CDNOW INC, S-1/A, 1998-01-16

CDNOW INC
S-1/A, 1998-01-16
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AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON JANUARY 16, 1998
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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AMENDMENT NO. 1

TO
FORM S-1
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
--------------
CDNOW, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN CHARTER)
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PENNSYLVANIA 5735 23-2813867
(STATE OR OTHER (PRIMARY STANDARD INDUSTRIAL (I.R.S. EMPLOYER
JURISDICTION OF CLASSIFICATION CODE NUMBER) IDENTIFICATION NO.)
INCORPORATION OR
ORGANIZATION)

610 OLD YORK ROAD
SUITE 300
JENKINTOWN, PA 19046
(215) 517-7325
(ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER,
INCLUDING AREA CODE, OF REGISTRANT'S PRINCIPAL EXECUTIVE OFFICES)
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JASON OLIM

PRESIDENT, CHIEF EXECUTIVE OFFICER AND CHAIRMAN OF THE BOARD
610 OLD YORK ROAD
SUITE 300
JENKINTOWN, PA 19046
(215) 517-7325
(NAME, ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING
AREA CODE, OF AGENT FOR SERVICE)

COPIES TO:
ALAN SINGER, ESQ. ALAN H. LIEBLICH, ESQ.
MORGAN, LEWIS & BOCKIUS LLP SCHNADER HARRISON SEGAL & LEWIS LLP
2000 ONE LOGAN SQUARE 1600 MARKET STREET
PHILADELPHIA, PA 19103 SUITE 3600
(215) 963-5000 PHILADELPHIA, PA 19103
(215) 751-2000

APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC: As soon as
practicable after the effective date of this Registration Statement.
--------------
If any of the securities being registered on this Form are to be offered on
a delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, check the following box. [_]
If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, please check the following
box and list the Securities Act registration statement number of the earlier
effective registration statement for the same offering. [_]
If this Form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [_]
If this Form is a post-effective amendment filed pursuant to Rule 462(d)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [_]
If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box. [_]

THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT
SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS
REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH
SECTION 8(A) OF THE SECURITIES ACT OF 1933, AS AMENDED, OR UNTIL THIS
REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION,
ACTING PURSUANT TO SUCH SECTION 8(A), MAY DETERMINE.

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++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
+INFORMATION CONTAINED HEREIN IS SUBJECT TO COMPLETION OR AMENDMENT. A +
+REGISTRATION STATEMENT RELATING TO THESE SECURITIES HAS BEEN FILED WITH THE +
+SECURITIES AND EXCHANGE COMMISSION. THESE SECURITIES MAY NOT BE SOLD NOR MAY +
+OFFERS TO BUY BE ACCEPTED PRIOR TO THE TIME THE REGISTRATION STATEMENT +
+BECOMES EFFECTIVE. THIS PROSPECTUS SHALL NOT CONSTITUTE AN OFFER TO SELL OR +
+THE SOLICITATION OF AN OFFER TO BUY NOR SHALL THERE BE ANY SALE OF THESE +
+SECURITIES IN ANY STATE IN WHICH SUCH OFFER, SOLICITATION OR SALE WOULD BE +
+UNLAWFUL PRIOR TO REGISTRATION OR QUALIFICATION UNDER THE SECURITIES LAWS OF +
+ANY SUCH STATE. +
++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
SUBJECT TO COMPLETION,

JANUARY 16, 1998

3,600,000 SHARES

[LOGO OF CDNOW APPEARS HERE]

COMMON STOCK

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All of the 3,600,000 shares of Common Stock offered hereby will be sold by
CDnow, Inc. ("CDnow" or the "Company"). Prior to the Offering, there has been
no public market for the Common Stock. For factors considered in determining
the initial public offering price, see "Underwriting." It is currently
estimated that the initial public offering price of the Common Stock will be
between $13.00 and $15.00 per share. Immediately upon completion of the
Offering, the officers and directors of the Company and entities that employ
certain directors collectively will beneficially own approximately 69.3% of the
outstanding Common Stock. Application has been made for quotation of the Common
Stock on the Nasdaq National Market under the symbol "CDNW."

------------

THE COMMON STOCK OFFERED HEREBY INVOLVES A HIGH DEGREE OF RISK.
SEE "RISK FACTORS" BEGINNING ON PAGE 7.

------------

THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES
AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS
A CRIMINAL OFFENSE.

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<TABLE>
<CAPTION>
PRICE UNDERWRITING PROCEEDS
TO DISCOUNTS AND TO
PUBLIC COMMISSIONS(1) COMPANY(2)
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<S> <C> <C> <C>
Per Share................................ $ $ $
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Total(3)................................. $ $ $
</TABLE>
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(1) See "Underwriting" for information relating to indemnification of the
Underwriters.

(2) Before deducting expenses for this Offering, payable by the Company,
estimated at $800,000.

(3) The Company and certain shareholders of the Company (the "Selling
Shareholders") have granted the Underwriters a 30-day option to purchase up
to 405,000 and 135,000 additional shares of Common Stock, respectively,
solely to cover over-allotments, if any. To the extent that the option is
exercised, the Underwriters will offer the additional shares at the Price
to Public shown above. If the option is exercised in full, the total Price
to Public, Underwriting Discounts and Commissions and Proceeds to Company
will be $ , $ and $ , respectively, and the selling stockholders
would receive aggregate net proceeds of $ . The Company will not receive
any of the proceeds from the sale of shares by the Selling Shareholders.
See "Underwriting."

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The shares of Common Stock are offered by the several Underwriters, subject
to prior sale, when, as and if delivered to and accepted by them, and subject
to the right of the Underwriters to reject any order in whole or in part. It is
expected that delivery of the shares of Common Stock will be made at the
offices of BT Alex. Brown Incorporated, Baltimore, Maryland, on or about ,
1998.

NATIONSBANC MONTGOMERY
BT ALEX.BROWN
SECURITIES LLC

THE DATE OF THIS PROSPECTUS IS , 1998
<PAGE>

[DESCRIPTIONS TO BE ADDED FOR EDGAR FILING]

CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS
THAT STABILIZE, MAINTAIN OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK.
SPECIFICALLY, THE UNDERWRITERS MAY OVER-ALLOT IN CONNECTION WITH THE COMMON
STOCK OFFERING AND MAY BID FOR AND PURCHASE SHARES OF THE COMMON STOCK IN THE
OPEN MARKET. FOR A DESCRIPTION OF THESE ACTIVITIES, SEE "UNDERWRITING".

2
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PROSPECTUS SUMMARY

The following summary is qualified in its entirety by, and should be read in
conjunction with, the more detailed information and financial statements of the
Company and the notes thereto included elsewhere in this Prospectus. Unless
otherwise indicated, all information presented in this Prospectus assumes (i)
no exercise of the over-allotment option granted by the Company and the Selling
Shareholders to the Underwriters, (ii) a 1.5-for-1 stock split to be effected
prior to the consummation of this Offering, (iii) the automatic conversion of
all outstanding shares of the Company's Series A Convertible Preferred Stock,
no par value (the "Series A Preferred Stock"), and Series B Convertible
Preferred Stock, no par value (the "Series B Preferred Stock"), into an
aggregate of 2,790,131 shares of Common Stock upon the consummation of this
Offering, and (iv) the cashless exercise of a warrant held by Alan Meltzer, a
director of the Company, for 800,313 shares of Common Stock upon the
consummation of this Offering. Unless the context otherwise requires, each
reference to the "Company" or "CDnow" refers to CDnow, Inc. and its
subsidiaries and each reference to "CDs" refers collectively to compact discs,
cassettes and vinyl records.

THE COMPANY

CDnow is the leading online retailer of CDs and other music-related products.
Its early entry into the online music retailing industry has helped the Company
gain a well-recognized brand and a large customer base. The Company strives to
combine the advantages of online commerce with superior customer focus in order
to be the authoritative source for CDs and other music-related products. The
Company's online store, cdnow.com, offers broad selection, informative content,
easy-to-use navigation and search capabilities, a high level of customer
service, competitive pricing and personalized merchandising and
recommendations. With over 250,000 items, the Company believes that it provides
a selection of readily-available products that is five to ten times that of a
typical music retailer. To assist customers in making music selections, the
CDnow store contains approximately 115,000 product notes, reviews and related
articles and 270,000 sound samples. The CDnow store is open 24 hours a day,
seven days a week and offers its customers convenient and timely product
fulfillment, including an overnight delivery option.

CDnow has grown rapidly since its inception in 1994. Of the 296,000 customers
who have made purchases from inception through 1997, 209,000 made their initial
purchases in 1997. Average daily visits to the CDnow store have grown from
approximately 12,000 in January 1996 to approximately 132,000 in December 1997.
The Company's net sales grew to $17.4 million in 1997 compared to $6.3 million
in 1996. Net sales for the first, second, third and fourth quarters of 1997
were $2.6 million, $3.0 million, $3.9 million and $7.9 million, respectively.
The Company has also generated significant customer loyalty. Despite the
Company's rapid acquisition of new customers, repeat customers accounted for
over 50% of net sales in 1997.

The Company believes that a significant opportunity exists for the retailing
of music on the Internet. According to the International Federation of the
Phonographic Industry, worldwide sales of pre-recorded music in 1996 were
approximately $39.8 billion, of which one-third was in North America. Online
music retailers currently account for a small but growing portion of total
sales. According to Jupiter Communications, Inc. ("Jupiter"), worldwide sales
of pre-recorded music over the Internet are projected to grow from
approximately $18 million in 1996 to $1.6 billion in 2002.

3
<PAGE>

music by genre, title or artist and access a wealth of information and events,
including reviews, related articles, music history, news and recommendations.
Internet-based retailers can also offer consumers significantly broader product
selection, the convenience of home shopping and 24-hour-a-day, seven-day-a-week
operations. In addition, Internet-based retailers can serve international
consumers without significant incremental cost and more effectively target
their direct marketing activities as a result of the extensive customer
demographic and behavioral data that they are able to obtain.

The Company's business strategy is designed to promote the CDnow brand and
expand its leadership position by (i) focusing on recorded music retailing,
(ii) providing an innovative and easy-to-use retail concept, (iii) acquiring
customers on an efficient basis, (iv) maximizing customer retention, and (v)
expanding its customer base through multiple marketing channels. The Company
believes that the use of multiple marketing channels allows it to reduce its
reliance on any one source of customers, maximize brand awareness and lower
average customer acquisition costs. These marketing channels include:

. Online and Traditional Advertising. The Company promotes its brand
through an aggressive marketing campaign using a combination of online
and traditional advertising. The Company advertises on the sites of
major Internet content and service providers, including Infoseek, Lycos
and CNN Interactive, and targeted music-related sites, such as
Billboard. CDnow's traditional advertising efforts include radio
advertising, such as advertising on the Howard Stern program, and print
advertising in music-related publications, including Rolling Stone, Spin
and Variety. The Company intends to deploy television advertising and
has purchased from CBS national advertising as the exclusive online
retailer of recorded music during the 1998 Grammy Awards. The Company
has also purchased national advertising during the 1998 American Music
Awards.

. Strategic Alliances with Major Content and Service Providers. The
Company seeks to enter into strategic alliances with major Internet
content and service providers in order to enhance its new customer
acquisition efforts, increase purchases by current customers and expand
brand recognition. The Company has recently entered into alliances with
Yahoo!, GeoCities and Excite's WebCrawler service that provide for the
Company to be the premier online recorded music retailer on certain of
their sites with the exclusive right to place music banner
advertisements and integrated links to the CDnow store on certain music-
related or other specified pages.

. Cosmic Credit Program. Through its Cosmic Credit Program, CDnow has
arrangements with over 10,000 small Web sites, typically fan sites
devoted to particular musical artists. The Company provides these sites
with embedded hyperlinks through which potential customers can
immediately be connected to the CDnow store.

The business of the Company was commenced as a sole proprietorship in
February 1994. The Company was incorporated in Pennsylvania in April 1995. Its
principal offices are located at 610 Old York Road, Suite 300, Jenkintown,
Pennsylvania, 19046 and its telephone number is (215) 517-7325.

4
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THE OFFERING

Common Stock offered by the Company... 3,600,000 shares

Common Stock to be outstanding
after the Offering.................. 15,036,128 shares(1)

Use of proceeds....................... For the repayment of short-term
indebtedness; sales and marketing
expenses, including payments due under
strategic alliances; improvements to
the Company's Web site and other
capital expenditures; working capital;
and other general corporate purposes.

Proposed Nasdaq National Market symbol.. CDNW
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(1) Excludes (i) 721,914 shares of Common Stock issuable upon the exercise of
options outstanding as of December 31, 1997 under the Company's 1996 Equity
Compensation Plan (the "Equity Compensation Plan") at a weighted average
exercise price of $2.99 per share, (ii) 878,086 shares reserved for future
grants under the Equity Compensation Plan and (iii) 367,253 shares of
Common Stock issuable upon the exercise of warrants outstanding as of
December 31, 1997 at a weighted average exercise price of $4.05 per share.
See "Management--Equity Compensation Plan" and "Description of Capital
Stock."

This Prospectus contains forward-looking statements that address, among other
things, the Company's business strategy, use of proceeds, projected capital
expenditures, liquidity, possible business relationships and possible effects
of changes in government regulation. These statements may be found under
"Prospectus Summary," "Risk Factors," "Use of Proceeds," "Management's
Discussion and Analysis of Financial Condition and Results of Operations," and
"Business" as well as in the Prospectus generally. Actual events or results may
differ materially from those discussed in forward-looking statements as a
result of various factors, including those factors discussed below under "Risk
Factors" and set forth in this Prospectus generally.

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SUMMARY FINANCIAL AND OPERATING DATA

<TABLE>
<CAPTION>
PERIOD FROM
INCEPTION
(FEBRUARY 12,
1994) TO YEAR ENDED DECEMBER 31,
DECEMBER 31, -------------------------------------
1994(1) 1995(1) 1996 1997
------------- ---------- ----------- ------------
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS
DATA:
Net sales................................ $103,116 $2,176,474 $ 6,300,294 $ 17,372,795
Cost of sales............................ 92,962 1,844,612 5,363,989 14,541,765
-------- ---------- ----------- ------------
Gross profit............................ 10,154 331,862 936,305 2,831,030
Operating expenses:
Operating and development............... 26,946 149,982 523,080 2,179,726
Sales and marketing..................... 12,945 200,972 621,454 9,242,179
General and administrative.............. 28,712 180,573 563,593 1,968,218
Dispute settlement(2)................... -- -- 1,024,030 --
-------- ---------- ----------- ------------
Total operating expenses................ 68,603 531,527 2,732,157 13,408,123
-------- ---------- ----------- ------------
Operating loss.......................... (58,449) (199,665) (1,795,852) (10,577,093)
Interest expense, net.................... -- (1,248) (14,556) (170,312)
-------- ---------- ----------- ------------
Net loss................................. $(58,449) $ (200,913) $(1,810,408) $(10,747,405)
======== ========== =========== ============
Pro forma net loss per share(3).......... $ (0.91)
============
Pro forma weighted average number of
common and common equivalent shares(3).. 11,765,287

OPERATING DATA:
Customers(4)...... 1,787 26,953 87,859 296,450
<CAPTION>
DECEMBER 31, 1997
-----------------------------------------
PRO FORMA
ACTUAL PRO FORMA(5) AS ADJUSTED(6)
BALANCE SHEET DATA: ----------- ------------ --------------
<S> <C> <C> <C>
Cash and cash equiva-
lents.................. $10,686,001 $10,686,001 $50,980,501
Working capital (defi-
cit)................... (1,218,005) (1,218,005) 44,564,386
Total assets............ 16,448,425 16,448,425 56,655,528
Long-term debt, exclud-
ing current portion.... 962,144 962,144 962,144
Redeemable convertible
preferred stock........ 9,492,594 -- --
Total shareholders' eq-
uity (deficit)......... (9,752,450) (259,856) 45,522,535
</TABLE>

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(1) The business of the Company was established as a sole proprietorship in
February 1994 and commercial operations were commenced in August 1994. The
Company was incorporated in April 1995.

(2) In December 1996, in settlement of a dispute, the Company issued 882,606
shares of Common Stock to certain persons. See "Certain Relationships and
Related Transactions" and Note 7 to Notes to Financial Statements.

(3) See Note 2 to Notes to Financial Statements for an explanation of the
determination of the number of Common shares and Common share equivalents
used in computing the pro forma net loss per share.
(4) Cumulative number of customers who have purchased products from the Company
from inception of its business in August 1994 through the end of period.

(5) Represents actual data as adjusted to give effect to the conversion of the
outstanding shares of Series A Preferred Stock and Series B Preferred Stock
into 2,790,131 shares of Common Stock upon the consummation of this
Offering. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations," "Certain Relationships and Related
Transactions" and "Principal Stockholders."

(6) Represents pro forma data as adjusted to give effect to the sale of
3,600,000 shares of Common Stock offered by the Company at an assumed
initial public offering price of $14.00 per share (after deducting
underwriting discounts and commissions and estimated offering expenses),
the application of the estimated net proceeds therefrom and the write-off
of approximately $290,000 of debt discount and deferred financing costs in
connection with the repayment of the Series A Notes. See "Capitalization"
and "Use of Proceeds."

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RISK FACTORS

The following risk factors, as well as the other information contained in
this Prospectus, should be considered carefully before purchasing the Common
Stock offered hereby.

Limited Operating History; History of Losses and Expectation of Future
Losses. The Company was founded in February 1994 and began selling music-
related products in August 1994. Accordingly, the Company has only a limited
operating history on which to base an evaluation of its business and
prospects. The Company's prospects must be considered in light of the risks,
expenses and difficulties frequently encountered by companies in their early
stage of development, particularly companies in new and rapidly evolving
markets such as online commerce. Such risks include, but are not limited to,
possible inability to respond promptly to changes in a rapidly evolving and
unpredictable business environment and the risk of inability to manage growth.
To address these risks, the Company must, among other things, expand its
customer base, successfully implement its business and marketing strategies,
continue to develop and upgrade its Web site and transaction-processing
systems, provide superior customer service, respond to competitive
developments, and attract and retain qualified personnel. If the Company is
not successful in addressing such risks, it will be materially adversely
affected.

Since inception, the Company has incurred significant losses, and as of
December 31, 1997 had accumulated losses of $12.8 million. For the year ended
December 31, 1997, the Company's net loss was $10.7 million. The Company
intends to invest heavily in marketing and promotion, Web site development and
technology, and development of its administrative organization. As a result,
the Company believes that it will incur substantial operating losses for the
foreseeable future, and that the rate at which such losses will be incurred
will increase significantly from current levels. Because the Company has
relatively low product gross margins, achieving profitability given planned
investment levels depends upon the Company's ability to generate and sustain
substantially increased revenue levels. There can be no assurance that the
Company will be able to generate sufficient revenues to achieve or sustain
profitability in the future. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations."

Dependence on Continued Growth of Online Commerce. The Company's long-term
viability is substantially dependent upon the widespread consumer acceptance
and use of the Internet as a medium of commerce. Use of the Internet as a
means of effecting retail transactions is at an early stage of development,
and demand and market acceptance for recently introduced services and products
over the Internet is very uncertain. The Company cannot predict the extent to
which consumers will be willing to shift their purchasing habits from
traditional retailers to online retailers.

The Internet may not become a viable commercial marketplace for a number of
reasons, including potentially inadequate development of the necessary network
infrastructure, delayed development of enabling technologies and inadequate
performance improvements. In addition, the Internet's viability as a
commercial marketplace could be adversely affected by delays in the
development of services or due to increased government regulation. Changes in
or insufficient availability of telecommunications services to support the
Internet also could result in slower response times and adversely affect usage
of the Internet generally and CDnow in particular. Moreover, adverse publicity
and consumer concern about the security of transactions conducted on the
Internet and the privacy of users may also inhibit the growth of commerce on
the Internet. If the use of the Internet does not continue to grow or grows
more slowly than expected, or if the infrastructure for the Internet does not
effectively support growth that may occur, the Company would be materially
adversely affected.

Competition. The online commerce market is new, rapidly evolving and
intensely competitive, and the Company expects that competition will further
intensify in the future. Barriers to entry are minimal, and current and new
competitors can launch new sites at a relatively low cost. According to
Jupiter, there were approximately 100 online music retailers as of June 1997.
In addition, the broader retail music

7
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industry is intensely competitive. The Company currently competes with a
variety of companies, including (i) online vendors of music, music videos and
other related products, (ii) online vendors of movies, books and other related
products, (iii) online service providers which offer music products directly
or cooperation with other retailers, (iv) traditional retailers of music
products, including specialty music retailers, (v) other retailers that offer
music products, including mass merchandisers, superstores and consumer
electronic stores; and (vi) non-store retailers such as music clubs. Many of
these traditional retailers also support dedicated Web sites which compete
directly with the Company.

The Company believes that the principal competitive factors in its online
market are brand recognition, selection, variety of value-added services, ease
of use, site content, quality of service, technical expertise and price. Many
of the Company's current and potential competitors have longer operating
histories, larger customer bases, greater brand recognition and significantly
greater financial, marketing and other resources than the Company. The Company
is aware that certain of its competitors have and may continue to adopt
aggressive pricing or inventory availability policies and devote substantially
more resources to Web site and systems development than the Company. Increased
competition may result in reduced operating margins, loss of market share and
diminished brand recognition.

There can be no assurance that the Company will be able to compete
successfully against current and future competitors. New technologies and the
expansion of existing technologies may increase the competitive pressures of
the Company. For example, applications that select specific titles from a
variety of Web sites based on factors such as price may channel customers to
online retailers that compete with the Company. In addition, many companies
that allow access to transactions through network access or Web browsers
promote the Company's competitors and could charge the Company a substantial
fee for inclusion.

Risk of Inability to Manage Potential Growth. The Company has rapidly
expanded its operations. This expansion has placed, and is expected to
continue to place, a significant strain on the Company's management,
operations, systems, and financial resources. From December 31, 1994 to
December 31, 1997, the Company has grown from three to 111 employees, and
several members of the Company's senior management have only recently joined
the Company. CDnow's recently hired employees also include a number of key
managerial, technical and operations personnel, and the Company expects to add
additional key personnel in the near future. To manage its recent growth and
any further growth of its operations and personnel, the Company must improve
existing operations and systems and expand and integrate its employee base. If
the Company is unable to manage its growth effectively, it will be materially
adversely affected. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and "Business--Employees."

Need for Additional Funds. The Company anticipates that the net proceeds
from this Offering, together with other available resources, will be
sufficient to fund the Company's operations for at least the next 12 months.
However, the Company's capital requirements depend on several factors,
including the rate of market acceptance, the ability to expand the Company's
customer base, the level of expenditures for sales and marketing, the cost of
Web site upgrades and other factors. If capital requirements vary materially
from those currently planned, the Company may require additional financing
sooner than anticipated. Regardless of when needed, there can be no assurance
that financing will be available in amounts or on terms acceptable to the
Company, if at all. If equity securities are issued in connection with a
financing, dilution to the Company's shareholders may result, and if
additional funds are raised through the incurrence of debt, the Company may
become subject to restrictions on its operations and finances. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operation."

Reliance on Certain Vendors. The Company's primary provider of order
fulfillment for recorded music titles is Valley Record Distributors, Inc.
("Valley"). For the year ended December 31, 1997,

8
<PAGE>

payments to Valley accounted for approximately 78% of the Company's cost of
sales. The Company has no fulfillment operation or facility of its own and,
accordingly, is dependent upon maintaining its existing relationship with
Valley or establishing a new fulfillment relationship with one of the few
other fulfillment operations. There can be no assurance that the Company will
maintain its relationship with Valley beyond the term of its existing two year
agreement with Valley, which expires in June 1999, or that it will be able to
find an alternative, comparable vendor capable of providing fulfillment
services on terms satisfactory to the Company should its relationship with
Valley terminate. An unanticipated termination of the Company's relationship
with Valley, particularly during the fourth quarter of the calendar year in
which a high percentage of recorded music sales are made, could materially
adversely affect the Company's results of operations for the quarter in which
such termination occurred even if the Company was able to establish a
relationship with an alternative vendor. Valley may terminate its existing
agreement with the Company upon 30 days' written notice, in the event that
Valley decides to discontinue providing fulfillment services to all of
Valley's online service customers. To date, Valley has satisfied the Company's
requirements on a timely basis. However, to the extent that Valley does not
have sufficient capacity and is unable to satisfy on a timely basis increasing
requirements of the Company, the Company would be materially adversely
affected.

As is the case with Valley, the Company generally relies on a single vendor
for order fulfillment with respect to each product line carried by the
Company. Therefore, the loss of any one vendor could materially and adversely
affect the Company's sales of that product line. While the Company seeks to
negotiate multi-year contracts with its vendors to ensure the availability of
merchandise, there can be no assurance that the Company's current vendors will
continue to sell merchandise to the Company on current terms or that the
Company will be able to establish new vendor relationships to ensure
acquisition of merchandise in a timely and efficient manner and on acceptable
commercial terms. If the Company were unable to develop and maintain
relationships with vendors that would allow it to obtain sufficient quantities
of merchandise on acceptable commercial terms, it would be materially
adversely affected. See "Business--Fulfillment."

Risk of System Failure; Absence of Redundant Facilities; Capacity
Constraints. The Company's business is dependent on the efficient and
uninterrupted operation of its computer and communications hardware systems.
Substantially all of the Company's computer and communications hardware is
located at a single leased facility in Jenkintown, Pennsylvania. The Company's
systems and operations are vulnerable to damage or interruption from fire,
flood, power loss, telecommunications failure, break-ins, earthquake and
similar events. Any system interruptions, including any interruptions in the
Company's Internet connections or internal systems problems, that result in
the unavailability of the Company's Web site or reduced transaction processing
performance would reduce the volume of products sold and the attractiveness of
the Company's product and service offerings and could, therefore, materially
adversely affect the Company. The Company has, from time to time, experienced
periodic systems interruptions, and anticipates that such interruptions will
occur in the future. The Company does not presently have redundant systems or
a formal disaster recovery plan and does not carry sufficient business
interruption insurance to compensate it for losses that may occur.

Any substantial increase in the volume of traffic on the Company's Web site
or the number of orders placed by customers will require the Company to expand
and upgrade further its technology, transaction-processing systems and network
infrastructure. There can be no assurance that the Company will be able to
accurately project the rate or timing of increases, if any, in the use of its
Web site or expand and upgrade its systems and infrastructure to accommodate
such increases. The failure to appropriately upgrade its systems and
infrastructure would have a material adverse effect on the Company.

Security Risks. A significant barrier to online commerce is concern
regarding the security of transmission of confidential information. The
Company relies on encryption and authentication technology licensed from third
parties that is designed to facilitate the secure transmission of confidential
information, such as customer credit card numbers. Nevertheless, the Company's
infrastructure is

9
<PAGE>

potentially vulnerable to physical or electronic computer break-ins, viruses
and similar disruptive problems. A party who is able to circumvent the
Company's security measures could misappropriate proprietary information or
cause interruptions in the Company's operations. To the extent that activities
of the Company or third-party contractors involve the storage and transmission
of proprietary information, such as credit card numbers, security breaches
could damage the Company's reputation and expose the Company to a risk of loss
or litigation and possible liability. Therefore, the Company may be required
to expend significant capital and other resources to protect against such
security breaches or to alleviate problems caused by such breaches. There can
be no assurance that the Company's security measures will prevent security
breaches or that failure to prevent such security breaches will not have a
material adverse effect on the Company. See "Business--Technology."

Risk of Reliance on Internally Developed Systems. The Company uses an
internally developed system for its Web site, search engine and substantially
all aspects of its transaction processing and order management. The Company's
inability to modify this system as necessary to accommodate increased traffic
on its Web site or increased volume through its transaction processing and
order management systems may cause unanticipated system disruptions, slower
response times, impaired quality and speed of order fulfillment, degradation
in customer service, and delays in reporting accurate financial information.
Any of these events could have a material adverse effect on the Company.

Increased Reliance Upon Online and Traditional Advertising and Strategic
Alliances. The Company is increasingly relying on online and traditional
advertising and certain strategic alliances to attract users to its Web site.
The Company has recently committed substantial resources to promoting its
brand name through a campaign that includes online, radio and television
advertising. The Company has also entered into strategic alliances with Yahoo!
Inc. ("Yahoo!") with respect to certain areas on the Yahoo! service, Excite,
Inc. ("Excite") with respect to its WebCrawler service and GeoCities Inc.
("GeoCities") with respect to certain areas on the GeoCities service. The
Company's ability to generate revenues will depend on increased traffic and
purchases that the Company expects to generate through these efforts. There
can be no assurance that these efforts will generate any substantial number of
new customers or net sales or that the Company's infrastructure will be
sufficient to handle the increased traffic resulting therefrom. Moreover,
there can also be no assurance that the Company will be able to renew
successful advertising programs or maintain its strategic alliances beyond
their initial terms or that additional third-party alliances will be available
to the Company on acceptable commercial terms or at all. The inability to
maintain and further develop its advertising campaign or strategic alliances
could have a material adverse effect on the Company.

Potential Fluctuation in Quarterly Operating Results. The Company expects to
experience significant fluctuations in its future quarterly operating results
due to a variety of factors, many of which are outside the Company's control.
Factors that may affect the Company's quarterly operating results include (i)
its ability to retain existing customers, attract new customers and maintain
customer satisfaction, (ii) the introduction of new or enhanced Web pages,
services, products and strategic alliances by the Company and its competitors,
(iii) price competition or higher wholesale prices, (iv) the level of use of
the Internet and consumer acceptance of the Internet for the purchase of
recorded music, (v) seasonality of recorded music sales, (vi) its ability to
upgrade and develop its systems and infrastructure and attract qualified
personnel, (vii) technical difficulties, system downtime or Internet
brownouts, (viii) the amount and timing of operating costs and capital
expenditures relating to expansion of the Company's business, operations and
infrastructure, (ix) the timing of Company promotions and sales programs,
(xii) the level of merchandise returns experienced by the Company, (xi)
government regulation and (xii) general economic conditions and economic
conditions specific to the Internet and the music industry.

10
<PAGE>

history and rapid growth make it difficult to ascertain the effects of
seasonality on its business. Therefore, the Company believes that period-to-
period comparisons of the Company's historical results are not necessarily
meaningful and should not be relied upon as an indication of future results.
The Company's results of operations in future periods may not meet the
expectations of securities analysts and investors, in which case the price of
the Common Stock would likely be materially adversely affected. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Quarterly Results and Seasonality".

Rapid Technological Change. To remain competitive, the Company must continue
to enhance and improve the responsiveness, functionality and features of its
site and develop new features to meet customer needs. The Internet is
characterized by rapid technological change, changes in user and customer
requirements and preferences, frequent new product and service introductions
and the emergence of new industry standards and practices that could render
the Company's existing Web site, technology and systems obsolete. The
Company's success will depend, in part, on its ability to license leading
technologies useful in its business, enhance its existing services, develop
new services and technology that address the needs of its customers, and
respond to technological advances and emerging industry standards and
practices on a cost-effective and timely basis. If the Company is unable to
use new technologies effectively or adapt its Web site, proprietary technology
and transaction-processing systems to customer requirements or emerging
industry standards, it would be materially adversely affected. See "Business--
Technology."

No Designated Use for Substantial Portion of Net Proceeds. The Company has
not designated any specific use for a significant portion of the net proceeds
from the sale by the Company of the Common Stock offered hereby. The net
proceeds of this offering will be used by the Company to repay certain short-
term indebtedness, to fund its obligations under its strategic alliances, to
finance its sales and marketing campaign, to make improvements to and expand
the capacity of its Web site, to make certain other capital expenditures and
for working capital and other general corporate purposes. However, the Company
cannot, with precision, estimate the portion of the net proceeds to be devoted
to certain of these uses. From time to time, the Company may evaluate
potential acquisitions involving complementary businesses, content, products
or technologies. However, the Company has no present agreements with respect
to any material acquisition or investment. Accordingly, management will have
significant flexibility in applying the net proceeds of this Offering. See
"Use of Proceeds."

Trademarks and Proprietary Rights; Unlicensed Arrangements and Materials;
Risk of Claims Resulting from Lack of License Rights. The Company regards its
trademarks, trade secrets and similar intellectual property as valuable to its
business, and relies on trademark and copyright law, trade secret protection
and confidentiality and/or license agreements with its employees, partners and
others to protect its proprietary rights. There can be no assurance that the
steps taken by the Company will be adequate to prevent misappropriation or
infringement of its proprietary property.

The Company has licensed in the past, and expects that it may license in the
future, certain of its proprietary rights, such as trademarks or copyrighted
material, to third parties. While the Company attempts to ensure that the
quality of its brand is maintained by such licensees, there can be no
assurance that such licensees will not take actions that might materially
adversely affect the value of the Company's proprietary rights or reputation,
which could have a material adverse effect on the Company.

Through its Cosmic Credit Program, the Company is establishing a network of
links with numerous small Web sites, typically fan sites devoted to particular
musical artists, that permit customers to connect to the Company's site
through an embedded hyperlink. See "Business--Marketing and Promotion. " Many
of the sites are not officially sanctioned by the artists to which they
relate, nor do they have licenses from the artists for use of any intellectual
property of the artists, their licensees or record companies which the sites
may display. There can be no assurance that the artists, their licensees or
record companies will not assert infringement claims against the Cosmic Credit
sites and the Company because of its relationships

11
<PAGE>

with these sites. In addition, the Company's primary provider of artist and
music-related information, such as reviews, articles, photographs and images,
which the Company displays in its online retail store, has represented to the
Company that it may not have a license to distribute a portion of such
information. There can be no assurance that the owners (or their licensees) of
intellectual property rights in such information will not assert infringement
claims against the provider and the Company. Moreover, the Company has been
subject to claims and expects to be subject to legal proceedings and claims
from time to time in the ordinary course of its business, including claims of
alleged infringement of the trademarks and other intellectual property rights
of third parties by the Company and its licensees. Such claims could result in
substantial costs and diversion of resources, even if ultimately decided in
favor of the Company, and could have a material adverse effect on the Company,
particularly if judgments on such claims are adverse to the Company. If a
claim is asserted alleging that the Company has infringed the proprietary
rights of a third party, the Company may be required to seek licenses to
continue to use such intellectual property. The failure to obtain the
necessary licenses or other rights at a reasonable cost could have a material
adverse effect on the Company.

Government Regulation and Legal Uncertainties. The Company is subject, both
directly and indirectly, to various laws and regulations relating to its
business, although there are few laws or regulations directly applicable to
access to the Internet. However, due to the increasing popularity and use of
the Internet, it is possible that a number of laws and regulations may be
adopted with respect to the Internet. Such laws and regulations may cover
issues such as user privacy, pricing, content, copyrights, distribution and
characteristics and quality of products and services. Furthermore, the growth
and development of the market for online commerce may prompt calls for more
stringent consumer protection laws that may impose additional burdens on those
companies conducting business online. The enactment of any additional laws or
regulations may impede the growth of the Internet which could, in turn,
decrease the demand for the Company's products and services and increase the
Company's cost of doing business, or otherwise have an adverse effect on the
Company.

The applicability to the Internet of existing laws in various jurisdictions
governing issues such as property ownership, sales and other taxes, contests
and sweepstakes, libel, personal privacy, rights of publicity, language
requirements and content restrictions, is uncertain and could expose the
Company to substantial liability. The laws of certain foreign countries
provide the owner of copyrighted products with the exclusive right to expose,
through sound and video samples, copyrighted items for sale to the public and
the right to distribute such products. Any new legislation or regulation, or
the application of existing laws and regulations to the Internet could have a
material adverse effect on the Company. For example, major U.S.-based online
services (and personnel) have been challenged by German authorities for making
certain content accessible in Germany. If the Company were alleged to violate
federal, state or foreign, civil or criminal law, even if the Company could
successfully defend such claims, it could have a material, adverse impact on
the Company. The Company is also aware that one foreign distribution affiliate
of a major record label has sought to enjoin the sale of music-related
products by an Internet retailer in a particular foreign country. If
successful, this and other distributors located in certain foreign countries
could similarly seek to enjoin Internet retailers such as the Company, which
could materially adversely affect the Company.

The Company believes that its use of third party material on its Web sites
is permitted under current provisions of copyright law. However, legal rights
to certain aspects of Internet content and commerce are not clearly settled
and the Company's ability to rely upon one or more exemptions or defenses
under copyright law is uncertain. There can be no assurance that the Company
will be able to continue to provide rights to information, including
downloadable music samples and artist, record and other information. The
failure to be able to offer such information could have a material adverse
effect on the Company.

In addition, several telecommunications carriers are seeking to have
telecommunications over the Internet regulated by the Federal Communications
Commission (the "FCC") in the same manner as other

12
<PAGE>

telecommunications services. For example, America's Carriers
Telecommunications Association has filed a petition with the FCC for this
purpose. In addition, because the growing popularity and use of the Internet
has burdened the existing telecommunications infrastructure and many areas
with high Internet use have begun to experience interruptions in phone
service, local telephone carriers, such as Pacific Bell, have petitioned the
FCC to regulate Internet service providers and online service providers in a
manner similar to long distance telephone carriers and to impose access fees
on such providers. If either of these petitions are granted, or the relief
sought therein is otherwise granted, the costs of communicating on the
Internet could increase substantially, potentially slowing the growth in use
of the Internet. Any such new legislation or regulation or application or
interpretation of existing laws could have a material adverse effect on the
Company's business, results of operations and financial condition.

U.S. and foreign laws regulate certain uses of customer information and
development and sale of mailing lists. The Company believes that it is in
material compliance with such laws, but new restrictions may arise in this
area that could have an adverse affect on the Company.

The law regarding linking to and framing of third party Web sites without
permission is uncertain. The Company believes that its linking and framing
activities are lawful, but there is a possibility that it may be asked to pay
a license fee or cease linking or framing.

Possible Liability for Publishing or Distributing Content over the
Internet. Due to the fact that the Company may be considered a publisher or
distributor of both its own and third party content, as well as the fact that
such material may be downloaded or copied from its Web sites and may be
subsequently distributed to others, there is a potential that claims will be
made against the Company for defamation, negligence, copyright or trademark
infringement, invasion of privacy and publicity, unfair competition or other
theories based on the nature and content of such material. Such claims have
been brought, and sometimes successfully pressed, against online services in
the past. For example, claims could be made against the Company if material
deemed inappropriate for viewing by young children could be accessed though
the Company Web sites. Although the Company carries general liability
insurance, the Company's insurance may not cover potential claims of this type
or may not be adequate to cover all costs incurred in defense of potential
claims or to indemnify the Company for all liability that may be imposed. Any
costs or imposition of liability that is not covered by insurance or is in
excess of insurance coverage could have a material adverse effect on the
Company.

Potential Liability for Sales and Other Taxes. The Company does not
currently collect sales or other similar taxes in respect of shipments of
goods into states other than Pennsylvania, California and Florida. New state
tax regulations may subject the Company to the assessment of sales and income
taxes in additional states. Tax authorities in a number of states are
currently reviewing the appropriate tax treatment of companies engaged in
Internet and catalogue retailing and are currently considering an agreement
with certain of these companies regarding the assessment and collection of
sales taxes. The Company is not a party to any such discussions. As the
Company's service is available over the Internet in multiple states and
foreign countries, such jurisdictions may claim that the Company is required
to qualify to do business as a foreign corporation in each such state and
foreign country. The failure by the Company to qualify as a foreign
corporation in a jurisdiction where it is required to do so could subject the
Company to taxes and penalties for the failure to qualify.

Dependence on Key Personnel; Need for Additional Personnel. The Company's
success is substantially dependent on the ability and experience of its senior
management and other key personnel, particularly Jason Olim, its President,
Chief Executive Officer and Chairman of the Board. Moreover, to accommodate
its current size and manage its anticipated growth, the Company must maintain
and expand its employee base. Competition for personnel, particularly persons
having software development and other technical expertise, is intense, and
there can be no assurance that the Company will retain existing personnel or
hire additional, qualified personnel. The inability of the Company to retain
and attract the

13
<PAGE>

necessary personnel or the loss of services of any of its key personnel could
have a material adverse effect on the Company. See "Business--Employees" and
"Management."

Control of the Company. Immediately upon completion of this offering,
approximately 20.0%, 20.0%, 11.5% and 15.4% of the outstanding Common Stock
will be beneficially owned by Jason Olim, the Company's President, Chief
Executive Officer and Chairman of the Board; Matthew Olim, the Company's
Technical Lead and Jason Olim's brother; Alan Meltzer, a director of the
Company; and Grotech Partners, IV, one of the managing directors of which is
Patrick Kerins, a director of the Company. As a result, such persons, acting
together, will have the ability to control all matters submitted to
shareholders of the Company for approval (including the election and removal
of directors and any merger, consolidation or sale of all or substantially all
of the Company's assets) and to control the management and affairs of the
Company. Such concentration of ownership may have the effect of delaying,
deferring or preventing a change in control of the Company, impede a merger,
consolidation, takeover or other business combination involving the Company or
discourage a potential acquirer from making a tender offer or otherwise
attempting to obtain control of the Company, which in turn could have an
adverse effect on the market price of the Company's Common Stock. See
"Principal Shareholders" and "Certain Relationships and Related Transactions."

No Prior Market; Possible Volatility of Stock Price. Prior to this offering,
there has been no public market for the Company's Common Stock, and there can
be no assurance that an active public market for the Common Stock will develop
or continue after this offering. The initial public offering price has been
determined by negotiations among the Company and BT Alex. Brown Incorporated
and NationsBanc Montgomery Securities LLC, as representatives of the
Underwriters, and may not be indicative of the market price for the Common
Stock after this offering. See "Underwriting" for factors to be considered in
determining the initial public offering price. From time to time after this
offering, there may be significant volatility in the market price of the
Common Stock. Quarterly operating results of the Company, deviations in
results of operations from estimates of securities analysts, changes in
general conditions in the economy or the Internet services industry or other
developments affecting the Company or its competitors could cause the market
price of the Common Stock to fluctuate substantially. The equity markets have,
on occasion, experienced significant price and volume fluctuations that have
affected the market prices for many companies' securities and that have often
been unrelated to the operating performance of these companies. Any such
fluctuations that occur following completion of this offering may adversely
affect the market price of the Common Stock.

Risks Associated with International Sales. For the year ended December 31,
1997, international sales accounted for approximately 29% of the Company's net
sales. While the Company expects that its percentage of net sales from
international markets may decrease in future periods due to a substantial
increase in domestic marketing and advertising, it expects that international
sales will continue to represent a significant portion of its net sales. The
Company's international business activities are subject to a variety of
potential risks, including the adoption of laws or political and economic
conditions that would restrict or eliminate the Company's ability to do
business in certain jurisdictions. While the Company currently transacts
business in U.S. dollars, to the extent that it determines to transact
business in foreign currencies, the Company will become subject to the risks
attendant to transacting in foreign currencies, including potential adverse
effects of exchange rate fluctuations. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations."

Potential Adverse Market Impact of Shares Eligible for Future Sale. The
3,600,000 shares of Common Stock offered hereby (other than shares purchased
by "affiliates" of the Company) will be freely tradeable immediately following
this offering. All of the remaining outstanding shares (the "Restricted
Shares"), have or will become available for sale in the public market during
1998 subject, in certain instances, to the applicable resale limitations of
Rule 144 promulgated under the Securities Act of 1933, as amended (the
"Securities Act"). In addition, the Company intends to file a Registration
Statement on Form S-8 covering up to 1,600,000 shares issuable upon exercise
of stock options under the Equity

14
<PAGE>

Compensation Plan. Such shares, upon issuance, will be immediately available
for resale (in the case of holders that are affiliates of the Company, subject
to certain limitations under Rule 144). The Company's officers, directors and
certain shareholders, who hold, in the aggregate, approximately 11,394,884
shares of Common Stock, have agreed not to sell any shares of Common Stock
(excluding shares of Common Stock offered by this Prospectus or shares
purchased in the open market) for a period of 180 days following the
consummation of this offering without the prior written consent of BT Alex.
Brown Incorporated. Thereafter, these shares may become either freely
resalable or eligible for sale pursuant to the applicable resale limitations
of Rule 144. In addition, beneficial owners of approximately 5,746,307 shares
of Restricted Stock have demand and piggyback registration rights with respect
to those shares. Sales of substantial amounts of Common Stock in the public
market or the availability of substantial amounts of such stock for sale
subsequent to this Offering could adversely affect the prevailing market price
of the Common Stock and could impair the Company's ability to raise capital
through the sale of its equity securities.

Anti-Takeover Provisions; Possible Issuances of Preferred Stock and
Classified Board. Certain provisions of Pennsylvania law could make it more
difficult for a third party to acquire, or could discourage a third party from
attempting to acquire control of the Company. Such provisions could limit the
price that certain investors might be willing to pay in the future for shares
of the Common Stock. In addition, shares of the Company's Preferred Stock, no
par value (the "Preferred Stock"), may be issued by the Board of Directors
without shareholder approval on such terms and conditions, and having such
rights, privileges and preferences, as the Board of Directors may determine.
The rights of the holders of the Common Stock will be subject to, and may be
adversely affected by, the rights of the holders of any Preferred Stock that
may be issued in the future. In addition, the Company's Amended and Restated
Bylaws divide the Board of Directors into three classes, each serving a
staggered three-year term. The issuance of Preferred Stock and the existence
of a classified board could have the effect of delaying, deterring or
preventing a change in control of the Company. The Company has no current
plans to issue any shares of Preferred Stock. See "Management" and
"Description of Capital Stock--Preferred Stock."

Immediate and Substantial Dilution. The purchasers of the shares of Common
Stock offered hereby will experience immediate and substantial dilution in the
net tangible book value of their shares of Common Stock in the amount of
$10.97 per share (based on an assumed offering price of $14.00 per share and
after giving effect to underwriting discounts and commissions and estimated
offering expenses). See "Dilution." In the event the Company offers additional
Common Stock in the future, including shares that may be issued upon exercise
of stock options, purchasers of Common Stock in this offering may experience
further dilution in the net tangible book value per share of the Common Stock
of the Company.

15
<PAGE>

USE OF PROCEEDS

The net proceeds to the Company from the sale of 3,600,000 shares of Common
Stock offered hereby at an assumed public offering price of $14.00 per share
are estimated to be $46.1 million (approximately $51.3 million if the
Underwriters' overallotment option is exercised in full) after deducting
underwriting discounts and commissions and estimated offering expenses.

The net proceeds from this offering will be used by the Company as follows:
approximately $5.8 million to retire the Series A Notes; approximately $12.0
million on advertising and promotion; an aggregate minimum of $6.4 million due
under the Company's strategic alliance agreements expected to be paid to
Yahoo!, GeoCities and Excite during the next 12 months; approximately $3.0
million to make enhancements to, and expand the capacity of, the Company's Web
site, and for other capital expenditures; and the balance for working capital
and other general corporate purposes, which may include additional payments
due under the Company's existing strategic alliances, payments due under any
new strategic alliances and future advertising and promotion activities. The
Series A Notes were issued on November 26, 1997 to certain investors
(including $1.0 million to Grotech Partners IV, L.P., a significant
stockholder of the Company), bear interest at the rate of 12% per annum and
are repayable in full upon the consummation of this offering. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Certain Relationships and Related Transactions."

The amounts actually expended for each purpose, other than the repayment of
the indebtedness and the payments due under strategic alliance agreements
described above, will be determined at the discretion of the Company. The
Company's future capital requirements and the allocation of the net proceeds
of this offering, will depend on many factors, including the entrance into new
strategic alliances, increases in advertising and promotions, growth of the
Company's customer base and other factors. Accordingly, the actual amount of
proceeds devoted to each purpose other than the repayment of indebtedness may
vary substantially from the amount set forth above. From time to time the
Company may evaluate potential acquisitions involving complementary
businesses, content, products or technologies. The Company has no present
agreements or understanding with respect to any such acquisition.

Pending utilization of the net proceeds of this offering, the Company
intends to invest the funds in short-term, interest-bearing, investment-grade
obligations. The Company believes that the net proceeds from this offering,
together with its current cash and cash equivalents, will be sufficient to
meet its anticipated cash needs for working capital and capital expenditures
for at least the next 12 months. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations."

DIVIDEND POLICY

The Company has not paid any cash dividends on its Common Stock and does not
anticipate paying any cash dividends in the foreseeable future. The Company
currently intends to retain future earnings, if any, to fund the development
and growth of its business. Any future determination to pay cash dividends
will be at the discretion of the Board of Directors and will be dependent upon
the Company's financial condition, operating results, capital requirements,
applicable contractual restrictions and such other factors as the Board of
Directors deems relevant.

16
<PAGE>

CAPITALIZATION

The following table sets forth, as of December 31, 1997, (i) the actual
capitalization of the Company, (ii) the pro forma capitalization of the
Company after giving effect to the conversion of the outstanding Series A
Preferred Stock and Series B Preferred Stock into 2,790,131 shares of Common
Stock upon the consummation of this offering and the cashless exercise of a
warrant into 800,313 shares of Common Stock by Alan Meltzer, a director of the
Company, which is expected to occur upon the consummation of this offering and
(iii) the pro forma capitalization, as adjusted to reflect the issuance and
sale of the 3,600,000 shares of Common Stock offered by the Company hereby at
an assumed initial public offering price of $14.00 per share, the application
of the estimated net proceeds therefrom and the write-off of approximately
$290,000 of debt discount and deferred financing costs in connection with the
repayment of the Series A Notes. See "Use of Proceeds." This table should be
read in conjunction with the Financial Statements and the notes thereto and
the other financial information included elsewhere in this Prospectus.

<TABLE>
<CAPTION>
DECEMBER 31, 1997
-------------------------------------
PRO FORMA
ACTUAL PRO FORMA AS ADJUSTED
----------- ----------- -----------
<S> <C> <C> <C>
Cash.................................... $10,686,001 $10,686,001 $50,980,501
=========== =========== ===========
Series A Notes.......................... $ 5,575,288 $ 5,575,288 $ --
=========== =========== ===========
Long-term debt, excluding current
portion................................ $ 962,144 $ 962,144 $ 962,144
----------- ----------- -----------
Redeemable Series A and Series B
Convertible Preferred Stock............ 9,492,594 -- --
----------- ----------- -----------
Shareholders' equity (deficit):
Preferred Stock, no par value;
20,000,000 shares authorized; 254,582
shares Series A Convertible Preferred
Stock and 1,605,505 shares of Series
B Convertible Preferred Stock issued
and outstanding actual; no shares
issued and outstanding pro forma and
pro forma as adjusted................ -- -- --
Common Stock, no par value; 50,000,000
shares authorized; 7,845,684 shares
issued and outstanding actual;
11,436,128 shares issued and
outstanding pro forma; 15,036,128
shares issued and outstanding pro
forma as adjusted(1)................. 579,549 10,072,143 56,144,143
Additional paid-in capital............ 1,325,817 1,325,817 1,325,817
Deferred compensation................. (434,776) (434,776) (434,776)
Accumulated deficit................... (11,223,040) (11,223,040) (11,512,649)
----------- ----------- -----------
Total shareholders' equity (defi-
cit)............................... (9,752,450) (259,856) 45,522,535
----------- ----------- -----------
Total capitalization.............. $ 702,288 $ 702,288 $46,484,679
=========== =========== ===========
</TABLE>
- ---------------------

(1) Excludes (i) 721,914 shares of Common Stock issuable upon the exercise of
options outstanding as of December 31, 1997 under the Company's 1996
Equity Compensation Plan (the "Equity Compensation Plan") at a weighted
average exercise price of $2.99 per share, (ii) 878,086 shares of Common
Stock reserved for future grants under the Equity Compensation Plan and
(iii) 367,253 shares of Common Stock issuable upon the exercise of
warrants outstanding as of December 31, 1997 at a weighted average
exercise price of $4.05 per share. See "Management--Equity Compensation
Plan" and "Description of Capital Stock."

17
<PAGE>

DILUTION

At December 31, 1997, the pro forma net tangible book value of the Company
was a deficit of approximately $(473,000) or $(0.04) per share of Common Stock
after giving effect to the conversion of the outstanding Series A Preferred
Stock and Series B Preferred Stock into 2,790,131 shares of Common Stock upon
the consummation of this Offering. Pro forma net tangible book value per share
is equal to the Company's total tangible assets less its total liabilities,
divided by the total number of shares of Common Stock outstanding on a pro
forma basis for the period immediately prior to this offering. After giving
effect to the sale by the Company of 3,600,000 shares of Common Stock offered
hereby at an assumed initial public offering price of $14.00 per share and
after deducting underwriting discounts and commissions and estimated offering
expenses and the write-off of $290,000 of debt discount and deferred financing
costs in connection with the repayment of the Series A Notes, the pro forma
net tangible book value of the Company at December 31, 1997 would have been
$45.5 million or approximately $3.03 per share. This represents an immediate
increase in the pro forma net tangible book value of $3.07 per share to
existing shareholders and immediate dilution of $10.97 per share to new
investors purchasing shares of Common Stock in this offering. The following
table illustrates this per share dilution:

<TABLE>
<S> <C> <C>
Assumed initial public offering price per share............. $14.00
Pro forma net tangible book value per share as of December
31, 1997................................................. $(0.04)
Increase in pro forma combined net tangible book value per
share attributable to new investors...................... 3.07
------
Pro forma net tangible book value per share after this
offering................................................... 3.03
------
Dilution per share to new investors......................... $10.97
======
</TABLE>

The following table sets forth, on an adjusted basis as of December 31,
1997, the number of shares of Common Stock purchased from the Company
(assuming the conversion of the Series A Preferred Stock and Series B
Preferred Stock into 2,790,131 shares of Common Stock and the cashless
exercise of a warrant for 800,313 shares of Common Stock which is expected to
occur upon the consummation of this offering), the total cash consideration
paid and the average price per share paid by the existing holders of Common
Stock and by new investors, before deducting estimated underwriting discounts
and commissions and expenses payable by the Company, at an assumed initial
public offering price of $14.00 share:

<TABLE>
<CAPTION>
SHARES PURCHASED TOTAL CONSIDERATION
------------------ ------------------- AVERAGE PRICE
NUMBER PERCENT AMOUNT PERCENT PER SHARE
---------- ------- ----------- ------- -------------
<S> <C> <C> <C> <C> <C>
Existing shareholders.. 11,436,128 76.1% $12,585,825 20.0% $ 1.10
New investors.......... 3,600,000 23.9% 50,400,000 80.0% 14.00
---------- ----- ----------- -----
Total................ 15,036,128 100.0% $62,985,825 100.0%
========== ===== =========== =====
</TABLE>

The foregoing tables exclude (i) 721,914 shares of Common Stock issuable
upon the exercise of options outstanding as of December 31, 1997 under the
Equity Compensation Plan at a weighted average exercise price of $2.99 per
share, (ii) 878,086 shares of Common Stock reserved for future grants under
the Equity Compensation Plan and (iii) 367,253 shares of Common Stock issuable
upon the exercise of warrants outstanding as of December 31, 1997 at a
weighted average exercise price of $4.05 per share. See "Management--Equity
Compensation Plan," "Description of Common Stock" and Note 8 to Notes to
Financial Statements. The exercise of outstanding options and warrants having
an exercise price less than the initial public offering price would increase
the dilution to new investors illustrated by the foregoing tables.

18
<PAGE>

SELECTED FINANCIAL AND OPERATING DATA

The selected financial data set forth below should be read in conjunction
with "Management's Discussion and Analysis of Financial Condition and Results
of Operations" and the Financial Statements and notes thereto appearing
elsewhere in this Prospectus. The selected statement of operations data for
the years ended December 31, 1995, 1996 and 1997 and the selected balance
sheet data as of December 31, 1996 and 1997 have been derived from the
Financial Statements, which have been audited by Arthur Andersen LLP,
independent public accountants, and are included elsewhere in this Prospectus.
The selected statement of operations data for the period from inception
(February 12, 1994) to December 31, 1994 and the selected balance sheet data
as of December 31, 1994 and 1995 have been derived from financial statements
audited by Arthur Andersen LLP, independent public accountants, not included
in this prospectus.

<TABLE>
<CAPTION>
PERIOD FROM
INCEPTION
(FEBRUARY 12,
1994) TO YEAR ENDED DECEMBER 31,
DECEMBER 31, -------------------------------------
1994(1) 1995(1) 1996 1997
------------- ---------- ----------- ------------
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS
DATA:
Net sales................ $103,116 $2,176,474 $ 6,300,294 $ 17,372,795
Cost of sales............ 92,962 1,844,612 5,363,989 14,541,765
-------- ---------- ----------- ------------
Gross profit............ 10,154 331,862 936,305 2,831,030
Operating expenses:
Operating and develop-
ment................... 26,946 149,982 523,080 2,179,726
Sales and marketing..... 12,945 200,972 621,454 9,242,179
General and administra-
tive................... 28,712 180,573 563,593 1,986,218
Dispute settlement(2)... -- -- 1,024,030 --
-------- ---------- ----------- ------------
Total operating ex-
penses................. 68,603 531,527 2,732,157 13,408,123
-------- ---------- ----------- ------------
Operating loss.......... (58,449) (199,665) (1,795,852) (10,577,093)
Interest expense, net.... -- (1,248) (14,556) (170,312)
-------- ---------- ----------- ------------
Net loss................. $(58,449) $ (200,913) $(1,810,408) $(10,747,405)
======== ========== =========== ============
Pro forma net loss per
share(3)................ $ (0.91)
============
Pro forma weighted
average number of common
and common equivalent
shares(3)............... 11,765,287
OPERATING DATA:
Customers(4)............. 1,787 26,953 87,859 296,450
<CAPTION>
DECEMBER 31,
---------------------------------------------------
1994 1995 1996 1997
------------- ---------- ----------- ------------
<S> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash and cash
equivalents............. $ 2,008 $ 43,812 $ 775,865 $ 10,686,001
Working capital
(deficit)............... (42,206) (235,478) 231,455 (1,218,005)
Total assets............. 25,765 268,468 1,575,459 16,448,425
Long-term debt, excluding
current portion......... -- 9,519 91,133 962,144
Redeemable convertible
preferred stock......... -- -- -- 9,492,594
Total shareholders'
equity (deficit)........ (18,449) (99,362) 514,017 (9,752,450)
</TABLE>
- ---------------------

(1) The business of the Company was established as a sole proprietorship in
February 1994 and commercial operations were commenced in August 1994. The
Company was incorporated in April 1995.

(3) See Note 2 to Notes to Financial Statements for an explanation of the
determination of the number of Common shares and Common share equivalents
used in computing pro forma per share amount.
(4) Cumulative number of customers who have purchased products from the
Company from inception of its business in August 1994 through the end of
period.

19
<PAGE>

MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Prospectus contains certain statements of a forward-looking nature
relative to future events or the financial performance of the Company. Actual
events or results may differ materially from those indicated by such forward-
looking statements for a variety of reasons, including the matters set forth
under the caption "Risk Factors."

CDnow is the leading online retailer of CDs and other music-related
products. Its early entrance into the online music retailing industry has
helped the Company gain a well-recognized brand and a large customer base. The
Company strives to combine the advantages of online commerce with superior
customer focus in order to be the authoritative source for CDs and other
music-related products. CDnow offers broad selection, informative content,
easy-to-use navigation and search capabilities, a high level of customer
service, competitive pricing and personalized communication. Due to the
Company's dedicated retail focus, revenues are almost entirely derived from
the sale of pre-recorded music and related products, drawing from its
comprehensive selection of over 250,000 items. The Company does not seek to
generate advertising or other ancillary revenues.

CDnow has grown rapidly since its inception in 1994. Of the 296,000
customers who have made purchases since inception through 1997, 209,000 made
their initial purchases in 1997. Average daily visits to the CDnow store have
grown from approximately 12,000 in January 1996 to approximately 132,000 in
September 1997. The Company's net sales grew to $17.4 million in 1997 compared
to $6.3 million in 1996. Net sales for the first, second, third and fourth
quarters of 1997 were $2.6 million, $3.0 million, $3.9 million and $7.9
million, respectively. The Company has also generated significant customer
loyalty. Despite the Company's rapid acquisition of new customers, repeat
customers accounted for over 50% of net sales in 1997.

The Company believes that the key factors affecting its long-term financial
success include its ability to obtain new customers at reasonable costs,
retain customers and encourage repeat purchases. The Company seeks to expand
its customer base through multiple marketing channels which include (i)
pursuing an aggressive marketing campaign using a combination of online and
traditional marketing, (ii) establishing strategic alliances with major
Internet content and service providers, (iii) entering into linking
arrangements with other Web sites as part of its Cosmic Credit Program, and
(iv) using direct marketing techniques to target new and existing customers
with personalized communications. The Company recently accelerated its
marketing campaign and entered into strategic alliances with Yahoo!, Excite
and GeoCities in August 1997, September 1997 and January 1998, respectively.

Since its inception, the Company has incurred significant net losses and, as
of December 31, 1997, had accumulated losses of $12.8 million. As it seeks to
expand aggressively, the Company believes that its operating expenses will
significantly increase as a result of the financial commitments related to the
development of marketing channels, future strategic relationships, and
improvements to its Web site and other capital expenditures. The Company
expects that it will continue to incur losses and generate negative cash flow
from operations for the foreseeable future as it continues to develop its
business. Since the Company has relatively low product gross margins, the
ability of the Company to generate and enhance profitability depends upon its
ability to substantially increase its net sales. To the extent that
significantly higher net sales do not result from the Company's marketing
efforts, the Company will be materially adversely affected. There can be no
assurance that the Company will be able to generate sufficient revenues from
the sale of CDs and other music-related products to achieve or maintain
profitability on a quarterly or annual basis.

For the year ended December 31, 1997, international sales accounted for
approximately 29% of net sales. While the Company expects that net sales from
international markets will continue to represent a significant portion of net
sales, the Company believes that the percentage of its net sales from
international

20
<PAGE>

markets may decrease in future periods due to the substantial increase in the
Company's domestic marketing and advertising expenditures.

The Company's business started as a sole proprietorship in February 1994.
The Company, which was incorporated in April 1995, was taxed as an S-
corporation until December 6, 1996 and has been taxed as a C-corporation since
such date.

RESULTS OF OPERATIONS

The following table sets forth statement of operations data as a percentage
of net sales for the periods indicated:

<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
---------------------
1995 1996 1997
----- ----- -----
<S> <C> <C> <C>
Net sales................. 100.0% 100.0% 100.0%
Cost of sales............. 84.8 85.1 83.7
----- ----- -----
Gross profit............ 15.2 14.9 16.3
Operating Expenses:
Operating and
development............ 6.9 8.3 12.5
Sales and marketing..... 9.2 9.9 53.2
General and
administrative......... 8.3 8.9 11.5
Dispute settlement...... -- 16.3 --
----- ----- -----
Total operating
expenses............... 24.4 43.4 77.2
----- ----- -----
Operating loss............ (9.2) (28.5) (60.9)
Interest expense, net..... -- (0.2) (1.0)
----- ----- -----
Net loss.................. (9.2)% (28.7)% (61.9)%
===== ===== =====
</TABLE>

YEAR ENDED DECEMBER 31, 1997 COMPARED TO THE YEAR ENDED DECEMBER 31, 1996

Net Sales. Net sales primarily reflect the sales of CDs and related
merchandise, net of estimated returns, and include outbound shipping and
handling charges. Net sales increased by $11.1 million, or 176%, to $17.4
million for the year ended December 31, 1997 compared to $6.3 million for the
year ended December 31, 1996. This increase is primarily attributable to the
significant growth of the Company's customer base and repeat purchases from
the Company's existing customers, who have typically purchased more units per
order than new customers. International sales represented approximately 29%
and 40% of net sales for the years ended December 31, 1997 and December 31,
1996, respectively. The Company believes that this decrease in international
sales as a percentage of net sales is due to the substantial increase in the
Company's domestic marketing and advertising expenditures. At December 31,
1997, the Company had approximately 296,000 customer accounts compared to
approximately 88,000 customer accounts at December 31, 1996.

Cost of Sales. Cost of sales consists primarily of the cost of merchandise
sold to customers, including product fulfillment and outbound shipping and
handling. Cost of sales also includes fees charged by credit card processors
and royalties paid by the Company on CD sales in return for licensing of
ratings, reviews and other information. Cost of sales increased by $9.2
million, or 171%, to $14.5 million for the year ended December 31, 1997
compared to $5.4 million for the year ended December 31, 1996. This increase
is primarily attributable to the Company's increased sales volume. The
Company's gross profit margin was 16.3% for the year ended December 31, 1997
compared to 14.9% for the year ended December 31, 1996. The increase in gross
margin as a percentage of net sales was primarily due to price reductions from
the Company's suppliers and a change to a lower-price supplier for imported
music and music-related

21
<PAGE>

products. The Company's gross profit margin declined in the fourth quarter of
1997 due to increased sales promotions during the holiday season.

Operating and Development Expense. Operating and development expense
consists primarily of payroll and related expenses for design, development and
network operations personnel and systems and telecommunications
infrastructure. Operating and development expense increased by $1.7 million to
$2.2 million for the year ended December 31, 1997 compared to $523,000 for the
year ended December 31, 1996. As a percentage of net sales, these expenses
were 12.5% for the year ended December 31, 1997 and 8.3% for the year ended
December 31, 1996. This increase was due to increased staffing and associated
costs related to enhancing the features, content and functionality of the
Company's Web site and transaction-processing systems, as well as increased
investment in systems and telecommunications infrastructure. Store development
costs are charged to expense as incurred.

Sales and Marketing Expense. Sales and marketing expense consists primarily
of payments related to advertising and promotion and strategic alliances as
well as public relations, payroll and related expenses for personnel engaged
in marketing, selling and customer service activities. Sales and marketing
expense increased by $8.6 million to $9.2 million for the year ended December
31, 1997 compared to $621,000 for the year ended December 31, 1996, with $5.8
million of this expense incurred in the fourth quarter. As a percentage of net
sales, these expenses increased to 53.2% for the year ended December 31, 1997
from 9.9% for the year ended December 31, 1996. This increase was due to the
significant expansion of the Company's advertising expenditures, costs
associated with the strategic alliances with Yahoo! and Excite and to the
increased staffing and associated costs related to implementing the Company's
marketing strategy and supporting the Company's increased customer base. The
Company increased its advertising expense to $6.8 million for the year ended
December 31, 1997 compared to $61,000 for the year ended December 31, 1996.
The Company intends to aggressively expand its sales and marketing campaign
and expects the dollar amount of sales and marketing expense generally, and
advertising expense in particular, to increase significantly in future
periods. While the Company is hopeful that its net sales will increase in
future periods so that its sales and marketing expenses will not represent a
higher percentage of net sales, the Company is not able to predict whether its
net sales will increase by a sufficient amount for this to occur. No assurance
can be given that the Company will achieve increased net sales or that sales
and marketing expenses will not continue to increase as a percentage of net
sales.

General and Administrative Expense. General and administrative expense
consists of payroll and related expenses for executive, accounting and
administrative personnel, recruiting, professional fees and other general
corporate expenses. General and administrative expense increased by $1.4
million to $2.0 million for the year ended December 31, 1997 compared to
$564,000 for the year ended December 31, 1996. As a percentage of net sales,
these expenses increased to 11.5% for the year ended December 31, 1997
compared to 8.9% for the year ended December 31, 1996. This increase was
primarily due to the recruitment and hiring of additional personnel and
increases in professional fees and travel expenses.

Net Loss. The Company incurred a net loss of $10.7 million for the year
ended December 31, 1997 compared to a net loss of $1.8 million for the year
ended December 31, 1996.

YEAR ENDED DECEMBER 31, 1996 COMPARED TO THE YEAR ENDED DECEMBER 31, 1995

Net Sales. Net sales increased 189% to $6.3 million for the year ended
December 31, 1996 from $2.2 million for the year ended December 31, 1995 as a
result of the significant growth of the Company's customer base and repeat
purchases from existing customers. International sales represented
approximately 40% and 22% of net sales for the year ended December 31, 1996
and the year ended December 31, 1995, respectively. At December 31, 1996, the
Company had approximately 91,000 customer accounts compared to approximately
28,000 customer accounts at December 31, 1995.

22
<PAGE>

Cost of Sales. Cost of sales increased 191% to $5.4 million for the year
ended December 31, 1996 from $1.8 million for the year ended December 31,
1995, reflecting the Company's increased sales volume. The Company's gross
profit margin decreased to 14.9% for the year ended December 31, 1996 from
15.2% for the year ended December 31, 1995.

Operating and Development Expense. Operating and development expense
increased to $523,000 for the year ended December 31, 1996 from $150,000 for
the year ended December 31, 1995. As a percentage of net sales, operating and
development expense grew to 8.3% for the year ended December 31, 1996 from
6.9% for the year ended December 31, 1995. This increase in both absolute
dollars and as a percentage of net sales was primarily attributable to
increased staffing and associated costs related to enhancing the features,
content and functionality of the Company's Web site and transaction-processing
systems, as well as increased investment in systems and telecommunications
infrastructure.

Sales and Marketing Expense. Sales and marketing expense increased to
$621,000 for the year ended December 31, 1996 from $201,000 for the year ended
December 31, 1995. As a percentage of net sales, sales and marketing expense
grew to 9.9% for the year ended December 31, 1996 from 9.2% for the year ended
December 31, 1995. This increase in both absolute dollars and as a percentage
of net sales was primarily attributable to increased staffing and associated
costs related to implementing the Company's marketing strategy and supporting
the Company's increased customer base, as well as to expansion of the
Company's online advertising, promotional and public relations expenditures.

General and Administrative Expense. General and administrative expense
increased to $564,000 for the year ended December 31, 1996 from $181,000 for
the year ended December 31, 1995. As a percentage of net sales, general and
administrative expense grew to 8.9% for the year ended December 31, 1996 from
8.3% for the year ended December 31, 1995. This increase in both absolute
dollars and as a percentage of net sales was primarily due to the hiring of
additional personnel and increases in professional fees and travel expenses.

Dispute Settlement. In December 1996, in settlement of a dispute related to
certain business arrangements and discussions among the Company and certain
persons who are now shareholders of the Company, the Company issued Common
Stock valued at approximately $1.0 million to the three shareholders of MBL
Entertainment Inc. See "Certain Relationships and Related Transactions--Stock
Purchase and Shareholders' Agreement" and Note 7 to Notes to Financial
Statements.

Net Loss. The Company's net loss increased by $1.6 million to a loss of $1.8
million for the year ended December 31, 1996 compared to a loss of $201,000
for the year ended December 31, 1995.

23
<PAGE>

QUARTERLY RESULTS OF OPERATIONS AND SEASONALITY

The following table sets forth certain unaudited quarterly statement of
operations data for the eight quarters ended December 31, 1997. This unaudited
quarterly information has been derived from unaudited financial statements of
the Company and, in the opinion of management, include all adjustments
(consisting only of normal recurring adjustments) necessary for a fair
presentation of the information for the periods covered. The quarterly data
should be read in conjunction with the Financial Statements and the notes
thereto. The operating results for any quarter are not necessarily indicative
of the operating results for any future period.

<TABLE>
<CAPTION>
THREE MONTHS ENDED
----------------------------------------------------------------------------------
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, DEC. 31,
1996 1996 1996 1996 1997 1997 1997 1997
-------- -------- --------- -------- -------- -------- --------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Net sales....................... $1,128 $1,352 $1,629 $ 2,191 $2,582 $ 2,964 $ 3,907 $ 7,920
Cost of sales................... 965 1,169 1,412 1,818 2,102 2,408 3,221 6,811
------ ------ ------ ------- ------ ------- ------- -------
Gross profit.................... 163 183 217 373 480 556 686 1,109
Operating expenses:
Operating and development...... 77 106 146 194 254 423 551 952
Sales and marketing............ 92 127 174 228 430 722 2,254 5,836
General and administrative..... 83 115 157 209 342 410 530 704
Dispute settlement............. -- -- -- 1,024 -- -- -- --
------ ------ ------ ------- ------ ------- ------- -------
Total operating expenses...... 252 348 477 1,655 1,026 1,555 3,335 7,492
------ ------ ------ ------- ------ ------- ------- -------
Operating loss.................. (89) (165) (260) (1,282) (546) (999) (2,649) (6,383)
Interest income (expense), net.. (2) (3) (6) (3) 2 (6) 69 (235)
------ ------ ------ ------- ------ ------- ------- -------
Net loss........................ $ (91) $ (168) $ (266) $(1,285) $ (544) $(1,005) $(2,580) $(6,618)
====== ====== ====== ======= ====== ======= ======= =======
<CAPTION>
AS A PERCENTAGE OF NET SALES
----------------------------------------------------------------------------------
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, DEC. 31,
1996 1996 1996 1996 1997 1997 1997 1997
-------- -------- --------- -------- -------- -------- --------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Net sales....................... 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of sales................... 85.5 86.5 86.7 83.0 81.4 81.2 82.4 86.0
------ ------ ------ ------- ------ ------- ------- -------
Gross profit.................... 14.5 13.5 13.3 17.0 18.6 18.8 17.6 14.0
Operating expenses:
Operating and development...... 6.8 7.8 9.0 8.9 9.8 14.3 14.1 12.0
Sales and marketing............ 8.2 9.4 10.7 10.4 16.7 24.4 57.7 73.7
General and administrative..... 7.4 8.5 9.6 9.5 13.2 13.8 13.6 8.9
Dispute settlement............. -- -- -- 46.7 -- -- -- --
------ ------ ------ ------- ------ ------- ------- -------
Total operating expenses...... 22.4 25.7 29.3 75.5 39.7 52.5 85.4 94.6
------ ------ ------ ------- ------ ------- ------- -------
Operating loss.................. (7.9) (12.2) (16.0) (58.5) (21.1) (33.7) (67.8) (80.6)
Interest income (expense), net.. (0.2) (0.2) (0.3) (0.1) -- (0.2) 1.8 (3.0)
------ ------ ------ ------- ------ ------- ------- -------
Net loss........................ (8.1)% (12.4)% (16.3)% (58.6)% (21.1)% (33.9)% (66.0)% (83.6)%
====== ====== ====== ======= ====== ======= ======= =======
</TABLE>

The Company expects to experience significant fluctuations in its future
quarterly operating results due to a variety of factors, many of which are
outside the Company's control. Factors that may affect the Company's quarterly
operating results include (i) its ability to retain existing customers,
attract new customers and maintain customer satisfaction, (ii) the
introduction of new or enhanced Web pages, services, products and strategic
alliances by the Company and its competitors, (iii) price competition or
higher wholesale prices, (iv) the level of use of the Internet and consumer
acceptance of the Internet for the purchase of recorded music, (v) seasonality
of recorded music sales, (vi) its ability to upgrade and

24
<PAGE>

develop its systems and infrastructure and attract qualified personnel, (vii)
technical difficulties, system downtime or Internet brownouts, (viii) the
amount and timing of operating costs and capital expenditures relating to
expansion of the Company's business, operations and infrastructure, (ix) the
timing of Company promotions and sales programs, (xii) the level of
merchandise returns experienced by the Company, (xi) government regulation and
(xii) general economic conditions and economic conditions specific to the
Internet and the music industry.

The Company expects that it will experience seasonality in its business,
reflecting a combination of seasonal fluctuations in Internet usage and
traditional retail seasonality patterns affecting sales of recorded music.
Sales in the traditional retail music industry are significantly higher in the
fourth calendar quarter of each year than in the preceding three quarters.
However, to date, the Company's limited operating history and rapid growth
make it difficult to ascertain the effects of seasonality on its business. The
Company believes that period-to-period comparisons of the Company's historical
results are not necessarily meaningful and should not be relied upon as an
indication of future results.

LIQUIDITY AND CAPITAL RESOURCES

Since inception, the Company has primarily financed its operations through
private sales of capital stock (which, through December 31, 1997, totaled
$10.5 million, including $9.3 million raised in July and August of 1997), the
private sale of $5.8 million of the Series A Notes in November 1997,
internally-generated cash flow, advances from related parties and certain
other short-term loans.

Net cash used in operating activities was $3.2 million and $116,000 for the
years ended December 31, 1997 and 1996, respectively, while net cash provided
by operating activities was $41,000 in the year ended December 31, 1995. For
the year ended December 31, 1997, cash used in operating activities was
attributable to a $10.7 million net loss and increases in prepaid expenses of
$2.4 million, partially offset by an $8.5 million increase in accounts payable
and $1.1 million of depreciation and amortization expense (including
amortization of deferred compensation, deferred financing costs and debt
discount). Net cash used in operating activities for the year ended December
31, 1996 was attributable to a net loss of $1.8 million (however, $1.0 million
of the net loss was attributable to the issuance of common stock in settlement
of a dispute, which had no cash effect on the Company) and increases in
accounts receivable and prepaid expenses, partially offset by increases in
certain current liabilities and non-cash items, including $118,000
representing the deemed fair value of services contributed by the Company's
founders (one of whom served as President and the other developed the
Company's systems architecture and transactions systems).

Net cash used in investing activities totaled $1.7 million, $445,000 and
$136,000 for the years ended December 31, 1997, 1996 and 1995, respectively.
The increases were attributable to purchases of short-term marketable
securities and increased purchases of property and equipment.

Net cash provided by financing activities was $14.8 million, $1.3 million,
and $136,000 for the years ended December 31, 1997, 1996 and 1995,
respectively. Cash flows from financing activities in 1997 increased compared
to 1996 primarily as the result of $10.0 million in proceeds received from the
sale of Series A Preferred Stock and Series B Preferred Stock, net of issuance
costs of approximately $700,000; $5.8 million in proceeds from the sale of
Series A Notes, net of issuance costs of approximately $175,000; and the
proceeds from term loans payable of $219,000. The Company also repaid $200,000
of short-term loans from private investors that were outstanding as of
December 31, 1996. Cash flows from financing activities in 1996 increased
compared to 1995 principally as the result of $1.2 million in proceeds from
the sale of Common Stock in December 1996 to Alan Meltzer, a director of the
Company. See "Certain Relationships and Related Transactions."

On July 15, 1997, the Company sold 254,582 shares of Series A Preferred
Stock to Keystone Ventures IV, L.P. ("Keystone Ventures") for an aggregate
price of $1.3 million. The outstanding shares of Series A

25
<PAGE>

Preferred Stock will automatically convert upon the consummation of this
offering into an aggregate of 381,873 shares of Common Stock. On August 5,
1997, the Company sold 1,543,505 shares of Series B Preferred Stock to Grotech
Partners IV, LP ("Grotech") and 62,000 shares of Series B Preferred Stock to
ABS Employees' Venture Fund Limited Partnership ("ABS") for an aggregate price
of $8.7 million. Each outstanding share of Series B Preferred Stock will
automatically convert upon the consummation of this offering into an aggregate
of 2,408,258 shares of Common Stock. See "Certain Relationships and Related
Transactions."

In November 1997, the Company issued $5.8 million aggregate principal amount
of Series A Notes to a group of investors, including Grotech. The Series A
Notes bear interest at 12% per annum, are due upon the consummation of this
offering and will be repaid from a portion of the net proceeds of this
offering. The Company issued warrants to these investors to purchase 48,550
shares of Common Stock at an exercise price of $11.90 per share. The Series A
Notes have been recorded net of the estimated value ($404,000) associated with
these warrants. This discount is being amortized over the anticipated term of
the Series A Notes.

On August 21, 1997, the Company entered into a one-year Advertising and
Promotion Agreement with Yahoo! (the "Yahoo! Agreement") which automatically
extends for an additional one year period unless CDnow provides Yahoo! with a
notice of termination prior to July 1998. Under the Yahoo! Agreement, (i)
CDnow has exclusivity on music-related pages on the main Yahoo! site,
including the Yahoo! Metro Sites and My Yahoo!, with respect to music banner
advertising opportunities, integrated links and specific keywords, (ii) CDnow
has exclusive advertising rights with respect to any additional music-related
pages created by Yahoo! under such sites and (iii) Yahoo! is required to
deliver a minimum number of page views during the term of the Agreement. The
Company is required to pay Yahoo! minimum fees of $3.9 million during the
first year of the Agreement, of which an aggregate of $900,000 was paid in
1997, and $3.0 million is due in periodic installments between January and
October of 1998. If the Yahoo! Agreement is extended for an additional one
year period, the Company will be required to pay Yahoo! certain additional
fees during such period based on the number of users that access the CDnow Web
site through the links with Yahoo! during the last two months of the initial
term, provided that such fees may not be less than $4.5 million in the
aggregate. In addition, during the term of the Yahoo! Agreement, the Company
is required to pay Yahoo! an additional variable fee based on the number of
users that access the CDnow Web site through the links with Yahoo! in excess
of certain stated minimums. The Company expects to fund its future payment
obligations under the Yahoo! Agreement from its cash and cash equivalents,
including a portion of the net proceeds from this offering. See "Use of
Proceeds" and "Business--Marketing and Promotion."

On September 30, 1997, the Company and Excite entered into a two-year
Linking Agreement (the "Excite Agreement"). Under the Excite Agreement, (i)
the Company has been designated as the exclusive online music retailer within
Excite's WebCrawler service and has obtained the exclusive right to sponsor
targeted links, advertising banners and specific keywords for online retail
music purchases within WebCrawler and (ii) Excite is required to provide the
Company with a minimum number of banners and links on the WebCrawler service
during each year of the Agreement and is limited in its right to advertise
other music retailers on the remainder of the WebCrawler service. The Company
is required to pay Excite $2.0 million and $2.5 million in fees during the
first and second years, respectively, of the Excite Agreement. As of December
31, 1997, the Company had paid Excite $500,000. The Company is required to pay
Excite additional variable fees based on the number of users which access the
CDnow site through links with the WebCrawler service in excess of certain
minimums. The Company has the right to terminate the Excite Agreement and
eliminate any obligation to pay Excite any of the fees scheduled to be paid
during the second year of the term if a certain minimum level of links and
advertising banners have not been delivered by the WebCrawler service within
30 days after the first anniversary of such Agreement. The Company expects to
fund its future payment obligations under the Excite Agreement from its cash
and cash equivalents, including a portion of the net proceeds from this
offering. See "Use of Proceeds" and "Business--Marketing and Promotion."

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On January 5, 1998, the Company entered into a strategic alliance agreement
(the "GeoCities Agreement") with GeoCities pursuant to which the Company has
been designated as the exclusive music retailer and one of four key commerce
partners that will occupy a premier position on certain pages of the GeoCities
Web site. The Company has also committed to purchase national advertising
during the 1998 Grammy Awards and the 1998 American Music Awards. The
Company's aggregate commitment under these arrangements, together with certain
other advertising commitments in 1998, is approximately $3.9 million.

As of December 31, 1997, the Company had $10.7 million of cash and cash
equivalents and short-term marketable securities of $1.0 million. As of that
date, the Company's principal commitments consisted of its obligations to
Yahoo!, Excite, GeoCities and CBS as well as its obligations outstanding under
operating and capital leases. Although the Company has no material commitments
for capital expenditures, it anticipates a substantial increase in its capital
expenditures and lease commitments consistent with anticipated growth in
operations, infrastructure and personnel.

The Company believes that the net proceeds from this Offering, together with
its current cash and cash equivalents, will be sufficient to meet its
anticipated cash needs for working capital and capital expenditures for at
least the next 12 months. However, the Company's capital requirements depend
on several factors, including the rate of market acceptance, the ability to
expand the Company's customer base, the cost of Web site upgrades, the level
of expenditures for sales and marketing, and other factors. The timing and
amount of such capital requirements cannot accurately be predicted. If capital
requirements vary materially from those currently planned, the Company may
require additional financing sooner than anticipated. The Company has no
commitments for any additional financing, and there can be no assurance that
any such commitments can be obtained on favorable terms, if at all. Any
additional equity financing may be dilutive to the Company's shareholders, and
debt financing, if available, may involve restrictive covenants with respect
to dividends, raising future capital and other financial and operational
matters which could restrict its operations or finances. If the Company is
unable to obtain additional financing as needed, the Company may be required
to reduce the scope of its operations or its anticipated expansion, which
could have a material adverse effect on the Company.

At December 31, 1997, the Company had a net operating loss ("NOL")
carryforward of approximately $9.7 million, which begins to expire in 2005.
The utilization of the NOL carryforward will be limited pursuant to the Tax
Reform Act of 1986, due to cumulative changes in ownership in excess of 50%.
See Note 5 to Notes to Financial Statements.

See Note 2 to Notes to Financial Statements for information regarding
recently adopted accounting standards and recently issued accounting
standards.

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BUSINESS

INTRODUCTION

CDnow is the leading online retailer of CDs and other music-related
products. Its early entry into the online music retailing industry has helped
the Company gain a well-recognized brand and a large customer base. The
Company strives to combine the advantages of online commerce with superior
customer focus in order to be the authoritative source for CDs and other
music-related products. The Company's online store, cdnow.com, offers broad
selection, informative content, easy-to-use navigation and search
capabilities, a high level of customer service, competitive pricing and
personalized merchandising and communication. With over 250,000 items, the
Company believes that it provides a selection of readily-available products
that is five to ten times that of a typical music retailer. To assist
customers in making music selections, the CDnow store contains approximately
115,000 product notes, reviews and related articles and 270,000 sound samples.
The CDnow store is open 24 hours a day, seven days a week and offers its
customers convenient and timely product fulfillment, including an overnight
delivery option.

CDnow has grown rapidly since its inception in 1994. Of the 296,000
customers who have made purchases since inception through 1997, 209,000 made
their initial purchases in 1997. Average daily visits to the CDnow store have
grown from approximately 12,000 in January 1996 to approximately 132,000 in
December 1997. The Company's net sales grew to $17.4 million for 1997 compared
to $6.3 million for 1996. Net sales for the first, second, third and fourth
quarters of 1997 were $2.6 million, $3.0 million, $3.9 million and $7.9
million, respectively. The Company has also generated significant customer
loyalty. Despite the Company's rapid acquisition of new customers, repeat
customers accounted for over 50% of net sales in 1997.

INDUSTRY OVERVIEW

The Internet is an increasingly significant global medium for
communications, information and commerce. International Data Corporation
("IDC") estimates that the number of Web users grew to approximately 28
million by the end of 1996 and will grow to approximately 175 million by 2001.
The Company believes that the growth in Internet usage has resulted from a
number of factors, including the large and growing installed base of PCs in
the workplace and home, advances in the performance and speed of PCs and
modems, improvements in network infrastructure, easier and cheaper access to
the Internet and increased awareness of the Internet among businesses and
consumers. Jupiter Communications ("Jupiter") estimates that the number of
online households (households using e-mail, the Internet or a consumer online
service) making purchases will grow from an estimated 15.2 million households
in 1996 to 57.0 million households, representing over 50% of U.S. households,
by the year 2002. IDC estimates that the total value of services and products
purchased over the Web grew from $296 million in 1995 to approximately $2.6
billion in 1996, and will increase to approximately $123 billion by 2000.

The Company believes that a significant opportunity exists for the retailing
of music on the Internet. According to the International Federation of the
Phonographic Industry, worldwide sales of pre-recorded music and music videos
in 1996 were approximately $39.8 billion, of which one-third was in North
America. Online music retailers currently account for a small but growing
portion of total sales. According to Jupiter, sales of pre-recorded music over
the Internet are projected to grow on a worldwide basis from approximately $18
million in 1996 to $1.6 billion in 2002.

A number of characteristics of online music retailing make the sale of pre-
recorded music via the Internet particularly attractive relative to
traditional retail stores. The Internet offers many data management and
multimedia features which enable consumers to listen to sound samples, search
for music by genre, title or artist and access a wealth of information and
events, including reviews, related articles, music history, news and
recommendations. Internet retailers can more easily obtain extensive

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demographic and behavioral data about their customers, providing them with
greater direct marketing opportunities and the ability to offer a more
personalized shopping experience. In addition, Internet retailers can also
offer consumers significantly broader product selection, the convenience of
home shopping and 24-hour-a-day, seven-day-a-week operations, available to any
location, foreign or domestic, that has access to the Internet.

While physical store-based music retailers must make significant investments
in inventory, real estate and personnel for each store location, online
retailers incur a fraction of these costs, generally use centralized
distribution, and have virtually unlimited merchandising space. Traditional
retailers are compelled to limit the amount of inventory they carry at each
store and focus on a smaller selection of faster-selling hit releases. As a
result, the Company believes that a typical music store may carry up to 12,000
SKUs and a megastore may carry up to 50,000 SKUs, compared to the more than
250,000 SKUs carried by the CDnow store. According to Jupiter, approximately
80% of unit sales at traditional retail stores come from approximately 20% of
the available titles. Online retailers can offer consumers a broader range of
titles and information and can also offer products from a wider range of music
labels, including smaller independent labels which account for an increasing
percentage of new titles. According to Soundscan, independent labels accounted
for 21% of the total music market in 1996 versus 12% in 1992. While
independent labels released 66% of new titles in 1996, traditional music
stores often lack the capacity to stock or promote the vast majority of these
titles.

The Company also believes that online retailers will benefit from the
changing demographic profile of music consumers. According to the Recording
Industry Association of America, domestic purchases of recorded music by
persons age 30 and over have increased from approximately 34% of total U.S.
sales in 1986 to approximately 47% of sales, or approximately $5.9 billion, in
1996. The Company believes that the Internet represents a particularly
attractive medium for retailing to customers in this age group as they are
typically less "hits-driven" than younger age groups and are more likely to
purchase a wide variety of titles. These customers generally can afford to buy
more titles at one time, have access to computers and use the Internet, and
have credit cards with which to make electronic payments.

STRATEGY

The Company focuses on promoting its brand and extending its leadership
position through the following key strategies:

Focus on Recorded Music Retailing. CDnow is dedicated to online music
retailing. By focusing on its core competency, the Company is able to offer a
high quality, customer-oriented online music store and build a clearly
delineated brand, which the Company believes will make CDnow the site of
choice for recorded music customers. The Company believes that this focus
enables it to better direct its sales and marketing campaigns, form effective
relationships with Internet content and service providers, and minimize
potential conflicts of interest with alternate distribution channels or
recorded music labels.

Provide Innovative and Easy-to-Use Retail Concept. The Company strives to
make its customer experience informative, efficient and intuitive by
constantly updating and improving its store format and features. The CDnow
store incorporates "point and click" options, supported by technical
enhancements including easy-to-use search capabilities (by artist, album
title, song title or record label), personalized music suggestions, order
tracking and confirmation. The CDnow store promotes music learning and
discovery by enabling visitors to access information on titles, music reviews,
ratings, articles on music topics and approximately 270,000 sound samples.
These features are designed to make shopping at the store entertaining and
informative and encourage purchases and repeat visits. The Company is
dedicated to providing its customers with a comprehensive selection of both
popular and hard-to-find CDs and offers over 250,000 items. The account
registration and ordering instructions contained in the CDnow store are
available in several foreign language versions to facilitate international
sales.

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Expand Customer Base Through Multiple Marketing Channels. The Company seeks
to expand its customer base through multiple marketing channels. The Company
believes that this strategy enables it to reduce reliance on any one source of
customers, maximize brand awareness and lower average customer acquisition
cost.

. Online and Traditional Advertising. The Company promotes its brand
through an aggressive marketing campaign using a combination of online
and traditional marketing. The Company advertises on the sites of major
Internet content and service providers, including Infoseek, Lycos and
CNN Interactive, and targeted music-related sites, such as Billboard. As
part of these arrangements, the Company typically purchases the right to
display its banners and hyperlinks, often in conjunction with specified
search keywords such as "music store." The Company's traditional
advertising effort includes radio advertising, including advertising on
the Howard Stern program, and print advertising in music-related
publications such as Rolling Stone, Spin and Variety. The Company
intends to deploy television advertising and has recently purchased from
CBS national advertising as the exclusive online retailer of recorded
music during the 1998 Grammy Awards. The Company has also purchased
national advertising during the 1998 American Music Awards.

. Strategic Alliances with Major Content and Service Providers. The
Company believes it can enhance its new customer acquisition efforts,
increase purchases by current customers and expand brand recognition
through strategic alliances with major Internet content and service
providers. The Company has recently entered into alliances with Yahoo!,
GeoCities and Excite's WebCrawler service to be the premier online
recorded music retailer on certain of their sites with the exclusive
right to place music banner advertisements and integrated links to the
CDnow store on certain music-related or other specified pages. These
pages will prominently feature the CDnow branded link that allows users
to click through to the CDnow site. The Company has also entered into
marketing arrangements with, among others, ABC News Starwave Partners,
USA TODAY Information Network and will seek to develop relationships
with other major content and service providers. In conjunction with the
Company's television advertising agreement with CBS, the Company has
been designated as the exclusive online music retailer on the soon-to-
be-launched cbsnow Web site and the existing cbs.com Web site, excluding
portions of cbsnow not controlled by CBS.

. Cosmic Credit Program. Through its Cosmic Credit program, CDnow has
arrangements with over 10,000 small Web sites, typically fan sites
devoted to particular musical artists. The Company provides these sites
with embedded hyperlinks through which potential customers can
immediately be connected to the CDnow site. The Company believes that
highly-focused, music-oriented sites, while having less traffic than
major content providers, are likely to have a high percentage of users
that will be attracted to the CDnow store.

. Direct Marketing Techniques. The Company uses direct marketing
techniques to target new and existing customers with communications and
promotions. The Company sends a personalized e-mail newsletter to its
customers that includes purchase recommendations based on demonstrated
customer preferences and prior purchases, as well as more general
information concerning new releases and Company promotions. The Internet
allows rapid and effective experimentation and analysis, instant user
feedback and efficient personalization of the store for each customer,
all of which CDnow seeks to incorporate in its merchandising.

Acquire Customers Efficiently. The Company seeks to target its marketing
expenditures towards sources that most efficiently attract new customers. The
Company utilizes its three years of online retailing experience and its
database of approximately 300,000 customers to better evaluate and predict the
effectiveness of potential advertising opportunities and strategic
relationships. To enhance the possibility that its banners and other links
will be effective, the Company works closely with Internet content and service
providers with respect to the placement of banners and other links as well as
the surrounding content. As a result, the Company believes that it can acquire
new customers and retain existing customers on a more cost-effective basis.

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Maximize Customer Retention. The Company seeks to maximize customer
retention through its emphasis on customer service and personalized
communications. The success of this strategy is evidenced by CDnow's high
level of repeat customers, which accounted for over 50% of net sales during
the year ended December 31, 1997. The Company strives to accommodate its
customers by providing 24-hour-a-day, seven-day-a-week operations and rapid
order fullfillment. Products are typically shipped within two business days
after an order is placed and confirmation is provided within minutes via e-
mail. Customers can make separate inquiries through e-mail or telephone access
during extended business hours. The Company strives to ensure prompt response
to customer inquiries, which are generally answered within 24 hours of
receipt. The Company also maintains ongoing customer contact through its
customized e-mail newsletter, The CDnow Update.

THE CDNOW ONLINE RETAIL STORE

The Company strives to make the CDnow store informative and authoritative,
allowing customers to easily learn about, discover and purchase CDs and other
music-related products. The store is designed to be intuitive and easy to use
and to enable the ordering process to be completed with a minimum of customer
effort. Customers enter the CDnow store through its Web site, cdnow.com, and
in addition to ordering music products, can conduct targeted searches, browse
among top sellers and other featured titles, read reviews, listen to music
samples, register for personalized communications, participate in promotions
and check order status. New users may access a page specifically designed to
provide a quick understanding of the site and its many features.

Merchandising. CDnow believes that its ability to offer a substantially
larger selection than traditional retail stores is a significant competitive
advantage. The Company currently offers over 200,000 CDs, 40,000 movies and
10,000 music videos as well as t-shirts, music books and CD-ROMs. To encourage
purchases, the Company features various promotions on a rotating basis
throughout the store. The Company also launched its Gift Center in November
1997 and an Album Advisor in January 1998, both featuring an online
recommendation service. The Company adjusts pricing strategies and tactics as
necessary to maintain competitiveness and generally prices all recent releases
and popular titles aggressively. The Company seeks to encourage the purchase
of multiple titles by providing more favorable shipping terms for larger
orders.

Searching. Through the Company's "FastFind" search engine, customers can
quickly and easily navigate the store to find CDs or other products of
interest. Customers can search for products based on artist, album title, song
title, record label, musical genre or release date for new releases. By
clicking on the "Info" buttons, a visitor can browse among CDnow's database of
reviews, cover art, sound samples and album notes. Through the Company's
"Lexicon" feature, customers can browse alphabetical lists based on artists,
types of products, record labels and album cover art.

Content and Music Discovery. The Company believes that effective use of
content encourages purchases by customers who may be browsing the site without
a specific title in mind. The Company's Web site contains approximately
270,000 sound samples, extensive information with regard to titles, reviews,
ratings, articles on music topics and other information. To help customers
browse and discover CDs, CDnow recently launched six music spaces organized by
genre: Rock/Pop, Jazz/Blues, Urban/Electronic, Country/Folk, World/New Age and
Classical. The main page of each space features links to genre-specific lists,
articles, reviews and contests. Within each space, customers can browse sale
items, new releases, advance orders and charts, read exclusive CDnow reviews,
listen to sound samples and purchase CDs recommended by the Company.

Purchasing. Once a CD has been selected, customers simply click on the price
to add products (including, advance orders of yet-to-be released products) to
their virtual shopping carts. Customers can add and remove products from their
shopping carts as they browse, prior to making a final purchase. The shopping
cart page displays each item that has been placed in the cart, including
title, price and any

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applicable discount. To execute orders, customers click on the "Place Order"
button and are prompted to select shipping and payment methods online or by e-
mail, facsimile or telephone. Customers can also add products which they may
wish to purchase on future visits to their "lunch box," a special section of
the shopping cart where items may be stored over multiple visits.

Payment. In paying for orders, customers may use credit cards, personal
checks or money orders. For convenience, the Company enables customers to
store credit card information on the Company's secure server, thereby avoiding
the need to re-enter this information when making future purchases. Customers
are offered a variety of shipping options, including overnight delivery. The
Company automatically confirms each order by e-mail within minutes after the
order is placed and subsequently confirms shipment of each order by e-mail.
The Company offers a money back returns policy.

Distribution and Fulfillment. All of the Company's inventory is owned and
held by outside vendors and shipped directly from these vendors to customers.
The breadth of the inventory maintained by these vendors provides CDnow with
the ability to maintain high order fill rates. CDnow updates its site daily
with inventory information received from its vendors, which enables customers
to check the availability of products before ordering. The Company
electronically transmits orders to its outside vendors at least once daily.
Orders are shipped by these vendors using a CDnow label and invoice, in most
cases within a day after an order is placed with the Company. A customer's
credit card is charged once an order is shipped.

Multilingual Capabilities. The Company believes that international markets
will continue to represent a significant portion of the Company's sales since
many products offered by CDnow are not otherwise available in these markets.
International music sales in 1996 were estimated to be approximately twice
that of the U.S. Approximately 29% of the Company's sales for the year ended
December 31, 1997 were generated from international markets. The Company has
introduced Spanish, French, German, Portuguese, Japanese and Korean language
versions of its Web site that contain translation of account registration and
ordering instructions, and supports its international sales efforts with
customer service representatives fluent in these languages. The Company
intends to introduce additional foreign language versions in the near future.

MARKETING AND PROMOTION

CDnow's marketing and promotion strategy is designed to broaden awareness of
the CDnow brand, increase customer traffic to the Company's Web site and
encourage new and repeat purchases. The Company utilizes multiple channels to
market and promote its brand, including online and traditional advertising,
strategic alliances, the Company's Cosmic Credit Program, and direct
marketing. The Company believes that the use of multiple marketing channels
reduces reliance on any one source of customers, maximizes brand awareness and
lowers average customer acquisition cost.

Online and Traditional Advertising

The Company promotes its brand through an aggressive marketing campaign
using a combination of online and traditional advertising. The Company
advertises on the sites of major Internet content and service providers,
including Infoseek, Lycos and CNN Interactive, and targeted music-related
sites, such as Billboard. As part of these arrangements, the Company typically
purchases banner advertisements, often in conjunction with specified search
keywords or on contextually appropriate pages, that allow consumers to
immediately click through to the CDnow site. The significant flexibility of
online advertising allows the Company to quickly adjust its advertising plans
in response to seasonal and promotional activities.

CDnow believes that traditional advertising is a key ingredient in building
brand recognition and promoting the benefits of online retail shopping.
Traditional advertising can be an effective means of

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promoting widespread brand awareness and attracting traditional retail
consumers to the Company's Website, including consumers with little or no
history of online purchases. The Company's traditional advertising effort
includes radio advertising, such as advertising on the Howard Stern program,
and print advertising in music-related publications such as Rolling Stone,
Spin and Variety. The Company intends to deploy television advertising and has
purchased from CBS national advertising as the exclusive online retailer of
recorded music during the 1998 Grammy Awards. The Company has also purchased
national advertising during the 1998 American Music Awards. The Company
conducts an active public relations campaign and regularly participates in
trade shows and conferences relating to online commerce.

Strategic Alliances

The Company believes that the Web sites of major Internet service and
content providers can be a source of a significant number of new customers.
These sites have a high volume of user traffic, and the Company believes that
the utilization of carefully targeted links and other advertising on the sites
can be very effective in attracting potential customers. The Company has
recently entered into agreements with Yahoo! and Excite's WebCrawler, two
widely used Internet search engines, and also has arrangements with several
other content and service providers.

Yahoo! The Company and Yahoo!, the leading Internet search engine, have
entered into the Yahoo! Agreement, under which CDnow has been granted
exclusivity on selected pages within music-related pages on the main Yahoo!
site, including the Yahoo! Metro Sites and My Yahoo (collectively, the
"Yahoo! Service"). In particular, Yahoo! has agreed to place integrated
links to the CDnow store and banner advertisements on certain pages
generated from the Yahoo! Service. The Yahoo! Agreement requires Yahoo! to
deliver a minimum number of page views during each quarter of the term of
the Agreement and limits the ability of other music retailers to place
links or advertise on these pages. In addition, CDnow was granted a right-
of-first-refusal regarding any promotional opportunity developed by Yahoo!
that is similar in scope and nature to that provided by the Yahoo!
Agreement. The initial term of the Yahoo! Agreement expires in October
1998, subject to an automatic one year renewal unless otherwise terminated
by the Company. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Liquidity and Capital Resources."

WebCrawler. The Company and Excite have entered into the Excite Agreement,
under which the Company has been designated as the exclusive online music
retailer within Excite's WebCrawler service and has been granted the
exclusive right to sponsor targeted links, advertising banners and specific
keywords for online retail music purchases within WebCrawler. The Excite
Agreement also requires Excite to deliver a minimum number of links and
banners on the WebCrawler service during each year of the Agreement and
limits the ability of Excite to include advertising for other music
retailers on the WebCrawler service. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Liquidity and
Capital Resources."

GeoCities. The Company and GeoCities, Inc. have entered into the GeoCities
Agreement, under which the Company has been designated as the exclusive
retailer of music and video products and one of the four key commerce
partners that will occupy a premier position on certain portions of the
GeoCities Web site. The GeoCities Agreement requires GeoCities to deliver a
minimum number of impressions per month, with each impression consisting of
a user's viewing of a page on the GeoCities site containing a link to the
Company's Web site. The initial term of the GeoCities Agreement expires 12
months after GeoCities implements links to the Company's Web site, which
expiration date is expected to be in January 1999, subject to the Company's
option to renew the GeoCities agreement for a 12 month renewal term. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Liquidity and Capital Resources."

Other Alliances. The Company has established relationships with other major
Internet content and service providers, including ABC News Starwave
Partners, USA TODAY Information Network ("USA TODAY") and CBS Broadcasting,
Inc ("CBS"), designed to attract additional users to, and increase brand
awareness of, the Company's Web site. The Company and ABC News Starwave
Partners are

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parties to an agreement dated September 22, 1997, under which ABC News
Starwave Partners has created links to the Company's Web site from certain
music-related pages of its Mr. Showbiz, CelebSite and Wall of Sound Web
sites and is required to provide the Company with a minimum number of
banner advertisements per month on these Web sites. The Company and USA
TODAY are parties to an agreement dated April 8, 1997, under which USA
TODAY places links to the Company's Web site from the Market Place segment
of its Web site and shares in a portion of the revenues realized by the
Company as a result of these links. The Company and CBS are parties to an
agreement dated January 7, 1998, under which, in addition to purchasing
commercial advertising time during the 1998 Grammy Awards, the Company has
been designated as the exclusive online music retailer on the soon-to-be-
launched cbsnow Web site and the existing cbs.com Web site, excluding
portions of cbsnow not controlled by CBS.

Cosmic Credit Program

Through its Cosmic Credit Program, CDnow has entered into arrangements with
over 10,000 small Web sites, typically fan sites devoted to particular music
artists. The Company provides these sites with embedded hyperlinks through
which potential customers can immediately be connected to the CDnow site. The
Company pays Cosmic Credit participants commissions in store credit or cash
based upon the dollar amount of purchases made by persons using the link. The
Company believes that highly focused, music-oriented sites, while having less
traffic than major content providers, are likely to have a high percentage of
users that will be attracted to the CDnow store. Cosmic Credit participants
sign up online at a special Web page, cdnow.com/credit, and are listed inside
the CDnow store to assist the Company's customers in finding these sites. The
Company rewards the best Cosmic Credit sites with special incentives.

Direct Marketing

The Company uses direct marketing techniques to target new and existing
customers with communications and promotions. The Company sends a personalized
e-mail newsletter to its customers, The CDnow Update, that includes purchase
recommendations based on demonstrated customer preferences and prior
purchases. The newsletter also includes more general information concerning
new releases and Company promotions. The Internet allows rapid and effective
experimentation and analysis, instant user feedback and efficient
personalization of the store for each customer, all of which CDnow seeks to
incorporate in its marketing and merchandising activities.

CUSTOMER SERVICE

The Company believes that a high level of customer service and support is
critical to retaining and expanding its user base. CDnow customer service
representatives are available from midnight to 10:00 PM Eastern Time on
weekdays and 10:00 AM to 6:00 PM Eastern Time on weekends to provide
assistance via e-mail, phone or fax. Inquiries are generally answered within
24 hours. The Company currently has 29 customer service representatives,
including representatives fluent in eight foreign languages. These customer
service representatives handle questions about orders, assist customers in
finding CDs and other music-related products, and register customer's credit
card information over the telephone. The customer service representatives are
a valuable source of feedback regarding user satisfaction. CDnow uses BizRate,
an online market research company, to compile customer comments on their
experiences. BizRate provides monthly reports that enable CDnow to make
improvements in response to its customers' comments. The CDnow store also
contains a customer service page that outlines store policies and provides
answers to frequently asked questions.

DISTRIBUTION AND FULFILLMENT

The Company does not carry any inventory and relies exclusively on third
party vendors for distribution and fulfillment. The Company believes that this
distribution strategy allows it to offer

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extensive selection while avoiding the high fixed costs and capital
requirements associated with owning and warehousing product inventory and the
significant operational effort associated with same-day shipment. CDnow has
experienced a return rate of approximately one percent of all merchandise
sold.

The Company primarily uses Valley Record Distributors to ship CDs, cassettes
and vinyl records. CDnow transmits data to Valley through a secure network to
ensure customer security and data integrity. Valley picks, packs and ships
customer orders and charges CDnow for merchandise, shipping and handling. In
most cases, products are shipped within a day after an order is placed with
the Company. Customer billing is performed by CDnow through a third-party
credit card processor. To date, Valley has satisfied the Company's
requirements on a timely basis. For the year ended December 31, 1997, payments
to Valley accounted for approximately 78% of the Company's cost of sales. The
Company's agreement with Valley expires in June 1999, although Valley may
terminate its existing agreement with the Company upon 30 days' written
notice, if Valley discontinues providing fulfillment services to all of its
online service customers.

TECHNOLOGY

CDnow has developed technologies and implemented systems to support
distributed, reliable and scalable online retailing in a secure and easy-to-
use format. Using a combination of proprietary solutions and commercially
available, licensed technologies, the Company has deployed systems for online
content dissemination, online transaction processing, customer service, market
analysis and electronic data interchange.

Multimedia and User Database. CDnow has developed a database management
system to index, retrieve and manipulate product information, content, product
catalog, orders and transactions, and customer information. This system allows
for rapid searching, sorting, viewing and distribution of a large volume of
content including audio samples, music reviews, track lists, cover art and
photos. The Company uses Oracle 7.3 as the technology for database management.
In December 1997, the Company deployed a data warehouse that enables it to
access detailed transaction and customer interaction data and perform
sophisticated market analysis and predictive modeling.

Store Architecture. The Company's hardware and software systems are based
upon a distributed transaction processing model that allows applications to be
distributed among multiple parallel servers. Many of the software components,
and the pages of the Website, are developed using a proprietary technology
that extends HTML with product, transaction, retail, and advanced programming
constructs. This technology results in the separation of the page look and
feel from the individual data elements and their associated database lookups
thus reducing software updates for Website changes and minimizing the
engineering required to maintain a growing amount of items and content.
CDnow's technology also enables Web sites with different formats to integrate
CDnow store elements such as search, discography (artist) and product (album)
pages.

Interfaces. CDnow has developed technologies and tools for managing
interfaces with Internet service and content providers. A switchboard system
and linking interface are made available to businesses with which the Company
has developed strategic alliances and to Cosmic Credit sites. These allow the
linking of external Web sites, banners, and promotions to items and functions
contained in the CDnow store. Proprietary tools are used by the Company's
Client Relations department to manage the strategic alliances and Cosmic
Credit relationships in an efficient and scalable manner. Similar systems and
tools have been developed by CDnow for its Customer Service department. The
ability to manage customer accounts and orders enables CDnow's Customer
Service department to scale effectively and communicate efficiently, thereby
responding to most inquiries within 24 hours. These systems automate many
routine communications and allow customers to better manage their accounts and
orders.

35
<PAGE>

Fault Tolerance and Scalability. CDnow's hardware servers, storage systems,
Internet connections and networks allow its online systems to operate
continuously and enable it to maintain a 24-hour-a-day, seven-day-a-week
retail store. The Company runs its Oracle databases and Web Servers on a
series of Sun Enterprise 3000 and 4000 servers with fault tolerant
characteristics including "hot-swappable" components. The Company maintains
dedicated DS-3 connections to the Internet lines provided by multiple Internet
service providers. This technology, combined with the architecture of the
systems, allows the Company to scale by adding new components or servers while
maintaining performance and cost effectiveness. Both proprietary and
commercially available tools are used to monitor and manage these systems with
minimal operator participation.

Security. The Company employs a proprietary firewall integrated into the
architecture of its system to keep its Internet connections secure. The
Company uses the Netscape SSL Commerce Server for secure electronic
transactions over the Internet and uses proprietary EDI interfaces and private
networks to ensure the security of customer order information and credit card
transactions shared with its vendors and credit card processor.

Advanced Technologies. The Company continually evaluates emerging
technologies and new developments in many areas including electronic commerce,
database management, and networking. The Company is currently evaluating
technologies that allow for the digital distribution of music recordings.
Since April 1997, the Company has been using collaborative filtering to make
personal music recommendations in its customer newsletter, The CDnow Update.
In November 1997, as part of the Company's Gift Center, online recommendation
technology was made available to all CDnow shoppers, and this application was
expanded with the introduction of the Album Advisor feature in January 1998.

COMPETITION

The online commerce market is new, rapidly evolving and intensely
competitive, and the Company expects that competition will further intensify
in the future. Barriers to entry are minimal, and current and new competitors
can launch new sites at a relatively low cost. According to Jupiter, there
were approximately 100 online music retailers as of June 1997. In addition,
the broader retail music industry is intensely competitive. The Company
currently competes with a variety of companies, including (i) online vendors
of music, music videos and other related products, (ii) online vendors of
movies, books and other related products, (iii) online service providers which
offer music products directly or in cooperation with other retailers, (iv)
traditional retailers of music products, including specialty music retailers,
(v) other retailers that offer music products, including mass merchandisers,
superstores and consumer electronic stores; and (vi) non-store retailers such
as music clubs. Many of these traditional retailers also support dedicated Web
sites which compete directly with the Company.

36
<PAGE>

Web browsers promote the Company's competitors and could charge the Company a
substantial fee for inclusion.

INTELLECTUAL PROPERTY

The Company regards its trademarks, trade secrets and similar intellectual
property as valuable to its business, and relies on trademark and copyright
law, trade secret protection and confidentiality and/or license agreements
with its employees, partners and others to protect its proprietary rights.
There can be no assurance that the steps taken by the Company will be adequate
to prevent misappropriation or infringement of its intellectual property.

EMPLOYEES

As of December 31, 1997, the Company had 95 full-time and 16 part-time
employees. The Company also employs independent contractors and other
temporary employees in its editorial, operations and administrative functions.
None of the Company's employees is represented by a labor union, and the
Company considers its employee relations to be good. Competition for qualified
personnel in the Company's industry is intense, particularly among software
development and other technical staff. The Company believes that its future
success will depend in part on its continued ability to attract, hire and
retain qualified personnel. See "Risk Factors--Risk of Inability to Manage
Potential Growth" and "--Dependence on Key Personnel; Need for Additional
Personnel."

FACILITIES

The Company's executive offices are located in, and substantially all of its
operating activities are conducted from, leased office space located in
Jenkintown, Pennsylvania. The Company has leased this facility, which contains
approximately 17,000 square feet, under a lease that expires in September
2002. The Company believes that additional space may be required as its
business expands and believes that it will be able to obtain suitable space as
needed. The Company does not own any real estate.

LEGAL PROCEEDINGS

From time-to-time, the Company may be involved in litigation relating to
claims arising out of its ordinary course of business. The Company believes
that there are no claims or actions pending or threatened against the Company,
the ultimate disposition of which would have a materially adverse effect on
the Company.

37
<PAGE>

MANAGEMENT

OFFICERS AND DIRECTORS

The executive officers and directors of the Company are as follows:

<TABLE>
<CAPTION>
NAME AGE POSITION
---- --- --------
<S> <C> <C>
Jason Olim.............. 28 President, Chief Executive Officer and Chairman of the Board of Directors
Matthew Olim............ 28 Technical Lead, Secretary, Treasurer and Director
Rod Parker.............. 54 Senior Vice President of Product Management and Marketing
Joel Sussman............ 49 Vice President and Chief Financial Officer
Michael Krupit.......... 34 Vice President of Technology
Robert Saltzman......... 46 Vice President of Strategic Business Development
Alan Meltzer(2)......... 53 Director
Patrick Kerins(1)(2).... 42 Director
John Regan(1)(2)........ 38 Director
</TABLE>
- ---------------------
(1) Member of the Audit Committee of the Company's Board of Directors.
(2) Member of the Compensation Committee of the Company's Board of Directors.

Jason Olim co-founded the Company in February 1994 and has been its
President since the Company's inception and its Chief Executive Officer since
November 1997. Previously, Mr. Olim was employed in the Professional Services
group of Soft-Switch, Inc. where he designed and built software systems for
routing mail and documents for domestic and international clients. Mr. Olim
has a Bachelor of Arts degree in Computer Science from Brown University.

Matthew Olim co-founded the Company in February 1994 and has been
responsible for the development of the Company's system architecture and
transactions systems. Mr. Olim has a Bachelor of Arts degree in Astrophysics
from Columbia University.

Rod Parker has been the Senior Vice President of Product Management and
Marketing since June 1997. Mr. Parker served as the Vice President of
Interactive Merchandising at Time Warner Cable Programming from September 1995
to June 1997; General Manager of Catalog I, a joint venture between Time
Warner and Spiegel, Inc., from October 1993 to September 1995; and in various
other positions with Spiegel, Inc. (including Vice President, New Media and
Vice President, Creative Division) from April 1987 to September 1995. Mr.
Parker spent more than twenty years in the advertising industry, including
service as a Senior Vice President in account management with Ogilvy and
Mather.

Joel Sussman has been the Vice President and Chief Financial Officer since
September 1997. From June 1995 to September 1997, Mr. Sussman was an
independent financial management consultant and served as Interim Chief
Financial Officer of a number of companies, including CDnow. From July 1994 to
June 1995, Mr. Sussman was Vice President, Finance and Administration, and
Chief Financial Officer of Personnel Data Systems, Inc. From January 1991 to
December 1994, Mr. Sussman was Vice President of Finance and Chief Financial
Officer of The Devereux Foundation. Prior to January 1991, Mr. Sussman served
for 10 years as Treasurer of Decision Data, Inc. and six years in commercial
banking and leasing. Mr. Sussman is a Certified Public Accountant and
Certified Management Accountant and holds a Masters degree in Business
Administration from the Wharton School of the University of Pennsylvania.

Michael Krupit has been the Vice President of Technology since October 1997
and was the Director of Technology from April 1997 to October 1997. Mr. Krupit
was the Director of Technology and Product

38
<PAGE>

Development at Infonautics, Inc., a provider of searching, viewing, and
retrieval applications for the Internet, from February 1994 to March 1997. Mr.
Krupit was the Development Manager at Verity, Inc., a provider of online
information and archive services, from October 1989 to November 1993.

Robert Saltzman has been the Vice President of Strategic Business
Development since December 1997. Mr. Saltzman served as the Director of
Business Development at Bell Atlantic Network Integration from November 1995
to December of 1997. From 1987 to 1995, Mr. Saltzman held various sales and
marketing positions with Unisys Corporation.

Alan Meltzer has been a director since December 1996. Mr. Meltzer has been
the Chairman and Chief Executive Officer of Wind-up Entertainment, Inc., a New
York based record label distributed through Bertelsman Music Group. Mr.
Meltzer was the founder of CD One Stop, Inc., a distributor of CDs, and was
its Chief Executive Officer from April 1986 to August 1993 and was the
President of Alliance Entertainment, a distributor and the successor to CD One
Stop, Inc., from September 1993 to September 1994. Mr. Meltzer was elected to
the Board of Directors in December 1996 pursuant to an agreement among certain
shareholders of the Company that terminates upon the consummation of this
Offering.

Patrick Kerins has been a director since August 1997. Mr. Kerins is a
Managing Director of Grotech Capital Group IV, LLC ("Grotech Capital"). From
1987 to March 1997, he served in the Investment Banking Division of Alex.
Brown & Sons Incorporated, most recently as a Managing Director beginning in
January 1994.

John Regan has been a director since July 1997. Since February 1995, Mr.
Regan has been a Vice President of Keystone Venture IV Management Company,
L.P. which is the general partner of Keystone Venture IV, L.P. From 1989 to
February 1995, he was an associate and then general partner of Apex Management
Partnership, a venture capital partnership.

The Company's Amended and Restated Bylaws divide the Board of Directors into
three classes, and each director will serve for a staggered three year term.
Messrs. Kerins and Regan will initially serve as the Class I directors until
the annual meeting of shareholders held in 1998, or until their respective
successors have been elected and qualified. Matthew Olim will initially serve
as the Class II director until the annual meeting of shareholders held in
1999, or until his successor has been elected and qualified. Alan Meltzer and
Jason Olim will initially serve as the Class III directors until the annual
meeting of shareholders held in 2000, or until their respective successors
have been elected and qualified. At each meeting of shareholders, a class of
directors will be elected for a three-year term to succeed the directors of
the same class whose terms are then expiring. To the extent there is an
increase in the number of directors, additional directorships resulting
therefrom will be distributed among the three classes so that, as nearly as
possible, each class will consist of an equal number of directors.

Executive officers of the Company are elected by, and serve at the pleasure
of, the Board of Directors. Jason Olim and Matthew Olim are brothers.

DIRECTOR COMPENSATION

The Company will reimburse its directors for out-of-pocket expenses incurred
in connection with their rendering of services as directors. The Company
currently does not intend to pay cash fees to directors for attendance at
meetings. Directors who are not currently receiving compensation as officers
or employees of the Company will be eligible to receive options under the 1996
Equity Compensation Plan.

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

Since August 1997, recommendations concerning the aggregate compensation of
the Company's employees were made to the Compensation Committee by the
Company's President. The Compensation

39
<PAGE>

Committee was formed in August 1997. The members of the Compensation Committee
are Alan Meltzer, Patrick Kerins and John Regan. Mr. Kerins is a Managing
Director of Grotech Capital, the general partner of Grotech Capital Partners
IV, L.P., a significant shareholder of the Company. See "Certain
Transactions." Prior to August 1997, decisions concerning the compensation of
the Company's employees, including its executive officers, were made by the
Company's Board of Directors, which included Jason Olim and Matthew Olim.

EXECUTIVE COMPENSATION

The following table provides information concerning compensation paid or
accrued in the year ended December 31, 1997 with respect to the Company's
President and Chief Executive Officer and the two other most highly
compensated executive officers of the Company.

SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION
----------------
ANNUAL COMPENSATION SHARES OF COMMON
NAME AND --------------------- STOCK UNDERLYING
PRINCIPAL POSITION YEAR SALARY($) BONUS($) OPTIONS(#)
- ------------------ ---- ---------- --------- ----------------
<S> <C> <C> <C> <C>
Jason Olim.......................... 1997 $ 95,630 $ -- --
President, Chief Executive Officer
and Chairman of the Board of
Directors
Matthew Olim........................ 1997 95,630 -- --
Technical Lead, Secretary and
Treasurer
Rod Parker.......................... 1997 122,098 55,000 120,000
Senior Vice President of Product
Management and Marketing
</TABLE>

The following table sets forth certain information regarding stock options
granted by the Company during 1997 to Rod Parker. Neither Jason Olim nor
Matthew Olim have been granted any options by the Company.

OPTION GRANTS IN LAST FISCAL YEAR

<TABLE>
<CAPTION>
INDIVIDUAL GRANTS
--------------------------------------------
POTENTIAL
REALIZABLE
VALUE AT ASSUMED
PERCENT OF ANNUAL RATES OF
NUMBER OF TOTAL STOCK PRICE
SHARES OPTIONS APPRECIATION FOR
UNDERLYING GRANTED TO EXERCISE OPTION TERM(1)
OPTIONS EMPLOYEES IN PRICE PER EXPIRATION ---------------------
NAME GRANTED FISCAL YEAR SHARE DATE 5% 10%
- ---- ---------- ------------ --------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C>
Rod Parker.. 120,000 17.6% $1.33 5/29/2007 $2,577,000 $4,198,000
</TABLE>
- ---------------------
(1) Based on the initial public offering price per share.

The following table sets forth information regarding stock options held as
of December 31, 1997 by Rod Parker. Mr. Parker did not exercise any stock
options in 1997.

FISCAL YEAR END OPTION VALUES

<TABLE>
<CAPTION>
VALUE OF UNEXERCISED IN-
NUMBER OF SECURITIES UNDERLYING THE-
UNEXERCISED OPTIONS AT MONEY OPTIONS AT
DECEMBER 31, 1997 DECEMBER 31, 1997(1)
----------------------------------- -------------------------
NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ---- -------------- ----------------- ----------- -------------
<S> <C> <C> <C> <C>
Rod Parker.... -- 120,000 -- $1,520,000
</TABLE>
- ---------------------
(1) There was no public trading market for the Common Stock as of December 31,
1997. These values have been calculated based on the difference between
the initial public offering price and the applicable exercise price.

40
<PAGE>

EQUITY COMPENSATION PLAN

The Company has adopted the Equity Compensation Plan pursuant to which it
has awarded and expects to award in the future stock options to its employees,
officers, non-employee directors and certain independent contractors and
consultants.

The Equity Compensation Plan provides for the issuance to employees, non-
employee directors and eligible independent contractors and consultants of up
to 1,600,000 shares of Common Stock pursuant to the grant of incentive stock
options ("ISOs"), non-qualified stock options ("NQSOs"), Stock Appreciation
Rights ("SARs") and restricted stock. The Equity Compensation Plan is
administered by a Committee of directors appointed by the Board of Directors
(the "Committee") that currently consists of Messrs. Meltzer, Kerins and
Regan. Upon the completion of this Offering, the Committee will consist of two
directors that are not employees of the Company. Subject to the provisions of
the Equity Compensation Plan, the Committee has the authority to determine to
whom stock options will be granted and the terms of any such grant, including
the number of shares subject to, the exercise price and the vesting provisions
of, the award. Subject to the terms of the Equity Compensation Plan, the
Committee may also amend the terms of any outstanding award.

As of December 31, 1997, options to purchase a total of 721,899 shares of
Common Stock at a weighted average exercise price per share of $2.99 were
outstanding. Of these options, options to purchase 42,000 shares of Common
Stock were fully vested and exercisable as of December 31, 1997. As of
December 31, 1997, the Company had an additional 878,086 shares of Common
Stock available for future grants under the Equity Compensation Plan.

The option price per share of Common Stock under the Equity Compensation
Plan is determined by the Committee at the time of each grant, provided,
however, that the option price per share for any ISO may not be less than the
fair market value of the Common Stock at the time of the grant. In addition,
if a person who owns 10 percent or more of the Company's Common Stock (a "10%
Shareholder") is granted an ISO, the exercise price for such ISO may not be
less than 110% of the fair market value on the date of grant. The term of each
stock option may not exceed ten years; in the case of a 10% shareholder, the
term may not exceed five years. Payment for the exercise of an option may be
made by cash, check or other instrument as the Committee may accept,
including, in the discretion of the Committee, unrestricted Common Stock of
the Company. The Committee may also allow an option holder to surrender all or
a portion of a stock option and receive a number of shares of Common Stock
with a value equal to the excess of the fair market value over the option
price of the surrendered stock option or portion of the stock option.

41
<PAGE>

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

SERIES A CONVERTIBLE NOTES

In November 1997, the Company issued $5.8 million aggregate principal amount
of Series A Notes to a group of investors, including $1.0 million to Grotech
and $127,500 to the ABS Employees' Venture Fund Limited Partnership. The
Series A Notes, which will be repaid upon the consummation of this offering,
bear interest at the rate of 12% per annum. In addition, the Company issued
warrants to these investors to purchase an aggregate of 48,529 shares of
Common Stock at an exercise price of $11.90 per share, including a warrant
issued to Grotech exercisable for 8,403 shares of Common Stock.

SERIES A PREFERRED STOCK

Pursuant to the terms of the Stock Purchase Agreement dated July 15, 1997 by
and among the Company, Keystone Ventures IV, L.P. ("Keystone Ventures"), Jason
Olim and Matthew Olim (the "Stock Purchase Agreement"), Keystone Ventures
purchased 254,582 shares of Series A Convertible Preferred Stock, no par value
(the "Series A Preferred Stock"), of the Company at a purchase price of $4.91
per share. The outstanding shares of Series A Preferred Stock will
automatically convert upon the consummation of this Offering into an aggregate
of 381,873 shares of Common Stock. John Regan is a Vice President of the
general partner of Keystone Ventures and was elected to the Company's Board of
Directors pursuant to an agreement among certain shareholders of the Company
that terminates upon the consummation of this Offering. Keystone Ventures
received certain registration rights in connection with this transaction. See
"Shares Eligible for Future Sale--Registration Rights."

SERIES B PREFERRED STOCK

Pursuant to the terms of the Stock Purchase Agreement, as amended by the
Amendment No. 1 to the Stock Purchase Agreement dated as of August 5, 1997 by
and among the Company, Keystone Ventures, Jason Olim, Matthew Olim, Grotech
Partners IV, LP ("Grotech IV") and ABS Employees' Venture Fund Limited
Partnership ("ABS"), (i) Grotech purchased 1,543,505 shares of Series B
Convertible Preferred Stock, no par value (the "Series B Preferred Stock"), of
the Company at a purchase price of $5.45 per share, (ii) ABS purchased 62,000
shares of Series B Preferred Stock at a purchase price of $5.45 per share,
(iii) the Company issued to Grotech Capital a warrant to purchase up to 18,349
shares of Series B Preferred Stock at an exercise price of $5.45 per share,
and (iv) the Company issued to Alex. Brown & Sons Incorporated, a predecessor-
in-interest to BT Alex. Brown Incorporated ("BT Alex. Brown"), a warrant to
purchase up to 103,211 shares of Series B Preferred Stock at an exercise price
of $5.45 per share in partial consideration of its services as the placement
agent for the offering of the Series A and Series B Preferred Stock. The
outstanding shares of Series B Preferred Stock will automatically convert upon
the consummation of this Offering into an aggregate of 2,408,258 shares of
Common Stock and these warrants will automatically become exercisable for an
aggregate of 182,340 shares Common Stock upon the consummation of this
Offering. Patrick Kerins is a Managing Director of Grotech Capital, the
general partner of Grotech IV, and was elected to the Company's Board of
Directors pursuant to an agreement among certain shareholders of the Company
that terminates upon the consummation of this Offering. Grotech IV, Grotech
Capital, ABS and BT Alex. Brown received certain registration rights in
connection with this transaction. See "Shares Eligible for Future Sale."

STOCK PURCHASE AND SHAREHOLDERS' AGREEMENT

In May 1995, Milo Productions, Inc. ("Milo"), a corporation owned by Jason
and Matthew Olim, entered into a general partnership with MBL Entertainment,
Inc. ("MBL") to form a partnership company known as "Music Now." In December
1995, MBL, Alan Meltzer and Jason and Matthew Olim entered into non-binding
discussions for the purpose of creating a new company ("NewCo") which would
merge with Music Now. These discussions contemplated, among other things, that
Alan Meltzer would make a

42
<PAGE>

significant cash investment in, and Jason and Matthew Olim would contribute
all of the outstanding capital stock of both Milo and CDnow to, NewCo. The
parties abandoned these discussions and, in August 1996, MBL and Alan Meltzer
instituted a legal action against CDnow, Milo and Jason and Matthew Olim (the
"Legal Action"). On December 6, 1996, the Company entered into a Stock
Purchase and Shareholders' Agreement (the "Stock Purchase and Shareholders
Agreement") with Milo, Jason Olim, Matthew Olim, Alan Meltzer, Jeffrey
McClusky, Anthony Lucenti, William Brennan and MBL pursuant to which (i) Mr.
Meltzer purchased, for an aggregate purchase price of $1,200,000, 921,834
shares of Common Stock and a warrant presently exercisable for 871,710 shares
of Common Stock, and (ii) an aggregate of 882,606 shares of Common Stock were
issued to Messrs. McClusky, Lucenti and Brennan, the sole shareholders of MBL,
in exchange for substantially all of the assets and business of MBL. A primary
inducement for these transactions was the mutual release by all parties to the
Stock Purchase Agreement relating to (i) the Legal Action and (ii) all other
prior agreements and relationships among such parties. At the time of the
settlement, MBL and Music Now were inactive and had no assets or liabilities.
In addition, pursuant to the terms of the Stock Purchase and Shareholders
Agreement, each of Jason and Matthew Olim is generally restricted from
competing with the Company's business for a three-year period ending on the
termination of his relationship (either as an employee, director or
consultant) with the Company. Mr. Meltzer has delivered written notice to the
Company that he intends to exercise his warrant upon the consummation of this
offering and will receive 871,710 shares of Common Stock for an aggregate
exercise price of $1.0 million.

SHAREHOLDER ADVANCES

The Company had indebtedness due to Dave Olim, the father of Jason and
Matthew Olim, in the amount of $81,923, at December 31, 1995. On August 16,
1996, in consideration of the cancellation of this debt, the Company issued
41,244 shares of the Company's Common Stock to Dave Olim.

NOTES PAYABLE

On December 31, 1995, the Company issued a note for $100,000 to Alan
Meltzer, a director of the Company. The proceeds from this loan were used for
working capital purposes. All remaining amounts due under the note, which bore
interest at the rate of 10%, were repaid on December 31, 1996.

From November 16, 1996 through January 31, 1997, the Company received short-
term loans aggregating $190,000 from Saltzman Music Partners and Nathan
Schwartz and $60,000 from Robert Saltzman, an Executive Officer of the Company
and a partner in Saltzman Music Partners. The proceeds from these loans, which
bore interest at the rate of 6%, were used for working capital purposes. On
May 15, 1997, the Company repaid $110,000 of the principal amount due under
these loans. The remaining principal balance was repaid on July 16, 1997. As
additional consideration for these loans, these private investors received
warrants to purchase an aggregate of 136,362 shares of Common Stock (32,727
with respect to Robert Saltzman) at a price of $1.83 per share. The warrants
expire on May 16, 1998 with respect to 59,997 shares of Common Stock and July
16, 1998 with respect to 76,365 shares of Common Stock.

In 1997, the Company obtained three term loans at rates ranging from 8 to 9%
from a bank for an aggregate amount of $219,000. The proceeds from these loans
were used to purchase equipment and are secured by a lien on such equipment.
These loans are guaranteed by Jason Olim and Matthew Olim.

43
<PAGE>

PRINCIPAL AND SELLING SHAREHOLDERS

The following table sets forth certain information regarding beneficial
ownership of the Common Stock as of the date of this Prospectus and as
adjusted to reflect the sale of the shares offered hereby by (i) each person
known by the Company to own beneficially more than 5% of the outstanding
shares of Common Stock, (ii) each director of the Company, (iii) each
executive officer of the Company and (iv) all directors and executive officers
of the Company as a group. Unless otherwise indicated below, to the knowledge
of the Company, all persons listed below have sole voting and investment power
with respect to their shares of Common Stock, except to the extent authority
is shared by spouses under applicable law.

<TABLE>
<CAPTION>
BENEFICIAL OWNERSHIP BENEFICIAL OWNERSHIP
PRIOR TO OFFERING AFTER OFFERING#
----------------------- -----------------------
NAME OF BENEFICIAL OWNER SHARES PERCENT SHARES PERCENT
- ------------------------ ------------ ---------- ------------ ----------
<S> <C> <C> <C> <C>
EXECUTIVE OFFICERS AND
DIRECTORS
Jason Olim(1).................. 3,000,000 26.2% 3,000,000 20.0%
Matthew Olim(1)................ 3,000,000 26.2 3,000,000 20.0
Alan Meltzer(2)................ 1,722,147 15.1 1,722,147 11.5
Robert Saltzman(3)............. 32,727 * 32,727 *
Joel Sussman(4)................ 3,000 * 3,000 *
Patrick Kerins(5).............. 1,569 * 1,569 *
Michael Krupit(6).............. -- -- -- --
Rod Parker(7).................. -- -- -- --
John Regan(8).................. -- -- -- --
All executive officers and
directors as a group
(9 persons)(9)................ 7,759,443 67.6 7,759,443 51.5
FIVE PERCENT HOLDERS
Grotech Partners IV, L.P.(10).. 2,315,258 20.2 2,315,258 15.4
POTENTIAL SELLING STOCKHOLDERS
Jeffrey McCluskey.............. 323,622 2.8 323,622 2.2
Anthony Lucenti................ 279,492 2.4 279,492 1.9
William Brennan................ 279,492 2.4 279,492 1.9
Keystone Ventures IV, L.P. .... 381,873 3.3 381,873 2.5
</TABLE>
- ---------------------

# Assumes no exercise of the Underwriters' over-allotment option. In the
event such option is exercised in full, the selling stockholders will sell
135,000 shares allocated among them as follows: Jason Olim-35,100 shares;
Matthew Olim-35,100 shares; Jeffrey McCluskey-16,200 shares; Anthony
Lucent-16,200 shares; William Brennan-16,200 shares; and Alan Meltzer-
16,200 shares.

* Less than one percent.

(1) Excludes 41,244 shares owned by Dave Olim, the father of Jason and
Matthew Olim. Jason and Matthew Olim each disclaim beneficial ownership
of these shares. The address of Jason and Matthew Olim is 610 Old York
Road, Suite 300, Jenkintown, Pennsylvania 19046.

(2) Includes 800,313 shares of Common Stock issuable upon the exercise of a
presently exercisable warrant Mr. Meltzer has notified the Company that
he intends to exercise this warrant upon the consummation of this
Offering. The address of Mr. Meltzer is 944 Park Avenue, New York, New
York 10028.

(3) Represents 32,727 shares of Common Stock obtainable upon conversion of a
presently exercisable warrant held by a trust of which Mr. Saltzman is
the beneficiary. Excludes 75,000 shares of Common Stock that are not
exercisable with the next 60 days under a stock option granted under the
Equity Compensation Plan.

(4) Represents shares of Common Stock obtainable upon the exercise of a stock
option granted under the Equity Compensation Plan. Excludes 75,000 shares
which are not exercisable within the next 60 days under a stock option
granted under a stock option granted under such Plan.

(5) Represents 1,569 shares of Common Stock obtainable upon the conversion of
a presently exercisable warrant held by Patrick Kerins. Excludes
2,315,258 shares of Common Stock held by Grotech Partners IV, L.P.
Patrick Kerins is a managing director of Grotech Partners IV, L.P. Mr.
Kerins disclaims beneficial ownership of any shares owned by Grotech
Partners IV L.P.

(6) Excludes 30,000 shares of Common Stock that are not exercisable within
the next 60 days under a stock option granted under the Equity
Compensation Plan.

(7) Represents shares of Common Stock obtainable upon the exercise of a stock
option granted under the Equity Compensation Plan. Excludes 120,000
shares of Common Stock that are not exercisable within the next 60 days
under a stock option granted under such Plan.

(8) Excludes 381,873 shares of Common Stock held by Keystone Ventures IV,
L.P. ("Keystone"). John Regan is a Vice President of the general partner
of Keystone and disclaims beneficial ownership of any shares owned by
Keystone.

(9) Includes an aggregate of 37,296 shares of Common Stock obtainable upon
the exercise of presently exercisable options and warrants.

(10) The address of Grotech Partners IV, L.P. is 9600 Deerco Road, Timonium,
Maryland 21093. Grotech Partners IV, L.P. disclaims beneficial ownership
of any shares beneficially owned by Patrick Kerins.

44
<PAGE>

DESCRIPTION OF CAPITAL STOCK

The authorized capital stock of the Company consists of 50,000,000 shares of
Common Stock, no par value (the "Common Stock"), and 20,000,000 shares of
Preferred Stock, no par value (the "Preferred Stock"). Immediately after the
sale of the 3,600,000 shares of Common Stock offered hereby, there will be
15,036,128 shares of Common Stock outstanding and no shares of Preferred Stock
outstanding. The following summary is qualified in its entirety by reference
to the Company's Amended and Restated Articles of Incorporation (the "Articles
of Incorporation"), which is included as an exhibit to the Registration
Statement of which this Prospectus is a part.

COMMON STOCK

Holders of Common Stock are entitled to one vote for each share held of
record on all matters submitted to a vote of shareholders and do not have
cumulative voting rights. The election of directors is determined by a
plurality of the votes cast and, except as otherwise required by law, all
other matters are determined by a majority of the votes cast. The holders of
Common Stock are entitled to receive ratably such dividends, if any, as may be
declared by the Board of Directors out of funds legally available therefor,
subject to any preferential dividend rights of outstanding Preferred Stock.
Upon the liquidation, dissolution or winding up of the Company, subject to any
preferential liquidation rights of any outstanding shares of Preferred Stock,
the holders of Common Stock are entitled to receive ratably the net assets of
the Company available after the payment of all debts and other liabilities.
The holders of Common Stock have no preemptive, subscription, redemption,
sinking fund or conversion rights. The rights and preferences of holders of
Common Stock will be subject to the rights of any series of Preferred Stock
which the Company may issue in the future.

PREFERRED STOCK

The Company, by resolution of the Board of Directors and without any further
vote or action by the shareholders, has the authority, subject to certain
limitations prescribed by law, to issue from time to time up to an aggregate
of 20,000,000 shares of Preferred Stock in one or more classes or series and
to determine the designation and the number of shares of any class or series
as well as the voting rights, preferences, limitations and special rights, if
any, of the shares of any such class or series, including the dividend rights,
conversion rights, voting rights, redemption rights, and liquidation
preferences. The issuance of Preferred Stock may have the effect of delaying,
deferring or preventing a change of control of the Company.

Prior to the Offering, 254,582 shares of Series A Preferred Stock and
1,605,505 shares of Series B Preferred Stock were outstanding. Upon the
consummation of this Offering, all outstanding shares of Series A Preferred
Stock and Series B Preferred Stock will be converted into 381,873 and
2,408,258 shares of Common Stock, respectively. No such shares of Series A
Preferred Stock or shares of Series B Preferred Stock will be available for
reissuance.

PENNSYLVANIA ANTI-TAKEOVER LAWS

The Pennsylvania Business Corporation Law of 1988, as amended (the "BCL"),
contains provisions applicable to publicly held Pennsylvania corporations that
may be deemed to have an anti-takeover effect. The Company has specifically
opted out of all but one of these provisions. The following is a description
of the provision of the BCL that remains applicable to the Company.

Under Section 1715 of the BCL, directors of the corporation are not required
to regard the interests of the shareholders as being dominant or controlling
in considering the best interests of the corporation. The directors may
consider, to the extent they deem appropriate, such factors as the effects of
any action upon any group affected by such action (including shareholders,
employees, suppliers, customers and

45
<PAGE>

creditors of the corporation and upon communities in which offices or other
establishments of the corporation are located); the short term and long term
interests of the corporation (including benefits that may accrue to the
corporation from its long term plans and the possibility that these interests
may be best served by the continued independence of the corporation); the
resources, intent and conduct of any person seeking to acquire control of the
corporation; and all other pertinent factors. Section 1715 of the BCL further
provides that any act of the board of directors, a committee of the board or an
individual director relating to or affecting an acquisition or potential or
proposed acquisition of control to which a majority of disinterested directors
have assented will be presumed to satisfy the standard of care set forth in the
BCL, unless it is proven by clear and convincing evidence that the
disinterested directors did not consent to such act in good faith after
reasonable investigation. As a result of this and the other provisions of
Section 1715 of the BCL, directors are provided with broad discretion with
respect to actions that may be taken in response to acquisitions or proposed
acquisitions of corporate control.

Section 1715 of the BCL may discourage open market purchases of Common Stock
or a non-negotiated tender or exchange offer for the Common Stock and,
accordingly, may be considered disadvantageous by a shareholder who would
desire to participate in any such transaction. In addition, Section 1715 of the
BCL may have a depressive effect on the price of the Common Stock.

46
<PAGE>

SHARES ELIGIBLE FOR FUTURE SALE

The market price of the Common Stock will be adversely affected by the sale
of substantial amounts of the Common Stock in the public market following this
Offering. Upon completion of this Offering, the Company will have 15,036,128
shares of Common Stock outstanding. Of these shares, the Common Stock sold in
this Offering to persons other than affiliates of the Company, will be freely
tradeable without restriction or further registration under the Act. The
remaining 11,436,128 shares of Common Stock (the "Restricted Shares") were sold
by the Company in reliance on exemptions from the registration requirements of
the Securities Act and are "restricted securities" as defined in Rule 144 and
may not be sold in the absence of registration under the Securities Act unless
an exemption is available, including an exemption afforded by Rule 144 or Rule
701 under the Securities Act. Subject to the contractual restrictions described
below, approximately 7,845,684 Restricted Shares will be eligible for sale
ninety days after the date of this Prospectus, subject to certain restrictions
imposed by Rule 144. Certain restrictions apply to any shares of Common Stock
purchased in this Offering by affiliates of the Company, which may be sold
subject to volume limitations and certain other conditions of Rule 144. In
addition, 721,914 shares subject to options issued under the Equity
Compensation Plan will be eligible for sale pursuant to Rule 701 under the
Securities Act.

It is anticipated that a Registration Statement on Form S-8 covering the
Common Stock that may be issued pursuant to the options granted under the
Equity Compensation Plan will be filed shortly after the consummation of this
Offering. The shares of Common Stock issued pursuant to the Form S-8
Registration Statement generally may be resold in the public market without
restriction or limitation, except in the case of affiliates of the Company, who
generally may only resell such shares in accordance with the provisions of Rule
144, other than the holding period requirement.

The Company and its officers, directors and certain shareholders who
collectively beneficially own 11,398,884 shares of Common Stock, have agreed
with the underwriters that they will not sell or otherwise dispose of any
shares of Common Stock (excluding shares offered by this Prospectus or shares
purchased in the open market) for a period of 180 days from the date of this
Prospectus without the prior written consent of BT Alex. Brown Incorporated.

Keystone Ventures, Grotech IV, ABS, BT Alex. Brown, Alan Meltzer, Jeffrey
McClusky, Anthony Lucenti and William Brennan (collectively, the "Registration
Rights Holders"), who collectively beneficially own 5,577,224 shares of Common
Stock, have been granted by the Company certain demand and incidental
registration rights. Under these registration rights, the Registration Rights
Holders may require, on not more than two occasions at any time after six
months following the date of this Offering, that the Company use its best
efforts to file a registration statement covering the public sale of Common
Stock having an aggregate public offering price of at least $10,000,000;
provided, however, that the Company will have the right to delay such a demand
registration under certain circumstances for a period not in excess of 120 days
each in any 12-month period. The Registration Rights Holders will also have
piggyback registration rights, subject to underwriter cut back, and the
Registration Rights Holders, as separate classes, will have the right to one
demand registration every 12 months on Form S-3, provided at least 30% of the
securities within such class join in the demand, at least $500,000 worth of
securities are to be sold in the registration and the Company will have the
right to delay the registration for up to 120 days if, in the good faith
judgment of the Company, the registration would be seriously detrimental to the
Company and its shareholders. The registration rights expire six years after
the date of this Offering, and no Registration Rights Holder can exercise any
registration rights for an intended sale that can be effectuated in compliance
with Rule 144 under the Securities Act.

47
<PAGE>

UNDERWRITING

Subject to the terms and conditions set forth in the underwriting agreement
(the "Underwriting Agreement"), the Company has agreed to sell to the
underwriters named below (the "Underwriters"), and each of the Underwriters,
for whom BT Alex. Brown Incorporated and NationsBanc Montgomery Securities LLC
are acting as representatives (the "Representatives"), has severally agreed to
purchase from the Company, the aggregate number of shares of Common Stock set
forth opposite its name below.

<TABLE>
<CAPTION>
UNDERWRITERS NUMBER OF SHARES
------------ ----------------
<S> <C>
BT Alex. Brown Incorporated..............................
NationsBanc Montgomery Securities LLC....................
---
Total..................................................
===
</TABLE>

In the Underwriting Agreement, the Underwriters have agreed, subject to the
terms and conditions set forth therein, to purchase all of the shares of Common
Stock offered by this Prospectus (other than those subject to the Over-
allotment Option described below) if any such shares are purchased. In the
event of a default by the Underwriters, the Underwriting Agreement provides
that, in certain circumstances, the purchase commitments of non-defaulting
Underwriters may be increased or the Underwriting Agreement may be terminated.

The Company and the Selling Shareholders have granted to the Underwriters an
option, exercisable by the Representatives during the 30-day period after the
date of this Prospectus, to purchase up to an aggregate of 540,000 shares of
Common Stock at the same price per share as the initial shares of Common Stock
to be purchased by the Underwriters. The Representative may exercise such
option only to cover over-allotments in the sale of shares of Common Stock. To
the extent that the Representatives exercise such option, the Underwriters will
have a firm commitment, subject to certain conditions, to purchase the same
proportion of such additional shares of Common Stock as the number of shares of
Common Stock to be purchased and offered by such Underwriters in the above
table bears to the total number of shares in the above table.

The Company has been advised by the Representatives that the Underwriters
propose initially to offer the shares of Common Stock to the public at the
offering price set forth on the cover page of this Prospectus, and through the
Representatives to certain dealers at such price less a concession not in
excess of per share. The Underwriters may allow, and such dealers may
reallow, a concession not in excess of per share to certain other dealers.
After the Offering, the public offering price and other selling terms may be
changed.

The Company and its officers, directors and certain shareholders have agreed
that, except for shares offered by this Prospectus, the underlying shares sold
by the Company upon the exercise of options or warrants or shares purchased in
the open market, they will not offer, sell, contract to sell, or otherwise
dispose of, directly or indirectly, any shares of Common Stock, or any
interests therein, or any securities convertible into, or exchangeable for,
shares of Common Stock, or rights to acquire the same, for a

48
<PAGE>

period of 180 days from the date of this Prospectus without the prior written
consent of the Representatives, except pursuant to the Underwriting Agreement.
Such consent may be given without any public notice.

The Company and the Selling Shareholders have agreed to indemnify the
Underwriters against certain liabilities, including liabilities under the
Securities Act, or to contribute to payments that the Underwriters may be
required to make in respect thereof.

Prior to the Offering, there has been no public market for the Common Stock.
Consequently, the initial public offering price of the Common Stock was
determined after negotiation among the Company and the Representatives. Among
the factors considered in such negotiations were prevailing market conditions,
the results of the operations of the Company in recent periods, the market
capitalization and stages of development of other companies which the Company
and the Representatives believed to be comparable to the Company, estimates of
the business potential of the Company, the present state of the Company's
development and other factors deemed relevant.

In connection with the Offering, certain persons participating in the
Offering may engage in transactions that stabilize, maintain or otherwise
affect the price of the Common Stock. Specifically, the Representatives may bid
for and purchase Common Stock in the open market to stabilize the price of the
Common Stock. The Underwriters may also over-allot the Offering, creating a
syndicate short position, and may bid for and purchase Common Stock in the open
market to cover the syndicate short position. The Representatives may also
impose a penalty bid pursuant to which the Representatives may reclaim from any
Underwriter or dealer participating in the Offering the selling concession on
shares sold by them and purchased by the Representatives in stabilizing or
short covering transactions. In addition, the Underwriters may bid for and
purchase the Common Stock above market levels that may otherwise prevail. The
Underwriters are not required to engage in these activities, and may end these
activities at any time.

The Underwriters have reserved for sale, at the initial public offering
price, up to 252,000 shares of the Common Stock offered hereby for employees
and directors of the Company and certain other individuals who have expressed
an interest in purchasing such shares of Common Stock in the Offering. The
number of shares available for sale to the general public will be reduced to
the extent such persons purchase such reserved shares. Any reserved shares not
so purchased will be offered by the Underwriters to the general public on the
same basis as other shares offered hereby.

The Underwriters have informed the Company that they do not intend to confirm
sales of Common Stock offered hereby for accounts over which they exercise
discretionary authority.

On August 5, 1997 the Company issued to a predecessor-in-interest to BT Alex.
Brown a warrant (the "Warrant") to purchase 103,211 shares of Series B
Preferred Stock at an exercise price of $5.45 per share in partial
consideration of its services as the placement agent for the offering by the
Company of the Series A Preferred Stock and Series B Preferred Stock. On the
same date the ABS Employees' Venture Fund Limited Partnership ("ABS") purchased
62,000 shares of Series B Preferred Stock (the "ABS Shares") at a purchase
price of $5.45 per share. (As a result of the 1.5-for-1 stock split to be
effected prior to the consummation of the offering, the Warrant will instead
become exercisable for 154,817 shares of Common Stock and the ABS Shares will
be convertible into 93,000 shares of Common Stock.) On November 26, 1997, ABS
was issued $127,500 of the Series A Notes with associated warrants ("Associated
Warrants") to purchase 1,071 shares of Common Stock at an exercise price of
$11.90 per share. Subject to final determination by NASD Regulation Inc., the
Warrant, the Associated Warrants and the ABS Shares may be deemed to be
underwriter's compensation for BT Alex. Brown.

49
<PAGE>

LEGAL MATTERS

The validity of the Common Stock offered hereby will be passed upon for the
Company by Morgan, Lewis & Bockius LLP, Philadelphia, Pennsylvania. Certain
legal matters in connection with the Offering are being passed upon for the
Underwriters by Schnader Harrison Segal & Lewis LLP, Philadelphia,
Pennsylvania.

EXPERTS

The financial statements of the Company, as of December 31, 1996 and 1997
and for the years ended December 31, 1995, 1996 and 1997, included in this
Prospectus have been audited by Arthur Andersen LLP, independent public
accountants, as indicated in their report with respect thereto, and are
included herein in reliance upon the authority of such firm as experts in
giving said report.

ADDITIONAL INFORMATION

The Company has filed with the Commission a Registration Statement on Form
S-1 under the Securities Act (the "Registration Statement") with respect to
the Common Stock offered hereby. This Prospectus does not contain all of the
information set forth in the Registration Statement and the exhibits and
schedules thereto. For further information with respect to the Company and the
Common Stock offered hereby, reference is hereby made to the Registration
Statement and to the exhibits and schedules filed therewith. Statements
contained in this Prospectus as to the contents of any agreement or other
document are not necessarily complete, and in each instance, reference is made
to the copy of such agreement or document filed as an exhibit to the
Registration Statement, each such statement being qualified in all respects by
such reference. A copy of the Registration Statement may be inspected without
charge at the Commission's principal office in Washington, D.C. at 450 Fifth
Street, N.W., Washington, D.C. 20549, and at the Commissions's Regional
Offices at Seven World Trade Center, Suite 1300, New York, New York 10048, and
Northwest Atrium Center, 500 West Madison Street, Suite 1400, Chicago,
Illinois 60661, and copies may be obtained at prescribed rates from the Public
Reference Section of the Commission at 450 Fifth Street, N.W., Washington,
D.C. 20549. In addition, the Registration Statement and certain other filings
made with the Commission through its Electronic Data Gathering Analysis and
Retrieval ("EDGAR") system are publicly available through the Company's Web
site located at http://www.sec.gov. The Registration Statement has been filed
with the Commission through EDGAR.

50
<PAGE>

CDNOW, INC.

INDEX TO FINANCIAL STATEMENTS

<TABLE>
<S> <C>
Report of Independent Public Accountants.................................. F-2
Balance Sheets............................................................ F-3
Statements of Operations.................................................. F-4
Statements of Redeemable Convertible Preferred Stock and Shareholders'
Equity (Deficit)......................................................... F-5
Statements of Cash Flows.................................................. F-6
Notes to Financial Statements............................................. F-7
</TABLE>
<PAGE>

After the stock split discussed in Note 2 to the Financial Statements is
effected, we will be in a position to render the following report.

/s/ ARTHUR ANDERSEN LLP

Philadelphia, Pa.,

January 16, 1998

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To CDnow, Inc.:

We have audited the accompanying balance sheets of CDnow, Inc. (a
Pennsylvania Corporation) as of December 31, 1996 and 1997, and the related
statements of operations, redeemable convertible preferred stock and
shareholders' equity (deficit) and cash flows for each of the three years in
the period ended December 31, 1997. These financial statements are the
responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.

In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of CDnow, Inc. as of December
31, 1996 and 1997, and the results of its operations and its cash flows for
each of the three years in the period ended December 31, 1997, in conformity
with generally accepted accounting principles.

Philadelphia, Pa.,

January 14, 1998 (except for the
stock split discussed in Note 2,
as to which the date is February
, 1998)

F-2
<PAGE>

CDNOW, INC.

BALANCE SHEETS

<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------
1996 1997
---------- -----------
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents............................ $ 775,865 $10,686,001
Short-term investments............................... 245,641 1,003,045
Accounts receivable, net of reserve of $12,000 and
$77,000............................................. 130,437 324,411
Prepaid expenses and other........................... 49,821 2,457,958
---------- -----------
Total current assets................................ 1,201,764 14,471,415
PROPERTY AND EQUIPMENT, net........................... 362,035 1,884,296
OTHER ASSETS.......................................... 11,660 92,714
---------- -----------
$1,575,459 $16,448,425
========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES:
Notes payable........................................ $ 200,000 $ 5,575,288
Current portion of term loans payable................ -- 54,091
Current portion of capitalized lease obligations..... 35,942 307,471
Accounts payable..................................... 435,682 8,981,430
Accrued expenses..................................... 129,317 579,413
Deferred revenues.................................... 166,107 188,466
Advances due to related parties...................... 3,261 3,261
---------- -----------
Total current liabilities........................... 970,309 15,689,420
---------- -----------
TERM LOANS PAYABLE.................................... -- 136,293
---------- -----------
CAPITALIZED LEASE OBLIGATIONS......................... 91,133 825,851
---------- -----------
DEFERRED RENT LIABILITY............................... -- 56,717
---------- -----------
REDEEMABLE SERIES A AND B CONVERTIBLE PREFERRED STOCK
(liquidation value of $10,328,219)................... -- 9,492,594
---------- -----------
COMMITMENTS AND CONTINGENCIES (Note 10)
SHAREHOLDERS' EQUITY (DEFICIT):
Preferred stock, no par value, 20,000,000 shares
authorized, 254,582 Redeemable Series A Convertible
shares and 1,605,505 Redeemable Series B Convertible
shares issued and outstanding at December 31, 1997.. -- --
Common stock, no par value, 50,000,000 shares
authorized, 7,845,684 shares issued and outstanding
at December 31, 1996 and 1997....................... 579,549 579,549
Additional paid-in capital........................... -- 1,325,817
Deferred compensation................................ -- (434,776)
Accumulated deficit.................................. (65,532) (11,223,040)
---------- -----------
Total shareholders' equity (deficit)................ 514,017 (9,752,450)
---------- -----------
$1,575,459 $16,448,425
========== ===========
</TABLE>

The accompanying notes are an integral part of these statements.

F-3
<PAGE>

CDNOW, INC.

STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------------
1995 1996 1997
---------- ----------- ------------
<S> <C> <C> <C>
NET SALES............................... $2,176,474 $ 6,300,294 $ 17,372,795
COST OF SALES........................... 1,844,612 5,363,989 14,541,765
---------- ----------- ------------
Gross profit.......................... 331,862 936,305 2,831,030
---------- ----------- ------------
OPERATING EXPENSES:
Operating and development.............. 149,982 523,080 2,179,726
Sales and marketing.................... 200,972 621,454 9,242,179
General and administrative............. 180,573 563,593 1,986,218
Dispute settlement (Note 7)............ -- 1,024,030 --
---------- ----------- ------------
531,527 2,732,157 13,408,123
---------- ----------- ------------
Operating loss........................ (199,665) (1,795,852) (10,577,093)
INTEREST INCOME......................... -- -- 201,650
INTEREST EXPENSE........................ (1,248) (14,556) (371,962)
---------- ----------- ------------
NET LOSS................................ (200,913) (1,810,408) (10,747,405)
ACCRETION OF PREFERRED STOCK TO
REDEMPTION VALUE....................... -- -- (410,103)
---------- ----------- ------------
NET LOSS APPLICABLE TO COMMON
SHAREHOLDERS........................... $ (200,913) $(1,810,408) $(11,157,508)
========== =========== ============
PRO FORMA NET LOSS PER COMMON SHARE
(unaudited)............................ $ (0.91)
============
PRO FORMA WEIGHTED AVERAGE NUMBER OF
COMMON AND COMMON EQUIVALENT SHARES
(unaudited)............................ 11,765,287
============
</TABLE>

The accompanying notes are an integral part of these statements.

F-4
<PAGE>

CDNOW, INC.

STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND
SHAREHOLDERS' EQUITY (DEFICIT)

<TABLE>
<CAPTION>
SHAREHOLDERS' EQUITY (DEFICIT)
-------------------------------------------------------------------------
REDEEMABLE
CONVERTIBLE COMMON STOCK ADDITIONAL
PREFERRED --------------------- PAID-IN DEFERRED ACCUMULATED
STOCK SHARES AMOUNT CAPITAL COMPENSATION DEFICIT TOTAL
----------- --------- ----------- ---------- ------------ ------------ -----------
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE, DECEMBER 31,
1994................... $ -- -- $ -- $ 40,000 $ -- $ (58,449) $ (18,449)
Issuance of common
stock to founders..... -- 6,000,000 -- -- -- -- --
Services contributed by
the founders (Note
9).................... -- -- -- 120,000 -- -- 120,000
Net loss............... -- -- -- -- -- (200,913) (200,913)
---------- --------- ----------- ---------- --------- ------------ -----------
BALANCE, DECEMBER 31,
1995................... -- 6,000,000 -- 160,000 -- (259,362) (99,362)
Sale of common stock
and warrants.......... -- 921,834 1,069,250 130,750 -- -- 1,200,000
Issuance of common
stock in settlement of
a dispute (Note 7).... -- 882,606 1,024,030 -- -- -- 1,024,030
Issuance of common
stock to repay
advances due to a
related party......... -- 41,244 81,923 -- -- -- 81,923
Services contributed by
the founders (Note
9).................... -- -- -- 117,834 -- -- 117,834
Termination of S
Corporation status.... -- -- (1,595,654) (408,584) -- 2,004,238 --
Net loss............... -- -- -- -- -- (1,810,408) (1,810,408)
---------- --------- ----------- ---------- --------- ------------ -----------
BALANCE, DECEMBER 31,
1996................... -- 7,845,684 579,549 -- -- (65,532) 514,017
Sale of Redeemable
Series A and B
Convertible Preferred
Stock, net of expenses
and value of warrants
issued................ 9,082,491 -- -- 170,000 -- -- 170,000
Value of warrants
issued with Series A
Convertible Notes..... -- -- -- 404,425 -- -- 404,425
Grant of common stock
options below deemed
fair value for
accounting purposes... -- -- -- 751,392 (751,392) -- --
Amortization of
deferred
compensation.......... -- -- -- -- 316,616 -- 316,616
Accretion of preferred
stock to redemption
value................. 410,103 -- -- -- -- (410,103) (410,103)
Net loss............... -- -- -- -- -- (10,747,405) (10,747,405)
---------- --------- ----------- ---------- --------- ------------ -----------
BALANCE, DECEMBER 31,
1997................... $9,492,594 7,845,684 $ 579,549 $1,325,817 $(434,776) $(11,223,040) $(9,752,450)
========== ========= =========== ========== ========= ============ ===========
</TABLE>

The accompanying notes are an integral part of these statements.

F-5
<PAGE>

CDNOW, INC.

STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------------
1995 1996 1997
--------- ----------- ------------
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net loss................................ $(200,913) $(1,810,408) $(10,747,405)
Adjustments to reconcile net loss to net
cash provided by (used in)
operating activities--
Depreciation and amortization.......... 32,999 105,439 1,066,815
Provision for doubtful accounts........ -- 12,000 65,000
Common stock issued in settlement of a
dispute............................... -- 1,024,030 --
Services contributed by the founders... 120,000 117,834 --
Increase in operating assets and
liabilities--
Accounts receivable................... (56,127) (86,310) (258,974)
Prepaid expenses and other............ (26,994) (34,487) (2,401,794)
Accounts payable...................... 109,386 326,296 8,545,748
Accrued expenses...................... 58,124 68,139 450,096
Deferred revenue...................... 4,952 161,155 22,359
Deferred rent liability............... -- -- 56,717
--------- ----------- ------------
Net cash provided by (used in)
operating activities................ 41,427 (116,312) (3,201,438)
--------- ----------- ------------
INVESTING ACTIVITIES:
Purchases of short-term investments..... -- (245,641) (757,404)
Purchases of property and equipment..... (135,777) (198,985) (912,560)
--------- ----------- ------------
Net cash used in investing
activities.......................... (135,777) (444,626) (1,669,964)
--------- ----------- ------------
FINANCING ACTIVITIES:
Borrowings on term loans payable........ -- -- 218,563
Payments on term loans payable.......... -- -- (28,179)
Borrowings on notes payable............. 100,000 200,000 --
Payments on notes payable............... -- (100,000) (200,000)
Proceeds from sale of common stock and
warrants............................... -- 1,200,000 --
Proceeds from issuance of Series A Notes
and warrants........................... -- -- 5,602,706
Proceeds from sale of preferred stock... -- -- 9,252,491
Proceeds from advances due to related
parties................................ 37,683 6,341 --
Payments on capitalized lease
obligations............................ (1,529) (13,350) (64,043)
--------- ----------- ------------
Net cash provided by financing
activities.......................... 136,154 1,292,991 14,781,538
--------- ----------- ------------
INCREASE IN CASH AND CASH EQUIVALENTS.... 41,804 732,053 9,910,136
CASH AND CASH EQUIVALENTS, BEGINNING
OF PERIOD............................... 2,008 43,812 775,865
--------- ----------- ------------
CASH AND CASH EQUIVALENTS, END
OF PERIOD............................... $ 43,812 $ 775,865 $ 10,686,001
========= =========== ============
</TABLE>

The accompanying notes are an integral part of these statements.

F-6
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS

1. THE COMPANY:

CDnow, Inc. (the "Company") is an online retailer of compact discs ("CDs")
and other music-related products. The Company strives to combine the advantage
of online commerce with superior customer focus in order to be the
authoritative source of CDs and other music-related products. The Company
contracts with outside warehouses for fulfillment services to deliver products
to customers and, therefore, the Company maintains no inventories.

Since inception (February 12, 1994), the Company has incurred significant
losses, and as of December 31, 1997 had accumulated losses of $12,817,175. For
the year ended December 31, 1997, the Company's net loss was $10,747,405. The
Company intends to invest heavily in marketing and promotion, Web site
development and technology, and development of its administration
organization. As a result, the Company believes that it will incur substantial
operating losses for the foreseeable future, and that the rate at which such
losses will be incurred will increase significantly from current levels.
Because the Company has relatively low product gross margins, achieving
profitability given planned investment levels depends upon the Company's
ability to generate and sustain substantially increased revenue levels. There
can be no assurance that the Company will be able to generate sufficient
revenues to achieve or sustain profitability in the future. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations" in
the Prospectus.

In order to make the investments necessary to expand its business and to
meet its cash flow requirements, the Company plans to raise capital through an
initial public offering of its common stock (the "Offering"). If successfully
completed, the net proceeds from the Offering, together with other available
resources, will be sufficient to fund the Company's operations for at least
the next twelve months after the Offering. If capital requirements vary
materially from those currently planned, the Company may require additional
financing sooner than anticipated.

Based on the variable nature of a significant portion of the Company's
expenditures, the cash balance at December 31, 1997, additional credit that
may be secured from key vendors and management's belief that additional debt
and equity financing can be raised, the Company believes that it has the
ability to continue its business through December 31, 1998.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

Management's Use of Estimates

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.

Pro Forma Net Loss Per Common Share (unaudited)

Pro forma net loss per share was calculated by dividing the net loss by the
weighted average number of common shares outstanding for 1997 adjusted for the
dilutive effect of common stock equivalents, which consist of stock options,
using the treasury stock method. Pursuant to the requirements of the
Securities and Exchange Commission, common stock issued by the Company during
the twelve months immediately preceding the Offering, plus the number of
common equivalent shares which became issuable during the same period pursuant
to the grant of common stock options, have been included in the calculation of
the shares used in computing pro forma net loss per share as if they were
outstanding

F-7
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS--(CONTINUED)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED)

for all of 1997 (using the treasury stock method and the estimated initial
public offering price of $14.00 per share). Pursuant to the policy of the
Securities and Exchange Commission, the calculation of shares used in
computing pro forma net loss per share also includes the Redeemable Series A
and B Convertible Preferred Stock, which will convert into 2,790,131 shares of
common stock effective upon the closing of the Offering.

Historical net loss per share amounts are not presented, since such amounts
are not considered meaningful as a result of the significant change in the
Company's capital structure that will occur in connection with the Offering
(see Note 8).

Cash and Cash Equivalents

Cash equivalents are carried at cost plus accrued interest, which
approximates fair value. The Company considers all highly liquid investments
with an original maturity date of three months or less to be cash equivalents.
Cash equivalents of $742,784 and $10,005,132 at December 31, 1996 and 1997,
respectively, included government mortgage-backed bonds and highly rated
corporate securities.

Short-Term Investments

At December 31, 1996 and 1997, short-term investments were comprised of
government mortgage-backed bonds maturing in less than a year, which have been
classified as available-for-sale. Pursuant to Statement of Financial
Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in
Debt and Equity Securities," available-for-sale securities are carried at fair
value, based on quoted market prices, with unrealized gains and losses, net of
tax, reported as a separate component of shareholders' equity. At December 31,
1996 and 1997, unrealized gains and losses were immaterial.

Prepaid Expenses

At December 31, 1997 prepaid expenses include $87,397 of net deferred
financing costs related to the Series A Notes. Amortization of deferred
financing costs was $87,397 in 1997 and is included in interest expense.

Property and Equipment

Property and equipment are stated at cost. Depreciation and amortization are
provided using the straight-line basis over the estimated useful lives of the
assets or the lease term, whichever is shorter.

Internally Developed Systems and Software

The costs to develop internal systems and software, primarily payroll and
related expenses for development and design of software, are charged to
expense as incurred.

Revenue Recognition

Net sales, which consist primarily of recorded music sold via the Internet,
include outbound shipping and handling charges and are recognized when the
products are shipped. The Company records a reserve for estimated returns,
which is based on historical return rates.

Operating and Development

Operating and development expenses consist principally of payroll and
related expenses for development, editorial, and network operations personnel
and consultants and expenses for systems and telecommunications
infrastructure.

F-8
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS--(CONTINUED)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED)

Sales and Marketing

Advertising costs are included in sales and marketing expenses and are
charged to expense as incurred. Such costs were $40,523, $61,432, and
$6,834,000, for the years ended December 31, 1995, 1996 and 1997,
respectively. The Company gives merchandise credit to the providers of various
small Web sites through its Cosmic Credit Program. Expenses related to this
program are included in sales and marketing expenses and, to date, have been
immaterial. The Company estimates the amount of unused credits and includes
this amount in accrued expenses.

Gift Certificates and Coupons

Gift certificates are included in deferred revenues in the accompanying
balance sheets and are recognized as net sales when they are redeemed. The
Company estimates the amount of outstanding coupons which will be redeemed and
includes that amount in accrued expenses. This accrual is immaterial for all
periods presented. Coupon expense is included in sales and marketing expenses.

Supplemental Cash Flow Information

For the years ended December 31, 1995, 1996 and 1997, the Company paid
interest of $2,329, $19,467, and $284,565, respectively. In addition, the
Company incurred $15,000, $126,954, and $1,070,290 in capitalized lease
obligations for the years ended December 31, 1995, 1996 and 1997,
respectively. Prior to 1995, the Company incurred no capitalized lease
obligations and paid no interest. In 1996 the Company issued 41,244 shares of
common stock to retire $81,923 of advances due to a related party (see Note
9).

Recapitalization

In April 1996, the Company amended its Articles of Incorporation to effect a
10,000-for-1 split of its common shares and to change the number of authorized
common shares to 5,000,000. In July 1997, the Company amended its Articles of
Incorporation to effect a 4-for-1 split of its common shares, to change the
number of authorized common shares to 50,000,000, and to authorize 20,000,000
shares of preferred stock. In January 1998, the Company amended its Articles
of Incorporation to effect a 1.5-for-1 split of its common shares. All
references in the financial statements to the number of shares and to per
share amounts have been retroactively restated to reflect all of these
changes.

F-9
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS--(CONTINUED)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED)

Recently Adopted Accounting Pronouncements

In February 1997, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 128, "Earnings per Share." This statement establishes standards for
computing and presenting earnings per share. The adoption of SFAS No. 128 had
no impact on the Company's calculation of earnings per share.

In February 1997, the FASB issued SFAS No. 129, "Disclosure of Information
about Capital Structure." This statement establishes standards for disclosing
information about an entity's capital structure. The Company has complied with
the disclosure requirements of this statement.

Recently Issued Accounting Pronouncements

In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income"
("SFAS 130"). This statement requires companies to classify items of other
comprehensive income by their nature in a financial statement and display the
accumulated balance of other comprehensive income separately from retained
earnings and additional paid-in capital in the equity section of a statement
of financial position. SFAS 130 is effective for financial statements issued
for fiscal years beginning after December 15, 1997. Management believes that
SFAS 130 will not have a material effect on the Company's financial
statements.

In June 1997, the FASB issued SFAS No. 131, "Disclosure About Segments of an
Enterprise and Related Information" ("SFAS 131"). This statement establishes
additional standards for segment reporting in the financial statements and is
effective for fiscal years beginning after December 15, 1997. Management
believes that SFAS 131 will not have an effect on the Company's financial
statements.

3. RISKS AND UNCERTAINTIES:

The Company's future results of operations involve a number of risks and
uncertainties. Factors that could affect the Company's future operating
results and cause actual results to vary materially from expectations include,
but are not limited to, dependence on key personnel, uncertain growth of
online commerce, reliance on suppliers of entertainment products, government
regulation, online commerce security risks, substantial competition, reliance
on certain vendors, risk of system failure, absence of redundant facilities,
and capacity constraints. See "Risk Factors" in the Prospectus.

Dependence on Suppliers

The Company's primary provider of order fulfillment for recorded music
titles is Valley Record Distributors ("Valley"). The Company has no
fulfillment operation or facility of its own and, accordingly, is dependent
upon maintaining its existing relationship with Valley or establishing a new
fulfillment relationship with one of the few other fulfillment operations.
There can be no assurance that the Company will maintain its relationship with
Valley beyond the term of its existing two year agreement, which expires in
June 1999, or that it will be able to find an alternative, comparable vendor
capable of providing fulfillment services on terms satisfactory to the Company
should its relationship with Valley terminate. Valley accounted for 70%, 72%
and 78% of the cost of sales in 1995, 1996 and 1997, respectively.
Additionally, the Company purchased all of its import music titles from
another vendor. This vendor

F-10
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS--(CONTINUED)

3. RISKS AND UNCERTAINTIES: (CONTINUED)

accounted for 21% and 14% of the cost of sales in 1995 and 1996. The Company
replaced this vendor during the year ended December 31, 1997 and neither the
current nor the former vendor accounted for more than 10% of cost of sales in
the year ended December 31, 1997.

International Sales

The Company derived 22%, 40% and 29% of revenues in 1995, 1996 and 1997,
respectively, from customers outside the United States. All international
sales are paid in U.S. dollars.

4. PROPERTY AND EQUIPMENT:

<TABLE>
<CAPTION>
DECEMBER 31,
USEFUL LIFE/ -------------------------------
LEASE TERM 1995 1996 1997
------------ -------- --------- ----------
<S> <C> <C> <C> <C>
Computers and equipment...... 3 years $164,530 $ 387,348 $2,090,144
Office furniture and
equipment................... 5 years 14,755 117,876 397,930
-------- --------- ----------
179,285 505,224 2,488,074
Less--Accumulated
depreciation and
amortization................ (37,750) (143,189) (603,778)
-------- --------- ----------
$141,535 $ 362,035 $1,884,296
======== ========= ==========
</TABLE>

Depreciation and amortization expense in 1995, 1996 and 1997 was $32,999,
$105,439, and $460,589 respectively. Total property and equipment under
capital leases was $15,000, $141,954 and, $1,217,130, less accumulated
amortization of $2,500, $25,659 and $252,988, at December 31, 1995, 1996 and
1997, respectively.

5. INCOME TAXES:

The Company records income taxes using the asset and liability method.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax
rates expected to apply to taxable income in the years in which those
temporary differences are expected to be recovered or settled. The effect on
deferred tax assets and liabilities of a change in tax rates is recognized in
income in the period that includes the enactment date.

From inception (February 12, 1994) until April 25, 1995, the Company
operated as an unincorporated entity. From April 25, 1995 until December 5,
1996, the Company was incorporated and elected to be taxed under Subchapter S
of the Internal Revenue Code. As a result, the Company was not subject to
federal or state income taxes, and the taxable loss of the Company was
included in the shareholders' individual tax returns. On December 6, 1996, the
Company terminated its status as an S corporation and is now subject to
federal and state income taxes.

At December 31, 1997, the Company had a net operating loss carryforward for
federal income tax purposes of approximately $9,700,000. The net operating
loss carryforward will expire in 2005. The

F-11
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS--(CONTINUED)

5. INCOME TAXES: (CONTINUED)

Company's utilization of its loss carryforward will be limited pursuant to the
Tax Reform Act of 1986, due to cumulative changes in ownership in excess of
50%.

The approximate income tax effect of each type of temporary difference and
the loss carryforward is as follows:

<TABLE>
<CAPTION>
DECEMBER 31,
----------------------
1996 1997
--------- -----------
<S> <C> <C>
Accruals and reserves not currently deductible.......... $ 6,275 $ 38,590
Benefit of net operating loss carryforward.............. 1,592 3,240,322
Development expenses not currently deductible........... 160,062 476,736
Depreciation methods.................................... 12,134 37,634
Deferred revenues....................................... 42,500 64,078
--------- -----------
222,563 3,857,360
Valuation allowance..................................... (222,563) (3,857,360)
--------- -----------
$ -- $ --
========= ===========
</TABLE>

Due to the uncertain realization of the deferred tax asset, the Company has
provided a full valuation allowance.

6. DEBT:

On December 31, 1995, the Company issued a note for $100,000 to a private
investor who is also a member of the Company's Board of Directors. The note
plus accrued interest of 10% was repaid on December 31, 1996.

From November 16, 1996 through January 31, 1997, the Company received short-
term loans of $250,000 from certain unrelated investors. The investors
received warrants as part of the consideration for the loans (see Note 8).
These loans bore interest at 6% per year. On May 15, 1997, the Company repaid
$110,000 of the loans and, on July 16, 1997, the remaining unpaid balance plus
accrued interest was paid.

In 1997, the Company obtained three term loans from a bank for an aggregate
of $218,563. The proceeds from the loans were used to purchase equipment,
which equipment collateralizes the loans. The two founders of the Company have
personally guaranteed the loans. The loans bear interest at rates ranging from
8.0% to 9.0% and are repayable in installments over 36 to 48 months. Annual
principal repayments are $57,351 in 1998, $62,300 in 1999, $45,676 in 2000 and
$25,061 in 2001.

In November 1997, the Company sold $5,777,500 of Series A Convertible Notes
(Series A Notes) to certain investors, including $1,000,000 to an existing
shareholder. The notes bear interest at an annual rate of 12% and are due upon
consummation of the Offering. In connection with the sale of the Series A
Notes, the Company issued warrants to these investors. The warrants allow the
investors to purchase 48,550 shares of common stock at an exercise price of
$11.90. The warrants were valued using the Black-Scholes model and the Series
A Notes were recorded net of the value of $404,425 assigned to the warrants.
The notes are being amortized to their face amount over their estimated term,
with $202,213 of amortization included in interest expense for the year ended
December 31, 1997. If the Offering is not

F-12
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS--(CONTINUED)

consummated, the loan will convert into a class of Preferred Stock at a price
per share, as defined, and the warrants will enable the investors to purchase
$1,155,000 of the security received upon the above conversion.

7. DISPUTE SETTLEMENT:

In May 1995, MILO Productions, Inc. ("MILO"), which was owned by the
Company's then shareholders, entered into a partnership with MBL
Entertainment, Inc. ("MBL") called Music Now. In December 1995, MBL, an
investor and the Company's then shareholders entered into nonbinding
discussions for the purpose of creating a new company ("NewCo") which would
merge with Music Now. These discussions contemplated, among other things, that
the private investor would make a significant cash investment in, and the
Company's then shareholders would contribute all of the outstanding capital
stock of both MILO and the Company, to NewCo. The parties abandoned these
discussions in August 1996, and MBL and the private investor subsequently
instituted a legal action against the Company, MILO and the Company's then
shareholders. On December 6, 1996, the Company and all parties involved in
this dispute negotiated a settlement pursuant to which (i) the private
investor made an investment in the Company (see Note 8) and (ii) the
shareholders of MBL were issued an aggregate of 882,606 shares of common
stock. The shares issued to the shareholders of MBL were valued at $1,024,030
based on the sale of common stock to the investor, which valued the common
stock at $1.16 per share (see Note 8), with the related charge recorded as an
expense in the accompanying statement of operations for the year ended
December 31, 1996. At the time of the settlement, MBL and Music Now were
inactive and had no assets or liabilities.

8. REDEEMABLE CONVERTIBLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY:

Common Stock

In December 1996, the Company sold to an investor 921,834 shares of common
stock and a warrant to purchase an additional 871,710 common shares at $1.15
per share, for aggregate consideration of $1,200,000. Using the Black-Scholes
model, the warrants were valued at $130,750. The remaining amount of the
proceeds of $1,069,250 was allocated to common stock, resulting in a value per
share of $1.16. The warrant expires on June 16, 1998. The investor received
the right to appoint two members of the Company's Board of Directors, each
having one-half vote. This right will terminate upon the consummation of the
Offering.

Preferred Stock

As of December 31, 1997, the Company had 20,000,000 shares of preferred
stock authorized, of which 254,582 were designated, issued and outstanding as
no par value Redeemable Series A Convertible Preferred Stock ("Series A
Preferred") and 1,605,505 were designated, issued and outstanding as no par
value Redeemable Series B Convertible Preferred Stock ("Series B Preferred").
The Series A Preferred was sold to an investor in July 1997 for $4.91 per
share, resulting in proceeds to the Company of $1,152,186, net of expenses.
The Series B Preferred was sold to investors in August 1997 for $5.45 per
share, resulting in proceeds to the Company of $8,100,305, net of expenses.

Each share of Series A and B Preferred is convertible into shares of the
Company's common stock at a rate of 1.5 to 1. In addition, effective upon the
closing of the Offering, all shares of Series A and Series B Preferred will
automatically convert into common stock on a 1.5-for-1 basis, subject to
certain adjustments. Each preferred stockholder is entitled to 1.5 votes per
share and registration rights, as defined. The Series A and B Preferred
shareholders each have the right to appoint one Board member. This right
terminates upon the closing of the Offering.

F-13
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS--(CONTINUED)

8. REDEEMABLE CONVERTIBLE PREFERRED STOCK AND
SHAREHOLDERS' EQUITY: (CONTINUED)

Beginning January 1, 2003, the Series A and B Preferred are redeemable at
the option of a majority of the holders at $4.91 per share and $5.45 per
share, respectively, plus accrued but unpaid dividends, if any. The Series A
and B Preferred are being accreted to their redemption values for accounting
purposes. The holders of Series A and B Preferred are entitled to receive
cumulative dividends of 8% per share per year, when and if declared by the
Company; provided, however, that no dividends may be declared or paid on
common stock unless all cumulative dividends have been declared and paid on
the preferred stock. The Series A and Series B Preferred have liquidation
preferences equal to $4.91 per share and $5.45 per share, respectively, plus
any accrued and unpaid dividends.

Equity Compensation Plan

On June 1, 1996, the Company adopted the Equity Compensation Plan (the
"Plan"). Under the Plan, incentive and nonqualified stock options, restricted
stock and stock appreciation rights may be granted to employees, officers,
employee directors and independent contractors and consultants. An aggregate
of 1,600,000 shares of common stock have been reserved for issuance under the
Plan. No stock options, restricted stock or stock appreciation rights were
granted in 1996.

Information relative to the Plan is as follows:

<TABLE>
<CAPTION>
WEIGHTED
AVERAGE
RANGE OF AGGREGATE EXERCISE
SHARES EXERCISE PRICES EXERCISE PRICE PRICE
------- --------------- -------------- --------
<S> <C> <C> <C> <C>
Outstanding January 1,
1997...................... -- -- -- --
Granted.................... 721,914 $1.33-$10.00 $2,157,680 $2.99
------- ------------ ---------- -----
Outstanding December 31,
1997...................... 721,914 $1.33-$10.00 $2,157,680 $2.99
======= ============ ========== =====
</TABLE>

As of December 31, 1997, there were 42,000 options exercisable with a
weighted average exercise price of $2.17 per share. In addition, as of
December 31, 1997, there were 878,086 additional options to purchase common
stock available for grant under the Plan.

The Company accounts for its option grants under APB Opinion No. 25 and
related interpretations. Accordingly, compensation has been recorded for the
Plan based on the intrinsic value of the stock option at the date of grant
(i.e., the difference between the exercise price and the fair value of the
Company's stock). Compensation, if any, is deferred and recorded as expense
over the vesting period. For the year ended December 31, 1997, deferred
compensation of $751,392 was recorded for options granted, of which $316,616
was charged to compensation expense.

In 1995, the FASB issued SFAS No. 123 "Accounting for Stock Based
Compensation" (SFAS 123). SFAS 123 establishes a fair value based method of
accounting for stock-based compensation plans.

This statement also applies to transactions in which an entity issues its
equity instruments to acquire goods or services from non-employees. SFAS 123
requires that an employer's financial statements include certain disclosures
about stock-based employee compensation arrangements regardless of the method

F-14
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS--(CONTINUED)

8. REDEEMABLE CONVERTIBLE PREFERRED STOCK AND
SHAREHOLDERS' EQUITY: (CONTINUED)

used to account for the plan. Had the Company recognized compensation cost for
its stock option plan consistent with the provisions of SFAS 123, the
Company's pro forma net loss and net loss per common share for the year ended
December 31, 1997 would have been as follows:

<TABLE>
<CAPTION>
YEAR
ENDED
DECEMBER 31,
1997
------------
<S> <C>
Net loss:
As reported................................................. $(10,747,405)
============
Pro forma................................................... $(10,855,135)
============
Net loss per common share:
As reported................................................. $ (0.91)
============
Pro forma................................................... $ (0.93)
============
</TABLE>

The weighted average fair value of the stock options granted during the year
ended December 31, 1997 was $2.63. The fair value of each option grant is
estimated on the date of grant using the Black-Scholes option pricing model,
with the following weighted average assumptions: risk free interest rates
ranging from 6.4% to 6.8% based on the rates in effect on the date of grant, a
volatility of 60% for options granted subsequent to the filing date of the
Company's registration statement, no expected dividend yield, and an expected
life of eight years for the options.

Warrants

In August 1997, the Company issued warrants to purchase 121,560 shares of
Series B Preferred at an exercise price of $5.45 per share in connection with
the Series B Preferred financing. The warrants were issued to one of the
investors in the Series B Preferred and to the agent who represented the
Company in that financing. These warrants expire in August 2002. Upon the
closing of the Offering, the warrants will convert to warrants to purchase
182,341 shares of common stock at $3.63 per share. Using the Black-Scholes
model, the warrants were valued at $170,000. This amount was recorded as a
reduction in the carrying value of the preferred stock and will be amortized
and included in the accretion to the redemption value of the preferred stock
recorded in each period.

As consideration for certain loans, the lenders received warrants to
purchase 59,997 and 76,365 shares of common stock at a price of $1.83 per
share until May 16, 1998 and July 16, 1998, respectively (see Note 6). Based
on the warrants' 18-month term and exercise price, the Black-Scholes model
calculated a minimal value for the warrants.

9. RELATED-PARTY TRANSACTIONS:

Additional paid-in capital represents the deemed fair value of services
contributed to the Company by the founders in 1994, 1995 and 1996. During this
period, one of the founders served as President and the other was responsible
for the development of the Company's system architecture and transactions
systems. In 1994 and 1995, the founders were paid no compensation and in 1996
the founders' compensation was below market.

F-15
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS--(CONTINUED)

9. RELATED-PARTY TRANSACTIONS: (CONTINUED)

The Company had advances due to a founder and his father of $4,103 and
$74,740, respectively, at December 31, 1995. On August 16, 1996, in
consideration of the cancellation of $81,923 debt due to the father, the
Company issued 41,244 shares of the Company's common stock.

10. COMMITMENTS AND CONTINGENCIES:

Yahoo Agreement

In August 1997, the Company entered into an agreement with Yahoo! Inc. (the
"Yahoo Agreement"), pursuant to which the Company became the exclusive retail
music store sponsor of the www.yahoo.com Web site. The Yahoo Agreement
consists of two one-year terms. The initial term began in October 1997 and
will expire on October 5, 1998. The Company can terminate the contract after
the first year by providing Yahoo with notice, as defined, and paying a
termination fee. During the first one-year term, the Company is required to
pay Yahoo $3,900,000 (of which $900,000 was paid in 1997, ) in exchange for a
specified number of page views. The Company expects to amortize the costs
associated with the Yahoo Agreement over the contract term, with the
amortization method primarily based on the rate of delivery of a guaranteed
number of impressions to be received during the contract term. The Company
will continue to evaluate the realizability of this asset and, if necessary,
write down the asset to realizable value. In connection with the Yahoo
Agreement, the Company paid Yahoo an additional $600,000 for advertising in
August and September 1997, which amount was charged to expense.

Excite Agreement

On September 30, 1997, the Company entered into a two-year agreement with
Excite, Inc. (the "Excite Agreement"), pursuant to which the Company became
the exclusive retail music store sponsor of the WebCrawler.com Web site. The
Excite Agreement requires the Company to pay Excite a set-up fee, an annual
exclusivity fee and an annual sponsorship fee for ongoing programming, links,
placements, advertisements and promotions. The Company has agreed to pay
Excite a minimum of $4,500,000 over the contract term, of which $500,000 was
paid by December 31, 1997, $2,125,000 will be paid in 1998 and $1,875,000 will
be paid in 1999. The Company expects to amortize the costs associated with
Excite agreement over the contract term, with the amortization method
primarily based on the rate of the delivery of a guaranteed number of
impressions to be received during the contract term. The Company will continue
to evaluate the realizability of the unamortized balance and, if necessary,
write down the balance to realizable value.

Other Agreements

On January 5, 1998 the Company entered into a strategic alliance with
GeoCities pursuant to which the Company has been designated as the exclusive
music retailer as well as one of four key commerce partners that will occupy a
premier position on certain pages of the GeoCities Web site. In January 1998,
the Company has also committed to purchase national advertising on the 1998
Grammy(R) Awards and the 1998 American Music Awards. The Company's aggregate
commitment under these arrangements, together with certain other advertising
commitments in 1998, is approximately $3.9 million.

F-16
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS--(CONTINUED)

10. COMMITMENTS AND CONTINGENCIES: (CONTINUED)

Leases

The Company has entered into various noncancelable operating and capital
leases for office space, telephones and other equipment. Future minimum lease
payments under operating and capital leases as of December 31, 1997 are as
follows:

<TABLE>
<CAPTION>
OPERATING CAPITAL
---------- ----------
<S> <C> <C>
1997.................... $ 291,033 $ 464,103
1998.................... 302,044 453,629
1999.................... 320,714 388,761
2000.................... 316,775 146,407
2001.................... 226,037 --
---------- ----------
Total minimum lease
payments............... $1,456,603 1,452,900
==========
Less--Amount
representing interest.. (319,578)
----------
Present value of minimum
capitalized lease
payments............... $1,133,322
==========
</TABLE>

Rent expense under operating leases was $51,836, $16,905 and $207,724, in
1995, 1996 and 1997, respectively.

Legal Actions

From time-to-time, the Company may be involved in litigation relating to
claims arising out of its ordinary course of business. The Company believes
that there are no claims or actions pending or threatened against the Company,
the ultimate disposition of which, would have a materially adverse effect on
the Company.

F-17
<PAGE>

================================================================================

NO DEALER, SALESPERSON OR ANY OTHER PERSON HAS BEEN AUTHORIZED TO GIVE ANY
INFORMATION OR TO MAKE ANY REPRESENTATIONS NOT CONTAINED IN THIS PROSPECTUS,
AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED
UPON AS HAVING BEEN AUTHORIZED BY THE COMPANY OR ANY OF THE UNDERWRITERS. THIS
PROSPECTUS DOES NOT CONSTITUTE AN OFFER OF ANY SECURITIES OTHER THAN THOSE TO
WHICH IT RELATES OR AN OFFER TO SELL, OR A SOLICITATION OF AN OFFER TO BUY, TO
ANY PERSON IN ANY JURISDICTION WHERE SUCH AN OFFER OR SOLICITATION WOULD BE
UNLAWFUL. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER
SHALL, UNDER ANY CIRCUMSTANCES, CREATE ANY IMPLICATION THAT THE INFORMATION
CONTAINED HEREIN IS CORRECT AS OF ANY TIME SUBSEQUENT TO THE DATE HEREOF.

----------------

TABLE OF CONTENTS

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Prospectus Summary....................................................... 3
Risk Factors............................................................. 7
Use of Proceeds.......................................................... 16
Dividend Policy.......................................................... 16
Capitalization........................................................... 17
Dilution................................................................. 18
Selected Financial and Operating Data.................................... 19
Management's Discussion and Analysis of Financial Condition and Results
of Operations............................................................ 20
Business................................................................. 28
Management............................................................... 38
Certain Relationships and Related Transactions........................... 42
Principal and Selling Shareholders....................................... 44
Description of Capital Stock............................................. 45
Shares Eligible for Future Sale.......................................... 47
Underwriting............................................................. 48
Legal Matters............................................................ 50
Experts.................................................................. 50
Additional Information................................................... 50
Index to Financial Statements............................................ F-1
</TABLE>

----------------

UNTIL , 1998 (25 DAYS AFTER THE DATE OF THIS PROSPECTUS), ALL DEALERS
EFFECTING TRANSACTIONS IN THE COMMON STOCK, WHETHER OR NOT PARTICIPATING IN
THIS DISTRIBUTION, MAY BE REQUIRED TO DELIVER A PROSPECTUS. THIS IS IN
ADDITION TO THE OBLIGATIONS OF DEALERS TO DELIVER A PROSPECTUS WHEN ACTING AS
UNDERWRITERS AND WITH RESPECT TO THEIR UNSOLD ALLOTMENTS OR SUBSCRIPTIONS.

================================================================================

3,600,000 Shares

[LOGO OF CDNOW APPEARS HERE]

Common Stock

----------------

PROSPECTUS

----------------

BT ALEX. BROWN

NATIONSBANC MONTGOMERY SECURITIES LLC

, 1998

================================================================================
<PAGE>

PART II

INFORMATION NOT REQUIRED IN PROSPECTUS

ITEM 13. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION.

The following table sets forth the estimated expenses, other than
underwriting discounts and commissions, in connection with the issuance and
distribution of the shares of Common Stock being registered, all of which are
being borne by the Company:

<TABLE>
<S> <C>
Registration fee................................................... $17,700
NASD filing fee.................................................... 6,500
Transfer agent and registrar fees.................................. 25,000
Printing and engraving............................................. 150,000
Legal fees......................................................... 250,000
Blue Sky fees and expenses......................................... 8,500
Nasdaq National Market listing fee................................. 50,000
Accounting fees.................................................... 225,000
Miscellaneous...................................................... 67,300
Total.............................................................. $800,000
========
</TABLE>

ITEM 14. INDEMNIFICATION OF DIRECTORS AND OFFICERS.

The Registrant's Amended and Restated Articles of Incorporation and By-laws
require the Registrant to indemnify any person who was or is a party or is
threatened to be made a party to any threatened, pending or completed
proceeding by reason of the fact that he is or was a director or officer of
the Registrant or any other person designated by the Board of Directors (which
may include any person serving at the request of the Registrant as a director,
officer, employee, agent, fiduciary or trustee of another corporation,
partnership, joint venture, trust, employee benefit plan or other entity or
enterprise), in each case, against certain liabilities (including damages,
judgments, amounts paid in settlement, fines, penalties and expenses
(including attorneys' fees and disbursements)), except where such
indemnification is expressly prohibited by applicable law, where such person
has engaged in willful misconduct or recklessness or where such
indemnification has been determined to be unlawful. Such indemnification as to
expenses is mandatory to the extent the individual is successful on the merits
of the matter. Pennsylvania law permits the Registrant to provide similar
indemnification to employees and agents who are not directors or officers. The
determination of whether an individual meets the applicable standard of
conduct may be made by the disinterested directors, independent legal counsel
or the stockholders. Pennsylvania law also permits indemnification in
connection with a proceeding brought by or in the right of the Registrant to
procure a judgment in its favor. Insofar as indemnification for liabilities
arising under the Securities Act of 1933, as amended (the "Act") may be
permitted to directors, officers, or persons controlling the Registrant
pursuant to the foregoing provisions, the Registrant has been informed that in
the opinion of the Securities and Exchange Commission such indemnification is
against public policy as expressed in that Act and is therefore unenforceable.
The Registrant has a directors and officers liability insurance policy.

ITEM 15. RECENT SALES OF UNREGISTERED SECURITIES

Since the Company's incorporation in April 1995, the Company has issued and
sold the following unregistered securities:

1. On August 16, 1996, the Company issued 41,244 shares to an accredited
investor in exchange for the cancellation of $81,923 of debt owed by the
Company to this investor.

II-1
<PAGE>

2. On December 6, 1996, the Company issued 921,834 shares of Common Stock
to an accredited investor for $1,200,000 and an aggregate of 882,606 shares
of Common Stock to three investors in exchange for substantially all of the
business and assets of an organization owned by these investors.

3. On July 15, 1997, the Company issued 254,582 shares of Series A
Preferred Stock to an accredited investor for $1,250,000.

4. On August 5, 1997, the Company issued 1,605,605 shares of Common Stock
to two accredited investors for an aggregate of $8,750,000.

5. On November 26, 1997, the Company issued $5,777,500 in aggregate
principal amount of its Series A Convertible Notes and associated warrants
exercisable for capital stock of the Company.

The Company believes that the transactions described above were exempt from
registration under Section 4(2) of the Act because the subject securities were
sold to a limited group of persons, each of whom was believed to have been
either an accredited investor or a sophisticated investor or had a pre-
existing business or personal relationship with the Company or its management
and was purchasing for investment without a view to further distribution.
Restrictive legends were placed on stock certificates evidencing the shares
and/or agreements relating to the right to purchase such shares described
above.

ITEM 16. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.

(a) Exhibits:

The following is a list of exhibits filed as part of this Registration
Statement.

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
1.1 Form of Underwriting Agreement. #
3.1 Amended and Restated Articles of Incorporation of the Company.*
3.2 Amended and Restated Bylaws of the Registrant.*
5.1 Opinion of Morgan, Lewis & Bockius LLP regarding legality of the
shares of Common Stock being registered.#
10.1 Stock Purchase Agreement dated as of July 15, 1997 by the Registrant
and certain shareholders of the Registrant.**
10.2 Amendment No. 1 to Stock Purchase Agreement dated as of August 5, 1997
by the Registrant and certain shareholders of the Registrant.**
10.3 Investors' Rights Agreement dated as of July 15, 1997 by the
Registrant and certain shareholders of the Registrant.**
10.4 CDnow, Inc. 1996 Equity Compensation Plan.**
10.5 Amendment 1997-1 to the CDnow, Inc. 1996 Equity Compensation Plan.**
10.6 Warrant dated August 5, 1997 issued by the Registrant to Alex. Brown &
Sons Incorporated**
10.7 Warrant dated August 5, 1997 issued by the Registrant to Grotech
Capital Group IV, L.L.P.**
10.8 Linking Agreement dated September 30, 1997 by and between the
Registrant and Excite, Inc.**
10.9 Advertising and Promotion Agreement dated as of August 21, 1997 by and
between the Registrant and Yahoo! Inc.**
10.10 Stock Purchase and Shareholders' Agreement dated December 6, 1996
among Registrant and others.*
10.11 Order Fulfillment Agreement dated as of June 24, 1997 between
Registrant and Sound Delivery.*
10.12 Advertising Agreement dated as of January 5, 1998 between the
Registrant and GeoCities.*
11.1 Statement re: Computation of Per Share Earnings.**
23.1 Consent of Arthur Andersen LLP. *
23.2 Consent of Morgan, Lewis & Bockius LLP (included in its opinion filed
as Exhibit 5 hereto).
24.1 Power of Attorney.**
27.1 Financial Data Schedule. *
</TABLE>
- ---------------------
*Filed herewith.

**Previously filed.
#To be filed by amendment.

II-2
<PAGE>

ITEM 17. UNDERTAKINGS.

(i) The undersigned Registrant hereby undertakes to provide to the
Underwriters at the closing specified in the Underwriting Agreement
certificates in such denominations and registered in such names as required by
the Underwriters to permit prompt delivery to each purchaser.

(ii) Insofar as indemnification for liabilities arising under the Securities
Act may be permitted to directors, officers and controlling persons of the
Registrant pursuant to the foregoing provisions, or otherwise, the Registrant
has been advised that in the opinion of the Commission such indemnification is
against public policy as expressed in the Securities Act and is, therefore,
unenforceable. In the event that a claim for indemnification against such
liabilities (other than the payment by the Registrant of expenses incurred or
paid by a director, officer or controlling person of the Registrant in the
successful defense of any action, suit or proceeding) is asserted by such
director, officer or controlling person in connection with the securities
being registered, the Registrant will, unless in the opinion of its counsel
the matter has been settled by controlling precedent, submit to a court of
appropriate jurisdiction the question whether such indemnification by it is
against public policy as expressed in the Securities Act and will be governed
by the final adjudication of such issue.

(iii) The undersigned Registrant hereby undertakes that:
(1) For purposes of determining any liability under the Securities Act,
the information omitted from the form of prospectus filed as part of this
Registration Statement in reliance upon Rule 430A and contained in a form
of prospectus filed by the Registrant pursuant to Rule 424(b)(1) or (4) or
497(h) under the Securities Act shall be deemed to be part of this
Registration Statement as of the time it was declared effective.
(2) For the purpose of determining any liability under the Securities
Act, each post-effective amendment that contains a form of prospectus shall
be deemed to be a new registration statement relating to the securities
offered therein, and the offering of such securities at that time shall be
deemed to be the initial bona fide offering thereof.

II-3
<PAGE>

SIGNATURES

PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1933, AS AMENDED, THE
REGISTRANT HAS DULY CAUSED THIS AMENDMENT NO. 1 TO THE REGISTRATION STATEMENT
TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, IN
JENKINTOWN, PENNSYLVANIA ON JANUARY 16, 1998.

CDnow, Inc.

By: /s/ Jason Olim
----------------------------------

JASON OLIM, PRESIDENT, CHIEF
EXECUTIVE OFFICER AND CHAIRMAN OF
THE BOARD

PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1933, AS AMENDED, THIS
REGISTRATION STATEMENT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS IN THE
CAPACITIES AND ON THE DATES INDICATED.

NAME CAPACITY DATE
---- -------- ----

/s/ Jason Olim President, Chief January 16, 1998
- ------------------------------------- Executive Officer
JASON OLIM and Chairman of the
Board (principal
executive officer)

/s/ Joel Sussman Vice President and January 16, 1998
- ------------------------------------- Chief Financial
JOEL SUSSMAN Officer (principal
financial and
accounting officer)

* Director January 16, 1998
- -------------------------------------
MATTHEW OLIM

* Director January 16, 1998
- -------------------------------------
ALAN MELTZER

* Director January 16, 1998
- -------------------------------------
PATRICK KERINS

* Director January 16, 1998
- -------------------------------------
JOHN REGAN

*By: /s/ Joel Sussman
---------------------------------
JOEL SUSSMAN, AS ATTORNEY-IN-FACT

II-4
<PAGE>

EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION PAGE
------- ----------- ----
<C> <S> <C>
1.1 Form of Underwriting Agreement. #
3.1 Amended and Restated Articles of Incorporation of the Company.*
3.2 Amended and Restated Bylaws of the Registrant.*
5.1 Opinion of Morgan, Lewis & Bockius LLP regarding legality of
the shares of Common Stock being registered.#
10.1 Stock Purchase Agreement dated as of July 15, 1997 by the
Registrant and certain shareholders of the Registrant.**
10.2 Amendment No. 1 to Stock Purchase Agreement dated as of August
5, 1997 by the Registrant and certain shareholders of the
Registrant.**
10.3 Investors' Rights Agreement dated as of July 15, 1997 by the
Registrant and certain shareholders of the Registrant.**
10.4 CDnow, Inc. 1996 Equity Compensation Plan.**
10.5 Amendment 1997-1 to the CDnow, Inc. 1996 Equity Compensation
Plan.**
10.6 Warrant dated August 5, 1997 issued by the Registrant to Alex.
Brown & Sons Incorporated**
10.7 Warrant dated August 5, 1997 issued by the Registrant to
Grotech Capital
Group IV, L.L.P.**
10.8 Linking Agreement dated September 30, 1997 by and between the
Registrant and Excite, Inc.**
10.9 Advertising and Promotion Agreement dated as of August 21, 1997
by and between the Registrant and Yahoo! Inc.**
10.10 Stock Purchase and Shareholders' Agreement dated December 6,
1996 among Registrant and others.*
10.11 Order Fulfillment Agreement dated as of June 24, 1997 between
Registrant and Sound Delivery.*
10.12 Advertising Agreement dated as of January 5, 1998 between the
Registrant and GeoCities.*
11.1 Statement re: Computation of Per Share Earnings.**
23.1 Consent of Arthur Andersen LLP. *
23.2 Consent of Morgan, Lewis & Bockius LLP (included in its opinion
filed as Exhibit 5 hereto).
24.1 Power of Attorney.**
27.1 Financial Data Schedule. *
</TABLE>
- ---------------------
* Filed herewith.

** Previously Filed.
# To be filed by amendment.

<PAGE>

Exhibit 3.1

AMENDED AND RESTATED
ARTICLES OF INCORPORATION
OF
CDNOW, INC.

1. The name of the corporation is CDnow, Inc. (the "Corporation").

2. The name of the Commercial Registered Office Provider is Corporation
Service Company, Montgomery County.

3. The Corporation is incorporated under the provisions of the Pennsylvania
Business Corporation Law of 1988, as amended (the "BCL").

4. The Corporation's board of directors (the "Board of Directors") shall have
such number of members as determined from time to time by the Corporation's
board of directors, which members shall not possess more than seven (7)
full votes in the aggregate.

5. Capital Stock.
-------------

The aggregate number of shares which the Corporation shall have authority
to issue is 50,000,000 common shares, no par value (the "Common Shares"), and
20,000,000 preferred shares, no par value (the "Preferred Shares"). The Board
of Directors may authorize the issuance from time to time of Preferred Shares in
one or more classes or series and with designations, voting rights, preferences,
and special rights, if any, as the Board of Directors may fix by resolution.
Without limiting the foregoing, the Board of Directors is authorized to fix with
respect to each series:

(a) the number of shares which shall constitute the series and the name of
the series;

(b) the rate and times at which, and the preferences and conditions under
which, dividends shall be payable on shares of the series, and the status of
such dividends as cumulative or non-cumulative and as participating or non-
participating;

(d) the rights, if any, of holders of shares of the series to convert such
shares into, or to exchange such shares for, shares of any other class of stock
of the Corporation;
<PAGE>

(e) the rights and preferences, if any, of the holders of shares of the
series upon any liquidation, dissolution or winding up of the affairs of, or
upon any distribution of the assets of, the Corporation;

(f) the limitations, if any, applicable while such series is outstanding,
on the payment of dividends or making of distributions on, or the acquisition
of, the Common Stock or any other class of stock which does not rank senior to
the shares of the series; and

(g) the voting rights, if any, to be provided for shares of the series.

6. Duties and Liabilities of Directors and Officers.
------------------------------------------------

(a) Directors and officers as fiduciaries. A director or officer of the
-------------------------------------
Corporation shall stand in a fiduciary relation to the Corporation and shall
perform his or her duties as a director or officer, including his or her duties
as a member of any committee of the Board of Directors upon which he or she may
serve, in good faith, in a manner he or she reasonably believes to be in the
best interests of the Corporation, and with such care, including reasonable
inquiry, skill and diligence, as a person of ordinary prudence would use under
similar circumstances. In performing his or her duties, a director or officer
shall be entitled to rely in good faith on information, opinions, reports or
statements, including financial statements and other financial data, in each
case prepared or presented by: (a) one or more officers or employees of the
Corporation whom the director or officer reasonably believes to be reliable and
competent with respect to the matters presented, (b) counsel, public accountants
or other persons as to matters that the director or officer reasonably believes
to be within the professional or expert competence of such person, or (c) a
committee of the Board of Directors upon which the director or officer does not
serve, duly designated in accordance with law, as to matters within its
designated authority, which committee the director or officer reasonably
believes to merit confidence. A director or officer shall not be considered to
be acting in good faith if he or she has actual knowledge concerning the matter
in question that would cause his or her reliance to be unwarranted. Absent
breach of fiduciary duty, lack of good faith or self-dealing, actions taken as a
director or officer of the Corporation or any failure to take any action shall
be presumed to be in the best interests of the Corporation.

(b) Personal liability of directors. A director of the Corporation shall
-------------------------------
not be personally liable for monetary damages as such (including, without
limitation, any judgment, amount paid in settlement, penalty, punitive damages
or expense of any nature (including, without limitation, attorneys' fees and
disbursements)) for any action taken, or any failure to take any action, unless
the director has breached or failed to perform the duties of his or her office
under these Amended and Restated Articles of Incorporation, the Amended and
Restated Bylaws of the Corporation or applicable provisions of law and the
breach or failure to perform constitutes self-dealing, willful misconduct or
recklessness.

-2-
<PAGE>

(c) Personal liability of officers. An officer of the Corporation shall
------------------------------
not be personally liable, as such, to the Corporation or its shareholders for
monetary damages (including, without limitation, any judgment, amount paid in
settlement, penalty, punitive damages or expense of any nature (including,
without limitation, attorneys' fees and disbursements)) for any action taken, or
any failure to take any action, unless the officer has breached or failed to
perform the duties of his or her office under these Amended and Restated
Articles of Incorporation, the Amended and Restated Bylaws of the Corporation or
applicable provisions of law and the breach or failure to perform constitutes
self-dealing, willful misconduct or recklessness.

7. The shareholders of the Corporation shall not have the right to cumulate
their votes for the election of directors of the Corporation.

8. Subchapters B, C, D, E, F, G, H, I and J of Section 25 of the Business
Corporation Law of 1988, as amended, shall not be applicable to the
Corporation.

9. The Corporation reserves the right, from time to time, to amend, alter or
repeal any provision contained in these Amended and Restated Articles of
Incorporation in the manner now or hereafter provided by statute for the
amendment of articles of incorporation.

-3-

<PAGE>

Exhibit 3.2

AMENDED AND RESTATED BYLAWS
OF
CDNOW, INC.

ARTICLE I
Name and Seal

Section 1.01. Name. The name of the corporation is CDnow, Inc.
----

Section 1.02. State of Incorporation. The Corporation is
----------------------
incorporated under the laws of the Commonwealth of Pennsylvania.

Section 1.03. Seal. The corporate seal of the Corporation shall have
----
inscribed thereon the name of the Corporation, the year of its organization, the
words "Corporate Seal," and the name of the State of Incorporation. The seal
may be used by any person authorized by the Corporation's board of directors
(the "Board of Directors") or by these bylaws by causing the seal or a facsimile
thereof to be impressed or affixed, or in any manner reproduced.

ARTICLE II
Offices and Fiscal Year

Section 2.01. Registered Office. The registered office of the
-----------------
Corporation in the Commonwealth of Pennsylvania shall be at c/o Corporation
Service Company, 319 Market Street, Harrisburg, PA 17101 until otherwise
established by an amendment of the Amended and Restated Articles of
Incorporation (the "Articles" of the Corporation) or by the Board of Directors
and a record of such change is filed with the Pennsylvania Department of State
in the manner provided by law.

Section 2.02. Other Offices. The Corporation may also have offices
-------------
at such other places within or without the Commonwealth of Pennsylvania as the
Board of Directors may from time to time appoint or the business of the
Corporation may require.

Section 2.03. Fiscal Year. The fiscal year of the Corporation shall
-----------
begin on the first day of January in each year.
<PAGE>

ARTICLE III
Notice--Waivers--Meetings Generally

Section 3.01. Manner of Giving Notice.
-----------------------

(a) General Rule. Whenever written notice is required to be given to
------------
any person under the provisions of the Pennsylvania Business Corporation Law, as
amended (the "BCL"), or by the Articles or these bylaws, it may be given to the
person either personally or by sending a copy thereof by first class or express
mail, postage prepaid, or by telegram (with messenger service specified), telex
or TWX (with answerback received) or courier service, charges prepaid, or by
facsimile transmission, to the address (or to the telex, TWX, facsimile or
telephone number) of the person appearing on the books of the Corporation or, in
the case of directors, supplied by the director to the Corporation for the
purpose of notice. If the notice is sent by mail, telegraph or courier service,
it shall be deemed to have been given to the person entitled thereto when
deposited in the United States mail or with a telegraph office or courier
service for delivery to that person or, in the case of telex or TWX, when
dispatched or, in the case of facsimile transmission, when received. A notice
of meeting shall specify the place, day and hour of the meeting and any other
information required by any other provision of the BCL, the Articles or these
bylaws.

(b) Bulk Mail. If the Corporation has more than 30 shareholders,
---------
notice of any regular or special meeting of the shareholders, or any other
notice required by the BCL or by the Articles or these bylaws to be given to all
shareholders or to all holders of a class or series of shares, may be given by
any class of postpaid mail if the notice is deposited in the United States mail
at least 20 days prior to the day named for the meeting or any corporate or
shareholder action specified in the notice.

(c) Adjourned Shareholder Meetings. When a meeting of shareholders is
------------------------------
adjourned, it shall not be necessary to give any notice of the adjourned meeting
or of the business to be transacted at an adjourned meeting, other than by
announcement at the meeting at which the adjournment is taken, unless the Board
of Directors fixes a new record date for the adjourned meeting in which event
notice shall be given in accordance with Section 3.03.

Section 3.02. Notice of Meetings of Board of Directors. Notice of a
----------------------------------------
regular meeting of the Board of Directors need not be given. Notice of every
special meeting of the Board of Directors shall be given to each director by
telephone or in writing at least 24 hours (in the case of notice by telephone,
telex, TWX or facsimile transmission) or 48 hours (in the case of notice by
telegraph, courier service or express mail) or five days (in the case of notice
by first class mail) before the time at which the meeting is to be held. Every
such notice shall state the time and place of the meeting. Neither the business
to be transacted at, nor the purpose of, any regular or special meeting of the
Board of Directors need be specified in a notice of the meeting.

2
<PAGE>

Section 3.03. Notice of Meetings of Shareholders.
----------------------------------

(a) General Rule. Except as otherwise provided in Section 3.01(b),
------------
written notice of every meeting of the shareholders shall be given by, or at the
direction of, the secretary or other authorized person to each shareholder of
record entitled to vote at the meeting at least (i) ten days prior to the day
named for a meeting (and, in case of a meeting called to consider a merger,
consolidation, share exchange or division, to each shareholder of record not
entitled to vote at the meeting) called to consider a fundamental change under
15 Pa.C.S. Chapter 19 or (ii) five days prior to the day named for the meeting
in any other case. If the secretary neglects or refuses to give notice of a
meeting, the person or persons calling the meeting may do so. In the case of a
special meeting of shareholders, the notice shall specify the general nature of
the business to be transacted.

(b) Notice of Action by Shareholders on Bylaws. In the case of a
------------------------------------------
meeting of shareholders that has as one of its purposes action on the bylaws,
written notice shall be given to each shareholder that the purpose, or one of
the purposes, of the meeting is to consider the adoption, amendment or repeal of
the bylaws. There shall be included in, or enclosed with, the notice a copy of
the proposed amendment or a summary of the changes to be effected thereby.

(c) Notice of Action by Shareholders on Fundamental Change. In the
------------------------------------------------------
case of a meeting of the shareholders that has as one of its purposes action
with respect to any fundamental change under 15 Pa.C.S. Chapter 19, each
shareholder shall be given, together with written notice of the meeting, a copy
or summary of the amendment or plan to be considered at the meeting in
compliance with the provisions of Chapter 19.

(d) Notice of Action by Shareholders Giving Rise to Dissenters Rights.
-----------------------------------------------------------------
In the case of a meeting of the shareholders that has as one of its purposes
action that would give rise to dissenters rights under the provisions of 15
Pa.C.S. Subchapter 15D, each shareholder shall be given, together with written
notice of the meeting:

(1) statement that the shareholders have a right to dissent and
obtain payment of the fair value of their shares by complying with the
provisions of Subchapter 15D (relating to dissenters rights); and

(2) copy of Subchapter 15D.

3
<PAGE>

Section 3.04. Waiver of Notice.
----------------

(a) Written Waiver. Whenever any written notice is required to be
--------------
given under the provisions of the BCL, the Articles or these bylaws, a waiver
thereof in writing, signed by the person or persons entitled to the notice,
whether before or after the time stated therein, shall be deemed equivalent to
the giving of the notice. Neither the business to be transacted at, nor the
purpose of, a meeting need be specified in the waiver of notice of the meeting.

(b) Waiver by Attendance. Attendance of a person at any meeting shall
--------------------
constitute a waiver of notice of the meeting except where a person attends a
meeting for the express purpose of objecting, at the beginning of the meeting,
to the transaction of any business because the meeting was not lawfully called
or convened.

Section 3.05. Modification of Proposal Contained in Notice. Whenever
--------------------------------------------
the language of a proposed resolution is included in a written notice of a
meeting required to be given under the provisions of the BCL or the Articles or
these bylaws, the meeting considering the resolution may without further notice
adopt it with such clarifying or other amendments as do not enlarge its original
purpose.

Section 3.06. Exception to Requirement of Notice.
----------------------------------

(a) General Rule. Whenever any notice or communication is required to
------------
be given to any person under the provisions of the BCL or by the Articles or
these bylaws or by the terms of any agreement or other instrument or as a
condition precedent to taking any corporate action and communication with that
person is then unlawful, the giving of the notice or communication to that
person shall not be required.

(b) Shareholders Without Forwarding Addresses. Notice or other
-----------------------------------------
communications need not be sent to any shareholder with whom the Corporation has
been unable to communicate for more than 24 consecutive months because
communications to the shareholder are returned unclaimed or the shareholder has
otherwise failed to provide the Corporation with a current address. Whenever
the shareholder provides the Corporation with a current address, the Corporation
shall commence sending notices and other communications to the shareholder in
the same manner as to other shareholders.

Section 3.07. Use of Conference Telephone and Similar Equipment. Any
-------------------------------------------------
director may participate in any meeting of the Board of Directors, and the Board
of Directors may provide by resolution with respect to a specific meeting or
with respect to a class of meetings that one or more persons may participate in
a meeting of the shareholders of the Corporation, by means of conference
telephone or similar communications equipment by means

4
<PAGE>

of which all persons participating in the meeting can hear each other.
Participation in a meeting pursuant to this section shall constitute presence in
person at the meeting.

ARTICLE IV
Shareholders

Section 4.01. Place of Meeting. All meetings of the shareholders of
----------------
the Corporation shall be held at such place, within or without the Commonwealth
of Pennsylvania, as shall be determined by the Board of Directors from time to
time.

Section 4.02. Annual Meeting. The Board of Directors may fix and
--------------
designate the date and time of the annual meeting of the shareholders, but if no
such date and time is fixed and designated by the Board of Directors, the
meeting for any calendar year shall be held on the third Tuesday in May in such
year, if not a legal holiday under the laws of Pennsylvania, and, if a legal
holiday, then on the next succeeding business day, not a Saturday, at 10 o'clock
A.M. and at said meeting the shareholders then entitled to vote shall elect
directors and shall transact such other business as may properly be brought
before the meeting. If the annual meeting shall not have been called and held
within six months after the designated time, any shareholder may call the
meeting at any time thereafter.

Section 4.03. Special Meetings. Special meetings of the shareholders
----------------
may be called at any time by the Chief Executive Officer or a majority of the
board of directors. At any time, upon the written request of any person or
persons who have duly called a special meeting, which written request shall
state the purpose or purposes of the meeting, it shall be the duty of the
secretary to fix the date of the meeting which shall be held at such date and
time as the secretary may fix, not less more than 60 days after the receipt of
the request, and to give due notice thereof.

Section 4.04. Quorum and Adjournment.
----------------------

(a) General Rule. A meeting of shareholders of the Corporation duly
------------
called shall not be organized for the transaction of business unless a quorum is
present. The presence of shareholders entitled to cast at least a majority of
the votes that all shareholders are entitled to cast on a particular matter to
be acted upon at the meeting shall constitute a quorum for the purposes of
consideration and action on the matter. Shares of the Corporation owned,
directly or indirectly, by it and controlled, directly or indirectly, by the
Board of Directors of this Corporation, as such, shall not be counted in
determining the total number of outstanding shares for quorum purposes at any
given time.

5
<PAGE>

(b) Withdrawal of a Quorum. The shareholders present at a duly
----------------------
organized meeting can continue to do business until adjournment notwithstanding
the withdrawal of enough shareholders to leave less than a quorum.

(c) Adjournments Generally. Any regular or special meeting of the
----------------------
shareholders, including one at which directors are to be elected and one which
cannot be organized because a quorum has not attended, may be adjourned for such
period and to such place as the shareholders present and entitled to vote shall
direct.

(d) Electing Directors at Adjourned Meeting. Those shareholders
---------------------------------------
entitled to vote who attend a meeting called for the election of directors that
has been previously adjourned for lack of a quorum, although less than a quorum
as fixed in this section, shall nevertheless constitute a quorum for the purpose
of electing directors.

(e) Other Action in Absence of Quorum. Those shareholders entitled to
---------------------------------
vote who attend a meeting of shareholders that has been previously adjourned for
one or more periods aggregating at least 15 days because of an absence of a
quorum, although less than a quorum as fixed in this section, shall nevertheless
constitute a quorum for the purpose of acting upon any matter set forth in the
notice of the meeting if the notice states that those shareholders who attend
the adjourned meeting shall nevertheless constitute a quorum for the purpose of
acting upon the matter.

Section 4.05. Action by Shareholders. Except as otherwise provided
----------------------
in the BCL or the Articles or these bylaws, whenever any corporate action is to
be taken by vote of the shareholders of the Corporation, it shall be authorized
upon receiving the affirmative vote of a majority of the votes cast by all
shareholders entitled to vote thereon and, if any shareholders are entitled to
vote thereon as a class, upon receiving the affirmative vote of a majority of
the votes cast by the shareholders entitled to vote as a class.

Section 4.06. Organization. At every meeting of the shareholders,
------------
the chairman of the Board of Directors, if there be one, or, in the case of
vacancy in office or absence of the chairman of the Board of Directors, one of
the following persons present in the order stated: the vice chairman of the
Board of Directors, if there be one, the president, the vice presidents in their
order of rank and seniority, or a person chosen by vote of the shareholders
present, shall act as chairman of the meeting. The secretary or, in the absence
of the secretary, an assistant secretary, or, in the absence of both the
secretary and assistant secretaries, a person appointed by the chairman of the
meeting, shall act as secretary of the meeting.

Section 4.07. Voting Rights of Shareholders. Unless otherwise
-----------------------------
provided in the Articles, every shareholder of the Corporation shall be entitled
to one vote for each full share having voting power standing in the name of the
shareholder on the books of the Corporation.

6
<PAGE>

Section 4.08. Voting and Other Action by Proxy.
--------------------------------

(a) General Rule.
------------

(1) every shareholder entitled to vote at a meeting of
shareholders may authorize another person to act for the shareholder
by proxy.

(2) The presence of, or vote or other action at a meeting of
shareholders by a proxy of a shareholder shall constitute the presence
of, or vote or action by the shareholder.

(3) Where two or more proxies of a shareholder are present, the
Corporation shall, unless otherwise expressly provided in the proxy,
accept as the vote of all shares represented thereby the vote cast by
a majority of them and, if a majority of the proxies cannot agree
whether the shares represented shall be voted or upon the manner of
voting the shares, the voting of the shares shall be divided equally
among those persons.

(b) Execution and Filing. Every proxy shall be executed in writing by
--------------------
the shareholder or by the duly authorized attorney-in-fact of the shareholder
and filed with the secretary of the Corporation. A telegram, telex, cablegram,
datagram or similar transmission from a shareholder or attorney-in-fact, or a
photographic, facsimile or similar reproduction of a writing executed by a
shareholder or attorney-in-fact:

(1) may be treated as properly executed for purposes of this
subsection; and

(2) shall be so treated if it sets forth a confidential and
unique identification number or other mark furnished by the
Corporation to the shareholder for the purposes of a particular
meeting or transaction.

(c) Revocation. A proxy, unless coupled with an interest, shall be
----------
revocable at will, notwithstanding any other agreement or any provision in the
proxy to the contrary, but the revocation of a proxy shall not be effective
until written notice thereof has been given to the secretary of the Corporation.
An unrevoked proxy shall not be valid after three years from the date of its
execution unless a longer time is expressly provided therein. A proxy shall not
be revoked by the death or incapacity of the maker unless, before the vote is
counted or the authority is exercised, written notice of the death or incapacity
is given to the secretary of the Corporation.

(d) Expenses. The Corporation shall pay the reasonable expenses of
--------
solicitation of votes, proxies or consents of shareholders by or on behalf of
the Board of

7
<PAGE>

Directors or its nominees for election to the Board of Directors,
including solicitation by professional proxy solicitors and otherwise.

Section 4.09. Voting by Fiduciaries and Pledgees. Shares of the
----------------------------------
Corporation standing in the name of a trustee or other fiduciary and shares held
by an assignee for the benefit of creditors or by a receiver may be voted by the
trustee, fiduciary, assignee or receiver. A shareholder whose shares are pledged
shall be entitled to vote the shares until the shares have been transferred into
the name of the pledgee, or a nominee of the pledgee, but nothing in this
section shall affect the validity of a proxy given to a pledgee or nominee.

Section 4.10. Voting by Joint Holders of Shares.
---------------------------------

(a) General Rule. Where shares of the Corporation are held jointly or
------------
as tenants in common by two or more persons, as fiduciaries or otherwise:

(1) if only one or more of such persons is present in person or
by proxy, all of the shares standing in the names of such persons
shall be deemed to be represented for the purpose of determining a
quorum and the Corporation shall accept as the vote of all the shares
the vote cast by a joint owner or a majority of them; and

(2) if the persons are equally divided upon whether the shares
held by them shall be voted or upon the manner of voting the shares,
the voting of the shares shall be divided equally among the persons
without prejudice to the rights of the joint owners or the beneficial
owners thereof among themselves.

(b) Exception. If there has been filed with the secretary of the
---------
Corporation a copy, certified by an attorney at law to be correct, of the
relevant portions of the agreement under which the shares are held or the
instrument by which the trust or estate was created or the order of court
appointing them or of an order of court directing the voting of the shares, the
persons specified as having such voting power in the document latest in date of
operative effect so filed, and only those persons, shall be entitled to vote the
shares but only in accordance therewith.

Section 4.11. Voting by Corporations.
----------------------

(a) Voting by Corporate Shareholders. Any Corporation that is a
--------------------------------
shareholder of this Corporation may vote at meetings of shareholders of this
Corporation by any of its officers or agents, or by proxy appointed by any
officer or agent, unless some other person, by resolution of the Board of
Directors of the other Corporation or a provision of its Articles or bylaws, a
copy of which resolution or provision certified to be correct by one of its
officers has been filed with the secretary of this Corporation, is appointed its
general or special proxy in which case that person shall be entitled to vote the
shares.

8
<PAGE>

(b) Controlled Shares. Shares of this Corporation owned, directly or
-----------------
indirectly, by it and controlled, directly or indirectly, by the Board of
Directors of this Corporation, as such, shall not be voted at any meeting and
shall not be counted in determining the total number of outstanding shares for
voting purposes at any given time.

Section 4.12. Determination of Shareholders of Record.
---------------------------------------

(a) Fixing Record Date. The Board of Directors may fix a time prior
------------------
to the date of any meeting of shareholders as a record date for the
determination of the shareholders entitled to notice of, or to vote at, the
meeting, which time, except in the case of an adjourned meeting, shall be not
more than 90 days prior to the date of the meeting of shareholders. Only
shareholders of record on the date fixed shall be so entitled notwithstanding
any transfer of shares on the books of the Corporation after any record date
fixed as provided in this subsection. The Board of Directors may similarly fix a
record date for the determination of shareholders of record for any other
purpose. When a determination of shareholders of record has been made as
provided in this section for purposes of a meeting, the determination shall
apply to any adjournment thereof unless the Board of Directors fixes a new
record date for the adjourned meeting.

(b) Determination When a Record Date is Not Fixed. If a record date
---------------------------------------------
is not fixed:

(1) The record date for determining shareholders entitled to
notice of or to vote at a meeting of shareholders shall be at the
close of business on the day next preceding the day on which notice is
given.

(2) The record date for determining shareholders for any other
purpose shall be at the close of business on the day on which the
Board of Directors adopts the resolution relating thereto.

(c) Certification by Nominee. The Board of Directors may adopt a
------------------------
procedure whereby a shareholder of the Corporation may certify in writing to the
Corporation that all or a portion of the shares registered in the name of the
shareholder are held for the account of a specified person or persons. Upon
receipt by the Corporation of a certification complying with the procedure, the
persons specified in the certification shall be deemed, for the purposes set
forth in the certification, to be the holders of record of the number of shares
specified in place of the shareholder making the certification.

Section 4.13. Voting Lists.
------------

(a) General Rule. The officer or agent having charge of the transfer
------------
books for shares of the Corporation shall make a complete list of the
shareholders entitled to vote at any

9
<PAGE>

meeting of shareholders, arranged in alphabetical order, with the address of and
the number of shares held by each. The list shall be produced and kept open at
the time and place of the meeting and shall be subject to the inspection of any
shareholder during the whole time of the meeting for the purposes thereof except
that, if the Corporation has 5,000 or more shareholders, in lieu of the making
of the list the Corporation may make the information therein available at the
meeting by any other means.

(b) Effect of List. Failure to comply with the requirements of this
--------------
section shall not affect the validity of any action taken at a meeting prior to
a demand at the meeting by any shareholder entitled to vote thereat to examine
the list. The original share register or transfer book, or a duplicate thereof
kept in the Commonwealth of Pennsylvania, shall be prima facie evidence as to
who are the shareholders entitled to examine the list or share register or
transfer book or to vote at any meeting of shareholders.

Section 4.14. Judges of Election.
------------------

(a) Appointment. In advance of any meeting of shareholders of the
-----------
Corporation, the Board of Directors may appoint judges of election, who need not
be shareholders, to act at the meeting or any adjournment thereof. If judges of
election are not so appointed, the presiding officer of the meeting may, and on
the request of any shareholder shall, appoint judges of election at the meeting.
The number of judges shall be one or three. A person who is a candidate for an
office to be filled at the meeting shall not act as a judge.

(b) Vacancies. In case any person appointed as a judge fails to
---------
appear or fails or refuses to act, the vacancy may be filled by appointment made
by the Board of Directors in advance of the convening of the meeting or at the
meeting by the presiding officer thereof.

(c) Duties. The judges of election shall determine the number of
------
shares outstanding and the voting power of each, the shares represented at the
meeting, the existence of a quorum, and the authenticity, validity and effect of
proxies, receive votes or ballots, hear and determine all challenges and
questions in any way arising in connection with nominations by shareholders or
the right to vote, count and tabulate all votes, determine the result and do
such acts as may be proper to conduct the election or vote with fairness to all
shareholders. The judges of election shall perform their duties impartially, in
good faith, to the best of their ability and as expeditiously as is practical.
If there are three judges of election, the decision, act or certificate of a
majority shall be effective in all respects as the decision, act or certificate
of all.

(d) Report. On request of the presiding officer of the meeting or of
------
any shareholder, the judges shall make a report in writing of any challenge or
question or matter determined by them, and execute a certificate of any fact
found by them. Any report or certificate made by them shall be prima facie
evidence of the facts stated therein.

10
<PAGE>

Section 4.15. Minors as Security Holders. The Corporation may treat
--------------------------
a minor who holds shares or obligations of the Corporation as having capacity to
receive and to empower others to receive dividends, interest, principal and
other payments or distributions, to vote or express consent or dissent and to
make elections and exercise rights relating to such shares or obligations
unless, in the case of payments or distributions on shares, the corporate
officer responsible for maintaining the list of shareholders or the transfer
agent of the Corporation or, in the case of payments or distributions on
obligations, the treasurer or paying officer or agent has received written
notice that the holder is a minor.

ARTICLE V
Board of Directors

Section 5.01. Powers.
------

(a) General Rule. Unless otherwise provided by statute, all powers
------------
vested by law in the Corporation shall be exercised by or under the authority
of, and the business and affairs of the Corporation shall be managed under the
direction of, the Board of Directors.

(b) Notation of Dissent. A director of the Corporation who is present
-------------------
at a meeting of the Board of Directors, or of a committee of the Board of
Directors, at which action on any corporate matter is taken on which the
director is generally competent to act, shall be presumed to have assented to
the action taken unless his or her dissent is entered in the minutes of the
meeting or unless the director files his or her written dissent to the action
with the secretary of the meeting before the adjournment thereof or transmits
the dissent in writing to the secretary of the Corporation immediately after the
adjournment of the meeting. The right to dissent shall not apply to a director
who voted in favor of the action. Nothing in this section shall bar a director
from asserting that minutes of the meeting incorrectly omitted his or her
dissent if, promptly upon receipt of a copy of such minutes, the director
notifies the secretary, in writing, of the asserted omission or inaccuracy.

Section 5.02. Qualifications and Election of Directors.
----------------------------------------

(a) Qualifications. Each director of the Corporation shall be a
--------------
natural person of full age who need not be a resident of the Commonwealth of
Pennsylvania or a shareholder of the Corporation.

(b) Election of Directors. In elections for directors, voting need
---------------------
not be by ballot, unless required by vote of the shareholders before the voting
for the election of directors begins. The nominees receiving the highest number
of votes shall be elected to the Board of Directors.

11
<PAGE>

Section 5.03. Number and Term of Office.
-------------------------

(a) Number. The Board of Directors shall consist of such number of
------
members as determined by the Articles.

(b) Term of Office. Each director shall hold office until the next
--------------
annual meeting of the shareholders and until their successors shall have been
elected and qualified, except in the event of death, resignation or

(c) Resignation. Any director may resign at any time upon written
-----------
notice to the Corporation. The resignation shall be effective upon receipt
thereof by the Corporation or at such subsequent time as shall be specified in
the notice of resignation.

Section 5.04. Vacancies
---------

(a) Vacancies and newly created directorships resulting from any
increase in the authorized number of directors may be filled by a majority of
the directors then in office, though less than a quorum, or by a sole remaining
director, and a director so chosen shall hold office until the next annual
election of directors and until a successor is duly elected and qualified. If
there are no directors in office, then an election of directors may be held in
the manner provided by statute.

(b) Whenever the holders of any class or classes of stock or series
thereof are entitled to elect one or more directors by the provisions of the
certificate of Incorporation, vacancies and newly created directorships of such
class or classes or series may be filled by a majority of the directors elected
by such class or classes or series thereof then in office, or by a sole
remaining director so elected.

Section 5.05. Removal of Directors.
--------------------

(a) Removal by the Shareholders. The entire Board of Directors or any
---------------------------
individual director may be removed from office only for cause by vote of a
majority of the shareholders entitled to vote thereon. In case the Board of
Directors or any one or more directors are so removed, new directors may be
elected at the same meeting. The repeal of a provision of the Articles or
bylaws prohibiting, or the addition of a provision to the Articles or bylaws
permitting, the removal by the shareholders of the Board of Directors or any
individual director without assigning any cause shall not apply to any incumbent
director during the balance of the term for which the director was selected.

(b) Removal by the Board of Directors. The Board of Directors may
---------------------------------
declare vacant the office of a director who has been judicially declared of
unsound mind or who has been convicted of an offense punishable by imprisonment
for a term of more than one year or if,

12
<PAGE>

within 60 days after notice of his or her selection, the director does not
accept the office either in writing or by attending a meeting of the Board of
Directors.

Section 5.06. Place of Meetings. Meetings of the Board of Directors
-----------------
may be held at such place within or without the Commonwealth of Pennsylvania as
the Board of Directors may from time to time appoint or as may be designated in
the notice of the meeting.

Section 5.07. Organization of Meetings. At every meeting of the
------------------------
Board of Directors, the chairman of the Board of Directors, if there be one, or,
in the case of a vacancy in the office or absence of the chairman of the Board
of Directors, one of the following officers present in the order stated: the
vice chairman of the Board of Directors, if there be one, the president, the
vice presidents in their order of rank and seniority, or a person chosen by a
majority of the directors present, shall act as chairman of the meeting. The
secretary or, in the absence of the secretary, an assistant secretary, or, in
the absence of the secretary and the assistant secretaries, any person appointed
by the chairman of the meeting, shall act as secretary of the meeting.

Section 5.08. Regular Meetings. Regular meetings of the Board of
----------------
Directors shall be held at such time and place as shall be designated from time
to time by resolution of the Board of Directors.

Section 5.09. Special Meetings. Special meetings of the Board of
----------------
Directors shall be held whenever called by the chairman or by three or more of
the directors.

Section 5.10. Quorum of and Action by Directors.
---------------------------------

(a) General Rule. A majority of the directors in office of the
------------
Corporation shall be necessary to constitute a quorum for the transaction of
business and the acts of a majority of the directors present and voting at a
meeting at which a quorum is present shall be the acts of the Board of
Directors.

(b) Action by Written Consent. Any action required or permitted to be
-------------------------
taken at a meeting of the directors may be taken without a meeting if, prior or
subsequent to the action, a consent or consents thereto by all of the directors
in office is filed with the secretary of the Corporation.

Section 5.11. Executive and Other Committees.
------------------------------

(a) Establishment and Powers. The Board of Directors may, by
------------------------
resolution adopted by a majority of the directors in office, establish one or
more committees to consist of one or more directors of the Corporation. Any
committee, to the extent provided in the resolution of the Board of Directors,
shall have and may exercise all of the powers and authority

13
<PAGE>

of the Board of Directors except that a committee shall not have any power or
authority as to the following:

(1) The submission to shareholders of any action requiring
approval of shareholders under the BCL.

(2) The creation or filling of vacancies in the Board of
Directors.

(3) The adoption, amendment or repeal of these bylaws.

(4) The amendment or repeal of any resolution of the Board of
Directors that by its terms is amendable or repealable only by the
Board of Directors.

(5) Action on matters committed by a resolution of the Board of
Directors to another committee of the Board of Directors.

(b) Alternate Committee Members. The Board of Directors may designate
---------------------------
one or more directors as alternate members of any committee who may replace any
absent or disqualified member at any meeting of the committee or for the
purposes of any written action by the committee. In the absence or
disqualification of a member and alternate member or members of a committee, the
member or members thereof present at any meeting and not disqualified from
voting, whether or not constituting a quorum, may unanimously appoint another
director to act at the meeting in the place of the absent or disqualified
member.

(d) Committee Procedures. The term "Board of Directors," when used in
--------------------
any provision of these bylaws relating to the organization or procedures of or
the manner of taking action by the Board of Directors, shall be construed to
include and refer to any executive or other committee of the Board of Directors.

Section 5.12. Compensation. The Board of Directors shall have the
------------
authority to fix the compensation of directors for their services as directors
and a director may be a salaried officer of the Corporation.

14
<PAGE>

ARTICLE VI
Officers

Section 6.01. Officers Generally.
------------------

(a) Number, Qualifications and Designation. The officers of the
--------------------------------------
Corporation shall be a chief executive officer and/or a president, one or more
vice presidents, a secretary, a treasurer, and such other officers as may be
elected in accordance with the provisions of Section 6.03. Officers may but
need not be directors or shareholders of the Corporation. The president and
secretary shall be natural persons of full age. The treasurer may be a
Corporation, but if a natural person shall be of full age. The Board of
Directors may elect from among the members of the Board of Directors a chairman
of the Board of Directors and a vice chairman of the Board of Directors who
shall be officers of the Corporation. Any number of offices may be held by the
same person.

(b) Bonding. The Corporation may secure the fidelity of any or all of
-------
its officers by bond or otherwise.

Section 6.02. Election, Term of Office and Resignations.
-----------------------------------------

(a) Election and Term of Office. The officers of the Corporation,
---------------------------
except those elected by delegated authority pursuant to Section 6.03, shall be
elected annually by the Board of Directors, and each such officer shall hold
office for a term of one year and until a successor has been selected and
qualified or until his or her earlier death, resignation or removal.

(b) Resignations. Any officer may resign at any time upon written
------------
notice to the Corporation. The resignation shall be effective upon receipt
thereof by the Corporation or at such subsequent time as may be specified in the
notice of resignation.

Section 6.03. Subordinate Officers, Committees and Agents. The Board
-------------------------------------------
of Directors may from time to time elect such other officers and appoint such
committees, employees or other agents as the business of the Corporation may
require, including one or more assistant secretaries, and one or more assistant
treasurers, each of whom shall hold office for such period, have such authority,
and perform such duties as are provided in these bylaws, or as the Board of
Directors may from time to time determine. The Board of Directors may delegate
to any officer or committee the power to elect subordinate officers and to
retain or appoint employees or other agents, or committees thereof, and to
prescribe the authority and duties of such subordinate officers, committees,
employees or other agents.

Section 6.04. Removal of Officers and Agents. Any officer or agent
------------------------------
of the Corporation may be removed by the Board of Directors with or without
cause. The removal shall

15
<PAGE>

be without prejudice to the contract rights, if any, of any person so removed.
Election or appointment of an officer or agent shall not of itself create
contract rights.

Section 6.05. Vacancies. A vacancy in any office because of death,
---------
resignation, removal, disqualification, or any other cause, may be filled by the
Board of Directors or by the officer or committee to which the power to fill
such office has been delegated pursuant to Section 6.03, as the case may be, and
if the office is one for which these bylaws prescribe a term, shall be filled
for the unexpired portion of the term.

Section 6.06. Authority. All officers of the Corporation, as between
---------
themselves and the Corporation, shall have such authority and perform such
duties in the management of the Corporation as may be provided by or pursuant to
resolutions or orders of the Board of Directors or, in the absence of
controlling provisions in the resolutions or orders of the Board of Directors,
as may be determined by or pursuant to these bylaws.

Section 6.07. The Chairman and Vice Chairman of the Board of
----------------------------------------------
Directors. The chairman of the Board of Directors or in the absence of the
- ---------
chairman, the vice chairman of the Board of Directors, shall preside at all
meetings of the shareholders and of the Board of Directors, and shall perform
such other duties as may from time to time be requested by the Board of
Directors.

Section 6.08. The Chief Executive Officer. The chief executive
---------------------------
officer shall be the chief executive officer of the Corporation and shall have
general supervision over the business and operations of the Corporation, subject
however, to the control of the Board of Directors. The chief executive officer
shall sign, execute, and acknowledge, in the name of the Corporation, deeds,
mortgages, bonds, contracts or other instruments, authorized by the Board of
Directors, except in cases where the signing and execution thereof shall be
expressly delegated by the Board of Directors, or by these bylaws, to some other
officer or agent of the Corporation; and, in general, shall perform all duties
incident to the office of president and such other duties as from time to time
may be assigned by the Board of Directors. The chief executive officer shall
from time to time make such reports of the affairs of the Corporation as the
Board of Directors may require and shall annually present to the annual meeting
of the shareholders a report of the business of the Corporation for the
preceding fiscal year.

Section 6.09. The President. The president shall perform the duties
-------------
of the chief executive officer in the absence of such officer and such other
duties as may from time to time be assigned to them by the Board of Directors or
the chief executive officer

Section 6.10. The Vice Presidents. The vice presidents shall perform
-------------------
the duties of the president in the absence of the president and such other
duties as may from time to time be assigned to them by the Board of Directors,
the chief executive officer or the president and if there is more than one vice
president, their seniority in performing such duties and exercising

16
<PAGE>

such powers shall be determined by the order in which they were first elected or
appointed, or as determined by the Board of Directors.

Section 6.11. The Secretary. The secretary or an assistant secretary
-------------
shall attend all meetings of the shareholders and of the Board of Directors and
all committees thereof and shall record all the votes of the shareholders and of
the directors and the minutes of the meetings of the shareholders and of the
Board of Directors and of committees of the Board of Directors in a book or
books to be kept for that purpose; shall see that notices are given and records
and reports properly kept and filed by the Corporation as required by law; shall
be the custodian of the seal of the Corporation and see that it is affixed to
all documents to be executed on behalf of the Corporation under its seal; and,
in general, shall perform all duties incident to the office of secretary, and
such other duties as may from time to time be assigned by the Board of
Directors, the chief executive officer or the president.

Section 6.12. The Treasurer. The treasurer shall be the chief
-------------
financial officer and shall have or provide for the custody of the funds or
other property of the Corporation; shall collect and receive or provide for the
collection and receipt of moneys earned by or in any manner due to or received
by the Corporation; shall deposit all funds in his or her custody as treasurer
in such banks or other places of deposit as the Board of Directors may from time
to time designate; shall, whenever so required by the Board of Directors, render
an account showing all transactions as treasurer, and the financial condition of
the Corporation; and, in general, shall discharge such other duties as may from
time to time be assigned by the Board of Directors, the chief executive officer
or the president.

Section 6.13. Salaries. The salaries of the officers elected by the
--------
Board of Directors shall be fixed from time to time by the Board of Directors or
by such officer as may be designated by resolution of the Board of Directors.
The salaries or other compensation of any other officers, employees and other
agents shall be fixed from time to time by the Board of Directors, or by the
officer or committee to which the power to elect such officers or to retain or
appoint such employees or other agents has been delegated pursuant to Section
6.03. No officer shall be prevented from receiving such salary or other
compensation by reason of the fact that the officer is also a director of the
Corporation.

ARTICLE VII
Certificates of Stock, Transfer, Etc.

Section 7.01. Share Certificates.
------------------

(a) Form of Certificates. Certificates for shares of the Corporation
--------------------
shall be in such form as approved by the Board of Directors, and shall state
that the Corporation is incorporated under the laws of the Commonwealth of
Pennsylvania, the name of the person to

17
<PAGE>

whom issued, and the number and class of shares and the designation of the
series (if any) that the certificate represents. If the Corporation is
authorized to issue shares of more than one class or series, certificates for
shares of the Corporation shall set forth upon the face or back of the
certificate (or shall state on the face or back of the certificate that the
Corporation will furnish to any shareholder upon request and without charge), a
full or summary statement of the designations, voting rights, preferences,
limitations and special rights, if any, of the shares of each class or series
authorized to be issued so far as they have been fixed and determined and the
authority of the Board of Directors to fix and determine the designations,
voting rights, preferences, limitations and special rights of the classes and
series of shares of the Corporation.

(b) Share Register. The share register or transfer books and blank
--------------
share certificates shall be kept by the secretary or by any transfer agent or
registrar designated by the Board of Directors for that purpose.

Section 7.02. Issuance. The share certificates of the Corporation
--------
shall be numbered and registered in the share register or transfer books of the
Corporation as they are issued. They shall be executed in such manner as the
Board of Directors shall determine. In case any officer, transfer agent or
registrar who has signed or authenticated, or whose facsimile signature or
authentication has been placed upon, any share certificate shall have ceased to
be such officer, transfer agent or registrar because of death, resignation or
otherwise, before the certificate is issued, the certificate may be issued with
the same effect as if the officer, transfer agent or registrar had not ceased to
be such at the date of its issue. The provisions of this Section 7.02 shall be
subject to any inconsistent or contrary agreement in effect at the time between
the Corporation and any transfer agent or registrar.

Section 7.03. Transfer. Transfers of shares shall be made on the
--------
share register or transfer books of the Corporation upon surrender of the
certificate therefor, endorsed by the person named in the certificate or by an
attorney lawfully constituted in writing. No transfer shall be made
inconsistent with the provisions of the Uniform Commercial Code, 13 Pa.C.S.
(S)(S) 8101 et seq., and its amendments and supplements.

Section 7.04. Record Holder of Shares. The Corporation shall be
-----------------------
entitled to treat the person in whose name any share or shares of the
Corporation stand on the books of the Corporation as the absolute owner thereof,
and shall not be bound to recognize any equitable or other claim to, or interest
in, such share or shares on the part of any other person.

Section 7.05. Lost, Destroyed or Mutilated Certificates. The holder
-----------------------------------------
of any shares of the Corporation shall immediately notify the Corporation of any
loss, destruction or mutilation of the certificate therefor, and the Board of
Directors may, in its discretion, cause a new certificate or certificates to be
issued to such holder, in case of mutilation of the certificate, upon the
surrender of the mutilated certificate or, in case of loss or destruction of the
certificate, upon

18
<PAGE>

satisfactory proof of such loss or destruction and, if the Board of Directors
shall so determine, the deposit of a bond in such form and in such sum, and with
such surety or sureties, as it may direct.

Section 7.06. Agreements Restricting Transfer of Shares. The Board
-----------------------------------------
of Directors may authorize the Corporation to become party to agreements with
shareholders and others relating to transfer, repurchase and issuance of shares
of stock of the Corporation; provided, however, that such agreement must be
filed with the Corporation and all share certificates affected thereby shall
have clearly imprinted thereon a legend containing such agreement or referring
thereto.

ARTICLE VIII
Indemnification of Directors, Officers and
Other Authorized Representatives

Section 8.01. Scope of Indemnification.
------------------------

(a) General Rule. The Corporation shall indemnify an indemnified
------------
representative against any liability incurred in connection with any proceeding
in which the indemnified representative may be involved as a party or otherwise
by reason of the fact that such person is or was serving in an indemnified
capacity, including, without limitation, liabilities resulting from any actual
or alleged breach or neglect of duty, error, misstatement or misleading
statement, negligence, gross negligence or act giving rise to strict or products
liability, except:

(1) where such indemnification is expressly prohibited by
applicable law;

(2) where the conduct of the indemnified representative has been
finally determined pursuant to Section 8.06 or otherwise:

(i) to constitute willful misconduct or recklessness
within the meaning of 15 Pa.C.S. (S) 1746(b) or any
superseding provision of law sufficient in the circumstances
to bar indemnification against liabilities arising from the
conduct; or

(ii) to be based upon or attributable to the receipt by
the indemnified representative from the Corporation of a
personal benefit to which the indemnified representative is
not legally entitled; or

(3) to the extent such indemnification has been finally
determined in a final adjudication pursuant to Section 8.06 to be
otherwise unlawful.

19
<PAGE>

(b) Partial Payment. If an indemnified representative is entitled to
---------------
indemnification in respect of a portion, but not all, of any liabilities to
which such person may be subject, the Corporation shall indemnify such
indemnified representative to the maximum extent for such portion of the
liabilities.

(c) Presumption. The termination of a proceeding by judgment, order,
-----------
settlement or conviction or upon a plea of nolo contendere or its equivalent
shall not of itself create a presumption that the indemnified representative is
not entitled to indemnification.

(d) Definitions. For purposes of this Article VIII:
-----------

(1) "indemnified capacity" means any and all past, present and
future service by an indemnified representative in one or more
capacities as a director, officer, employee or agent of the
Corporation, or, at the request of the Corporation, as a director,
officer, employee, agent, fiduciary or trustee of another Corporation,
partnership, joint venture, trust, employee benefit plan or other
entity or enterprise;

(2) "indemnified representative" means any and all directors and
officers of the Corporation and any other person designated as an
indemnified representative by the Board of Directors of the
Corporation (which may, but need not, include any person serving at
the request of the Corporation, as a director, officer, employee,
agent, fiduciary or trustee of another Corporation, partnership, joint
venture, trust, employee benefit plan or other entity or enterprise);

(3) "liability" means any damage, judgment, amount paid in
settlement, fine, penalty, punitive damages, excise tax assessed with
respect to an employee benefit plan, or cost or expense of any nature
(including, without limitation, attorneys' fees and disbursements);
and

(4) "proceeding" means any threatened, pending or completed
action, suit, appeal or other proceeding of any nature, whether civil,
criminal, administrative or investigative, whether formal or informal,
and whether brought by or in the right of the Corporation, a class of
its security holders or otherwise.

Section 8.02. Proceedings Initiated by Indemnified Representatives.
----------------------------------------------------
Notwithstanding any other provision of this Article VIII, the Corporation shall
not indemnify under this Article VIII an indemnified representative for any
liability incurred in a proceeding initiated (which shall not be deemed to
include counter claims or affirmative defenses) or participated in as an
intervenor or amicus curiae by the person seeking indemnification unless such
initiation of or participation in the proceeding is authorized, either before or
after its commencement, by the affirmative vote of a majority of the directors
in office. This section does

20
<PAGE>

not apply to reimbursement of expenses incurred in successfully prosecuting or
defending an arbitration under Section 8.06 or otherwise successfully
prosecuting or defending the rights of an indemnified representative granted by
or pursuant to this Article VIII.

Section 8.03. Advancing Expenses. The Corporation shall pay the
------------------
expenses (including attorneys' fees and disbursements) incurred in good faith by
an indemnified representative in advance of the final disposition of a
proceeding described in Section 8.01 or the initiation of or participation in
which is authorized pursuant to Section 8.02 upon receipt of an undertaking by
or on behalf of the indemnified representative to repay the amount if it is
ultimately determined pursuant to Section 8.06 that such person is not entitled
to be indemnified by the Corporation pursuant to this Article VIII. The
financial ability of an indemnified representative to repay an advance shall not
be a prerequisite to the making of such advance.

Section 8.04. Securing of Indemnification Obligations. To further
---------------------------------------
effect, satisfy or secure the indemnification obligations provided herein or
otherwise, the Corporation may maintain insurance, obtain a letter of credit,
act as self-insurer, create a reserve, trust, escrow, cash collateral or other
fund or account, enter into indemnification agreements, pledge or grant a
security interest in any assets or properties of the Corporation, or use any
other mechanism or arrangement whatsoever in such amounts, at such costs, and
upon such other terms and conditions as the Board of Directors shall deem
appropriate. Absent fraud, the determination of the Board of Directors with
respect to such amounts, costs, terms and conditions shall be conclusive against
all security holders, officers and directors and shall not be subject to
voidability.

Section 8.05. Payment of Indemnification. An indemnified
--------------------------
representative shall be entitled to indemnification within 30 days after a
written request for indemnification has been delivered to the secretary of the
Corporation.

Section 8.06. Arbitration.
-----------

(a) General Rule. Any dispute related to the right to
------------
indemnification, contribution or advancement of expenses as provided under this
Article VIII, except with respect to indemnification for liabilities arising
under the Securities Act of 1933 that the Corporation has undertaken to submit
to a court for adjudication, shall be decided only by arbitration in the
metropolitan area in which the principal executive offices of the Corporation
are located at the time, in accordance with the commercial arbitration rules
then in effect of the American Arbitration Association, before a panel of three
arbitrators, one of whom shall be selected by the Corporation, the second of
whom shall be selected by the indemnified representative and the third of whom
shall be selected by the other two arbitrators. In the absence of the American
Arbitration Association, or if for any reason arbitration under the arbitration
rules of the American Arbitration Association cannot be initiated, and if one of
the parties fails or refuses to select an arbitrator or the arbitrators selected
by the Corporation and the indemnified

21
<PAGE>

representative cannot agree on the selection of the third arbitrator within 30
days after such time as the Corporation and the indemnified representative have
each been notified of the selection of the other's arbitrator, the necessary
arbitrator or arbitrators shall be selected by the presiding judge of the court
of general jurisdiction in such metropolitan area.

(b) Qualifications of Arbitrators. Each arbitrator selected as
-----------------------------
provided herein is required to be or have been a director or executive officer
of a Corporation whose shares of common stock were listed during at least one
year of such service on the New York Stock Exchange or the American Stock
Exchange or quoted on the National Association of Securities Dealers Automated
Quotations System.

(c) Burden of Proof. The party or parties challenging the right of an
---------------
indemnified representative to the benefits of this Article VIII shall have the
burden of proof.

(d) Expenses. The Corporation shall reimburse an indemnified
--------
representative for the expenses (including attorneys' fees and disbursements)
incurred in successfully prosecuting or defending such arbitration.

(e) Effect. Any award entered by the arbitrators shall be final,
------
binding and nonappealable and judgment may be entered thereon by any party in
accordance with applicable law in any court of competent jurisdiction, except
that the Corporation shall be entitled to interpose as a defense in any such
judicial enforcement proceeding any prior final judicial determination adverse
to the indemnified representative under Section 8.01(a)(2) in a proceeding not
directly involving indemnification under this Article VIII. This arbitration
provision shall be specifically enforceable.

Section 8.07. Contribution. If the indemnification provided for in
------------
this Article VIII or otherwise is unavailable for any reason in respect of any
liability or portion thereof, the Corporation shall contribute to the
liabilities to which the indemnified representative may be subject in such
proportion as is appropriate to reflect the intent of this Article VIII or
otherwise.

Section 8.08. Mandatory Indemnification of Directors, Officers, etc.
-----------------------------------------------------
To the extent that an authorized representative of the Corporation has been
successful on the merits or otherwise in defense of any action, suit or
proceeding referred to in Sections 1741 or 1742 of the BCL or in defense of any
claim, issue or matter therein, such person shall be indemnified against
expenses (including attorneys' fees and disbursements) actually and reasonably
incurred by such person in connection therewith.

Section 8.09. Contract Rights; Amendment or Repeal. All rights under
------------------------------------
this Article VIII shall be deemed a contract between the Corporation and the
indemnified representative pursuant to which the Corporation and each
indemnified representative intend to

22
<PAGE>

be legally bound. Any repeal, amendment or modification hereof shall be
prospective only and shall not affect any rights or obligations then existing.

Section 8.10. Scope of Article VIII. The rights granted by this
---------------------
Article VIII shall not be deemed exclusive of any other rights to which those
seeking indemnification, contribution or advancement of expenses may be entitled
under any statute, agreement, vote of shareholders or disinterested directors or
otherwise, both as to action in an indemnified capacity and as to action in any
other capacity. The indemnification, contribution and advancement of expenses
provided by or granted pursuant to this Article VIII shall continue as to a
person who has ceased to be an indemnified representative in respect of matters
arising prior to such time, and shall inure to the benefit of the heirs,
executors, administrators and personal representatives of such a person.

Section 8.11. Reliance on Provisions. Each person who shall act as
----------------------
an indemnified representative of the Corporation shall be deemed to be doing so
in reliance upon the rights of indemnification, contribution and advancement of
expenses provided by this Article VIII.

Section 8.12. Interpretation. The provisions of this Article VIII
--------------
are intended to constitute bylaws authorized by 15 Pa.C.S. (S) 1746.

Section 8.13. Changes in Pennsylvania Law. References in this
---------------------------
Article VIII to Pennsylvania law or to any provision thereof shall be to such
law (including without limitation to the Directors' Liability Act) as it existed
on the date this Article VIII was adopted or as such law thereafter may be
changed; provided that (a) in the case of any change which expands the liability
of directors or limits the indemnification rights or the rights to advancement
of expenses which the Corporation may provide, the rights to limited liability,
to indemnification and to the advancement of expenses provided in this Article
VIII shall continue as theretofore to the extent permitted by law; and (b) if
such change permits the Corporation without the requirement of any further
action by shareholders or Directors to limit further the liability of directors
(or limit the liability of officers) or to provide broader indemnification
rights or rights to the advancement of expenses than the Corporation was
permitted to provide prior to such change, then liability thereupon shall be so
limited and the rights to indemnification and the advancement of expenses shall
be so broadened to the extent permitted by law.

ARTICLE IX
Dividends and Other Distributions to Shareholders

Section 9.01. Dividends. Subject to applicable law of the State of
---------
Incorporation and the Articles, and in accordance with the provisions thereof at
the pertinent applicable time, the Board of Directors of the Corporation may
from time to time declare, and the Corporation

23
<PAGE>

may pay, dividends on its outstanding shares in cash or property other than its
own shares, except when the Corporation is insolvent, or when the payment
thereof would render the Corporation insolvent, or when the declaration or
payment thereof would be contrary to any restriction contained in the Articles,
but:

(1) Dividends may be declared and paid in cash or property only
out of unreserved and unrestricted earned surplus of the Corporation,
except as otherwise provided by statute; and

(2) No dividends shall be paid which would reduce the remaining
net assets of the Corporation below the aggregate preferential amount
payable in the event of voluntary liquidation to the holders of shares
having preferential rights to the assets of the Corporation in the
event of liquidation. The Board of Directors may also, from time to
time, distribute to the holders of the Corporation's outstanding
shares having a cumulative preferential right to receive dividends in
discharge of their cumulative dividend rights, dividends payable in
cash out of the unrestricted capital surplus of the Corporation, if at
the time the Corporation has no earned surplus and is not insolvent
and would not thereby be rendered insolvent. Each such distribution,
when made, shall be identified as a payment of cumulative dividends
out of capital surplus.

Section 9.02 Distributions of Shares of the Corporation. Subject to
------------------------------------------
the Articles, the Board of Directors of the Corporation may, from time to time,
distribute pro rata to holders of any class or classes of its issued shares,
treasury shares and authorized but unissued shares, but

(1) If distribution is made, in the Corporation's authorized but
unissued shares having a par value, there shall be transferred to
stated capital at the time of such distribution an amount of surplus
at least equal to the aggregate par value of the shares so issued;

(2) If a distribution is made in the Corporation's authorized
but unissued shares without par value, the Board of Directors may fix
a stated value for the shares so issued, and there shall be
transferred to stated capital, at the time of such distribution, an
amount of surplus equal to the aggregate stated value, if any, so
fixed;

(3) The amount per share so transferred to stated capital, or
the fact that there was no such transfer, shall be disclosed to the
shareholders receiving such distribution concurrently with the
distribution thereof;

(4) No distribution of shares of any class shall be made to
holders of shares of any other class unless the Articles so provide or
such distribution is

24
<PAGE>

authorized by the affirmative vote or written consent of the holders
of a majority of the outstanding shares of the class in which the
distribution is to be made.

In lieu of issuing fractional shares in any such distribution, the
Corporation may pay in cash the fair value thereof, as determined by
the Board of Directors, to shareholders entitled thereto.

Section 9.03. Reserves. Subject to the Articles, there may be set
--------
aside out of any funds of the Corporation available for dividends such sum or
sums as the directors, from time to time, in their absolute discretion determine
as a reserve or reserves to meet contingencies, or for equalizing dividends, or
for repairing or maintaining any property of the Corporation, or for the
purchase of additional property, or for such other purpose as the Board of
Directors shall think conducive to the interests of the Corporation. The Board
of Directors may abolish or modify any such reserve.

Section 9.04 Distributions in Partial Liquidation. Subject to the
------------------------------------
Articles, the Board of Directors of the Corporation may, from time to time,
distribute to the shareholders in partial liquidation, out of unrestricted
capital surplus of the Corporation, a portion of its assets in cash or property,
subject to the following conditions:

(1) No such distribution shall be made at a time when the
Corporation is insolvent or when such distribution would render the
Corporation insolvent;

(2) No such distribution shall be made unless such distribution
shall have been authorized by the prior affirmative vote, obtained
within one (1) year of such distribution, of the holders of at least a
majority of the outstanding shares of each class, whether or not
entitled to vote thereon by the provisions of the Articles;

(3) No such distribution shall be made to the holders of any
class of shares unless all cumulative dividends accrued on all classes
of shares entitled to preferential dividends, prior to dividends on
the shares to the holders of which such distribution is to be made,
shall have been fully paid;

(4) No such distribution shall be made to the holders of any
class of shares which would reduce the remaining net assets of the
Corporation below the aggregate preferential amount payable in the
event of voluntary liquidation to the holders of shares having
preferential rights to the assets of the Corporation in the event of
liquidation;

25
<PAGE>

(5) Each such distribution, when made, shall be identified as a
distribution in partial liquidation and the amount per share disclosed
to the shareholders receiving the same concurrently with the
distribution thereof.

ARTICLE X
Miscellaneous

Section 10.01. Checks. All checks, notes, bills of exchange or other
------
similar orders in writing shall be signed by such one or more officers or
employees of the Corporation as the Board of Directors may from time to time
designate.

Section 10.02. Contracts.
---------

(a) General Rule. Except as otherwise provided in the BCL in the case
------------
of transactions that require action by the shareholders, the Board of Directors
may authorize any officer or agent to enter into any contract or to execute or
deliver any instrument on behalf of the Corporation, and such authority may be
general or confined to specific instances.

(b) Statutory Form of Execution of Instruments. Any note, mortgage,
------------------------------------------
evidence of indebtedness, contract or other document, or any assignment or
endorsement thereof, executed or entered into between the Corporation and any
other person, when signed by one or more officers or agents having actual or
apparent authority to sign it, or by the president or vice president and
secretary or assistant secretary or treasurer or assistant treasurer of the
Corporation, shall be held to have been properly executed for and in behalf of
the Corporation, without prejudice to the rights of the Corporation against any
person who shall have executed the instrument in excess of his or her actual
authority.

Section 10.03. Interested Directors or Officers; Quorum.
----------------------------------------

(a) General Rule. A contract or transaction between the Corporation
------------
and one or more of its directors or officers or between the Corporation and
another Corporation, partnership, joint venture, trust or other enterprise in
which one or more of its directors or officers are directors or officers or have
a financial or other interest, shall not be void or voidable solely for that
reason, or solely because the director or officer is present at or participates
in the meeting of the Board of Directors that authorizes the contract or
transaction, or solely because his, her or their votes are counted for that
purpose, if:

(1) the material facts as to the relationship or interest and as
to the contract or transaction are disclosed or are known to the Board
of Directors and the Board of Directors authorizes the contract or
transaction by the affirmative

26
<PAGE>

votes of a majority of the disinterested directors even though the
disinterested directors are less than a quorum;

(2) the material facts as to his or her relationship or interest
and as to the contract or transaction are disclosed or are known to
the shareholders entitled to vote thereon and the contract or
transaction is specifically approved in good faith by vote of those
shareholders; or

(3) the contract or transaction is fair as to the Corporation as
of the time it is authorized, approved or ratified by the Board of
Directors or the shareholders.

(b) Quorum. Common or interested directors may be counted in
------
determining the presence of a quorum at a meeting of the Board of Directors
which authorizes a contract or transaction specified in subsection (a).

Section 10.04. Deposits. All funds of the Corporation shall be
--------
deposited from time to time to the credit of the Corporation in such banks,
trust companies or other depositaries as the Board of Directors may approve or
designate, and all such funds shall be withdrawn only upon checks signed by such
one or more officers or employees of the Corporation as the Board of Directors
shall from time to time designate.

Section 10.05. Corporate Records.
-----------------

(a) Required Records. The Corporation shall keep complete and
----------------
accurate books and records of account, minutes of the proceedings of the
incorporators, shareholders and directors and a share register giving the names
and addresses of all shareholders and the number and class of shares held by
each. The share register shall be kept at either the registered office of the
Corporation in the Commonwealth of Pennsylvania or at its principal place of
business wherever situated or at the office of its registrar or transfer agent.
Any books, minutes or other records may be in written form or any other form
capable of being converted into written form within a reasonable time.

(b) Right of Inspection. Every shareholder shall, upon written
-------------------
verified demand stating the purpose thereof, have a right to examine, in person
or by agent or attorney, during the usual hours for business for any proper
purpose, the share register, books and records of account, and records of the
proceedings of the incorporators, shareholders and directors and to make copies
or extracts therefrom. A proper purpose shall mean a purpose reasonably related
to the interest of the person as a shareholder. In every instance where an
attorney or other agent is the person who seeks the right of inspection, the
demand shall be accompanied by a verified power of attorney or other writing
that authorizes the attorney or other agent to so act on behalf

27
<PAGE>

of the shareholder. The demand shall be directed to the Corporation at its
registered office in the Commonwealth of Pennsylvania or at its principal place
of business wherever situated.

Section 10.06. Amendment of Bylaws. These bylaws may be amended or
-------------------
repealed, or new bylaws may be adopted, either (i) by vote of the shareholders
at any duly organized annual or special meeting of shareholders, or (ii) with
respect to those matters that are not by statute committed expressly to the
shareholders and regardless of whether the shareholders have previously adopted
or approved the bylaw being amended or repealed, by vote of a majority of the
Board of Directors of the Corporation in office at any regular or special
meeting of directors. Any change in these bylaws shall take effect when adopted
unless otherwise provided in the resolution effecting the change. See Section
3.03(b) (relating to notice of action by shareholders on bylaws).

ARTICLE XI
Amendments

Section 11.01. Amendment by Shareholders. These bylaws may be
-------------------------
altered, amended or repealed by a majority vote of all of the shares of stock of
the Corporation issued and outstanding and entitled to vote at any annual or
special meetings of the shareholders duly convened after appropriate notice to
the shareholders of such proposed alteration, amendment or repeal.

Section 11.02. Amendment by the Board of Directors. These bylaws
-----------------------------------
may be altered, amended or repealed by the affirmative vote of a majority of the
Board of Directors at any regular or special meeting of the Board of Directors
duly convened after appropriate notice to the directors of such proposed
alteration, amendment or repeal.

Section 11.03. Recording Amendments and Alterations. The text of
------------------------------------
all amendments and alterations to these bylaws shall be attached to the bylaws
with a notation of the date of each such amendment or alteration and a notation
of whether such amendment or alteration was adopted by the shareholders or the
Board of Directors.

ARTICLE XII
Adoption of Bylaws - Record of Amendment

Section 12.1. Adoption. These Amended and Restated Bylaws have been
--------
adopted and filed with the undersigned on the 11th day of June, 1997, and shall
be effective as of this date.

<PAGE>

Exhibit 10.10

STOCK PURCHASE AND SHAREHOLDERS' AGREEMENT

STOCK PURCHASE AND SHAREHOLDERS' AGREEMENT, dated December 6, 1996
(the "Agreement"), by and among CDNOW, INC., a Pennsylvania corporation (the
"Company"), MILO PRODUCTIONS, INC., a Pennsylvania corporation ("Milo") , JASON
OLIM and MATTHEW OLIM (together, the "Olims" and, together with the Company and
Milo, the "Defendants") and JEFFREY McCLUSKY, ANTHONY LUCENTI and WILLIAM
BRENNAN (collectively, the "MBL Individuals"), MBL ENTERTAINMENT, INC., an
Illinois corporation ("MBL" and together with the "MBL Individuals," the "MBL
Investors") and ALAN MELTZER ("Meltzer" and together with the MBL Investors, the
"Investors") . As used herein, the term "Shareholders" shall mean the Olims and
the Investors, collectively.

Background
----------

The Investors and the Company wish to set forth certain agreements
regarding their future relationships and their rights and obligations with
respect to certain securities of the Company to be acquired by the Investors.

Terms
-----

In consideration of the mutual covenants contained herein and
intending to be legally bound hereby, the parties hereto agree as follows:

ARTICLE I

PURCHASE OF SECURITIES
----------------------

1.1 Sale and Purchase of Common Stock. In consideration of (a) the
---------------------------------
release and settlement of certain claims held by the Investors pursuant to
Section 1.3 of the Agreement; (b) the transfer to the Company by MBL of
substantially all of its properties, assets and rights pursuant to that certain
Agreement and Plan of Reorganization dated as of the date hereof by and among
the Company, MBL and each of the MBL Individuals (the "MBL Reorganization
Agreement") in the form attached hereto as Exhibit A; and (c) payment by Meltzer
---------
to the Company of $1.2 million, the receipt of which is hereby acknowledged, the
Company hereby issues and transfers (y) to MBL, 147,101 shares of the Company's
common stock, no par value ("Common Stock") , and (z) Meltzer, 153,639 shares of
Common Stock and a warrant to purchase Common Stock (the "Warrant") attached as

Exhibit B. As used herein, the term "Securities" shall mean the Warrant
- ---------
(including shares of Common Stock to be issued upon exercise thereof ) and the
Common Stock held by any party hereto, including shares of Common Stock and all
other securities of the Company (or a successor to the Company) received on
account of ownership of the Common Stock, including all securities issued in
connection with any merger, consolidation, stock dividend, stock distribution,
<PAGE>

stock split, reverse stock split, stock combination, recapitalization,
reclassification, subdivision, conversion or similar transaction in respect
thereof.

1.2 Simultaneous Deliveries. The following deliveries will be made
-----------------------
simultaneously with the signing of this Agreement: (a) the Company has
delivered to the Investors certificates for the Common Stock and the Warrant,
receipt of which is hereby acknowledged, in return for the consideration
specified in Section 1.1, receipt of which is hereby acknowledged by the
Company; and (b) the Company, the Olims, and the Investors have all executed and
delivered, a registration rights agreement (the "Registration Rights Agreement")
substantially in the form attached hereto as Exhibit C.
---------

1.3 Release; Waiver of California Civil Code Section 1542. Investors
-----------------------------------------------------
do hereby for themselves and for their respective agents, representatives,
predecessors, successors and assigns, and anyone claiming through or under them,
remise, release, and forever discharge Defendants and their present and former
agents, subsidiaries, affiliates, divisions, successors, representatives,
assigns, agents, officers, directors, partners, employees and shareholders, of
and from all manner of actions, causes of action, suits, claims, controversies,
covenants, contracts, agreements, promises, trespasses, damages, judgments, sums
of money, debts, dues, demands, obligations or liabilities of any nature
whatsoever, in law or in equity, known or unknown ("Claims"), which against the
said Defendants and their present and former parents, subsidiaries, affiliates,
divisions, successors, assigns, agents, officers, directors, partners, employees
and shareholders, the said Investors, their respective agents, representatives,
predecessors, successors and assigns ever had, or may have upon or by reason of
any matter alleged in MBL Entertainment, Inc., et al. v. CDNow, Inc., et al.,
------------------------------------------------------
95-CV-5721 (E.D. Pa.) or which are based in any way upon or relate in any way to
a General Partnership Agreement entered into between MBL and Milo as of May 11,
1995, a Merchandising Agreement between MusicNow! and Jason Olim, on behalf of
the Company, as of May 11, 1995, a Nondisclosure Agreement entered into between
Meltzer and Jason Olim on August 16, 1995, a Proposed Investment for the Company
and MusicNow! dated December 13, 1995 between the Olims, the Company, Milo, MBL,
JMA, Inc., Meltzer and the MBL Individuals and any written or oral employment or
consulting contract, agreement or other arrangement between MBL or any of the
MBL Individuals, on the one hand, and the Company or any of its affiliates, on
the other.

Defendants do hereby for themselves and for their respective agents,
representatives, predecessors, successors and assigns, and anyone claiming
through or under them, remise, release, and forever discharge the investors and
their present and former agents, subsidiaries, affiliates, divisions,
successors, representatives, assigns, agents, officers, directors, partners,
employees and shareholders, of and from all Claims, which against the said
Investors and their present and former parents, subsidiaries, affiliates,
divisions, successors, assigns, agents, officers, directors, partners, employees
and shareholders, the said Defendants, their respective agents, representatives,
predecessors, successors and assigns ever had, or may have upon or by reason of
any matter alleged in MBL Entertainment, Inc., et al. v. CDNow, Inc., et al.,
------------------------------------------------------
95-CV-5721 (E.D. Pa.) or which are based in any way upon or relate in any way to
a General Partnership Agreement entered into between MBL and Milo as of May 11,
1995, a Merchandising Agreement between MusicNow! and Jason Olim,

-2-
<PAGE>

on behalf of the Company, as of May 11, 1995, a Nondisclosure Agreement entered
into between Meltzer and Jason Olim on August 16, 1995, a Proposed Investment
for the Company and MusicNow! dated December 13, 1995 between the Olims, the
Company, Milo, MBL, JMA, Inc., Meltzer and the MBL Individuals, and any written
or oral employment or consulting contract, agreement or other arrangement
between MBL or any of the MBL Individuals, on the one hand, and the Company or
any of its affiliates, on the other.

The Investors and Defendants acknowledge that they have been advised
by legal counsel and are familiar with the provisions of California Civil Code
Section 1542, which provides as follows:

"A general release does not extend to claims which the creditor
does not know or suspect to exist in his favor at the time of
executing the release, which if known by him must have materially
affected his settlement with the debtor."

Pursuant to this statute, as well as any other statutes or common-law
principles, whether of federal or state origin, of similar effect, each of the
Investors and Defendants expressly waive any rights with respect to any claims
relating to or arising from any claims released in this Section 1.3, which any
of the Investors and Defendants may have. In connection with such waivers, the
Investors and Defendants acknowledge that each is aware that it or he may later
discover claims presently unknown or unsuspected, or facts in addition to or
different from those which it or he now knows or believes to be true, with
respect to the matters released by the Agreement. Nevertheless, it is the
intention of the Investors and Defendants, and each of them, through the
Agreement, fully, finally and forever to settle and release all such claims
and/or facts.

1.4 Reorganization. It is intended that the acquisition of assets of
--------------
MBL contemplated herein qualify as a tax-free reorganization pursuant to Section
368 (a) (1) (C) of the Internal Revenue Code of 1986, as amended (the "Code") .
In furtherance thereof, the MBL Individuals have agreed to cause the liquidation
of MBL pursuant to which the Common stock issued to MBL pursuant to Section 1.1
shall be distributed to the MBL Individuals as set forth
in the MBL Reorganization Agreement.

ARTICLE II

REPRESENTATIONS, WARRANTIES AND
COVENANTS RELATING TO THE COMPANY
---------------------------------

Milo, the Company and the Olims represent and warrant jointly and
severally (but, in the case of the Olims, insofar as the representations and
warranties in paragraphs (i) and (j) of this

-3-
<PAGE>

Article II, only to the best of their knowledge) to, and covenant and agree
with, each of the Investors as follows:

(a) The Company is a corporation validly existing and in good standing
under the laws of the Commonwealth of Pennsylvania and attached hereto as

Exhibit D and Exhibit E, respectively, are true and complete copies of the
- --------- ---------
Company's Articles of Incorporation, as amended to date, and the Company's
Bylaws, as in effect on the date hereof.

(b) Milo and the Olims have full legal right, power and authority
(including in the case of Milo, the due authorization by all necessary corporate
action) to enter into this Agreement and to perform his or its obligations, as
the case may be, hereunder without the need for the consent of any other person;
and this Agreement has been duly authorized, executed and delivered and
constitutes the legal, valid and binding obligation of Milo and the Olims,
enforceable against them in accordance with the terms hereof.

(c) The Company has full corporate power and corporate authority to
make, execute, deliver and perform this Agreement and to carry out all of the
transactions provided for herein.

(d) The Company has taken such corporate action as is necessary or
appropriate to enable it to perform its obligations hereunder, including, but
not limited to, the issuance and sale of the Common Stock and the Warrant to be
issued by it, and this Agreement constitutes the legal, valid and binding
obligation of the Company, Milo and the Olims, enforceable against the Company,
Milo and the Olims in accordance with the terms hereof.

(e) The Common Stock is, and the shares of Common Stock issuable upon
the exercise of the Warrant will be, when issued in compliance with the
provisions of the Warrant, validly issued, fully paid, non-assessable, and free
of preemptive rights and similar rights and claims.

(f) The warrant constitutes the legal, valid and binding obligation of
the Company, enforceable against the Company in accordance with its terms.

(g) The authorized capital stock of the Company consists solely of
5,000,000 shares of Common Stock, of which 1,006,827 shares are issued,
outstanding and held, as of the date hereof, as indicated in Schedule I. Except
----------
for the Warrant and this Agreement, there are no rights, subscriptions,
warrants, options, conversion rights, or agreements of any kind outstanding to
purchase from the Company, or otherwise require the Company to issue, any shares
of capital stock of the Company or securities or obligations of any kind
convertible into or exchangeable for any shares of capital stock of the Company
and the Company is not subject to any obligation (contingent or otherwise) to
repurchase or otherwise acquire or retire any shares of its capital stock.

-4-
<PAGE>

(h) Use of Proceeds. The Company shall use the proceeds from the sale
---------------
of Common Stock and the Warrant solely for working capital and general corporate
purposes.

(i) Financial Statements.
--------------------

(i) Attached hereto as Schedule II are the balance sheet of the
-----------
Company as of the end of the fiscal year ended December 31, 1995 and for the
eight months ended August 30, 1996 and the related statements of income and cash
flows for the respective fiscal periods then ended (all of the financial
statements referred to above in this provision are herein collectively referred
to as the "Financial Statements"). The Financial Statements fairly present the
financial position of the Company as of the respective dates set forth therein
and the results of the operations of the Company for the respective period or as
of the respective dates set forth therein, in each case in conformity with
generally accepted accounting principles applied on a consistent basis
throughout the periods involved, except as otherwise noted.

(ii) The Company has no material liability or obligation of
any nature, whether due or to become due, absolute, contingent or otherwise,
including liabilities for or in respect of federal, state, local or foreign
taxes and any interest or penalties related hereto except for liabilities that
are (a) fully reflected on the Balance Sheet and (b) incurred in the ordinary
course of business consistent with past practice since the date of the Balance
Sheet and fully reflected as liabilities on the Company's books of account, none
of which individually or in the aggregate, has been materially adverse.

(j) Material Contracts. The Company has no subsidiaries and does not
-------------------
own or control any capital stock, partnership interests or similar right in
respect of any other business entity. Schedule III contains a correct and
------------
complete listing of all contracts, arrangements or agreements that are or could
reasonably be expected to be material to the business, properties, assets,
liabilities, condition (financial or otherwise), prospects or competitive
position of the Company including, but not limited to, any acquisition,
disposition, intellectual property, employment, consulting, joint venture,
strategic alliance, or other similar contract or agreement and all contracts,
arrangements or agreements entered into with the Olims, Milo or Meltzer. The
Company is not in default under any such material contracts, and to the
Company's knowledge no other party to any such contracts is in default
thereunder.

ARTICLE III

REPRESENTATIONS, WARRANTIES AND
COVENANTS OF EACH INVESTOR
--------------------------

3.1 Representations, Warranties and Covenants of Each Investor. Each
----------------------------------------------------------
of the Investors, as to itself only, severally represents and warrants to, and
covenants and agrees with, the Company that:

-5-
<PAGE>

(a) Such Investor has full legal right, power and authority
(including in the case of MBL, the due authorization by all necessary corporate
action) to enter into this Agreement and to perform such Investor's obligations
hereunder without the need for the consent of any other person; and this
Agreement has been duly authorized, executed and delivered and constitutes the
legal, valid and binding obligation of such Investor enforceable against such
Investor in accordance with the terms hereof. Furthermore, MBL and each of the
MBL Investors represents and warrants that MBL is the exclusive owner of, and
has any and all rights, title and interest in and to any Claims that any of the
MBL investors may have ever had against the Defendants.

(b) The Securities are being acquired by such Investor for
investment, and not with a view to any distribution thereof that would violate
the Securities Act of 1933, as amended (the "Securities Act"), or the applicable
state securities laws of any state.

(c) Such Investor understands that the Securities have not been
registered under the Securities Act or the securities laws of any state and must
be held indefinitely unless subsequently registered under the Securities Act and
any applicable state securities laws or unless an exemption from such
registration becomes or is available.

(d) Such Investor is financially able to hold the Securities for
long-term investment, believes that the nature and amount of the Securities
being purchased are consistent with such Investor's overall investment program
and financial position, and recognizes that there are substantial risks involved
in the purchase of the Securities.

3.2 Legend. The Warrant and the certificates representing the Common
------
Stock shall bear the following legend in addition to any other legend required
under applicable law:

THESE SECURITIES HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF
1933, AS AMENDED (THE "SECURITIES ACT") OR THE SECURITIES LAWS OF ANY
STATE AND MAY NOT BE TRANSFERRED OR OTHERWISE DISPOSED OF WITHOUT
REGISTRATION OR EXEMPTION UNDER THE SECURITIES ACT OR APPLICABLE STATE
SECURITIES LAWS.

THE SECURITIES REPRESENTED BY THIS CERTIFICATE ARE ALSO SUBJECT TO THE
TERMS AND CONDITIONS OF A STOCK PURCHASE AND SHAREHOLDERS' AGREEMENT
BY AND AMONG THE COMPANY AND THE HOLDERS SPECIFIED THEREIN, A COPY OF
WHICH AGREEMENT IS ON FILE AT THE PRINCIPAL OFFICE OF THE COMPANY.
THE SALE, TRANSFER OR OTHER DISPOSITION OF THE SECURITIES IS SUBJECT
TO THE TERMS OF SUCH

-6-
<PAGE>

AGREEMENT AND THE SECURITIES ARE TRANSFERABLE ONLY UPON PROOF OF
COMPLIANCE THEREWITH.

3.3 Notation. A notation will be made in the appropriate transfer
--------
records of the Company with respect to the restrictions on transfer of the
Securities referred to in this Agreement.

3.4 Reliance. Each Investor acknowledges that the Company and each
---------
of the other Investors is entering into this Agreement in reliance upon such
Investor's representations and warranties and other covenants and agreements
contained herein.

ARTICLE IV

AGREEMENT AMONG SHAREHOLDERS
----------------------------

4.1 Restrictions on Transfers of Securities.
---------------------------------------

The following restrictions on Transfer (as such term is defined
in this Section 4.1) shall apply to all Securities owned by any Shareholder:

(a) No Shareholder or Permitted Transferee (as such term is
defined in this Section 4.1), other than a Permitted Transferee by virtue of
Section 4.1(b) (iii) hereof, shall Transfer (other than in connection with a
redemption or purchase by the Company) any Securities unless (i) such Transfer
is to a Permitted Transferee and (ii) such Transfer otherwise complies with the
provisions of Article IV. No Shareholder or Permitted Transferee shall effect
any Transfer of Securities unless the transferee executes an agreement pursuant
to which such transferee agrees to be bound by the terms and provisions of this
Agreement applicable to the transferor (except as otherwise specifically
provided herein). Any purported Transfer in violation of this Agreement shall be
null and void and of no force and effect and the purported transferee shall have
no rights or privileges in or with respect to the Company. As used herein,
"Transfer" includes the making of any sale, exchange, assignment, hypothecation,
gift, security interest, pledge or other encumbrance, or any contract therefor,
any voting trust or other agreement or arrangement with respect to the transfer
of voting rights or any other beneficial interest in any of the Securities,
(other than the voting rights provisions described in Section 4.2) the creation
of any other claim thereto or any other transfer or disposition whatsoever,
whether voluntary or involuntary, affecting the right, title, interest or
possession in or to such Securities.

Prior to any proposed Transfer of any Securities, the holder
thereof shall give written notice to the Company describing the manner and
circumstances of the proposed Transfer. In advance of any such Transfer, the
holder thereof shall provide evidence to the Company, sufficient to the Company
in its reasonable discretion, that the proposed transferee shall be subject to
this Agreement. No recipient of any Securities pursuant to a Transfer shall be
entitled to any rights under this Agreement, including in particular those
rights described in Section 4.6, until and unless such transferee is made
subject to the terms of this Agreement. Each certificate evidencing

-7-
<PAGE>

the Securities transferred (except in the case of a transaction contemplated in
Section 4.1(b)(iii) hereof) shall bear the legends set forth in Section 3.2,
except that such certificate shall not bear such legend if the holder delivers a
written opinion of counsel, addressed to the Company and reasonably satisfactory
in form and substance to the Company, to the effect that such legend is not
required in order to establish compliance with any provision of the Securities
Act or applicable state securities laws.

Nothing in this Section 4.1(a) shall prevent the Transfer of
Securities by a Shareholder or a Permitted Transferee to one or more of its
Permitted Transferees or to the Company; provided, however, that each such
-------- -------
Shareholder or Permitted Transferee (except a Permitted Transferee by virtue of
Section 4.1(b) (iii) hereof) shall take such Securities subject to and be fully
bound by the terms of this Agreement applicable to it with the same effect as if
it were a party hereto; and provided, further, that (i) no entity or person
-------- --------
(other than a Permitted Transferee by virtue of Section 4.1(b)(iii) hereof)
shall be a Permitted Transferee unless such transferee executes a joinder to
this Agreement reasonably satisfactory in form and substance to the Company, and
(ii) no Transfer shall be effected except in compliance with the registration
requirements of the Securities Act or pursuant to an available exemption
therefrom.

(b) As used herein, "Permitted Transferee" shall mean:

(i) in the case of any Shareholder who is a natural
person, his or her spouse, parents (and, in the case of William Brennan, his
spouse's parents), siblings, children or grandchildren (in each case, natural or
adopted), any trust for his or her benefit or the benefit of his or her spouse,
parents, siblings, children or grandchildren (in each case, natural or adopted),
or any corporation or partnership in which the direct and beneficial owner of
all of the equity interest is such individual Shareholder or Permitted
Transferee or his or her spouse, parents or his or her spouse's parents,
siblings, children or grandchildren (in each case, natural or adopted) (or any
trust for the benefit of such persons);

(ii) in the case of any Shareholder who is, in each case,
a natural person, the heirs, executors, administrators or personal
representatives upon the death of such Shareholder or Permitted Transferee or
upon the incompetency or disability of such Shareholder or Permitted Transferee
for purposes of the protection and management of his assets;

(iii) in the case of any Shareholder or Permitted
Transferee, any person or other entity if such person or other entity takes such
Securities pursuant to a sale in connection with a Public offering (as such term
is defined in this Section 4.1) or following a Public Offering in open market
transactions or pursuant to Rule 144 promulgated under the Securities Act;

(iv) in the case of MBL, any of Jeffrey McClusky, Anthony
Lucenti and William Brennan; and

-8-
<PAGE>

(v) in the case of Meltzer or any of the MBL Individuals,
any of Meltzer or another MBL Individual.

As used herein, "Public Offering" means a successfully
completed firm commitment underwritten public offering pursuant to an effective
registration statement under the Securities Act in respect of the offer and sale
of shares of Common Stock for the account of the Company resulting in aggregate
gross proceeds to the Company and any shareholder selling shares of Common Stock
in such offering of not less than $20,000,000.

4.2 Voting Rights. Until the earlier of (i) the occurrence of a
-------------
Public Offering or (ii) five (5) years from the date hereof, each MBL Investor
irrevocably agrees to vote such MBL Investor's Common Stock as directed by
Meltzer and does hereby make, constitute, and appoint Meltzer with full power of
substitution, the true and lawful attorney and proxy of such MBL Investor for
and in such MBL Investor's name, place, and stead in respect to the Common Stock
owned by such MBL Investor, to represent and vote for such MBL Investor at all
meetings, regular or special, of the shareholders of the company, to consent to
and waive notice of all such special or regular meetings, and to consent to any
matter requiring the consent of shareholders or for which the consent of
shareholders is requested by the Company; provided; however, that the provisions
-------- -------
of this Section 4.2 shall not apply to any matter or transaction in which
Meltzer or any of his Affiliates has a financial or other interest (other than
as a result of Meltzer's ownership of the Securities) and for which the approval
of certain holders of Common Stock is required pursuant to Section 4.7 hereof.
Each MBL Investor hereby agrees that this voting agreement, power of attorney
and proxy is coupled with an interest and is irrevocable, and each MBL Investor
hereby ratifies and confirms all that Meltzer may lawfully do or cause to be
done by virtue hereof.

4.3 Board of Directors.
------------------

(a) The Shareholders hereby agree to take, at any time and from
time to time, all action necessary and within their control (including without
limitation, calling special meetings of shareholders, voting in person or by
proxy the shares of Common Stock owned by them at annual or special meetings of
shareholders, and executing and delivering written consents) such that: (i) two
members of the Board of Directors of the Company, each with one half of one
vote, shall be Meltzer and/or a person or persons designated by Meltzer and (ii)
the Board of Directors of any direct or indirect subsidiary of the Company shall
be identical to that of the Company.

(b) Meltzer may request that any director designated, by him be
removed (with or without cause) by written notice to the other Shareholders,
and, in any such event, each Shareholder shall promptly consent in writing or
vote or cause to be voted all shares of Common Stock now or hereafter owned or
controlled by it for the removal of such person as a director. In the event any
person ceases to be a director, such person shall also cease to be a member of
any committee of the Board of Directors of the Company.

-9-
<PAGE>

(c) In the event that a vacancy is created on the Company's
Board of Directors at any time by the death, disability, retirement, resignation
or removal (with or without cause) of a director designated by Meltzer, or if
otherwise there shall exist or occur any vacancy on the Company's Board of
Directors in a directorship subject to designation by Meltzer, such vacancy
shall not be filled by the remaining members of the Company's Board of Directors
but each Shareholder hereby agrees promptly to consent in writing or vote or
cause to be voted all shares of Common Stock now or hereafter owned or
controlled by it to elect that individual designated to fill such vacancy and
serve as a director, as shall be designated by Meltzer.

(d) The provisions of this Section 4.3 shall not terminate as of
the occurrence of a Public Offering unless the underwriters for such Public
Offering deliver to the Investors an opinion to the effect that the continuation
of the provisions of this Section 4.3 would have a material adverse effect on
the pricing for such Public Offering; provided, however, that upon consummation
-------- -------
of a Public Offering, Meltzer shall resign or cause the resignation of one of
the directors of the Company appointed by him pursuant to subparagraph (a) of
this Section 4.3 and the non-resigning director shall remain a member of the
Board of Directors of the Company, with one vote.

4.4 Duties of the Olims; Noncompetition Agreements. In consideration
----------------------------------------------
of the payments, transfers and undertakings of the Investors pursuant to this
Agreement, each of the Olims agrees that so as long as he is employed or
otherwise serving as a director or consultant for the Company and, thereafter
(i) for three (3) years, if he voluntarily terminates his employment, director
or consulting relationship with the Company within three (3) years of the date
hereof, (ii) for three (3) years, if such employment, director or consulting
relationship is terminated by the Company for Cause, or (iii) for an additional
two (2) years if he voluntarily terminates his employment or consulting
relationship with the Company at any time after three (3) years from the date
hereof, he will not, directly or indirectly, engage or become interested
(whether as an owner, stockholder, partner, lender, investor, director, officer,
employee, consultant or otherwise) in any business or commercial enterprise that
is involved in Internet based retailing or any other business activity in which
the Company or any of its subsidiaries is now engaged or undertakes at any time
during such five (5) year term and while the Olims are employed by the Company
or, in the alternative, own, in the aggregate, at least ten percent (10%) of the
Common Stock then outstanding; provided that ownership by the Olims of not more
than one percent (1%) of the outstanding securities of any class of any
corporation that is listed on a national securities exchange or traded in the
over-the-counter market, shall not be considered a breach of this Section 4.4.
The Olims understand and hereby agree that the Investors would not be fairly
compensated by money damages for any breach of this Section 4.4 by the Olims and
therefore, in the event of a breach or threatened breach of this Section 4.4,
the Investors shall be entitled to seek specific performance, an injunction and
other equitable relief in addition to money damages and other legal remedies to
the extent that a court of competent jurisdiction determines such equitable
remedies to be appropriate under the circumstances.

As used herein, "Cause," shall mean a person's willful engagement in
conduct which violates the terms of this Section 4.4.

-10-
<PAGE>

4.5 Financial Statements and Other Information. So long as any
------------------------------------------
Investor owns any of the Securities, the Company shall deliver to Meltzer (it
being understood that Meltzer shall be permitted to provide copies of any
information provided to him pursuant to this Section 4.5 to any of the
Investors):

(a) as soon as available and in any event within forty-five (45)
days after the end of each of the first three quarters of each fiscal year of
the Company, a consolidated balance sheet of the Company as of the end of such
period, and consolidated statements of income and cash flows of the Company for
the period then ended, each internally prepared in conformity with generally
accepted accounting principles applied on a consistent basis, except as
otherwise noted therein, and subject to the absence of footnotes and to year-end
adjustments; and

(b) as soon as available and in any event within ninety (90)
days after the end of each fiscal year of the Company, a consolidated and
consolidating balance sheet of the Company as of the end of such year, and
consolidated and consolidating statements of income and cash flows of the
Company for the year then ended prepared in conformity with generally accepted
accounting principles applied on a consistent basis, except as otherwise noted
therein, together with an independent auditor's report thereon of a nationally
recognized, "Big Six" firm or a firm approved by a majority of the Common Stock
held by the Investors as of the earlier of (i) the date hereof or (ii) the date
such auditor is first appointed to audit the books, records and financial
statements of the Company.

4.6 Preemptive Rights.
-----------------

(a) Except (x) in a Public Offering, (y) as a dividend on
outstanding shares of Common Stock, or (z) pursuant to any incentive or bonus
plan, agreement or arrangement approved by the Board of Directors for officers
and key employees of the Company in an amount not to exceed, together with any
other such bonus plan, agreement or arrangement then in existence in the
aggregate fifteen percent (15%) of the outstanding shares of Common Stock at
that time, if the Company proposes to issue and sell any of its shares of Common
Stock or any securities containing options or rights to acquire any shares of
Common Stock or any securities convertible into shares of Common Stock
(collectively, such stock or securities are referred to as the "New Issuance" to
any existing holder of the Company's Common Stock or any of their respective
Affiliates (as such term is defined in this Section 4, then the Company will
first offer to sell to each Investor a portion of each such New Issuance (after
deducting the amounts described in Section 4.6(b) below) equal to the quotient
determined by dividing (1) the number of outstanding shares of Common Stock held
by such Investor plus, in the case of Meltzer, Common Stock which may be
acquired upon exercise of the Warrant on the date of such offer, by (2) the
aggregate number of outstanding shares of Common Stock immediately prior to such
issuance. Each Investor shall be entitled to purchase stock or other securities
in any New Issuance on the same terms and conditions (including price) as are
offered to any of the other Shareholders; provided that if all Shareholders
entitled to purchase stock or securities pursuant to this Section 4.6(a) are
required by the Company to also purchase other securities of the Company as a
condition to participating in such New

-11-
<PAGE>

Issuance, Shareholders exercising their rights pursuant to this Section 4.6
(a) shall also be required to purchase the same strip of securities (on the same
terms and conditions including price) that all Shareholders are required to
purchase in order to purchase any stock or securities in such New Issuance.

In the event that an Investor does not elect to purchase his or its
portion of such New Issuance as determined in this Section 4.6 (the "Declined
Portion"), the Company shall give notice of such failure to the other Investors,
and the other Investors shall thereupon have the right and option to purchase in
the aggregate all, but not less than all, of the Declined Portion and may give
notice to the Company of such intention at any time not later than thirty (30)
days after the date on which such notice is sent by the Company to such
Investors. Each electing Investor's notice shall indicate the amount of the
Declined Portion that such investor desires to purchase. If such Investors elect
to purchase an aggregate number of shares in excess of the Declined Portion, the
Declined Portion shall be allocated among the Investors who desire to purchase
such shares in proportion to the number of shares of Common Stock (including, in
the case of Meltzer, Common Stock issuable upon exercise of the Warrant) owned
by each of them; provided that no such other Investor shall become bound to
purchase any of such Declined Portion in excess of the number of such shares he,
she or it had elected to purchase. If the foregoing allocation procedure does
not allocate all of the Declined Portion (because one or more Investors would
otherwise have been allocated more than the number of shares he, she or it
elected to purchase), then the remaining part of the Declined Portion shall be
allocated among the other Investors who desire to purchase such shares in
proportion to the number of shares of Common Stock (including, in the case of
Meltzer, Common Stock issuable upon exercise of the Warrant) owned by each of
them, and such allocation procedure shall continue until all such shares shall
have been allocated. Promptly upon determining the number of the shares which
each purchasing Investor will purchase and the purchase price therefor, the
Company shall send notices thereof to each of the purchasing Investors.

As used in this Article IV, "Affiliate" shall mean, with respect to
any specified person, any other person directly or indirectly controlling or
controlled by or under direct or indirect common control with such specified
person; it being understood that for purposes of this definition, "control"
(including, with correlative meanings, the terms "controlling", "controlled by"
and "under common control with") , as used with respect to any person, shall
mean the possession, directly or indirectly, of the power to direct or cause the
direction of the management or policies of such person, whether through the
ownership of voting securities, by agreement or otherwise, provided that
--------
beneficial ownership (as such term is defined in Rule 13d-3 promulgated under
the Securities Exchange Act of 1934, as amended) of ten percent (10%) or more of
the equity securities of a Person shall be deemed to be control.

(b) The Company will cause to be given to each Investor a
written notice setting forth the terms and conditions upon which such
Shareholders may purchase such shares or other securities pursuant to this
Section 4.6 (the "Preemptive Notice"). After receiving a Preemptive Notice, each
Investor must reply, in writing, within fifteen (15) days of the date of such
Preemptive Notice that such person agrees to purchase the stock or other
securities offered pursuant to this

-12-
<PAGE>

Section 4.6 on the date of the proposed New Issuance (the "Preemptive Reply").
If any of such persons fails to make a Preemptive Reply in accordance with this
Section 4.6, the respective stock or other securities offered to such persons in
accordance with this Section 4.6 may thereafter, for a period not exceeding one
hundred twenty (120) days following the expiration of such fifteen (15) day
period, be issued, sold or subjected to rights or options at a price not less
than that at which they were offered to the Shareholders as provided herein. Any
such stock or other securities not so issued, sold or subjected to rights or
options during such one hundred twenty (120) day period will thereafter again be
subject to the preemptive rights provided for in this Section 4.6.

(c) Notwithstanding the foregoing, the provisions of this
Section 4.6 shall not be applicable to the issuance of shares of Common Stock
upon the conversion of shares of one class of Common Stock into shares of
another class or upon exercise of any securities previously issued by the
Company as a New Issuance pursuant to the terms and conditions of this Section
4.6.

4.7 Affiliate Transactions. Neither the Company nor any of its
----------------------
direct or indirect subsidiaries shall engage in any transactions with any
Affiliates except on terms and conditions that, in the reasonable judgment of
the Board of Directors of the Company, as evidenced by the unanimous approval of
such Board of Directors, are no less favorable to the Company or its direct or
indirect subsidiaries, as the case may be, than the terms and conditions which
the Company or such subsidiary, as the case may be, could obtain in a
transaction with an unaffiliated person on an arm's length basis; provided,
--------
however that so long as at the time of such transaction, there is one member of
- -------
the Board of Directors of the Company who is not an Affiliate and whose
appointment was reasonably acceptable to the Olims and Meltzer (the "Independent
Director"), only the approval of a majority of the Board of Directors, including
specifically the Independent Director, shall be required; provided, further that
-------- -------
any salary or other compensation to be paid to either of the Olims in any fiscal
year in excess of $150,000 shall require the unanimous approval of the Board of
Directors of the Company. In addition to such approval, if the Company proposes
to enter into any transaction with either or both of the Olims, on the one hand,
and Meltzer, on the other hand, the Company shall not enter into such
transaction except with the affirmative vote of the holders of a majority of the
shares of the Company's Common Stock that are held by persons other than the
Olims, Meltzer or any of their respective Affiliates. The restrictions
contained in this Section 4.7 shall not prohibit: (i) the payment of any
dividends, principal, interest or other amounts in respect of any of the
Securities in accordance with their terms; (ii) the prepayment or redemption of
any of the Securities in accordance with their terms; (iii) the grant of stock
options or similar rights to employees and directors of the Company in the
ordinary course of business and pursuant to plans approved by the Board of
Directors; provided further that such options or similar rights do not exceed,
-------- -------
in the aggregate, fifteen percent (15%) of the outstanding shares of Common
Stock at that time and (iv) fees, compensation, expense reimbursements or
employee benefit arrangements paid to and indemnity provided for the benefit of
directors, officers or employees of the Company or any direct or indirect
subsidiary of the Company in the ordinary course of business. The conditions of
this Section 4.7 will terminate upon the occurrence of a Public Offering.

-13-
<PAGE>

4.8 Tag-Along.
---------

(a) (i)on or after the date hereof, except as otherwise
provided in Section 4.8(a)(v), no Seller (as such term is defined herein) shall
sell any Common Stock or security convertible into or exercisable for Common
Stock (together, "Convertible Securities") in any transaction unless all Holders
(as such term is defined herein) are offered an equal opportunity to participate
in such transaction or transactions on a pro rata basis (based on the number of
shares of Common Stock outstanding on a fully-diluted basis) and on identical
terms (including price and type of consideration paid); provided, however, that
-------- -------
the Olims may sell Common Stock to any purchaser, other than the Company, in an
arms-length transaction which, in the aggregate when combined with all other
sales made pursuant to this Section 4.8, constitutes no more than five percent
(5%) of the Common Stock held by the Olims taken together on such date without
compliance with the provisions of this Section 4.8. As used in this Section
4.8, "Seller" means the Olims and their Permitted Transferees (other than a
Permitted Transferee by virtue of Section 4.1(b)(iii)); and "Holders" means the
investors and their Permitted Transferees (other than a Permitted Transferee by
virtue of Section 4.1(b)(iii).

(ii) Prior to any sale of Common Stock or Convertible
Securities subject to these provisions, the Seller shall notify the company in
writing of the proposed sale. Such notice (the "Seller's Notice") shall set
forth: (A) the number of shares of Common Stock subject to the proposed sale;
(B) the name and address of the proposed purchaser; and (C) the proposed type
and amount of consideration and terms and conditions of payment offered by such
proposed purchaser. The Company shall promptly, and in any event within fifteen
(15) days, mail or cause to be mailed the Seller's Notice to each Holder, along
with a notice setting forth the number of shares of Common Stock such Holder is
entitled to sell pursuant to this Section 4.8. A Holder may exercise the tag-
along right by delivery of a written notice (the "Tag-Along Notice") to the
Seller within fifteen (15) days of the date the Company mailed or caused to be
mailed the Seller's Notice. The Tag-Along Notice shall state the number of
shares of Common Stock that the Holder proposes to include in the proposed sale.
If no Tag-Along Notice is received during the fifteen (15) day period referred
to above, the Seller shall have the right for a one hundred and twenty (120) day
period to effect the proposed sale of shares of Common Stock or Convertible
Securities, as the case may be, on terms and conditions no more favorable than
those stated in the notice and in accordance with the provisions of this Section
4.8.

(iii) Notwithstanding anything to the contrary, a
Seller may make any of the following sales without offering the Holders the
opportunity to participate: (a) sales by a Seller to any Permitted Transferee,
provided that the proposed purchaser (except a Permitted Transferee by virtue of
- --------
Section 4.1(b)(iii) hereof) agrees in writing to be bound by the provisions of
this Agreement and (b) sales pursuant to an effective registration statement
under the Securities Act.

(iv) The tag-along obligations of the Sellers and the
rights of the Holders with respect thereto provided under this Section 4.8 shall
terminate upon the earlier of (a)

-14-
<PAGE>

the closing of a Public Offering and (b) the date on which the Investors
collectively own less than five percent (5%) of the Common Stock.

(v) Notwithstanding the requirements of this Section
4.8, a Seller may sell Common Stock at any time without complying with the
requirements of Section 4.8(a)(ii) so long as the Seller deposits into escrow
with a nationally recognized financial institution at the time of sale that
amount of the consideration received in the sale equal to the "Escrow Amount" in
accordance with the terms of this clause (v). The "Escrow Amount" shall equal
that amount of consideration as all the Holders would have been entitled to
receive if they had the opportunity to participate in the sale on a pro rata
basis, determined as if each Holder (A) delivered a Tag-Along Notice to the
seller in the time period set forth in Section 4.8(a)(ii) and (B) proposed to
include all of its shares of Common Stock in the sale.

No later than the date of the sale, the Seller shall notify the
Company in writing of the proposed sale. Such notice (the "Escrow Notice")
shall set forth the information required in the Seller's Notice, and in
addition, such notice shall state the name of the escrow agent and, if the
consideration (in whole or in part) for the sale was cash, then the account
number of the escrow account. The Company shall promptly, and in any event
within ten (10) days, mail or cause to be mailed the Escrow Notice to each
Holder.

A Holder may exercise the tag-along right by delivery to the Seller,
within fifteen (15) days of the date the Company mailed or caused to be mailed
the Escrow Notice, of (i) a written notice specifying the number of shares of
Common Stock it proposes to sell, and (ii) the certificates for such Common
Stock, with stock powers duly endorsed in blank, or Convertible Securities, with
a duly executed Exercise Notice and, if applicable, payment of the Exercise
Price.

Promptly after the expiration of the fifteenth (15th) day after the
Company has mailed or caused to be mailed the Escrow Notice, (A) the Seller
shall purchase that number of shares of Common stock proposed to be sold by the
Holders as Seller would have been required to include in the sale had Seller
complied with the provisions of Section 4.8(a)(ii), (B) all shares of Common
Stock not required to be purchased by Seller shall be returned to the Holders
thereof; and (C) all remaining funds and other consideration held in escrow
shall be released to Seller. If Seller received consideration other than cash in
its sale, Seller shall purchase the shares of Common Stock tendered by paying to
the Holders non-cash consideration and cash in the same proportion as received
by Seller in the sale.

Seller shall pay all costs and expenses of the Escrow Agent, and any
interest on the Escrow Amount shall accrue to the benefit of the Company.

4.9 Observers' Rights. So long as the MBL Investors own in the
-----------------
aggregate at least seven and one half percent (7.5%) of the Common Stock
outstanding, the MBL Investors shall have the right to designate one (1)
observer (other than any of the MBL Individuals or any person related by blood
or marriage to any of the MBL Individuals) (the "Observer") to attend meetings
of

-15-
<PAGE>

the Company's Board of Directors and committees thereof. The Company shall give
the Observer written notice of each meeting of the Board of Directors and
committees thereof at the same time and in the same manner as the members of the
Board of Directors or such committee receive notice of such meetings, and the
Company shall permit the Observer to attend as an observer all meetings of its
Board of Directors and committees thereof. The Observer shall be entitled to
receive all written materials and other information given to the directors in
connection with such meetings at the same time such materials and information
are given to the directors, and the Observer shall keep such materials and
information confidential. If the Company proposes to take any action by written
consent in lieu of a meeting of its Board of Directors or a committee thereof,
the Company shall give written notice thereof to the Observer prior to the
effective date of such consent. The Company shall provide to the Observer all
written materials and other information given to the directors in connection
with such action by written consent at the same time such materials and
information are given to the directors, and the Observer shall keep such
materials and information confidential. The Company shall pay the reasonable
out-of-pocket expenses of the Observer incurred in connection with attending
such meetings to the same extent that the Company pays for such expenses
incurred by the directors of the Company. The MBL Investors shall cause any
Observer to execute a confidentiality and nondisclosure agreement with the
Company, in form and substance reasonably satisfactory to the Company, whereby
the Observer covenants to keep confidential and not to disclose any and all
information Concerning the Company learned as a result of such person's status
as the Observer to the same extent that the directors of the Company are
obligated to do so under the Pennsylvania Business Corporation Law or any
successor statute.

4.1 Shareholder Suits. The investors and the Company hereby agree
-----------------
that in a shareholder derivative claim, suit or other proceeding (a
"Proceeding") involving, on the one hand, any of the investors and, on the other
hand, the Company, the non-prevailing party in such Proceeding shall pay any and
all costs, in particular the reasonable costs and expenses of attorneys and
other professionals, incurred by the prevailing party as a result of such
Proceeding.

4.1 Certain Tax Matters. In light of the Company's election to be
-------------------
treated as a subchapter S corporation for federal income tax purposes (a "S
Corporation") pursuant to the provisions of Section 1362 of the Code,
notwithstanding any other provisions of this Agreement or any other agreement
among the Company and the Shareholders, or any of them, the Shareholders shall
not sell, assign or transfer any shares of Common Stock to any person or
encumber any shares of Common Stock in any manner that could cause a termination
of the Company's status as a S Corporation without the prior written consent of
the Company. Any such sale, assignment, transfer or encumbrance shall be void.
If a transfer of shares of Common Stock does not comply with the provisions of
this Agreement, the purported transferee of the shares of Common Stock shall not
be considered a shareholder of the Company for any purpose whatsoever. Except
as otherwise provided in this Agreement, no Shareholder shall take any action
that would, whether standing alone or when taken with other actions, result in
the termination of the Company's status as a S corporation.

-16-
<PAGE>

ARTICLE V

DEFINED TERMS
-------------

As used in this Agreement, the following terms shall have the following
meanings:

Term As Defined
- ---- ----------
on Page
-------
<S> <C>
Agreement......................................................................... 1
Company........................................................................... 1
Milo.............................................................................. 1
Olims............................................................................. 1
Defendants........................................................................ 1
MBL Individuals................................................................... 1
MBL............................................................................... 1
MBL Investors..................................................................... 1
Meltzer........................................................................... 1
Investors......................................................................... 1
Shareholders...................................................................... 1
MBL Reorganization Agreement...................................................... 1
Common Stock...................................................................... 1
Warrant........................................................................... 1
Securities........................................................................ 1
Registration Rights Agreement..................................................... 2
Claims............................................................................ 2
Code.............................................................................. 3
Financial Statements.............................................................. 5
Securities Act.................................................................... 6
SECURITIES ACT.................................................................... 7
Transfer.......................................................................... 8
Permitted Transferee.............................................................. 8
Public Offering................................................................... 9
New Issuance......................................................................12
Declined Portion..................................................................12
Affiliate.........................................................................13
Control...........................................................................13
Preemptive Notice.................................................................13
Preemptive Reply..................................................................13
Convertible Securities............................................................15
Seller............................................................................15
Holders...........................................................................15
Seller's Notice...................................................................15
Tag-Along Notice..................................................................15
</TABLE>

-17-
<PAGE>

<TABLE>
<S> <C>
Escrow Amount.....................................................................16
Escrow Notice.....................................................................16
Observer..........................................................................17
Proceeding........................................................................17
S Corporation.....................................................................18
</TABLE>

ARTICLE VI

MISCELLANEOUS
-------------

6.1 Amendment and Modification. This Agreement may be amended or
--------------------------
modified, or any provision hereof may be waived, provided that such amendment or
waiver is set forth in a writing executed by: (i) the Company, (ii) the Olims,
(iii) Meltzer and (iv) the MBL Investors. No course of dealing between or among
any persons having any interest in this Agreement will be deemed effective to
modify, amend or discharge any part of this Agreement or any rights or
obligations of any person under or by reason of this Agreement.

6.2 Survival of Representations and Warranties. All representations,
------------------------------------------
warranties, covenants and agreements set forth in this Agreement will survive
the execution and delivery of this Agreement and the Closing Date and the
consummation of the transactions contemplated hereby, regardless of any
investigation made by an Investor or on its behalf.

6.3 Successors and Assigns; Entire Agreement. This Agreement and all
-----------------------------------------
of the provisions hereof shall be binding upon and inure to the benefit of the
parties hereto and their respective Successors and permitted assigns and
executors, administrators and heirs. This Agreement sets forth the entire
agreement and understanding among the parties as to the subject matter hereof
and merges and supersedes all prior discussions and understandings of any and
every nature among them.

6.4 Separability. In the event that any provision of this Agreement
------------
or the application of any provision hereof is declared to be illegal, invalid or
otherwise unenforceable by a court of competent jurisdiction, the remainder of
this Agreement shall not be affected except to the extent necessary to delete
such illegal, invalid or unenforceable provision unless that provision held
invalid shall substantially impair the benefits of the remaining portions of
this Agreement.

6.5 Notices. All notices provided for or permitted hereunder shall
-------
be made in writing by hand-delivery, registered or certified first-class mail,
telex, telecopier or air courier guaranteeing overnight delivery to the other
party at the following addresses (or at such other address as shall be given in
writing by any party to the others):

-18-
<PAGE>

If to the Company, to:

CDNow, Inc.
401 Old Pennlyn Pike
Suite 5
Pennlyn, PA 19422
Attention: Mr. Jason Olim
Telecopier No.: (215) 283-4965

with a required copy to:

Morgan Lewis & Bockius LLP
2000 One Logan Square
Philadelphia, PA 19103
Attention: Stephen M. Goodman, Esq.
Telecopier No.: (215) 963-5299

and

Karafin Gruenstein & Dubrow, P.C.
Suite 610
1900 Market Street
Philadelphia, PA 19103
Attention: Debra Lynne Gruenstein, Esq.
Telecopier No.: (215) 568-8260

If to Meltzer, to:

Windup Entertainment Group, Inc.
72 Madison Avenue
8th Floor
New York, NY 10016
Telecopier No.: (212) 843-0785

with required copies to:

Tyler Cooper & Alcorn
City Place, 35th Floor
Hartford, CT 06103-3488
Attention: Lewis Segal, Esq.
Telecopier No.: (860) 278-3802

and

-19-
<PAGE>

Dechert Price & Rhoads
4000 Bell Atlantic Tower
1717 Arch Street
Philadelphia, PA 19103
Attention: G. Daniel O'Donnell, Esquire
Telecopier No.: (215) 994-2222

If to the MBL investors, to:

MBL Entertainment, Inc.
c/o Jeff McClusky & Associates
719 W. Willow Street
Chicago, IL 60614
Attention: Anthony Lucenti/Jeffrey McClusky
Telecopier No.: (312) 280-9549

and

William Brennan
347 South Peck Drive
Beverly Hills, CA 90212
Telecopier No.: (310) 557-2556

with required copies to:

Kaye, Scholer, Fierman, Hays & Handler, LLP
1999 Avenue of the Stars
Suite 1600
Los Angeles, CA 90007
Attention: Robert Barnes, Esq.
Telecopier No.: (310) 229-1880

and

Sachnoff & Weaver, Ltd.
30 South Wacker Drive, 29th Floor
Chicago, IL 60606-7484
Attention: Lance Rodgers, Esquire
Telecopier No.: (312) 207-6400

and

-20-
<PAGE>

Dechert Price & Rhoads
4000 Bell Atlantic Tower
1717 Arch Street
Philadelphia, PA 19103
Attention: G. Daniel O'Donnell, Esquire
Telecopier No.: (215) 994-2222

If to Jason and/or Matthew Olim, to:

c/o CDNow, Inc.
401 Old Pennlyn Pike
Suite 5
Pennlyn, PA 19422
Attention: Mr. Jason Olim
Telecopier No.: (215) 283-4965

with a required copy to:

Morgan Lewis & Bockius LLP
2000 One Logan Square
Philadelphia, PA 19103
Attention: Stephen M. Goodman, Esq.
Telecopier No.: (215) 963-5299

and

Karafin Gruenstein & Dubrow, P.C.
Suite 610
1900 Market Street
Philadelphia, PA 19103
Attention: Debra Lynne Gruenstein, Esq.
Telecopier No.: (215) 568-8260

If to any of the Investors (other than as listed herein), to
their addresses as listed in the books of the Company.

All such notices shall be deemed to have been duly given:
when delivered by hand, if personally delivered; five (5) business days after
being deposited in the mail, postage prepaid, if mailed; when answered back, if
telexed; when receipt acknowledged, if telecopied; and an the next business day,
if timely delivered to an air courier guaranteeing overnight delivery.

-21-
<PAGE>

6.6 Governing Law. The validity, performance, construction and
-------------
effect of this Agreement shall be governed by and construed in accordance with
the internal law of the Commonwealth of Pennsylvania, without giving effect to
principles of conflicts of law.

6.7 Headings. The headings in this Agreement are for convenience of
--------
reference only and shall not constitute a part of this Agreement, nor shall they
affect their meaning, construction or effect.

6.8 Counterparts. This Agreement may he executed in two or more
------------
counterparts and by the parties hereto in separate counterparts, each of which
when so executed shall be deemed to be an original, and all of which taken
together shall constitute one and the same instrument.

6.9 Further Assurances. Each party shall use its reasonable efforts
------------------
to cooperate and take such action as may be reasonably requested by another
party in order to carry out the provisions and purposes of this Agreement and
the transactions contemplated hereby.

6.10 Remedies. In the event of a breach or a threatened breach by any
--------
party to this Agreement of its obligations under this Agreement, any party
injured or to be injured by such breach, in addition to being entitled to
exercise all rights granted by law, including recovery of damages, will be
entitled to specific performance of its rights under this Agreement. The
parties agree that the provisions of this Agreement shall be specifically
enforceable, it being agreed by the parties that the remedy at law, including
monetary damages, for breach of such provision will be inadequate compensation
for any loss and that any defense in any action for specific performance that a
remedy at law would be adequate is waived.

6.11 Party No Longer Owning Securities. If a party hereto ceases to
---------------------------------
own any Securities, such party will no longer be deemed to be an Investor for
purposes of this Agreement.

6.12 Pronouns. Whenever the context may require, and pronouns used
--------
herein shall be deemed also to include the corresponding neuter, masculine or
feminine forms.

-22-
<PAGE>

IN WITNESS WHEREOF, the parties hereto have executed this Stock
Purchase and Shareholders Agreement as of the day and year first above written.

CDNOW, INC.,
a Pennsylvania corporation

By: /s/ Matthew Olim
-----------------
Matthew Olim
Secretary and Treasurer

MILO PRODUCTIONS, INC.,
a Pennsylvania corporation

By: /s/ Matthew Olim
-------------------------------------------
Matthew Olim
Secretary and Treasurer

/s/ Jason Olim
-------------------------------------------
Jason Olim

/s/ Matthew Olim
-------------------------------------------
Matthew Olim

MBL ENTERTAINMENT, INC.,
an Illinois corporation

By: /s/ Jeffrey McClusky
-------------------------------------------------
Name:
Title:

/s/ Alan Meltzer
--------------------------------------------
Alan Meltzer

/s/ Jeffrey McClusky
--------------------------------------------
Jeffrey McClusky

/s/ Anthony Lucenti
--------------------------------------------
Anthony Lucenti

/s/ William Brennan
--------------------------------------------
William Brennan

-23-

<PAGE>

Exhibit 10.11

ORDER FULFILLMENT AGREEMENT

This Order Fulfillment Agreement ("Agreement") is entered into effective as
of June 20th, 1997, by and between CDnow, Inc. ("CDnow"), and Sound Delivery
("Sound Delivery"), a division of Valley Record Distributors, Inc. ("VRD").

BACKGROUND

A. VRD has created a database known as "Audiofile" which contains
information regarding pre-record music and music related products ("Music
Products").

B. Sound Delivery provides to various retailers direct-to-consumer order
fulfillment services, pursuant to which Sound Delivery provides, packs and ships
such products to the retailer's customers.

C. CDnow operates on the World Wide Web an "online music store" through
which it sells pre-recorded music and music related products to consumers (the
"Site").

AGREEMENT

Subject to the terms and conditions set forth below, the parties agree as
follows:

1. Additional Sites. The parties acknowledge that CDnow, during the term of
-----------------
this Agreement may own, or operate on a contract basis, online music stores in
addition to the Site. CDnow, at its election may choose to make such additional
sites subject to the terms and conditions of this Agreement (the "Additional
Sites"), CDnow shall pay to Sound Delivery a one time set-up fee of [***] for
each Additional Site that requires a new invoice format (e.g. new logo, address,
----
etc).

2. Audiofile. Upon execution and delivery of this Agreement, the parties
----------
will execute and deliver a license agreement substantially in the form attached
hereto as Exhibit A (the "Audiofile License"), pursuant to which Sound Delivery,
for the term of this Agreement, shall provide to CDnow a full copy of the
Audiofile database, including updates thereto, as provided in and subject to the
Audiofile License. CDnow must execute an Audiofile License for each Additional
Site, the license fee for which shall be [***] per quarter per Additional Site.
Sound Delivery warrants that the Audiofile database provided to CDnow will
contain all of the data provided to all other Sound Delivery licensees of the
same format Audiofile database and that during term of this Agreement, such data
will reflect substantially all of the inventory of VRD.

3. Electronic Data Interchange ("EDI")
-----------------------------------

(a) Sound Delivery Obligations. Sounds Delivery shall:
---------------------------
[Confidential treatment requested for redacted portions of document]

-1-
<PAGE>

(1) make commercially reasonable efforts to provide a daily status
file reporting "Stock on Hand" in electronic format on the VRD bulletin board
system;

(2) provide and maintain reasonable access to its database, ordering
and other systems and provide technical support and assistance so as to maintain
substantially uninterrupted, reasonable and efficient interfaces for support of
the services described herein;

(3) provide reasonable technical and operational support for CDnow's
development and operation of CDnow's EDI interface for fulfillment service under
this Agreement;

(4) notify CDnow in advance of any changes to the EDI Reference
Specifications (as defined in paragraph 3(b)(1) below);

(5) refrain from disclosing any transaction information regarding
CDnow except as necessary to perform its obligations under this Agreement; and

(6) retain EDI order information for at least four (4) months after
receipt thereof.

(b) CDnow Obligations. CDnow shall:
------------------

(1) comply in all respects with the EDI specifications and guidelines
attached hereto as Exhibit B (the "EDI Reference Specifications"), as may be
amended by Sound Delivery from time to time pursuant to paragraph 3(a)(4) above;
and

(2) maintain its modes of electronic access and transmission as
necessary for each party to perform its obligations under this Agreement.

(c) Mutual Obligations. Each party shall use commercially reasonable
-------------------
efforts to maintain the security of EDI and other transaction related
information.

4. Services Provided.
------------------

(a) Music Products. During the term of this Agreement, Sound Delivery
---------------
shall be the exclusive provider to CDnow of domestically manufactured CD,
audiocassette and vinyl Music Products and related order fulfillment services
and the nonexclusive provider of all other Music Products for the "Site" and all
"Additional Site," provided, however that CDnow may utilize third parties as
sources for Music Products not all "Additional Sites," provided, however, that
CDnow may utilize third parties as sources for Music Products not available
through Audiofile or otherwise through Sound Delivery. Notwithstanding the
foregoing, upon receipt of consent from Sound Delivery (which consent shall not
be unreasonably withheld or delayed), CDnow from time to time may acquire from
other sources Music Products for which Sound Delivery is otherwise

[Confidential treatment requested for redacted portions of document]

-2-
<PAGE>

the exclusive provider hereunder. Sound Delivery warrants that it will not
knowingly shop hereunder Music Products which infringe the copyright or other
intellectual property rights of any third party.

(b) Subsequent Developments. To the extent that Sound Delivery offers
------------------------
additional services or improvements relating to the fulfillment services
provided under this Agreement, it agrees to offer such additional service and/or
improvements to CDnow on terms and conditions substantially similar to the terms
and conditions therefor offered to such similarly customers.

(c) Sales Manager. At all times during the term of this Agreement, Sound
--------------
Delivery shall designate, and inform CDnow of the identity of, at least one
individual with the responsibility and authority to implement Sound Delivery's
obligations under this Agreement.

5. Music Product Pricing. Sound Delivery agrees to sell and CDnow agrees to
----------------------
purchase Music Products at Sound Delivery's published wholesale price as set
forth on Exhibit C attached hereto (the "Base Rate"), less the [***] discount
set forth therein. Base Rates may be updated VRD from time to time, effective
upon written notice to CDnow of such changes; provided, however, that any
increase in Base Rate shall reflect an increase in Sound Delivery's published
wholesale price. In the event that average Base Rates for CD, audiocassette and
vinyl Music Products increase by more than [***] during the term of this
Agreement, CDnow may elect to terminate this Agreement upon 30 days written
notice to Sound Delivery.

6. Order Placement and Fulfillment.
--------------------------------

(a) Transmission. CDnow will transmit all orders for products under
-------------
this Agreement in compliance with the EDI Reference Specifications. In
addition, CDnow will use commercially reasonable efforts to aggregate and
transmit its orders to Sound Delivery in batches.

(b) Fulfillment. Orders received on any business day by [***] Pacific
------------
Time will be shipped on the same day. Sound Delivery will use commercially
reasonable efforts to ship on the same day received, all orders received on any
business day between [***] Pacific Time and [***] Pacific Time. Orders received
between [***] Pacific Time will generally be shipped the next business day, but
may be shipped the same day received. Orders received after [***] Pacific Time
and orders received other than on business days will be shipped the following
business day. Orders received after [***] Pacific Time will be deemed received
the next business day.

(c) Reporting. Sound Delivery shall provide CDnow with reports and
----------
information regarding order status as set forth in the EDI Reference
Specifications.

[Confidential treatment requested for redacted portions of document]

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<PAGE>

(d) Pre-Orders.
-----------

(1) CDnow shall collect pre-orders until four days prior to the date
that a Music Product is first to be made available to consumers (the "street
date"), at which point such pre-orders will be forwarded in a separate batch to
Sound Delivery on the date and time of day required by Sound Delivery.

(2) Sound Delivery shall ship all pre-orders no later than street date
minus one day, provided Sound Delivery has received the new release title(s)
from the label/distributor of such new release(s) in time for processing.

(3) If a street date is delayed, CDnow will be responsible for holding
the pre-orders until four (4) days before the new street date.

(e) Back-Orders.
-----------

(1) Sound Delivery shall ship the in-stock items of an order
immediately and will cancel the out of stock items.

(2) CDnow may elect to have Sound Delivery hold an order that has one
or more items out of stock until it is completely fulfilled by typing a "Y" in
the "ship complete" field of the EDI inbound specifications. CDnow may inform
Sound Delivery from time to time of the number of days, up to a maximum of 25
days (the "Hold Period"), that Sound Delivery is to hold such "ship complete"
orders before shipping the available products and canceling the out of stock
products.

(3) In the event that all products included in an order are out of
stock, Sound Delivery will hold the order for the Hold Period before canceling
the order (subject to prior cancellation of such order by CDnow).

(4) Items not shipped due to "Ops Outs" (as defined in the EDI
Reference Specifications) will be canceled.

7. Shipping.
--------

(a) Risk of Loss. All shipments under this Agreement shall be F.O.B. VRD's
------------
shipping facility. Title and risk with respect to all orders and products
shipped by Sound Delivery or VRD under this Agreement shall pass to CDnow or its
customers upon delivery of the products to the carrier at the point of shipment.

(b) Choice of Carrier. Sound Delivery will use commercially reasonable
-----------------
efforts to ship the order with the requested carrier and will cancel any order
for which the delivery address is not serviced by the indicated carrier.

[Confidential treatment requested for redacted portions of document]

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<PAGE>

(c) Shipping Costs. Sound Delivery will invoice CDnow customers at such
--------------
rates as are requested by CDnow. CDnow will pay Sound Delivery all shipping
costs paid by Sound Delivery to the shipping agent (excluding any rebates
received by Sound Delivery) per the shipping tables attached hereto as Exhibit D
(as amended from time to time by Sound Delivery). Sound Delivery will provide
CDnow written notice of shipping rate changes and the effective date of such
changes.

(d) Damaged and Lost Shipments. In the event of shipping damage or orders
--------------------------
lost in shipment, Sound Delivery will assist in filing a claim on behalf of
CDnow for those orders shipped with an insured carrier, and will credit CDnow
with any amounts actually received by or credited to Sound Delivery in
connection wit such claim.

8. FULFILLMENT FEES.
----------------

(a) Packing and Handling Fees. CDnow will pay Sound Delivery the following
-------------------------
fees for each order fulfilled hereunder:

All Products: [***] per order including the first unit, plus
[***] per unit after the first unit.

International Surcharge: [***] per order shipped to an international
destination (any order shipped to any non-
U.S. or U.S. territory destination).

(b) Paper Inserts. CDnow will pay a fee of [***] per paper insert packed
-------------
by Sound Delivery in products shipped under this Agreement. CDnow shall supply
required paper inserts at no cost to Sound Delivery. For purposes of this
paragraph, paper inserts must be lightweight, paper-based, promotional items the
same size or smaller than a standard single CD, or pre-folded to such size.

(c) Merchandise Inserts. If CDnow desires to include promotional inserts
-------------------
other than the paper inserts described in the preceding paragraph ("Merchandise
Inserts") in its orders, CDnow shall supply, at no cost to Sound Delivery, such
Merchandise Inserts to be included in CDnow orders. Sound Delivery will
receive, warehouse, inventory and pack merchandise inserts for a mutually agreed
upon fee after a sample of the Merchandise Insert is received and reviewed for
packing and shipping requirements.

(d) Bar Codes on Inserts. A unique UPC bar-code is required for such paper
--------------------
or merchandise insert. CDnow should purchase and apply a proprietary bar-code
on all inserts. At CDnow's request, Sound Delivery will create and apply a bar-
code for a fee of [***] per applied bar-code.

[Confidential treatment requested for redacted portions of document]

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<PAGE>

(e) Custom Box Stickers. At CDnow's request, Sound Delivery will attach
-------------------
custom stickers to the outside of the shipping box at a cost of [***] per
sticker per order. CDnow shall supply required stickers at no cost to Sound
Delivery.

9. Segregated Inventory. Products designed by CDnow to be held in inventory
--------------------
by Sound Delivery or VRD on CDnow's behalf are referred to in this Agreement as
"Segregated Inventory." Risk of loss and ownership of Segregated Inventory
shall remain with CDnow or its customers at all times. CDnow will pay a product
management fee of [***] per Segregated Inventory unit received by Sound Delivery
in addition to any applicable fulfillment and other fees under this Agreement
with respect to such products and Sound Delivery's services in connection
therewith.

(a) Standard Product. Sound Delivery will inventory certain "standard
----------------
product" (e.g., single CDs or cassettes, tubed posters, single VHS, T-shirts,
and/or hats) for CDnow as Segregated Inventory.

(b) Bar Codes on Segregated Inventory. A UPC bar-code is required for each
---------------------------------
item of Segregated Inventory. CDnow should purchase and apply a proprietary
bar-code on all Segregated Inventory. At CDnow's request, Sound Delivery will
create and apply a bar-code for a fee of [***] per applied bar-code.

10. Imperfect Shipments and Product Returns.
---------------------------------------

(a) Sound Delivery Obligations. Under the following circumstances, Sound
--------------------------
Delivery will reship orders at no additional cost or credit CDnow the
appropriate invoice cost less earned discount, as applicable:

(1) except as otherwise herein provided, upon the return of defective
CDs and cassettes;

(2) in the event that items are listed on the applicable invoice and
reported by customers as not received; and

(3) in the event of returns due to items shipped that do not
correspond to the applicable CDnow order (i.e., product received by customer but
not ordered by CDnow for such customer).

Provided, however, that with respect to orders to reship under this
paragraph 10(a), CDnow must properly include in such order the replacement order
"source" code specified by Sound Delivery from time to time.

[Confidential treatment requested for redacted portions of document]

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<PAGE>

(b) CDnow Obligations: Under the following circumstances, CDnow may elect
-----------------
to reorder at its own expense or return the order for a credit equal to the Base
Price paid, excluding fulfillment and other fees.

(1) "buyers remorse" (i.e., customer does not want item or ordered
wrong item);

(2) return due to an address supplied incorrectly to Sound Delivery;
and

(3) returns due to refused delivery.

(c) Restricted Returns. Sound Delivery will not accept for return:
------------------
accessories, blank tape, any vinyl products (including, without limitation, LPs
and 12" singles), Imports, Limited Editions, Products identified in Audiofile as
nonreturnable, Record Club, Promotional (free product give-aways), Counterfeit
Product and product without the original artwork or liner notes or Product with
a Last Customer Return Date (as defined in the Audiofile documentation) prior to
the date the returned Product is received by Sound Delivery from CDnow. In
addition, Sound Delivery does not accept return of defective Sony, UNI or PGD
CDs, or defective PGD cassettes, or any PGD cassettes that do not have their
original wrapper intact. For purposes hereof, "defective" means Product
returned with the top spine label or original manufacturer's "dog-bone"
holographic sticker removed or cut in any way.

(d) Rejected Returns. Non-returnable merchandise received by Sound
----------------
Delivery will be shipped to CDnow at CDnow's expense as rejected returns, CDnow
will be charged a processing fee of [***] per rejected return.

(e) Returns Policy. Sound Delivery reserves the right, from time to time,
--------------
to modify its return policies, which modifications shall be effective upon
receipt by CDnow of written notice thereof; provided, however, that any such
modification shall be applicable to Sound Delivery's similarly situated
customers generally and imposed in response to modifications to the return
policies of Sound Delivery's suppliers.

11. Billing and Payment.
-------------------

(a) Invoices and Account Reconciliation. Sound Delivery will provide CDnow
-----------------------------------
with an invoice and account reconciliation by Tuesday of each week with respect
to activity the preceding week. Invoices are due and payable 60 days after the
invoice date. Account reconciliations shall be in substantially the form
attached hereto as Exhibit E.

(b) Timely Payment Discounts. Amounts invoiced as owed by CDnow to Sound
------------------------
Delivery include a [***] discount for timely payment. This discount will be
revoked and charged back to CDnow for invoices not paid by the due date.

[Confidential treatment requested for redacted portions of document]

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<PAGE>

(c) Past-due Amounts. CDnow agrees to pay interest on amounts more than 30
----------------
days past due at the lesser of [***] per month or the highest rate allowed by
law, such interest to accrue from the invoice date. Sound Delivery in its sole
discretion may refer to an agency or an attorney for collection any past due
amount, and CDnow will be liable for the payment thereof and all costs and
expenses incident thereto, including reasonable attorney's fees.

12. Proprietary Rights.
------------------

(a) Confidential Information. Each party acknowledges that, in the course
------------------------
of dealings between the parties, each party may acquire information, identified
as confidential, about the other party or the other party's customers, their
business activities and operations, and their technical information and trade
secrets, of a highly confidential and proprietary nature. The party that
acquires such information will hold it in strict confidence and will not use
such information except as reasonably necessary to perform its obligations under
this Agreement or disclose the same to third parties except for any information
generally available to or known to the public, independently developed outside
the scope of this Agreement, lawfully disclosed by a third party, or required to
be disclosed to a tribunal, provided that in the case of required disclosures to
tribunals, the party will use commercially reasonable efforts to obtain
protective orders maintaining the confidentiality of such information.

(b) Audiofile Database. The rights to intellectual property related to the
------------------
Audiofile database are governed by the Audiofile License.

(c) No Rights to Marks. Each party is hereby granted no rights in or to
------------------
the other party's Marks. "Marks" means the trademarks, service marks, trade
names or other marks, registered or otherwise, used by either Sound Delivery or
CDnow, as applicable.

13. Termination.
-----------

(a) Terms. The term of this Agreement begins on the date this Agreement is
-----
executed and delivered by both parties and expires [***] years thereafter;
provided, however, that this Agreement shall automatically be renewed for
subsequent one year terms unless one party notifies the other at least 90 days
prior to the expiration of the initial term or any subsequent one year term of
its intent not to renew this Agreement upon the expiration of such term.

(b) Early Termination. Either party may terminate this Agreement upon
-----------------
thirty (30) written notice under the following conditions:

(i) Sound Delivery discontinues fulfillment services to on-line
services, or CDnow discontinues the sale of pre-recorded music; or

(ii) Sound Delivery or CDnow delivers to the other party a 30-day
written notice of termination for a material breach of this Agreement, provided
such breach was

[Confidential treatment requested for redacted portions of document]

-8-
<PAGE>

previously identified in a written notice and the other party did not cure such
breach cause within 30 days.

14. Limitation of Remedies and Exclusion of Warranties. IN NO EVENT SHALL
--------------------------------------------------
EITHER PARTY BE LIABLE TO THE OTHER PARTY FOR LOST PROFITS, OR FOR
CONSEQUENTIAL, SPECIAL EXEMPLARY, PUNITIVE, INCIDENTAL, OR INDIRECT DAMAGES,
WHETHER OR NOT SUCH PARTY HAS BEEN ADVISED OF THEIR POSSIBILITY AND REGARDLESS
OF THE FORM OF ACTION. EXCEPT AS EXPRESSLY SET FORTH IN PARAGRAPHS 2 AND 4(a)
ABOVE, NEITHER SOUND DELIVERY NOR VRD MAKES ANY EXPRESS OR IMPLIED WARRANTIES
WITH RESPECT TO PRODUCTS SOLD UNDER THIS AGREEMENT AND DISCLAIMS ANY SUCH
WARRANTIES, INCLUDING ANY IMPLIED WARRANTY OF MERCHANTABILITY AND FITNESS FOR
PURPOSE.

15. GENERAL.
-------

(a) Effective Dates. The pricing, discounts and fee structure set forth
---------------
herein shall be deemed effective as of January 1, 1997. Sound Delivery will
provide a reconciliation and accounting statement setting forth the calculation
of any rebate due to CDnow as a result of such effective date and will credit
CDnow with any such rebate on the first invoices provided hereunder until such
credit has been applied in full.

(b) Survival. Paragraphs 12 and 14 hereof will survive any expiration or
--------
termination of this Agreement.

(c) Notice. All notices, other than those related to product pricing,
------
ordering and fulfillment, shall be in writing and delivered by certified mail,
postage prepaid and return receipt requested, or transmitted either by facsimile
or electronic mail if confirmed by such mailing, to the addresses provided in
writing from time to time by parties.

(d) Entire Agreement Amendments. This Agreement constitutes the entire
---------------------------
agreement of the parties concerning the subject matter hereof, superseding all
prior proposals, negotiations and agreements concerning the subject matter of
this Agreement. No representation or promise relating to and no amendment of
this Agreement will be binding unless it is in writing and signed by authorized
representatives of both parties.

(e) Assignment. This Agreement may not be assigned or otherwise
----------
transferred by either party without the prior written consent of the other
party, provided, however, that either party may assign or transfer all or any
portion of their rights and obligations under this Agreement to any affiliate of
such party without the prior written consent of the other party. For purposes
hereof, an "affiliate" of a party is any entity controlled by, under common
control with, or controlling such party. Subject to the foregoing, this
Agreement will bind and inure to the benefit of the successors and permitted
assigns of Sound Delivery, VRD and CDnow.

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-9-
<PAGE>

(f) Relationship of the Parties. Sound Delivery and CDnow are independent
---------------------------
parties and nothing in this Agreement shall be construed as constituting Sound
Delivery and CDnow as partners, joint venturers, or as creating the
relationships of employer and employee, franchiser and franchisee, master and
servant, principal and agent, or any other form of legal association that would
impose liability on one party for the act or failure to act of the other party.

(g) Governing Law; Captions; Waiver; Etc.. This Agreement will be governed
-------------------------------------
by and construed in accordance with the laws (excluding the laws of choice or
conflicts of laws) of the State of California. The captions appearing in this
Agreement are inserted only as a matter of convenience and in no way define,
limit, construe or describe the scope or interpretation of this Agreement. No
waiver by a party of any breach of any provision of this Agreement will
constitute a waiver of any other breach of that or any other provision of this
Agreement. In the event that any of the provisions contained in this Agreement
are held to be unenforceable, such provisions will be narrowed (or deleted if
necessary) to the minimum extent necessary to make them enforceable.

(h) Attorneys' Fees. In the event of any dispute or controversy arising
---------------
out of this Agreement, the prevailing party shall be entitled to reimbursement
of its costs, including court and arbitration costs and attorneys' and expert
witnesses' fees and costs.

In witness whereof, the parties hereto have executed this Agreement as of
June 28th, 1997.

SOUND DELIVERY, a division of CDnow, Inc.
VALLEY RECORD DISTRIBUTORS, INC.

By:/s/ Ken Alterwitz By: /s/ Jason Olim

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-10-

<PAGE>

Exhibit 10.12

ADVERTISING AGREEMENT

This Advertising Agreement ("Agreement"), dated as of January 5, 1998 is
made by and between CDnow, a Pennsylvania corporation, and GeoCities, a
California corporation ("GeoCities"). CDnow and GeoCities sometimes are
referred to collectively as the "Parties" and individually as a "Party."

In consideration of the mutual promises contained in this Agreement and
intending to be legally bound, CDnow and GeoCities hereby agree as follows:

Section 1. Definitions.

The following terms (and all declensions thereof) are used in this
Agreement with the respective meanings set forth below:

1.1 "Above-the-Fold" means situated within the portion of a page that is
designed to be visible on a standard computer screen with a resolution of 640
pixels by 480 pixels without requiring the user to scroll horizontally or
vertically through the page.

1.2 "Affiliate" means, with respect to either Party, any individual or
entity that, by virtue of a majority ownership interest, directly controls, is
controlled by or is under common control with that Party.

1.3 "Beyond the Banner" means, any type of promotion which involves
promotional techniques other than the placement of standard advertising banners
or standard advertising buttons.

1.4 "CDnow Icons" is defined in Section 2.1 of this Agreement.

1.5 "CDnow Site" means, collectively, all points of presence and/or
services maintained by CDnow or its Affiliates on the Internet or on any other
public data network.

1.6 "Commencement Date" means the date GeoCities first provides CDnow with
all links, advertisements and other promotional placements required under Stage
I described in the attached Exhibit B to this Agreement.

1.7 "Competitor" means [***]

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<PAGE>

1.8 "Confidential Information" is defined in Section 13.2 of this
Agreement.

1.9 "Cosmic Credit Program" means a syndicated selling program of CDnow
that sells Music or Video Products.

1.10 "Entity" means any individual, partnership, corporation, or division,
subsidiary or business unit thereof, retail site, World Wide Web site or other
entity

1.11 "Exclusive Areas" means [***]

1.12 "GeoCities Basic Commerce Platform" means the collection of links,
advertisements and promotional placements (as specified in Exhibit A to this
Agreement) associated with the GeoCities' neighborhood home pages and
neighborhood topic pages.

1.13 "GeoCities GeoShops Program" means the marketing program operated by
GeoCities which offers its homesteaders the opportunity to create a commercially
oriented homepage within the GeoCities Site. Participants in the GeoCities
GeoShops Program must confirm that their annual revenues are Two Hundred Fifty
Thousand Dollars ($250,000.00) or less upon application to the program.

1.14 "GeoCities Site" means, collectively, and subject to the limitations
set forth in the following sentences of this Section 1.13, all points of
presence and/or services maintained by GeoCities on the Internet as
www.geocities.com or on any other public data network; provided, however, that
"GeoCities Site" does not include any Homesteader Page or GeoShop Page with
revenues annually of Two Hundred Fifty Thousand Dollars ($250,000) or less. To
the extent that GeoCities enters into agreements with third parties relating to
the joint development and/or hosting of co-branded or outsourced personal home
page communities, such co-branded and outsourced communities shall not
constitute part of the GeoCities Site, unless GeoCities determines, in its
reasonable business judgment, that the inclusion of any such co-branded or
outsourced communities does not in any way conflict with or violate any such
agreement with a third party, or any agreements or other arrangements that such
third party may have with any other party, and provided such co-branding or
outsourced communities do not reduce the prominence of the GeoCities Site. If
GeoCities makes such a determination, it shall notify CDnow of such
determination, and the co-branded or outsourced community in question shall
thereupon become part of the "GeoCities Site."

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<PAGE>

1.15 "GeoShop Page" means any homepage created by a participant in
GeoCities GeoShops program.

1.16 "Homesteader Page" means any personal homepage, or commercial homepage
participating in GeoCities' GeoShop program (other than a GeoCities Affiliate)
which resides in a "member neighborhood" on the GeoCities Site.

1.17 "Impressions" is defined in Section 8.5 of this Agreement.

1.18 "Intellectual Property Rights" is defined in Section 10.1 of this
Agreement.

1.19 "Key Commerce Partners" means up to any four (4) primary commerce
partners of the GeoCities Site.

1.20 "Make Good Amount" is defined in Section 8.6 of this Agreement.

1.21 "Marks" means a Party's trademarks, tradenames, service marks,
symbols, logos, brand names and other proprietary indicia of a Party under
common law, state law, federal law and laws of foreign countries.

1.22 "Music or Video Products" means all forms and formats of pre-recorded
consumer audio and video products available for retail sale directly to
consumers, excluding used media which contain Music or Video Products.

1.23 "Qualifying Revenues" means, with respect to any monthly period, the
aggregate gross revenues resulting from Sessions less: (a) any shipping and
handling charges associated with the sale, (b) any sales taxes associated with
the sale, (c) any rebates associated with the sale and (d) any Qualifying
Revenues which are attributable to returned products and which have previously
been included in Qualifying Revenues.

1.24 "Return Icon" is defined in Section 2.2 of this Agreement.

1.25 "Session" means each instance in which a user accesses the CDnow Site
via a hypertext link embedded in any link, advertisement or other promotional
placement provided by GeoCities under this Agreement, and then views one or more
consecutive CDnow Site pages. A Session terminates when the user exits the
CDnow Site by any means.

1.26 "URL" means Uniform Resource Locator.

1.27 "Viewer" means any user of the GeoCities Site who executes a link and
is connected to the CDnow Site.

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<PAGE>

Section 2. Linkage

2.1 (a) The CDnow graphic or other visual cues depicted on the attached
Exhibit A and associated with one or more URLs, which may include CDnow's Marks
and/or other indicia of origin (the "CDnow Icons") shall be included among the
GeoCities Basic Commerce Platform hyperlink icons during the Term. When clicked
upon by a Viewer, the CDnow Icon will directly link the Viewer with the CDnow
Site. GeoCities shall implement the link between the CDnow Icon and the CDnow
Site.

(b) CDnow shall furnish GeoCities with full color representations of
the CDnow Icons at least ten (10) business days prior to the Commencement Date
for GeoCities' use under this Agreement. If CDnow subsequently modifies one or
more of the CDnow Icons or the URLs associated with the CDnow Icons, it shall
furnish a representation of same to GeoCities which GeoCities shall substitute
for the prior version within twenty (20) business days after receipt.

(c) During the initial term of this Agreement, GeoCities agrees that
CDnow is one of the Key Commerce Partners for the GeoCities Basic Commerce
Platform that will occupy premier positions on such platform, and CDnow will be
displayed and promoted in a manner no less commensurate with the display and
promotion of the other Key Commerce Partners on the GeoCities Basic Commerce
Platform.

(d) GeoCities further agrees that it will display the CDnow Icons in
a manner no less commensurate with its display of other vendor hyperlink icons
within the GeoCities Basic Commerce Platform.

2.2 The GeoCities graphic or other visual cue depicted on the attached
Exhibit A and associated with a single URL, which may include GeoCities' Marks
and/or other indicia of origin (the "Return Icon") shall be displayed by CDnow
on each page of the CDnow Site viewed by a Viewer during the Term (starting when
CDnow provides this capability) in the position within the page layout as shown
on Exhibit A. When clicked upon by a Viewer, the Return Icon will directly link
the Viewer with a specific URL in the GeoCities Basic Commerce Platform. CDnow
shall create the link on the CDnow Site between the Return Icon and the
GeoCities Basic Commerce Platform. GeoCities shall furnish CDnow with full
color representations of the Return Icon at least ten (10) business days prior
to the Commencement Date for CDnow's use under this Agreement. If GeoCities
subsequently modifies the Return Icon, it shall furnish a representation of same
to CDnow which CDnow shall substitute for the prior version within twenty (20)
business days after receipt. The Return Icon shall be visible at the CDnow Site
only to Viewers who link to the CDnow Site via the GeoCities Basic Commerce
Platform and to no other visitors at the CDnow Site.

2.3 CDnow shall ensure that the version of the CDnow Site viewed by
Viewers who link to the CDnow Site through the GeoCities Basic Commerce Platform
shall be substantially similar to the CDnow Site viewed by non-Viewers except
for CDnow co-branded sites with third parties, the Return Icon and as elsewhere
provided for in this Agreement.

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<PAGE>

Section 3. Promotional Placements

The promotional placements are specified in Exhibit B to this Agreement.

Section 4. Participation in Strategic Programs

The terms of participation in strategic programs are specified in Exhibit B
to this Agreement.

Section 5. Compensation

5.1 As full consideration for GeoCities' performance under this
Agreement (including, without limitation, GeoCities' provision of all links,
advertisements and promotions specified in Sections 2, 3 and 4), CDnow will pay
GeoCities the fixed placement fees and variable incentive payments specified in
this Section 5.

5.2 During the initial term of this Agreement (as specified in
Section 11.1 below), CDnow will pay GeoCities a fixed placement fee of [***] on
the Commencement Date and on each monthly anniversary of the Commencement Date.

5.3 For each month that occurs subsequent to the Commencement Date
during the term of this Agreement (including any renewal term), CDnow will pay
GeoCities the applicable percentage(s) of Qualifying Revenues set forth opposite
from the range of Qualifying Revenues occurring in the first column of the table
below.

Cumulative Revenues Revenue Share
(Computed from the Commencement Percentage
Date)

[ *** ]

5.4 For each Homesteader Page that (a) participates in the Cosmic
Credit Program during the term of this Agreement and (b) within the twelve (12)
months following the Homesteader Page's entering the Cosmic Credit Program, is
responsible for at least [***] in Qualifying Gross Revenue to CDnow as a result
of its participation in the Cosmic Credit Program, CDnow will pay

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<PAGE>

GeoCities a one-time bounty of [***]. This provision will survive the
expiration or termination of this Agreement with respect to those Homesteader
Pages that join the Cosmic Credit Program within twelve (12) months prior to
such expiration or termination.

5.5 With the exception of the fixed placement fee set forth in Section
5.2, CDnow will make payments under this Section 5 on a monthly basis, in
arrears. Specifically, within thirty (30) days following the end of each month
occurring subsequent to the Commencement Date, CDnow will pay GeoCities an
amount equal to the revenue share that accrued during such month pursuant to
Section 5.3 and any bounties payable pursuant to Section 5.4.

5.6 CDnow will deliver, together with each payment made pursuant to
Section 5.5, a written report signed by an authorized representative of CDnow
that describes (in reasonable detail) CDnow's calculation of the payment amount.

5.7 (a) GeoCities shall have the right, no more frequently than once
during the initial term and each renewal term, at its expense, upon thirty (30)
days advance written notice to CDnow and during CDnow's normal business hours,
to have an independent certified public accountant inspect and audit the books
and records of CDnow directly associated with CDnow's obligations to make
payments under this Agreement, for the purpose of verifying any payments due to
GeoCities under this Agreement. Any information obtained as a result of such
audit shall be the Confidential Information of CDnow, and GeoCities may use such
information only for the purpose of and only in such way as necessary for
collecting any amounts due it under this Agreement. In the event any shortfall
in payment to GeoCities is found which exceeds [***] of the total due GeoCities
for the reporting period audited, then CDnow shall promptly pay GeoCities the
shortfall amount and reimburse GeoCities for all reasonable costs of the audit.

(b) CDnow shall have the right, no more frequently than once during
the initial term and each renewal term, at its expense, upon thirty (30) days
advance written notice to GeoCities and during GeoCities' normal business hours,
to have an independent certified public accountant inspect and audit the books
and records of GeoCities directly associated with GeoCities' obligations under
this Agreement, for the purpose of verifying GeoCities' satisfaction of such
obligations. Any information obtained as a result of such audit shall be the
Confidential Information of GeoCities, and CDnow may use such information only
for the purpose of and only in such way as necessary for CDnow to enforce its
rights under this Agreement. In the event GeoCities' fails to meet any
obligations by more than [***] of the total requirement of such obligations as
set forth in this Agreement, then GeoCities shall promptly pay CDnow all
reasonable costs of the audit.

Section 6. Implementation

6.1 GeoCities and CDnow acknowledge that time is of the essence in the
design, development and commencement of the links, advertisements and
promotional placements specified in this Agreement. Accordingly, the Parties
will devote all commercially reasonable efforts to launch each link,
advertisement and promotional placement as soon as reasonably possible, in
accordance with a written development plan to be negotiated by the Parties in
good faith.

[Confidential treatment requested for redacted portions of document]
<PAGE>

6.2 GeoCities, in cooperation with CDnow, will test the links,
advertisements and promotional placements required under this Agreement prior to
the time that they "go live" on the GeoCities Site (e.g., prior to the time that
they are implemented and enabled on a production version of the GeoCities Site)
and will continue to test such links, advertisements and promotional placements
as is reasonable and necessary during the term of this Agreement to ensure that
they function properly and as specified under this Agreement. The Parties will
mutually agree when the program of links, advertisements and promotional
placements will go live on the GeoCities Site.

6.3 GeoCities will not cause any link, advertisement or promotional
placement under this Agreement to go live on the GeoCities Site prior to the
applicable date agreed by the Parties. Further, at CDnow's discretion, traffic
from promotional links and advertising placements will be enabled in stages;
provided, however, that such staging will not delay the Commencement Date.

Section 7. Traffic Data

7.1 On a monthly basis, GeoCities will provide CDnow with a report in a
form and via a distribution method mutually agreeable to the Parties concerning
search and browsing behavior on the GeoCities Site, to the extent such behavior
reasonably could relate to the online promotion or sale of Music or Video
Products, or other products that CDnow may sell from time to time. CDnow will
hold such data in confidence and will use it only in accordance with reasonable
guidelines to be mutually agreed upon by the Parties. Notwithstanding anything
to the contrary contained in this Section 7.1, GeoCities will not be required to
deliver to CDnow any user data in violation of its then-existing policies
regarding the protection of user information.

7.2 CDnow will provide GeoCities with a report at least once per month of
orders for CDnow's products submitted by GeoCities' users in a form and via a
distribution method mutually agreeable to the Parties. Such report is to be used
by GeoCities to actively track performance of various promotional tools that it
has in service. GeoCities will hold such data in confidence and will use it
only in accordance with reasonable guidelines to be agreed by the Parties.
Notwithstanding anything to the contrary contained in this Section, CDnow will
not be required to deliver to GeoCities any data in violation of its then-
existing privacy policies or policies regarding the protection of actual sales
information.

7.3 GeoCities will provide CDnow with a weekly report of Impressions
delivered to users of the GeoCities Site during the immediately preceding week
in a form and via a distribution method media mutually agreeable to the Parties.
Such report is to be used for CDnow to actively track whether GeoCities is
fulfilling its obligations under this Agreement.

Section 8. Exclusivity and Media Guarantee

8.1 [***]

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<PAGE>

8.2 GeoCities shall be allowed to sell limited quantities of Music or
Video Products through its GeoStore, though the GeoStore shall not offer more
than [***] separate Music or Video Products at any point in time and such Music
or Video Products shall not be sold through a Competitor. Participants in the
GeoCities GeoShops Program shall be allowed to sell products in the category of
Music or Video Products on the GeoCities Site.

8.3 To preserve the benefits provided to CDnow under this Agreement in the
event that GeoCities enters into any merger, acquisition, transfer of control,
sale of substantial assets or similar transaction with any Competitor, CDnow
shall have the right to terminate this Agreement upon thirty (30) days' written
notice.

8.4 GeoCities represents and warrants that (a) it will continue to expend
at least the same amount of resources (e.g. budget, staff) as it is currently
committing as of the time of execution of this Agreement for both the pages in
which the Impressions appear, the GeoCities Site and the GeoCities Basic
Commerce Platform generally; and (b) it will not develop or promote any space on
and/or linked from the GeoCities Site which functions in a substantially similar
manner to or provides the user with a substantially similar experience as the
GeoCities Basic Commerce Platform and which provides a substantially similar
level of integration throughout the GeoCities Site as the GeoCities Basic
Commerce Platform and which would contain any Competitor's advertising or
promotions for the category of Music or Video Products. If GeoCities fails or
determines not to meet the representations and warranties set forth in this
Section 8.4, then CDnow shall have the right to terminate this Agreement upon
thirty (30) days' written notice.

8.5 As a result of the deployment of the CDnow Icons on the GeoCities
Site, GeoCities will deliver a guaranteed minimum number of Impressions of at
least [***] Impressions per month. For purposes of this Agreement,
"Impressions" means a user's viewing of the CDnow ICON on a page on the
GeoCities Site.

8.6 If GeoCities fails to deliver the required minimum number of
Impressions in any given month during the initial term or the then current
renewal term, then GeoCities shall, within ten (10) days of the month following
the month in which GeoCities failed to deliver such minimum, make good the
shortfall from the prior month by using its best efforts to deliver additional
Impressions equal to the number of the prior month's shortfall (the "Make Good
Amount") by providing CDnow with additional advertising and promotional
opportunities at no additional charge to CDnow,

[Confidential treatment requested for redacted portions of document]
<PAGE>

with such additional advertising and promotional opportunities to be promptly,
mutually agreed upon in good faith by the Parties.

Section 9. Indemnification

9.1 CDnow will defend and indemnify GeoCities and its Affiliates (and
their respective employees, directors and representatives) against any claim or
action brought by a third party, to the extent relating to (a) the operation of
the CDnow Site, or (b) the violation of third-party intellectual property rights
by any editorial content or other materials provided by CDnow for display on the
GeoCities Site. Subject to GeoCities' compliance with the procedures described
in Section 9.3, CDnow will pay any award against GeoCities or its Affiliates (or
their respective employees, directors or representatives) and any costs and
attorneys' fees reasonably incurred by GeoCities and its Affiliates resulting
from any such claim or action.

9.2 GeoCities will defend and indemnify CDnow and its Affiliates (and
their respective employees, directors and representatives) against any claim or
action brought by a third party, to the extent relating to (a) the operation of
the GeoCities Site, or (b) the violation of any third-party intellectual
property rights by any editorial content or other materials provided by
GeoCities for display on the CDnow Site. Subject to CDnow's compliance with the
procedures described in Section 9.3, GeoCities will pay any award against CDnow
or its Affiliates (or their respective employees, directors or representatives)
and any costs and attorneys' fees reasonably incurred by CDnow and its
Affiliates resulting from any such claim or action.

9.3 In connection with any claim or action described in this Section, the
Party seeking indemnification (a) will give the indemnifying Party prompt
written notice of the claim, (b) will cooperate with the indemnifying Party (at
the indemnifying Party's expense) in connection with the defense and settlement
of the claim, and (c) will permit the indemnifying Party to control the defense
and settlement of the claim, provided that the indemnifying Party may not settle
the claim without the indemnified Party's prior written consent (which will not
be unreasonably withheld). Further, the indemnified Party (at its cost) may
participate in the defense and settlement of the claim.

Section 10. Intellectual Property Rights

10.1 Subject to the limited license granted to GeoCities under Section
10.2, CDnow reserves all of its ownership rights, title and interest in its
Intellectual Property Rights. Subject to the limited license granted to CDnow
under Section 10.3, GeoCities reserves all of its ownership rights, title and
interest in its Intellectual Property Rights. Neither Party grants any license
to any of the Party's Intellectual Property Rights to the other Party except as
specifically set forth in this Section 10. For purposes of this Agreement,
"Intellectual Property Rights" means all forms of intellectual property rights
and protections, including, without limitation, all right, title and interest in
and to all: (a) letters patent and all filed, pending or potential applications
for letters patent, including any reissue, reexamination, division, continuation
or continuation-in-part applications throughout the world now or hereafter filed
or issued; (b) trade secrets, and all trade secret rights and equivalent rights
arising under the common law, state law, federal law and laws of foreign
countries;

[Confidential treatment requested for redacted portions of document]
<PAGE>

(c) mask works, copyrights, other literary property or authors' rights, whether
or not protected by copyright or as a mask work, under common law, state law,
federal law and laws of foreign countries; and (d) Marks.

10.2 CDnow hereby grants to GeoCities, during the term of this Agreement, a
non-exclusive, non-transferable license to use CDnow's Marks as reasonably
necessary to perform its obligations under this Agreement; provided, however,
that any promotional materials containing CDnow's Marks will be subject to
CDnow's prior written approval.

10.3 GeoCities hereby grants to CDnow, during the term of this Agreement, a
non-exclusive, non-transferable license to use GeoCities' Marks as reasonably
necessary to perform its obligations under this Agreement; provided, however,
that any promotional materials containing GeoCities' Marks will be subject to
GeoCities' prior written approval.

10.4 Neither GeoCities nor CDnow will use the other Party's Marks in a
manner that disparages the other Party, its Marks or its products or services,
or portrays the other Party, its Marks or its products or services in a false,
competitively adverse or poor light. Each of GeoCities and CDnow will comply
with the other Party's requests as to the use of the other Party's Marks and
will avoid any action that diminishes the value of such Marks. Either Party's
unauthorized use of the other's Marks is strictly prohibited. Each Party's use
of the other Party's Marks and any and all goodwill associated therewith or that
may accrue as a result of such use will inure solely to the benefit of the other
Party (the owning Party).

Section 11. Term and Termination

11.1 The initial term of this Agreement will begin on the date of this
Agreement and will end twelve (12) months following the Commencement Date.

11.2 (a) CDnow will have the option to renew the term of this
Agreement for a single twelve (12) month renewal term beginning on the
expiration of the initial term by giving GeoCities written notice (indicating
CDnow's exercise of its option to renew the term of this Agreement) at least
thirty (30) days prior to the expiration of the initial term.

(b) During such renewal term, all terms and conditions of this
Agreement, except Section 11.2(a), will remain in full force and effect;
provided, however, that [***]

11.3 Either Party may terminate this Agreement if the other Party (a)
materially breaches this Agreement and does not cure the breach within thirty
(30) days following its receipt of written notice from the non-breaching Party,
or (b) ceases to carry on the portion of its business that relates

[Confidential treatment requested for redacted portions of document]
<PAGE>

to this Agreement. In the event that CDnow terminates this Agreement pursuant to
the terms of this Section 11.3, CDnow's obligation to make any further payments
not yet accrued under this Agreement will be eliminated.

11.4 Sections 1, 9, 10.1, 12 and 13 (together with all other
provisions that reasonably may be interpreted as surviving termination or
expiration of this Agreement) will survive the termination or expiration of this
Agreement.

Section 12. Disclaimers, Limitations and Reservations

12.1 EXCEPT AS EXPRESSLY PROVIDED IN THIS AGREEMENT, GEOCITIES DOES NOT
MAKE, AND HEREBY DISCLAIMS, ANY REPRESENTATIONS OR WARRANTIES REGARDING THE
GEOCITIES SITE, GEOCITIES' SERVICES OR ANY PORTION THEREOF, INCLUDING (WITHOUT
LIMITATION) IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR
PURPOSE. WITHOUT LIMITING THE GENERALITY OF THE FOREGOING, GEOCITIES
SPECIFICALLY DISCLAIMS ANY REPRESENTATION OR WARRANTY REGARDING (A) THE AMOUNT
OF SALES REVENUE THAT CDNOW MAY RECEIVE DURING THE TERM, AND (B) ANY ECONOMIC OR
OTHER BENEFIT THAT CDNOW MIGHT OBTAIN THROUGH ITS PARTICIPATION IN THIS
AGREEMENT.

12.2 EXCEPT AS EXPRESSLY PROVIDED IN THIS AGREEMENT, CDNOW DOES NOT
MAKE, AND HEREBY DISCLAIMS, ANY REPRESENTATIONS OR WARRANTIES REGARDING THE
CDNOW SITE, CDNOW'S SERVICES OR ANY PORTION THEREOF, INCLUDING (WITHOUT
LIMITATION) IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR
PURPOSE. WITHOUT LIMITING THE GENERALITY OF THE FOREGOING, CDNOW SPECIFICALLY
DISCLAIMS ANY REPRESENTATION OR WARRANTY REGARDING (A) THE AMOUNT OF SALES
REVENUES THAT MAY OCCUR DURING THE TERM, AND (B) ANY ECONOMIC OR OTHER BENEFIT
THAT GEOCITIES MIGHT OBTAIN THROUGH ITS PARTICIPATION IN THIS AGREEMENT.

12.3 NEITHER CDNOW NOR GEOCITIES WILL BE LIABLE TO THE OTHER FOR
CONSEQUENTIAL DAMAGES (INCLUDING, WITHOUT LIMITATION, LOST PROFITS OR LOST DATA)
ARISING OUT OF THIS AGREEMENT. EACH PARTY'S ENTIRE LIABILITY ARISING FROM THIS
AGREEMENT (EXCEPT FOR LIABILITIES ARISING UNDER SECTION 9 OR RESULTING FROM THE
PARTY'S GROSS NEGLIGENCE OR WILLFUL MISCONDUCT), WHETHER IN CONTRACT OR TORT,
WILL NOT EXCEED THE AMOUNTS TO BE PAID BY CDNOW UNDER SECTION 5.

12.4 CDnow will remain solely responsible for the operation of the CDnow
Site, and GeoCities will remain solely responsible for the operation of the
GeoCities Site. Each Party: (a) acknowledges that the CDnow Site and the
GeoCities Site may be subject to temporary

[Confidential treatment requested for redacted portions of document]
<PAGE>

shutdowns due to causes beyond the operating Party's reasonable control; and (b)
subject to the specific terms of this Agreement, retains sole right and control
over the programming, content and conduct of transactions over its respective
site.

Section 13. Miscellaneous

13.1 The Parties are entering this Agreement as independent contractors,
and this Agreement will not be construed to create a partnership, joint venture,
franchise or employment relationship between them. Neither Party will represent
itself to be an employee or agent of the other or enter into any agreement on
the other's behalf of or in the other's name.

13.2 Each Party agrees that the Confidential Information of the other Party
will be held in confidence to the same extent and the same manner as each Party
protects its own Confidential Information, but each Party agrees that in no
event will less than reasonable care be used. Each Party shall, however, be
permitted to disclose relevant aspects of such Confidential Information to its
officers, employees and consultants on a need-to-know basis for the purpose of
such Party's performance of its obligations under this Agreement, provided such
persons agree to protect the other party's Confidential Information to the same
extent as required under this Agreement. Each Party agrees to use all
reasonable steps to ensure that the other Party's Confidential Information
received under this Agreement is not disclosed in violation of this paragraph.
For purposes of this Agreement, "Confidential Information" means the terms of
this Agreement, except as otherwise specifically provided in this Agreement;
each Party's trade secrets, financial information, processes, formulas,
specifications, programs, instructions, source code, technical know-how, methods
and procedures for operation, benchmark test results, information about
employees, customers, marketing strategies, services, business or technical
plans and proposals, in any form; and any other information relating to either
Party that is not generally known to the public at large.

GeoCities agrees that it shall not be deemed a breach of this Agreement for
CDnow to disclose the terms and conditions of this Agreement in any regulatory
filing with the Securities & Exchange Commission, which CDnow in good faith
determines is required, provided CDnow seeks confidential treatment of the
material financial terms and conditions of this Agreement

Confidential Information shall not include information that (a) is or
becomes generally known or available to the public at large through no negligent
act or omission of either Party; (b) can be demonstrated to have been available
lawfully to either Party prior to the disclosure or had thereafter been
furnished to either Party without restrictions to disclosure or use; or (c) can
be demonstrated to be independently developed by the recipient of Confidential
Information without use of such Confidential Information and such independent
development is proven on the basis of either Party's records related to such
development.

13.3 Following the execution of this Agreement, CDnow and GeoCities will
prepare and distribute a joint press release (or coordinated press releases)
announcing the transaction. The contents and timing of the release (or
releases) shall be as mutually agreed by the Parties. Neither Party will issue
any further press releases or make any other disclosures regarding this
Agreement

[Confidential treatment requested for redacted portions of document]
<PAGE>

or its terms without the other Party's prior written consent or except as may be
required by law in the opinion of the Party's counsel.

13.4 In its performance of this Agreement, each Party will comply with all
applicable laws, regulations, orders and other requirements, now or hereafter in
effect, of governmental authorities having jurisdiction. Without limiting the
generality of the foregoing, each Party will pay, collect and remit such taxes
as may be imposed upon it with respect to any compensation, royalties or
transactions under this Agreement. Except as expressly provided herein, each
Party will be responsible for all costs and expenses incurred by it in
connection with the negotiation, execution and performance of this Agreement.

13.5 Neither CDnow nor GeoCities will be liable for, or will be considered
to be in breach of or default under this Agreement on account of, any delay or
failure to perform as required by this Agreement as a result of any causes or
conditions that are beyond such Party's reasonable control and that such Party
is unable to overcome through the exercise of commercially reasonable diligence.
If any force majeure event occurs, the affected Party will give prompt written
notice to the other Party and will use commercially reasonable efforts to
minimize the impact of the event.

13.6 Notices deliverable under this Agreement shall be given in writing,
addressed to the Parties set forth below and shall be deemed to have been given
either one (1) day after being given to an express overnight carrier with a
reliable system for tracking delivery; or when sent by a confirmed facsimile
with another copy sent by any other means specified in this paragraph; or three
(3) business days after having been mailed postage prepaid by United States
registered or certified mail, return receipt requested:

[Confidential treatment requested for redacted portions of document]
<PAGE>

<TABLE>
<S> <C>
For notices to CDnow: For notices to GeoCities:

Name: Rod Parker James A. Rea

Title: Senior Vice President, Marketing Vice President Business Development

Address: Jenkins Court, Suite 310 1918 Main Street, 3/rd/ Floor
610 Old York Road

City: Jenkintown PA 19046 Santa Monica, CA 90405-1030

Facsimile: (215) 517-4499 Facsimile: (310) 664-6520

with a copy to the CDnow General Counsel
</TABLE>

13.7 If any litigation is commenced to enforce any provision of this
Agreement or to seek a declaration of rights of the Parties hereunder or as a
result of any breach of any provision of this Agreement, the prevailing Party
will be entitled to recover from the non-prevailing Party all of its costs and
expenses incurred in connection with such litigation, including without
limitation reasonable attorneys' fees.

13.8 Neither CDnow nor GeoCities may assign this Agreement, in whole or
in part, without the other Party's prior written consent (which will not be
withheld unreasonably), except to (a) any corporation resulting from any merger,
consolidation or other reorganization involving the assigning Party, (b) any of
its Affiliates, or (c) any individual or entity to which the assigning Party may
transfer substantially all of its assets; provided that the assignee agrees in
writing to be bound by all the terms and conditions of this Agreement. Subject
to the foregoing, this Agreement will be binding on and enforceable by the
Parties and their respective successors and permitted assigns.

13.9 If any provision of this Agreement is declared null, void or
otherwise unenforceable, such provision will be deemed to have been severed from
this Agreement to the minimal extent if necessary, which Agreement will
otherwise be and remain in full force and effect to its remaining provisions.

13.10 This Agreement (a) represents the entire agreement between the
Parties with respect to the subject matter hereof and supersedes any previous or
contemporaneous oral or written agreements regarding such subject matter and (b)
may be amended or modified only by a written instrument signed by a duly
authorized agent of each Party. If any provision of this Agreement is held to
be invalid, such invalidity will not effect the remaining provisions.

13.11 This Agreement may be executed in any number of counterparts,
each of which shall be an original and all of which shall constitute together
one and the same document.

[Confidential treatment requested for redacted portions of document]
<PAGE>

IN WITNESS WHEREOF, the Parties have executed this Agreement on the date
first written above by their duly authorized representatives.

CDnow

By: /s/ Jason Olim
Jason Olim
Its: President and Chief Executive Officer

Jenkins Court, Suite 310
610 Old York Road
Jenkintown, PA 19046
Facsimile: (215) 517-4399
Attention: Jason Olim

GeoCities

By: /s/ James A. Rea
James A. Rea

Its: Vice President Business Development

1918 Main Street, 3/rd/ Floor
Santa Monica, California 90405
Facsimile: (310) 664-6520
Attention: James A. Rea

[Confidential treatment requested for redacted portions of document]

<PAGE>

EXHIBIT 23.1

CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS

As independent public accountants, we hereby consent to the use of our
report and all references to our firm included in or made part of this
registration statement.

/s/ Arthur Andersen LLP
Arthur Andersen LLP

Philadelphia, Pa.
January 16, 1998

<PAGE>

<ARTICLE> 5

<S> <C> <C>
<PERIOD-TYPE> 12-MOS 9-MOS
<FISCAL-YEAR-END> DEC-31-1996 DEC-31-1997
<PERIOD-START> JAN-01-1996 JAN-01-1997
<PERIOD-END> DEC-31-1996 SEP-30-1997
<CASH> 775,865 7,238,246
<SECURITIES> 245,641 983,600
<RECEIVABLES> 130,437 180,312
<ALLOWANCES> 12,000 17,000
<INVENTORY> 0 0
<CURRENT-ASSETS> 1,201,764 8,944,230
<PP&E> 505,224 1,803,025
<DEPRECIATION> 143,189 362,538
<TOTAL-ASSETS> 1,575,459 10,394,950
<CURRENT-LIABILITIES> 970,309 4,320,337
<BONDS> 0 0
0 9,516,239
0 0
<COMMON> 2,305,953 3,057,345
<OTHER-SE> (2,819,970) 6,717,588
<TOTAL-LIABILITY-AND-EQUITY> 1,575,459 10,394,950
<SALES> 6,300,294 9,452,864
<TOTAL-REVENUES> 6,300,294 9,452,864
<CGS> 5,363,989 7,730,975
<TOTAL-COSTS> 8,096,146 13,646,614
<OTHER-EXPENSES> 0 (94,045)
<LOSS-PROVISION> 12,000 5,000
<INTEREST-EXPENSE> 14,556 29,961
<INCOME-PRETAX> (1,810,408) (4,129,666)
<INCOME-TAX> 0 0
<INCOME-CONTINUING> (1,810,408) (4,129,666)
<DISCONTINUED> 0 0
<EXTRAORDINARY> 0 0
<CHANGES> 0 0
<NET-INCOME> (1,810,408) (4,129,666)
<EPS-PRIMARY> 0 0
<EPS-DILUTED> 0 0

</TABLE>