preferred stock of Orchard NY was cancelled and the former stockholders of Orchard NY received an aggregate of 2,862,910 shares of DMGI common stock (after giving effect to a one for three reverse stock split of DMGI’s common stock that took effect on November 14, 2007) and 446,918 shares of DMGI Series A convertible preferred stock (the “DMGI Series A Preferred Stock”). In addition, DMGI assumed the obligations of Orchard NY under its outstanding deferred common and preferred stock awards and reserved 157,683 shares of DMGI common stock (on a post-split basis) and 1,915 shares of DMGI Series A Preferred Stock for issuance pursuant to such awards. In connection with the Merger, Orchard NY became our wholly-owned subsidiary, with the former stockholders of Orchard NY collectively owning shares of our common and preferred stock representing approximately 60% of the voting power of our outstanding capital stock. The Orchard Enterprises, Inc. and its subsidiaries are referred to collectively as “we,” “us,” and the “Company.” See Note 4 to our consolidated financial statements appearing elsewhere in this annual report for further details on the Merger.

 

For accounting purposes, the Merger was treated as a reverse acquisition with Orchard NY being the accounting acquirer. Accordingly, the historical financial results prior to the Merger are those of Orchard NY and its consolidated subsidiaries and replace the historical financial results of DMGI as it existed prior to the Merger. The results of operations for DMGI and its pre-Merger consolidated subsidiaries are included in our consolidated financial results beginning on November 13, 2007. The presentation of Consolidated Statements of Stockholders’ Equity (Deficit) and Redeemable Preferred Stock reflects the historical stockholders’ equity of Orchard NY through November 12, 2007. The effect of the issuance of shares of DMGI common stock and DMGI Series A Preferred Stock in connection with the Merger and the inclusion of DMGI’s outstanding shares of common stock at the time of the Merger on November 13, 2007 is reflected in the year ended December 31, 2007.

 

Orchard NY was incorporated in New York in September 2000. On April 28, 2003, Dimensional Associates, LLC, or Dimensional, an entity formed by a group of private investors, invested in and acquired operating control of Orchard NY through the purchase of a convertible debt instrument followed by subsequent periodic funding events under similar conditions as the original convertible debt instrument. These debt instruments were redeemed or converted prior to completion of the Merger and are described below in “Liquidity and Capital Resources — Description of Indebtedness” and in Note 10 to our consolidated financial statements appearing elsewhere in this annual report.

 

We are a global leader in digital media services, controlling and distributing more than 1,000,000 music and other audio recordings, or tracks, and over 3,000 hours of video programming through hundreds of digital stores (e.g., iTunes, eMusic, Google, Netflix) and mobile carriers (e.g., Verizon, Vodafone, Bell Canada, Moderati, 3) worldwide. We generate income for our label, retailer, brand and agency clients by making these music and audio recordings and videos available for purchase at the online stores and through innovative marketing and promotional campaigns; branded entertainment programs; film, advertising, gaming and television licensing; among other services.

Significant Customers

 

Since inception through December 31, 2007, our revenue has been derived primarily from the distribution of digital music content. Two customers, iTunes and eMusic (which is controlled by our majority shareholder), account for a significant portion of our total revenue and related accounts receivable. For the years ended December 31, 2007 and 2006, iTunes represented 54% and 51% of total revenue and eMusic represented 11% and 12% of total revenue, respectively. Accounts receivable from iTunes were 34% and 35% of total accounts receivable at December 31, 2007 and 2006, respectively. Accounts receivable from eMusic were 14% and 15% of total accounts receivable at December 31, 2007 and 2006, respectively.

 

Sources of Revenues

 

Our revenues are derived from the following sources:

 

 

Combined revenue from digital downloads and subscription fees comprised approximately 78% of our total revenue for each of the years ended December 31, 2007 and 2006. Approximately 10% and 5% of our revenue for the years ended December 31, 2007 and 2006, respectively, was derived from mobile services.

 

Cost of Revenues

 

Our cost of revenues primarily consists of:

 

 

 

Our cost of revenues and corresponding gross profit is determined by the revenues earned on our available music and audio content. In our digital distribution agreements with content owners, which usually have terms of two to five years, we typically have an exclusive right to collect revenue directly from the digital entertainment services. We then pay a negotiated revenue sharing percentage to the content owner.

 

In certain instances, with respect to higher profile labels and/or as an inducement to enter into a longer-term license agreement, we may make a royalty advance against the content owner’s share of future royalties. We capitalize all such advances as a prepaid asset that we amortize as a cost of revenue as the related revenue is earned and the cash advances are recouped. We also include in cost of revenues the fees and direct costs incurred in obtaining content. For long-term distribution agreements, we amortize the legal fees and other direct costs incurred in acquiring the agreement on a straight-line basis over the shorter of the term of the related agreement or ten years. When we acquire digital rights or master recordings, we capitalize the purchase price and the direct ancillary costs and amortize the acquisition costs on a straight-line basis over ten years.

 

While we are typically not responsible for any third party royalties (such as artists and publishers) in our agreements with content owners, for music content that we own and for content distributed under most of our long-term distribution agreements, we are typically responsible for some or all third-party royalties (such as artists and publishers), the cost of which is included in cost of revenues. Artist royalty obligations for music and audio recordings have historically been between 0% and 15% of the revenue attributable to a specific track or album. The publisher royalties for music and audio recordings are a statutory rate in the United States, which was $.09 for 2006 and 2007.

 

In connection with the allocation of the purchase price to the assets we were deemed to have acquired from DMGI for accounting purposes, we established an asset called Digital Distribution Agreements, which is a component of “Music and Audio Content,” to reflect the estimated fair market value of DMGI’s license agreements at the Merger date. We are amortizing this asset to cost of revenues over the term of the related agreements.

 

We include in cost of revenues depreciation and amortization associated with equipment and computer software that we use to digitally encode music files. Historically, when we have utilized third parties to digitally encode music files into the specific formats required by digital entertainment services, we also included these costs in cost of revenues. We also charge any other third party costs directly associated with earning other revenue to cost of revenues.

 

Operating expenses include all costs associated with general and administrative expenses, sales and marketing and product development in order to operate the business.

 

Seasonality

 

We are not able to identify definitively seasonality in our business because of the early-stage nature of the entire digital distribution industry and our limited operating history. However, we suspect that the first and fourth quarters of the calendar year may have seasonally higher sales, because this is the peak time for sales of music recordings in physical format (generally ascribed to increased consumer spending due to the holidays).

 

Critical Accounting Policies and Estimates

 

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures in the consolidated financial statements. Critical accounting estimates and assumptions are those that may be material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change, and that have a material impact on financial condition or operating performance. We base our estimates and judgments on our experience and on various other

factors that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies used in the preparation of our consolidated financial statements require significant judgments and estimates. For additional information relating to these and other accounting policies, see Note 3 to our consolidated financial statements appearing elsewhere in this annual report.

 

Revenue Recognition and Assessing the Collectibility of Accounts Receivable

 

We follow the provisions of Staff Accounting Bulletin (“SAB”) 104, Revenue Recognition in Financial Statements (“SAB 104”), Emerging Issues Task Force (“EITF”) 00-21 “Revenue Arrangements with Multiple Deliverables” and EITF 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent. In general, we recognize revenue when there is persuasive evidence of an arrangement, the fee is fixed or determinable, the product or services have been delivered and collectibility of the resulting receivable is reasonably assured.

 

Our distribution revenue from the sale of music recordings through digital distribution channels is recognized when the products are sold by the digital service providers, which provide us with periodic notification of the sales.

 

For arrangements with multiple obligations (e.g., deliverable and undelivered music content, music publishing information and other services), we allocate revenues to each component of the contract based on objective evidence of its fair value. We recognize revenues allocated to undelivered products when the criteria for product revenues set forth above are met. If objective and reliable evidence of the fair value of the undelivered obligations is not available, the arrangement consideration allocable to a delivered item is combined with the amount allocable to the undelivered item(s) within the arrangement. Revenues are recognized as the remaining obligations are fulfilled. Revenues from multiple element arrangements were not significant during 2007 and 2006.

 

In accordance with industry practice and as is customary in many territories, certain physical products (such as CDs and cassettes) are sold to customers with the right to return unsold items. We recognize net distribution revenues from such physical sales when reported to us by the retail distributor for the products that are shipped based on gross sales typically less a provision for future estimated returns determined by distributor based on historical trends. During 2007 and 2006, revenues from physical sales were not significant.

 

We recognize reimbursements received from our customers for encoding our music content in the appropriate digital format for use by the customer under the proportional performance method as revenue in the period that the encoded content is delivered to the customer. We record cash received in advance of providing the service as deferred revenue.

 

We record the costs associated with shipping physical products as cost of revenues. Shipping and handling charges billed to customers are included in revenues. The physical products are the property of the recording labels and artists. Revenues and cost from shipping and handling were not significant in 2007 or 2006.

 

Because we receive payment at approximately the same time as we receive the detailed revenue reports, our accounts receivable therefore generally consists of approximately one month’s revenue for digital entertainment services that report on a monthly basis and one quarter’s revenue for digital entertainment services that report on a quarterly basis. In making estimates regarding the collectibility of our accounts receivable, our management considers the credit profile of our retailers, current economic trends, contractual terms and conditions, historic payment experience and known or expected events that may impact the retailer’s ability to pay its obligations. Historically, we have incurred minimal losses for bad debts, although this may not be the case in the future. We maintained a bad debt allowance of $427,000 at December 31, 2007 and $70,000 at December 31, 2006.

 

Recoverability of Royalty Advances

 

We pay advance royalties to certain record labels and artists and account for these advance royalty payments pursuant to the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 50, Financial Reporting in the Record and Music Industry (“SFAS 50”). Pursuant to SFAS 50, certain advance royalty payments that are believed to be recoverable from future royalties to be earned by the content owner or its distributor are capitalized as assets. The decision to capitalize an advance to a content owner or its distributor as an asset requires significant judgment as to the recoverability of these advances. We assess the recoverability of these assets upon initial

commitment of the advance based upon our forecast of anticipated revenues from the sale of future and existing music and publishing-related products. In determining whether these amounts are recoverable, we evaluate the current and past popularity of the artist or songwriter, the initial or expected commercial acceptability of the product, the current and past popularity of the genre of music that the product is designed to appeal to, and other relevant factors. Based upon this information, the portion of such advances that is believed not to be recoverable is expensed. All advances are assessed for recoverability periodically and, at minimum, on a quarterly basis.

 

Accounting for Income Taxes

 

Deferred income taxes result primarily from temporary differences between financial and tax reporting. Deferred tax assets and liabilities are determined based on the difference between the financial statement basis and tax basis of assets and liabilities using enacted tax rates. Future tax benefits are subject to a valuation allowance when management is unable to conclude that our deferred tax assets will more likely than not be realized from the results of operations. At each of the financial statement dates presented, we recorded a full valuation allowance against deferred income taxes due to our limited operating history and net losses recorded since inception. Our estimate for the valuation allowance for deferred tax assets requires management to make significant estimates and judgments about projected future operating results. If actual results differ from these projections or if management’s expectations of future results change, it may be necessary to adjust the valuation allowance.

 

We have generated losses for federal and state income tax reporting since inception. These tax losses are available for carryforward until their expiration. In addition to potential expiration, there are other factors that could limit our ability to use our federal and state tax loss carryforwards. For example, use of prior net operating loss carryforwards can be limited after an ownership change, such as the Merger. Accordingly, it is not certain how much of our existing net operating loss carryforwards will be available for use. In addition, we must generate taxable income in the future in order to use net operating loss carryforwards that have not expired.

 

Effective January 1, 2007, we began to measure and record uncertain tax positions in accordance with FIN 48 Accounting for Uncertainty in Income Taxes (“FIN 48”) an Interpretation of FASB Statement No. 109. FIN 48 prescribes a threshold for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Only tax positions meeting the more-likely-than-not recognition threshold at the effective date may be recognized or continue to be recognized upon adoption of this Interpretation. FIN 48 also provides guidance on accounting for derecognition, interest and penalties, and classification and disclosure of matters related to uncertainty in income taxes. Accounting for uncertainties in income tax positions under FIN 48 involves significant judgments by management.

 

Long-Lived Assets

 

We evaluate long-lived assets, including license rights, under the provisions of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which addresses financial accounting and reporting for the impairment of long-lived assets and for long-lived assets to be disposed of. Management reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of assets may not be recoverable. In connection with this review, we reevaluate the periods of depreciation and amortization. We recognize an impairment loss when the sum of the future undiscounted net cash flows expected to be realized from the asset is less than its carrying amount. If an asset is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair value, which is determined using the projected discounted future net cash flows. We measure fair value by discounting estimated future net cash flows using an appropriate discount rate. Considerable judgment is necessary to estimate the fair value of the assets and accordingly, actual results could vary significantly from such estimates. Our most significant estimates and judgments relating to the long-lived asset impairments include the timing and amount of projected future cash flows and the discount rate selected to measure the risks inherent in future cash flows.

 

Share-Based Compensation

 

We recognize compensation expense, under the provisions of Statement No. 123 (revised 2004) of the Financial Accounting Standards Board, Share-Based Compensation. As a result, we recognize compensation

expense in an amount equal to the estimated fair value of share-based awards and issuances, such as stock options and warrants granted to employees and non-employees. This estimation of the fair value of each share-based grant or issuance on the date of grant involves numerous assumptions by management. Although we calculate the compensatory element under the Trinomial Lattice Model, which is a standard option pricing model, this model still requires the use of numerous assumptions. Assumptions used in this model include, among others, the expected life (turnover), a risk-free interest rate, dividend yield, and assumptions as to volatility of the underlying equity security. The model and assumptions also attempt to account for changing employee behavior as the stock price changes and capture the observed pattern of increasing rates of exercise as the stock price increases. We based our assumption of the expected volatility of our stock using the historical volatility for our peer group public companies because sufficient historical trading data does not yet exist for our stock. The use of different peer group companies and other assumptions by management in the Trinomial Lattice Model could produce substantially different results.

 

Goodwill

 

Our goodwill represents the excess of the purchase price over the estimated fair values of the net tangible and intangible assets of DMGI as a result of the Merger. We will review goodwill for impairment annually and whenever events or changes in circumstances indicate its carrying value may not be recoverable in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. The provisions of SFAS 142 require that a two-step impairment test be performed on goodwill. In the first step, we will compare the fair value to its carrying value. If the fair value exceeds the carrying value, goodwill will not be considered impaired and we will not be required to perform further testing. If the carrying value exceeds the fair value, then we must perform the second step of the impairment test in order to determine the implied fair value of goodwill. If the carrying value of goodwill exceeds its implied fair value, then we would record an impairment loss equal to the difference. Determining the implied fair value involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates, future economic and market conditions and determination of appropriate market comparables. We base our fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates.

 

Impairment of Intangible Assets

 

We test our intangible assets (other than goodwill) for impairment annually, and more frequently if there are indications of a loss in value. The most significant intangible assets that we test for impairment are those resulting from the Merger. We test for impairment on the basis of the same objective criteria that were used for the initial valuation. Our initial valuation and ongoing tests are based on the relationship of the value of our projected future cash flows associated with the asset to either the purchase price of the asset (for its initial valuation) or the carrying amount of the asset (for ongoing tests). The determination of the underlying assumptions related to the recoverability of intangible assets is subjective and requires the exercise of considerable judgment by our management. Any changes in key assumptions about our business and prospects, or changes in market conditions, could result in an impairment charge.

 

Recent Accounting Pronouncements

 

In September 2006, FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value, and expands required disclosures about fair value measurements. The provisions of SFAS 157 are effective for our Company beginning January 1, 2008, except with respect to its non-financial assets for which the effective date is January 1, 2009. Our adoption of SFAS 157 is not expected to have a material impact on our consolidated financial position, results of operations or cash flows.

 

In February 2007, FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS 159 is effective for our company as of the beginning of fiscal year 2009. We have not yet determined the impact that adopting SFAS 159 may have on our consolidated financial position, results of operations or cash flows.

In December 2007, FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS 141R”). SFAS 141R establishes principles and requirements for how an acquirer in a business combination: (i) recognizes and measures the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree; (ii) recognizes and measures the goodwill acquired in a business combination or gain from a bargain purchase; and (iii) determines what information to disclose to enable financial statement users to evaluate the nature and financial effects of the business combination. SFAS 141R is applicable prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. After its effective date, SFAS No. 141R would have an impact on the accounting for any business we may acquire in the future.

 

In December 2007, FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements (“SFAS 160”). SFAS 160 establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 is effective for fiscal years beginning after December 15, 2008. Early adoption of SFAS 160 is prohibited. After its effective date, SFAS 160 would have an impact on the presentation and disclosure of the non-controlling interests of any non-wholly-owned businesses we may acquire in the future.

 

Internal Control over Financial Reporting

 

In connection with the audit for the year ended December 31, 2007, our independent auditors identified significant deficiencies in our internal controls over financial reporting regarding our lack of formalized written policies and procedures in the financial accounting area, our lack of appropriate resources to both manage the financial close process on a timely basis and handle the accounting for complex equity and other transactions, our lack of sophisticated financial reporting systems to allow the reporting of financial information on a timely basis, which is due in part to the small size of our company prior to the Merger, and our lack of a formalized disaster recovery plan in the information technology area. These significant deficiencies together constitute a material weakness in our internal controls over financial reporting. These significant deficiencies, along with the actions taken to remedy the significant deficiencies identified by our former independent auditors in connection with their audit of our 2006 consolidated financial statements, are described in Item 9A(T) “Controls and Procedures.”

 

Factors Affecting Future Results

 

We have incurred losses since inception and our ability to achieve profitability in the near term is primarily dependent on increasing revenue while controlling and limiting expenses at current levels. Some of the current industry conditions and factors that we expect could have a significant impact on our future results are discussed below:

 

Factors impacting revenue and download rates for music content.  Achieving profitable growth will require continued growth in the overall market for digital retail sales of music, video and other forms of media, and our ability to maintain a competitive suite of digital distribution and service offerings that will be attractive to independent record labels and other owners of digital media content. We expect continued competition from entrenched music distribution companies moving more aggressively into the digital sector (e.g., the distribution companies owned by the four major music companies), other independent distributors, and new entrants to the market. We believe that our revenue and download rates for music content might be affected by a number of macro-factors, including:

 

 

 

Gross profit.  Our gross profit is directly affected by our ability to negotiate favorable digital distribution agreements with record labels and other content owners. The current and future marketplace will continue to evolve and shape our ability to enter into new distribution agreements with content owners seeking to access the digital marketplace and renew existing agreements as they begin to expire. As more competitors enter this market and seek to sign similar agreements with content owners, this could adversely impact our gross profit.

 

Operating expenses.  Our operating expenses include all costs associated with general and administrative expenses, sales and marketing and product development in order to operate the business. These expenses increased in each of the past three years as we added additional personnel dedicated to expanding our operations and broadening our product and service offerings.

 

Business development.  We plan to continue to build our core music and video businesses by building on our established digital distribution relationships and by adding additional record labels and content owners, showcasing top-tier global artists, and expanding our marketing capabilities. We also plan to continue to develop our broad services platform, including:

 

 

Results of Operations

 

The following table sets forth items in our consolidated statements of operations as a percentage of revenue, as well as certain additional revenue and operating data for the periods indicated.

 

 

 

 

Comparison of Year Ended December 31, 2007 to December 31, 2006

 

Revenues.  Revenues increased to approximately $28.5 million for the year ended December 31, 2007 from approximately $14.9 million for the year ended December 31, 2006 with approximately $1.1 million of the increase attributable to the consolidation of DMGI following the November 2007 Merger. Revenue from digital distribution (including permanent downloads and subscription services) increased to approximately $22.4 million in 2007 from approximately $11.6 million in 2006, primarily as a result of the increase in paid downloads. The increase in paid downloads resulted from a significant increase in the average number of available tracks for sale, as well as a more efficient distribution process, in part due to the launch of our proprietary V.E.C.T.O.R.^tm system in the first half of 2007. Revenue from mobile distribution increased to approximately $2.8 million in 2007 from approximately $0.7 million in 2006 as a result of adding additional mobile stores, increased available content for our mobile channel partners and overall favorable industry trends. Other revenue from licensing and music services (including placement of master recordings for use in film, television and commercials), physical sales, and other sources such as service fees charged to digital music retailers and other non-retail clients, increased to approximately $3.4 million in the 2007 from approximately $2.6 million in 2006.

 

Cost of revenues.  Our cost of revenues increased to approximately $20.9 million for the year ended December 31, 2007 from approximately $10.7 million for the year ended December 31, 2006. Royalty expense

to artists, labels and other content owners increased to approximately $19.7 million in 2007 from approximately $9.9 million in 2006, primarily related to the increase in overall revenues. During the years ended December 31, 2007 and 2006, our royalties paid to artists, labels and other content owners amounted to 69% and 66% of revenues, respectively. The increase in royalties as a percentage of revenues is primarily due to a more competitive landscape in the digital distribution market. Other costs of revenues increased to $1.2 million in 2007 as compared to approximately $0.8 million in 2006. Gross profit margin declined to 26.8% of revenues in 2007 from 28.2% of revenues in 2006, primarily because 2006 included a one-time fee concession of $0.4 million (or 2.7% of revenues) from a digital encoding service provider.

 

Operating expenses.  The following table sets forth the individual components of our operating expenses for the year ended December 31, 2007 and 2006:

 

 

Operating expenses increased to approximately $14.4 million for the year ended December 31, 2007, from approximately $9.8 million for the year ended December 31, 2006 primarily due to increased personnel costs. The increase in personnel costs for 2007 is partly due to a one-time non-cash compensation expense of approximately $1.9 million. Excluding the one-time non-cash compensation expense, our personnel costs increased as a result of an overall increase in our head count, as we added to staff to keep up with growth, which growth also resulted in an increase in travel expenses and office expenses. Other expenses increased primarily as a result of an increase in the reserve for bad debts.

 

In prior periods, we analyzed the components of our operating expenses under the captions “General and Administrative,” “Sales and Marketing” and “Product Development,” which presentation reflected a grouping of the components of our operating expenses (including compensation and other personnel-related costs) that was generally based on headcount per function within our company. Going forward, we intend to analyze our operating expenses as set forth in the table above, as we believe this is a better reflection of how we view and manage our operating expenses internally.

 

Other (income) expense.  We had other expense of approximately $0.9 million for the year ended December 31, 2007, an increase from approximately $0.4 million for the year ended December 31, 2006. Interest expense decreased to approximately $0.4 million for the year ended December 31, 2007 from approximately $0.5 million for the year ended December 31, 2006. We had approximately $37,000 of interest income in 2007 compared to nominal interest income in 2006. We had approximately $516,000 of other expenses in 2007 primarily due to $477,000 in non-cash charges related to a beneficial conversion charge in connection with the recapitalization of shares while we had other income of $130,000 in 2006 from the write-off of both a disputed note payable and related interest for which the statute of limitations for enforcement of the debt had expired.

 

Liquidity and Capital Resources

 

We have incurred net losses of $7,602,316 and $5,968,960 for the years ended December 31, 2007 and 2006, respectively. Historically, we have received funds from Dimensional (our majority shareholder) to operate our business. However, subsequent to the Merger, we do not expect this to continue. At December 31, 2007, we had approximately $10.6 million in cash and cash equivalents, and management believes cash balances on-hand will be

sufficient to fund our net cash commitments and requirements over the next 12 months. Should additional resources be required, management may seek to raise funds through the issuance of debt or equity securities.

 

Cash Flows for the Year Ended December 31, 2007 compared to Year Ended December 31, 2006

 

Net cash used in operations for the year ended December 31, 2007 was approximately $4.3 million. The reconciliation of net loss of approximately $7.6 million to net cash used in operations for the year ended December 31, 2007 included non-cash charges for depreciation and amortization of approximately $0.3 million, bad debt expense of approximately $0.4 million and stock-based compensation of approximately $2.0 million. These net non-cash charges were partially offset by 2007 working capital requirements of approximately $0.2 million.

 

Net cash used in operations for the year ended December 31, 2006 was approximately $4.3 million. The reconciliation of net loss of approximately $6.0 million to net cash used in operations for the year ended December 31, 2006 included non-cash charges for depreciation and amortization of approximately $0.2 million, bad debt expense of $0.1 million and stock-based compensation of approximately $0.1 million of stock-based compensation, offset by non-cash income of approximately $0.1 million in connection with the write-off of a disputed note payable and related interest. These non-cash charges were further offset by reduced working capital requirements of approximately $1.4 million, primarily because royalties payable increased at a faster rate than accounts receivable as our business continued to expand in 2006.

 

Our investing activities resulted in a net cash contribution of approximately $8.9 million for the year ended December 31, 2007 primarily as a result of the Merger, but our investing activities also used $0.5 million in connection with the purchase of property and equipment. In 2006, investing activities resulted in a net cash outflow of approximately $0.7 million to purchase property and equipment, which was partially offset by $51,007 of proceeds from the sale of certain property and equipment. The property and equipment additions for both the years ended December 31, 2007 and 2006 were primarily due to the increase in headcount as our business continued to grow, and for designing, developing and implementing a direct digital delivery system during 2007.

 

Cash provided from financing activities for the years ended December 31, 2007 and 2006 was approximately $4.4 million and approximately $6.6 million, respectively, in both cases as a result of the proceeds from the issuance of additional convertible debt to Dimensional.

 

As of December 31, 2007, we had cash and cash equivalents of approximately $10.6 million and working capital of approximately $7.1 million, compared to cash and cash equivalents of approximately $1.7 million and a working capital deficit of approximately $9.5 million at December 31, 2006.

 

Description of Indebtedness

 

Convertible Debt Instruments

 

Since April 2003, Dimensional extended various loans to Orchard NY, which debt was convertible into that number of shares of Orchard NY’s Series A Convertible Preferred Stock, or the Orchard NY Series A Preferred Stock, determined by dividing the principal balance by a conversion price of $1.00 per share of Orchard NY Series A Preferred Stock (i) at any time, at Dimensional’s sole option or (ii) automatically, upon the closing of a sale of 3,000,000 shares of Orchard NY Series A Preferred Stock pursuant to a stock purchase agreement with and Dimensional.

 

In May 2006, Orchard NY issued 7,931,000 shares of its Series A Convertible Preferred Stock and 7,931,000 shares of its Series B Convertible Preferred Stock to Dimensional in exchange for the conversion and cancellation of convertible debt with a principal balance of approximately $7.9 million (the outstanding convertible debt principal balance at December 31, 2005). Accrued interest relating to this debt was not cancelled at this time. At December 31, 2006, the outstanding principal balance of the Dimensional convertible debt was approximately $6.6 million and the outstanding balance of the accrued interest was approximately $1.2 million (which includes interest on the approximately $7.9 million debt cancelled in May 2006). Interest expense on the convertible debt was approximately $0.5 million, for the year ending December 31, 2006.

In 2007 and prior to the Merger, Orchard NY undertook two recapitalizations (a July 2007 recapitalization and a September 2007 recapitalization) whereby Dimensional agreed to convert its then outstanding convertible debt in exchange for shares of preferred stock of Orchard NY and forgave accrued interest. These recapitalizations are described in Note 9 to our consolidated financial statements appearing elsewhere in this annual report. In November 2007, we amended the September 2007 recapitalization to recharacterize $600,000 of funding as a loan payable instead of a capital contribution. We repaid this $600,000 loan in November 2007.

 

On November 13, 2007, in conjunction with the Merger, all outstanding shares of Orchard NY’s Series A Convertible Preferred Stock, Series B Convertible Preferred Stock, Series C Convertible Preferred Stock and common stock were cancelled and the former Orchard NY stockholders received 448,833 shares of our Series A Preferred Stock and 3,021,202 shares of our common stock, including 1,915 shares of our Series A Preferred Stock and 157,683 shares of our common stock that are subject to deferred stock awards assumed in connection with the Merger.

 

At December 31, 2007, we had 446,918 shares (and 1,915 shares awarded but not issued or outstanding that are subject to deferred stock awards) of our Series A Preferred Stock outstanding. Our Series A Preferred Stock is not entitled to any dividend or any interest. Each share is convertible into 3.3 shares of our common stock at any time at the sole discretion of the preferred shareholders. The shares are redeemable for $55.70 per share (equivalent to $16.72 per common share) at the sole discretion of our board of directors after November 13, 2012 and only if our common stock is trading above $30.00 per share for more than thirty days in a row.

 

As of December 31, 2007, we had no outstanding convertible debt owed to Dimensional.

 

Off-Balance Sheet Arrangements

 

As of December 31, 2007, we had no off-balance sheet arrangements.

 

Related Party Transactions

 

From time to time, we have amounts due to and receivables from companies under common ownership with Dimensional. These amounts are billed and paid on a regular basis in the ordinary course of our business. We had a net receivable from affiliates of $1,075,602 and $483,037 at December 31, 2007 and December 31, 2006, respectively and net payables to affiliates of $0 and $46,286 at December 31, 2007, and December 31, 2006, respectively.

 

Our relationships with these related parties include the following:

 

 

 

For more information relating to our related party transactions, see Note 15 to our consolidated financial statements appearing elsewhere in this annual report.

 

 

Intentionally omitted.

 

The “Report of Independent Registered Public Accounting Firm” (Marcum & Kliegman LLP), the “Report of Independent Registered Public Accounting Firm” (Deloitte & Touche LLP), the “Consolidated Financial Statements” and the “Notes to Consolidated Financial Statements” appearing on pages F-1 to F-28 of this annual report on Form10-K are incorporated herein by reference.

 

Not applicable.

 

 

Disclosure controls and procedures.  In evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this annual report on Form 10-K. Due to the existence of a material weakness described below, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are not effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 (1) is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and (2) is accumulated and communicated to management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

 

Notwithstanding the conclusion that our disclosure controls and procedures were not effective as of the end of the period covered by this report, the Chief Executive Officer and the Chief Financial Officer believe that the consolidated financial statements and other information contained in this annual report present fairly, in all material respects, our business, financial condition and results of operations.

 

In connection with the audit of our 2007 consolidated financial statements, our independent auditors identified certain significant deficiencies that together constitute a material weakness in our internal control over financial reporting. These significant deficiencies primarily relate to our lack of formalized written policies and procedures in the financial accounting area, our lack of appropriate resources to both manage the financial close process on a timely basis and handle the accounting for complex equity and other transactions, our lack of sophisticated financial reporting systems to allow the reporting of financial information on a timely basis, which is due in part to the small size of our company prior to the Merger, and our lack of a formalized disaster recovery plan in the information technology area. These significant deficiencies together constitute a material weakness in our internal control over financial reporting.

 

Although we have taken steps to remedy some of these issues with our internal control over financial reporting, we still have additional work to do to bring our financial reporting procedures up to public-company standards so as to allow management to report on, and, when required by Section 404 of the Sarbanes-Oxley Act of 2002, our independent registered public accountants to attest to, our internal control over financial reporting. As discussed below, because the Merger occurred in the fourth quarter of 2007 and because Orchard NY was a small privately-held company, we were unable to upgrade our internal controls over financial reporting to the level required of a public company prior to the end of the period covered by this annual report. Nevertheless, we are initiating the remediation steps outlined below to rectify the identified significant deficiencies that together constitute a material weakness in our internal control over financial reporting. Because these remediation steps have not yet been completed, we have performed additional analyses and other post-closing procedures to ensure that our consolidated financial statements contained in this annual report were prepared in accordance with U.S. GAAP and applicable SEC regulations. Our planned remediation steps include:

 

 

 

In connection with their audit for the year ended December 31, 2006, our former independent auditors identified certain significant deficiencies related to our accounting for fixed assets, our tracking and accounting for hard drives, our lack of a formal period-end accrual process, our procedures for the reissuance of royalty checks, and our journal entry process that together constituted a material weakness in internal control over financial reporting. We have in the first quarter of 2008 hired a new Chief Financial Officer and hired a Controller with public company reporting experience, and we have implemented a direct digital delivery system, minimizing the impact of hard drives on our financial statements in order to address their significant deficiencies. Additionally, we have formalized our processes and procedures for reissuing royalty checks to ensure that the original check is properly voided prior to reissuing a new check. We still need to implement a fixed assets tracking system and maintain appropriate supporting documentation for fixed asset transactions, and plan to formalize our journal-entry process and implement formal policies regarding the preparation, approval and recording of manual journal entries, including period-end accruals.

 

Changes in internal control over financial reporting.  Notwithstanding our remedial actions and integration of our financial reporting systems, there was no change in our internal control over financial reporting that occurred during the fourth quarter of 2007 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

Management’s report on internal control over financial reporting.  This annual report on Form 10-K does not include a report of our management on our internal controls over financial reporting. In connection with the November 2007 Merger, we were deemed to be the acquired company for accounting and financial reporting purposes, and Orchard NY was deemed the acquiror. As such, Orchard NY’s historical financial statements became our historical financial statements. See Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Overview — Background and Basis of Presentation” for more information regarding the Merger. Prior to the Merger, Orchard NY was a small, privately-held company and was not subject to public company disclosure requirements, including the requirement to report on internal control over financial reporting in compliance with Section 404 of the Sarbanes-Oxley Act of 2002 and Item 308T of Regulation S-K.

 

As noted above, since the Merger, our internal operating procedures, information systems and accounting controls have been improved as our management works diligently to rapidly and aggressively integrate and assimilate all of our operations in our headquarters in New York City. Because of the closing of the Merger near the end of the fiscal year, the fact that Orchard NY was a small privately held company prior to the Merger, and the fact that our internal controls are in a state of transition as we integrate our business operations and work to remedy the significant deficiencies that together constitute a material weakness in our internal control over financial reporting, our management believes that any report on our internal controls at this time would not be meaningful to investors.

 

This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Had we included management’s report, it would not have been subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only management’s report in this annual report.

 

 

Not applicable.

 

 

The information required by this Item is incorporated by reference to the definitive proxy statement for our 2008 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission within 120 days after our fiscal year ended December 31, 2007, or our “2008 Proxy Statement.”

 

 

The information required by this Item is incorporated by reference to our 2008 Proxy Statement.

 

 

The information required by this Item is incorporated by reference to our 2008 Proxy Statement.

 

 

The information required by this Item is incorporated by reference to our 2008 Proxy Statement.

 

 

The information required by this Item is incorporated by reference to our 2008 Proxy Statement.

 

 

(a) The following documents are filed as part of this annual report on Form 10-K:

 

(1) Consolidated Financial Statements.

 

Reference is made to the Index to Consolidated Financial Statements under Item 8 of Part II hereof and incorporating by reference pages F-1 through F-28 hereto.

 

(2) Financial Statement Schedule.

 

All other schedules are omitted because they are not applicable or the amounts are immaterial or the required information is presented in the consolidated financial statements and notes thereto in Item 8 above.

(3) Exhibits.

 

 

 

 

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.

 

THE ORCHARD ENTERPRISES, INC.

 

Greg Scholl
Chief Executive Officer

 

Date: March 31, 2008

 

POWER OF ATTORNEY

 

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Greg Scholl and Nathan Fong, and each of them, his or her true and lawful attorneys-in-fact and agents, each with full power of substitution and resubstitution, to sign any and all amendments (including post-effective amendments) to this annual report on Form 10-K and to file the same, with all 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 and necessary to be done in connection therewith, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or their substitute or substitutes, or any of them, shall do or cause to be done by virtue thereof.

 

Pursuant to the requirements of the Securities and 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:

 

 

 

To the Audit Committee of the

Board of Directors and Stockholders of

The Orchard Enterprises, Inc.:

 

We have audited the accompanying consolidated balance sheet of The Orchard Enterprises, Inc. and subsidiaries (the “Company”) as of December 31, 2007 and the related consolidated statements of operations, stockholders’ equity (deficit) and redeemable preferred stock, and cash flows for the year then ended. These consolidated 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 audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The Orchard Enterprises, Inc. and subsidiaries as of December 31, 2007, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.

 

/s/ Marcum & Kliegman LLP

 

New York, NY

March 28, 2008

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders of

The Orchard Enterprises Inc.:

 

We have audited the accompanying consolidated balance sheet of The Orchard Enterprises Inc. and subsidiaries (the “Company”) as of December 31, 2006, and the related consolidated statements of operations, stockholders’ equity (deficit) and redeemable preferred stock and cash flows for the year then ended. These consolidated 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 audit in accordance with the standards of the Public Company Oversight Accounting Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of The Orchard Enterprises Inc. and subsidiaries as of December 31, 2006, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.

 

/s/ Deloitte and Touche LLP

 

New York, NY

July 30, 2007 (March 31, 2008 as to the effect of the

reverse acquisition on loss per share as described in Note 4)

THE ORCHARD ENTERPRISES, INC.

 

CONSOLIDATED BALANCE SHEETS

 

 

See notes to consolidated financial statements.

THE ORCHARD ENTERPRISES, INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

 

See notes to consolidated financial statements.

 

THE ORCHARD ENTERPRISES, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT) AND
REDEEMABLE PREFERRED STOCK
FOR THE YEARS ENDED DECEMBER 31, 2007 AND 2006

 

 

THE ORCHARD ENTERPRISES, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

See notes to consolidated financial statements.

FOR THE YEARS ENDED DECEMBER 31, 2007 AND 2006