CDNOW INC, S-1/A, 1998-07-27

CDNOW INC
S-1/A, 1998-07-27
RECORD & PRERECORDED TAPE STORES

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REGISTRATION NO. 333-52367

AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON JULY 24, 1998

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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AMENDMENT NO. 2
TO
FORM S-1
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933

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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.

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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. [_]

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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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<PAGE>

++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
+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

July 24, 1998
1,330,000 SHARES

LOGO
CDNOW

COMMON STOCK

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Of the shares of Common Stock offered hereby, 1,250,000 shares will be sold
by CDnow, Inc. ("CDnow" or the "Company") and 80,000 shares will be sold by a
selling shareholder of the Company (the "Selling Shareholder"). The Company's
Common Stock is quoted on the Nasdaq National Market under the symbol "CDNW".
On July 23, 1998, the last reported sale price of the Common Stock was $22.1875
per share. See "Price Range of Common Stock."

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

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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 PROCEEDS
TO DISCOUNTS AND TO TO
PUBLIC COMMISSIONS(1) COMPANY(2) SELLING SHAREHOLDER
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<S> <C> <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
Underwriter.
(2) Before deducting expenses for this Offering, payable by the Company,
estimated at $500,000.

(3) The Company has granted the Underwriter a 30-day option to purchase up to
199,500 additional shares of Common Stock, solely to cover over-allotments,
if any. To the extent that the option is exercised, the Underwriter 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. See "Underwriting."

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The shares of Common Stock are offered by the Underwriter, subject to prior
sale, when, as and if delivered to and accepted by it, and subject to the right
of the Underwriter 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.

BT ALEX.BROWN

THE DATE OF THIS PROSPECTUS IS , 1998
<PAGE>

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. The Registration Statement and any amendments thereto,
including exhibits filed or incorporated by reference as a part thereof, are
available for inspection and copying at the Commission's offices as described
in the following paragraph.

The Company is subject to the informational requirements of the Securities
Exchange Act of 1934, as amended (the "Exchange Act"), and, in accordance
therewith, is required to file reports, proxy statements and other information
with the Commission. Such reports, proxy statements and other information 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 Commission's Web site located at http://www.sec.gov. The
Registration Statement has been filed with the Commission through EDGAR.

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CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS
THAT STABILIZE, MAINTAIN OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK.
SPECIFICALLY, THE UNDERWRITER 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".

IN CONNECTION WITH THIS OFFERING, THE UNDERWRITER MAY ENGAGE IN PASSIVE
MARKET MAKING TRANSACTIONS IN THE COMMON STOCK ON NASDAQ IN ACCORDANCE WITH
RULE 103 OF REGULATION M. SEE "UNDERWRITING."

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"CDNOW" IS A FEDERALLY REGISTERED SERVICE MARK OF THE COMPANY. THE COMPANY
HAS ALSO APPLIED FOR FEDERAL REGISTRATION OF THE MARK "COSMIC CREDIT." ALL
OTHER TRADEMARKS OR SERVICE MARKS APPEARING IN THE PROSPECTUS ARE TRADEMARKS
OR SERVICE MARKS OF THE RESPECTIVE COMPANIES THAT USE THEM.

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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 consolidated financial
statements of the Company and the notes thereto included elsewhere in this
Prospectus. Unless otherwise indicated, all information presented in this
Prospectus assumes no exercise of the over-allotment option granted by the
Company to the Underwriter. 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. All share numbers used herein reflect all stock
splits that have been effected prior to the date hereof.

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 300,000 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 325,000 sound samples and 125,000 product
notes, reviews and related articles, including articles from Rolling Stone,
MTV/VH1 and CDnow's editorial staff. 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 569,000 customers
who have made purchases from inception through June 30, 1998, 273,000 made
their initial purchases during the six month period ended June 30, 1998.
Average daily visits to the CDnow store have grown from approximately 12,000 in
January 1996 to approximately 173,000 in June 1998. The Company's net sales
grew to $11.6 million in the second quarter of 1998 compared to $10.0 million
and $3.0 million in the first quarter of 1998 and the second quarter of 1997,
respectively. The Company has also generated significant customer loyalty.
Despite the Company's rapid acquisition of new customers, repeat customers
accounted for approximately 58% of net sales in the second quarter of 1998.

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 1997 were
approximately $38.1 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 $47 million in 1997 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-
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

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concept, (iii) acquiring customers on an efficient basis, (iv) maximizing
customer retention, (v) enhancing its international capabilities and (vi)
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:

. Strategic Alliances. The Company seeks to enter into strategic alliances
with major Internet content and service providers and global music-
oriented media companies in order to enhance its new customer
acquisition efforts, increase purchases by current customers and expand
brand recognition. Since February 1998, the Company has broadened its
strategic alliance with Yahoo! to include Yahoo! Mail and Yahoo!'s music
chat space. The Company has also entered into new strategic alliances
with Lycos and Tripod, Lycos Bertelsmann, JAMtv and Straight Arrow
Publishers (the latter two, collectively, "Rolling Stone Network") and
MTV Networks, a subsidiary of Viacom International, Inc. ("MTV/VH1"),
with respect to MTV and VH1. In addition, CDnow has preexisting
alliances with GeoCities and Excite's WebCrawler service. CDnow's
alliances generally provide for the Company to be the premier online
recorded music retailer on certain of the sites of these providers with
the exclusive right to place music banner advertisements and integrated
links to the CDnow store on certain music-related or other specified
pages. The alliance with Rolling Stone Network also entitles CDnow to
use the Rolling Stone brand name in conjunction with the display of
cover art and excerpts of feature stories, record reviews, artist
biographies and music news from current and past editions of Rolling
Stone magazine. Under the MTV/VH1 alliance, the Company is the premier
online retailer of recorded music on the MTV and VH1 cable television
channels with preferred advertising rights with respect to special
events and promotions, including exclusive online sponsorship of the
1998 Video Music Awards. The alliance with MTV/VH1 also entitles CDnow
to use the MTV and VH1 brand names in conjunction with the display of
MTV and VH1 content, music reviews and music news and provides CDnow
with integrated links from the MTV and VH1 Web sites.

. 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 AltaVista,
Infoseek and Microsoft Network, and targeted music-related sites, such
as Billboard. CDnow's traditional advertising efforts have included
radio advertising in major markets, such as advertising on the Howard
Stern program, and print advertising in music-related publications,
including Spin and Variety. In the first quarter of 1998, the Company
initiated television advertising, including national advertising during
the Grammy Awards and the American Music Awards. The Company intends to
increase its use of television advertising, including through its
alliance with MTV/VH1, and has purchased advertising on such programs as
MTV's 1998 Video Music Awards, VH1's Flashback Week and the 1999 Grammy
Awards.

. Cosmic Credit Program. Through its Cosmic Credit Program, CDnow has
arrangements with over 52,000 small Web sites, typically fan sites
devoted to particular musical artists. Approximately 42,000 of these
sites have enrolled since December 1997. The Company provides Cosmic
Credit sites with embedded hyperlinks through which potential customers
can immediately be connected 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. The Company also targets e-
mail campaigns to specific customer and prospect segments based upon
their recent activity at 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
<PAGE>

THE OFFERING

Common Stock offered by the Company...
1,250,000 shares

Common Stock offered by the Selling Shareholder..

80,000 shares

Common Stock to be outstanding after the Offering..

17,516,397 shares(1)

Use of proceeds....................... For 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.

Nasdaq National Market symbol......... CDNW
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(1) As of June 30, 1998 and excludes (i) 905,795 shares of Common Stock
issuable upon the exercise of options outstanding as of June 30, 1998 under
the Company's 1996 Equity Compensation Plan (the "Equity Compensation
Plan") at a weighted average exercise price of $8.78 per share, (ii)
659,892 shares reserved for future grants under the Equity Compensation
Plan, (iii) 490,515 shares of Common Stock issuable upon the exercise of
warrants outstanding as of June 30, 1998 at a weighted average exercise
price of $13.42 per share. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Liquidity," "Management--
Equity Compensation Plan" and "Description of Capital Stock."

This Prospectus contains forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995. These forward looking
statements address, among other things, growth in Internet usage and online
commerce; future music retailing opportunities on the Internet; the Company's
business strategy, including its sales and marketing plans; expectation of
future losses; competitive factors; reliance on online and traditional
advertising and strategic alliances; use of proceeds; reliance on certain
vendors; projected capital expenditures; liquidity; possible business
relationships; possible effects of changes in government regulation; dependence
on key personnel; exposure to Year 2000; increased net sales in future periods;
increased sales to international customers; and pricing policy. 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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<PAGE>

SUMMARY FINANCIAL AND OPERATING DATA

<TABLE>
<CAPTION>
PERIOD FROM
INCEPTION
(FEBRUARY 12, SIX MONTHS ENDED
1994) TO YEAR ENDED DECEMBER 31, JUNE 30,
DECEMBER 31, ------------------------------------- -------------------------
1994(1) 1995(1) 1996 1997 1997 1998
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<S> <C> <C> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Net sales....................... $103,116 $2,176,474 $ 6,300,294 $ 17,372,795 $ 5,546,203 $ 21,624,030
Cost of sales................... 92,962 1,844,612 5,217,789 14,316,028 4,412,843 18,154,598
-------- ---------- ----------- ------------ ----------- ------------
Gross profit................... 10,154 331,862 1,082,505 3,056,767 1,133,360 3,469,432
Operating expenses:
Operating and development...... 26,946 149,982 669,280 2,541,434 812,284 2,765,714
Sales and marketing............ 12,945 200,972 621,454 9,139,348 1,121,960 17,769,619
General and administrative..... 28,712 180,573 563,593 1,953,078 743,385 1,734,159
Dispute settlement(2).......... -- -- 1,024,030 -- -- --
-------- ---------- ----------- ------------ ----------- ------------
Total operating expenses....... 68,603 531,527 2,878,357 13,633,860 2,677,629 22,269,492
-------- ---------- ----------- ------------ ----------- ------------
Operating loss................. (58,449) (199,665) (1,795,852) (10,577,093) (1,544,269) (18,800,060)
Interest income (expense), net.. -- (1,248) (14,556) (170,312) (5,415) 733,137
-------- ---------- ----------- ------------ ----------- ------------
Net loss(3)..................... $(58,449) $ (200,913) $(1,810,408) $(10,747,405) $(1,549,684) $(18,066,923)
======== ========== =========== ============ =========== ============
Net loss per common share(4).... $ (1.42) $ (0.20) $ (1.29)
============ =========== ============
Weighted average number of
common shares outstanding(4)... 7,845,684 7,845,684 14,044,939
============ =========== ============
OPERATING DATA:
Customers(5).................... 1,787 26,953 87,859 296,450 143,257 569,034
</TABLE>

<TABLE>
<CAPTION>
JUNE 30, 1998
--------------------------
ACTUAL AS ADJUSTED(6)
BALANCE SHEET DATA: ----------- --------------
<S> <C> <C>
Cash and cash equivalents........................... $47,290,625 $73,068,945
Working capital .................................... 47,426,572 73,204,892
Total assets........................................ 60,760,152 86,538,472
Long-term debt, excluding current portion........... 1,098,935 1,098,935
Total shareholders' equity.......................... 53,900,694 79,679,014
</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 Consolidated Financial
Statements.

(3) Before the accretion of the redemption premium on Preferred Stock in 1997
and the first six months of 1998 of $410,103 and $115,542, respectively.

(4) See Note 2 to Notes to Consolidated Financial Statements for an
explanation of the computation of the net loss per common share amounts.

(5) Cumulative number of customers who have purchased products from the
Company from inception of its business in August 1994 through the end of
period.

(6) Represents actual data as adjusted to give effect to the sale of 1,250,000
shares of Common Stock offered by the Company (at an assumed offering
price of $22.1875 per share and after deducting underwriting discounts and
commissions and estimated offering expenses) and the application of the
estimated net proceeds therefrom. 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 June
30, 1998 had accumulated losses of $30.9 million. For the six months ended
June 30, 1998 and the year ended December 31, 1997, the Company's net loss was
$18.1 million and $10.7 million, respectively. 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 may 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

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<PAGE>

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.

The Company believes that the principal competitive factors in its online
market are brand recognition, selection, price, effectiveness of advertising,
strategic alliances and other customer acquisition efforts, variety of value-
added services, ease of use, site content, quality of service and technical
expertise. 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 adopted 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.

Increased Reliance Upon Strategic Alliances and Online and Traditional
Advertising. The Company increasingly relies on strategic alliances and online
and traditional advertising to attract users to its Web site. The Company has
entered into strategic alliances with Yahoo! Inc. ("Yahoo!"), Excite, Inc.
("Excite"), GeoCities Inc. ("GeoCities"), Lycos, Inc. and Tripod, Inc.
(collectively, "Lycos"), Lycos Bertelsmann GMBH & Co. KG ("Lycos
Bertelsmann"), Rolling Stone Network and MTV/VH1. The Company's ability to
generate increased revenues largely will depend on increased traffic and
purchases through these alliances. There can be no assurance that the
Company's strategic alliances will generate a substantial number of new
customers or net sales or that the Company's infrastructure will be sufficient
to handle the increased traffic that may result 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 Company has recently
committed substantial resources to promoting its brand name through a campaign
that includes online, radio and television advertising. The inability to
maintain and further develop its advertising campaign or strategic alliances
could have a material adverse effect on the Company. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations--
Liquidity and Capital Resources" and "Business--Marketing and Promotion--
Strategic Alliances."

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 June
30, 1998, the Company has grown from three to 161 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

8
<PAGE>

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."

Possible 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.
There can be no assurance that financing will be available in amounts or on
terms acceptable to the Company. 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 six months ended June 30, 1998 and year ended December 31,
1997, payments to Valley accounted for approximately 82% and 78%, respectively
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.
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

9
<PAGE>

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 fully redundant systems or a
formal disaster recovery plan and does not carry sufficient business
interruption insurance to compensate it for losses that may occur.
Substantially all of the Company's computer and communications hardware is
located at a single leased facility in Jenkintown, Pennsylvania. The Company
intends to move to a new facility by year -end, and chances of system
disruption during the move will increase.

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 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 Software. The Company uses
internally developed software in its Web site, search engine and substantially
all aspects of its transaction processing and order management. The Company's
inability to modify this software 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.

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, (x)
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>

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.
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."

Possible Volatility of Stock Price. The market price of the Common Stock has
been, and is likely to remain, highly volatile as is frequently the case with
new public companies and Internet companies in particular. Quarterly operating
results of the Company, deviations in results of operations from estimates of
securities analysts, changes in general conditions in the economy, in Internet
commerce and in the music retailing 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 the Offering may adversely
affect the market price of the Common Stock.

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. At June 30, 1998,
the Company had approximately $47.3 million in cash and cash equivalents. The
Company has not designated any specific use for a significant portion of the
Company's existing cash and cash equivalents and the net proceeds from the
sale by the Company of the Common Stock offered hereby. The net proceeds of
the Offering, together with its existing cash and cash equivalents, will be
used by the Company 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 agreement 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

11
<PAGE>

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 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 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,

12
<PAGE>

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.

A foreign distribution affiliate of a major record label has sought to
enjoin the sale of music-related products by another Internet retailer in
Germany. Moreover, in February and March of 1998 the Company received
correspondence from the foreign distribution affiliates of two other labels,
demanding that the Company cease the sale of certain titles in Germany and pay
damages. The Company has retained counsel and is in discussions with these
affiliates, each of which is represented by the same counsel, regarding a
possible resolution of this matter. There can be no assurance that this matter
will be resolved on a satisfactory basis, if at all, or that this and other
distribution affiliates will not seek to enjoin, or otherwise prevent, the
sale by the Company of music-related products in Germany and other countries.
If successful, these actions 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 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

13
<PAGE>

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 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 the Offering,
approximately 16.9%, 16.9%, 9.8% and 13.2% 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, L.P., 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 and Selling Shareholders" and "Certain Relationships and Related
Transactions."

Risks Associated with the Year 2000. The Year 2000 issue is the result of
computer programs being written using two digits rather than four to define
the applicable year. In other words, date-sensitive software may recognize a
date using "00" as the year 1900 rather than the year 2000. This could result
in system failures or miscalculations causing disruptions of operations,
including, among others, a temporary inability to process transactions, send
invoices, or engage in similar normal business activities.

14
<PAGE>

to which it would be vulnerable to the suppliers' failure to remediate any
Year 2000 issues on a timely basis. The failure of a major supplier subject to
the Year 2000 to convert its systems on a timely basis or a conversion that is
incompatible with the Company's systems could have a material adverse effect
on the Company. In addition, most of the purchases from the Company's store
are made with credit cards via the Internet, and the Company's operations may
be materially adversely affected to the extent its customers are unable to use
their credit cards or access the Internet due to the Year 2000 issues that are
not rectified by their credit card vendors or by those organizations
responsible for maintaining and providing access to the Internet.

Risks Associated with International Sales. For the six months ended June 30,
1998 and the year ended December 31, 1997, international sales accounted for
approximately 22% and 29%, respectively, 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, political and economic conditions and actions
by third parties that would restrict or eliminate the Company's ability to do
business in certain jurisdictions. See "--Government Regulation and Legal
Uncertainties." 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
1,330,000 shares of Common Stock offered hereby, together with the 4,715,000
shares of Common Stock sold in the Company's February 1998 registered
offering, will be freely tradeable immediately following the Offering. All of
the 11,471,397 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 has filed a Registration Statement on Form S-8
covering up to 1,600,000 shares issuable upon exercise of stock options under
the Equity 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 10,484,619 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 45 days
following the consummation of the Offering without the prior written consent
of BT Alex. Brown Incorporated. In addition, the Selling Shareholder, who upon
completion of the Offering will own 225,172 shares of Common Stock, has agreed
not to sell any shares of Common Stock (excluding any shares purchased in the
open market) for a period of 45 days following the consummation of the
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 5,088,008 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 the
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

15
<PAGE>

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. 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 the Offering may experience further dilution in the net tangible book
value per share of the Common Stock of the Company.

PRICE RANGE OF COMMON STOCK

The Company's Common Stock has been quoted on the Nasdaq National Market
since February 10, 1998. The following table sets forth, for the periods
indicated, the high and low sales prices for Common Stock on the Nasdaq
National Market.

<TABLE>
<CAPTION>
HIGH LOW
------ ------
<S> <C> <C>
1998
First Quarter (beginning February 10, 1998)................ $27.25 $16.00
Second Quarter............................................. $39.00 $16.00
Third Quarter (through July 23, 1998)...................... $27.50 $18.50
</TABLE>

On July 23, 1998, the last reported sale price of the Common Stock on the
Nasdaq National Market was $22.1875 per share. As of June 30, 1998, there were
16,266,397 shares of Common Stock outstanding, held by approximately 56
holders of record. This figure does not reflect beneficial ownership of shares
held in street or nominee name.

16
<PAGE>

USE OF PROCEEDS

The net proceeds to the Company from the sale of 1,250,000 shares of Common
Stock offered by the Company hereby are estimated to be $25.8 million
(approximately $30.0 million if the Underwriters' over-allotment option is
exercised in full) assuming an offering price of $22.1875 per share and after
deducting underwriting discounts and commissions and estimated offering
expenses payable by the Company. The Company will not receive any proceeds
from shares of Common Stock sold by the Selling Shareholder.

The net proceeds from the Offering, together with the Company's existing
cash and cash equivalents, will be used by the Company as follows: an
aggregate minimum of approximately $23.6 million expected to be due under the
Company's strategic alliance agreements during the next 12 months;
approximately $18.5 million on advertising and promotion; approximately $4.5
million to make enhancements to, and expand the capacity of, the Company's Web
site and 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. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."

The amount actually expended for each purpose, other than 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 the 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 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 agreement or
understanding with respect to any material acquisition.

Pending utilization of the net proceeds of the Offering, the Company intends
to invest the funds in short-term, interest-bearing, investment-grade
obligations. The Company believes that the net proceeds from the 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.

17
<PAGE>

CAPITALIZATION

The following table sets forth, as of June 30, 1998, (i) the actual
capitalization of the Company and (ii) the capitalization, as adjusted to
reflect the issuance and sale of the 1,250,000 shares of Common Stock offered
by the Company hereby and the application of the estimated net proceeds
therefrom. See "Use of Proceeds." The capitalization of the Company will not
be affected by the sale of Common Stock offered by the Selling Shareholder.
This table should be read in conjunction with the Consolidated Financial
Statements and the notes thereto and the other financial information included
elsewhere in this Prospectus.

<TABLE>
<CAPTION>
JUNE 30, 1998
------------------------
ACTUAL AS ADJUSTED
----------- -----------
<S> <C> <C>
Cash and cash equivalents............................ $47,290,625 $73,068,945
=========== ===========
Long-term debt, excluding current portion............ $ 1,098,935 $ 1,098,935
----------- -----------
Shareholders' equity:
Preferred Stock, no par value; 20,000,000 shares
authorized; no shares issued and outstanding
actual and as adjusted............................ -- --
Common Stock, no par value; 50,000,000 shares
authorized; 16,266,397 shares issued and
outstanding actual; 17,516,397 shares issued and
outstanding as adjusted(1)........................ 79,281,341 105,059,661
Additional paid-in capital......................... 4,325,817 4,325,817
Deferred compensation.............................. (300,959) (300,959)
Accumulated deficit................................ (29,405,505) (29,405,505)
----------- -----------
Total shareholders' equity....................... 53,900,694 79,679,014
----------- -----------
Total capitalization........................... $54,999,089 $80,777,949
=========== ===========
</TABLE>
- ---------------------

(1) Excludes (i) 905,795 shares of Common Stock issuable upon the exercise of
options outstanding as of June 30, 1998 under the Company's 1996 Equity
Compensation Plan (the "Equity Compensation Plan") at a weighted average
exercise price of $8.78 per share, (ii) 659,892 shares of Common Stock
reserved for future grants under the Equity Compensation Plan, (iii)
490,515 shares of Common Stock issuable upon the exercise of warrants
outstanding as of June 30, 1998 at a weighted average exercise price of
$13.42 per share. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Liquidity," "Management--Equity
Compensation Plan" and "Description of Capital Stock."

DILUTION

At June 30, 1998, the net tangible book value of the Company was
approximately $53.9 million or $3.31 per share of Common Stock. 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 for the period immediately prior to the Offering. After giving
effect to the sale by the Company of 1,250,000 shares of Common Stock offered
hereby of at assumed offering price of $22.1875 per share and after deducting
underwriting discounts and commissions and estimated offering expenses, the
pro forma net tangible book value of the Company at June 30, 1998 would have
been $79.7 million or approximately $4.55 per share. This represents an
immediate increase in the net tangible book value of $4.55 per share of
existing shareholders and immediate dilution of $17.64 per share to new
investors purchasing shares of Common Stock in the Offering. The following
table illustrates this per share dilution:

<TABLE>
<S> <C> <C>
Assumed Offering price per share.............................. $22.19
Net tangible book value per share as of June 30, 1998....... $3.31
Increase in net tangible book value per share attributable
to new investors........................................... 1.24
-----
Pro forma net tangible book value per share after the
Offering..................................................... 4.55
------
Dilution per share to new investors........................... $17.64
======
</TABLE>

18
<PAGE>

SELECTED FINANCIAL AND OPERATING DATA

The 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 Consolidated Financial Statements and notes thereto
appearing elsewhere in this Prospectus. The statement of operations data for
the years ended December 31, 1995, 1996 and 1997 and the balance sheet data as
of December 31, 1996 and 1997 have been derived from the Consolidated
Financial Statements, which have been audited by Arthur Andersen LLP,
independent public accountants, and are included elsewhere in this Prospectus.
The 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 consolidated financial statements
audited by Arthur Andersen LLP, independent public accountants, not included
in this Prospectus. The statement of operations data for the six months ended
June 30, 1997 and 1998 and the balance sheet data as of June 30, 1998 have
been derived from unaudited consolidated financial statements of the Company
that, in the opinion of the Company, include all adjustments (consisting only
of normal recurring adjustments) necessary for a fair presentation of the
results of operations for the period in accordance with generally accepted
accounting principles. The results of operations for the six months ended June
30, 1998 are not necessarily indicative of the results that may be expected
for any interim period or for the full year.

<TABLE>
<CAPTION>
PERIOD FROM
INCEPTION
(FEBRUARY 12, SIX MONTHS ENDED JUNE
1994) TO YEAR ENDED DECEMBER 31, 30,
DECEMBER 31, ------------------------------------- -------------------------
1994(1) 1995(1) 1996 1997 1997 1998
------------- ---------- ----------- ------------ ----------- ------------
<S> <C> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS
DATA:
Net sales............... $103,116 $2,176,474 $ 6,300,294 $ 17,372,795 $ 5,546,203 $ 21,624,030
Cost of sales........... 92,962 1,844,612 5,217,789 14,316,028 4,412,843 18,154,598
-------- ---------- ----------- ------------ ----------- ------------
Gross profit............ 10,154 331,862 1,082,505 3,056,767 1,133,360 3,469,432
Operating expenses:
Operating and develop-
ment................... 26,946 149,982 669,280 2,541,434 812,284 2,765,714
Sales and marketing..... 12,945 200,972 621,454 9,139,348 1,121,960 17,769,619
General and administra-
tive................... 28,712 180,573 563,593 1,953,078 743,385 1,734,159
Dispute settlement(2)... -- -- 1,024,030 -- -- --
-------- ---------- ----------- ------------ ----------- ------------
Total operating ex-
penses................. 68,603 531,527 2,878,357 13,633,860 2,677,629 22,269,492
-------- ---------- ----------- ------------ ----------- ------------
Operating loss.......... (58,449) (199,665) (1,795,852) (10,577,093) (1,544,269) (18,800,060)
Interest expense, net... -- (1,248) (14,556) (170,312) (5,415) 733,137
-------- ---------- ----------- ------------ ----------- ------------
Net loss................ (58,449) (200,913) (1,810,408) (10,747,405) (1,549,684) (18,066,923)
Accretion of preferred
stock to redemption
value.................. -- -- -- (410,103) -- (115,542)
-------- ---------- ----------- ------------ ----------- ------------
Net loss applicable to
common shareholders.... $(58,449) $ (200,913) $(1,810,408) $(11,157,508) $(1,549,684) $(18,182,465)
======== ========== =========== ============ =========== ============
Net loss per common
share(3)............... $ (1.42) $ (0.20) $ (1.29)
============ =========== ============
Weighted average number
of common shares
outstanding(3)......... 7,845,684 7,845,684 14,044,939
============ =========== ============
OPERATING DATA:
Customers(4)............ 1,787 26,953 87,859 296,450 143,257 569,034
</TABLE>

<TABLE>
<CAPTION>
DECEMBER 31,
------------------------------------------- JUNE 30,
1994 1995 1996 1997 1998
-------- --------- ---------- ----------- -----------
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash and cash
equivalents........... $ 2,008 $ 43,812 $ 775,865 $10,686,001 $47,290,625
Working capital
(deficit)............. (42,206) (235,478) 231,455 (1,218,005) 47,426,572
Total assets........... 25,765 268,468 1,575,459 16,448,425 60,760,152
Long-term debt,
excluding current
portion............... -- 9,519 91,133 962,144 1,098,935
Redeemable convertible
preferred stock....... -- -- -- 9,492,594 --
Total shareholders'
equity (deficit)...... (18,449) (99,362) 514,017 (9,752,450) 53,900,694
</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.
(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 Consolidated Financial
Statements.

(3) See Note 2 to Notes to Consolidated Financial Statements for an
explanation of the computation of the net loss per common share amounts.

(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 merchandising and
recommendations. 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 300,000 items.

CDnow has grown rapidly since its inception in 1994. Of the 569,000
customers who have made purchases since inception through June 30, 1998,
273,000 made their initial purchases during the six month period ended June
30, 1998. Average daily visits to the CDnow store have grown from
approximately 12,000 in January 1996 to approximately 173,000 in June 1998.
The Company's net sales grew to $11.6 million in the second quarter of 1998
compared to $10.0 million and $3.0 million in the first quarter of 1998 and
second quarter of 1997, respectively. The Company has also generated
significant customer loyalty. Despite the Company's rapid acquisition of new
customers, repeat customers accounted for approximately 58% of net sales in
the second quarter of 1998.

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 entered into strategic alliances
with Yahoo!, Excite and GeoCities in August 1997, September 1997 and January
1998, respectively, and has accelerated its marketing campaign since the
Company's initial public offering in February 1998 by expanding its
relationship with Yahoo! and entering into additional alliances with Lycos,
Lycos Bertelsmann, Rolling Stone Network and MTV/VH1.

Since its inception, the Company has incurred significant net losses and, as
of June 30, 1998, had accumulated losses of $30.9 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 six months ended June 30, 1998 and year ended December 31, 1997,
international sales accounted for approximately 22% and 29%, respectively, of
net sales. While the Company expects that net sales from international markets
will continue to represent a significant portion of net sales, the

20
<PAGE>

Company believes that the percentage of its net sales from international
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>
SIX MONTHS
YEAR ENDED ENDED
DECEMBER 31, JUNE 30,
--------------------- -------------
1995 1996 1997 1997 1998
----- ----- ----- ----- -----
<S> <C> <C> <C> <C> <C>
Net sales........................... 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of sales....................... 84.8 82.8 82.4 79.6 84.0
----- ----- ----- ----- -----
Gross profit...................... 15.2 17.2 17.6 20.4 16.0
Operating Expenses:
Operating and development......... 6.9 10.6 14.6 14.6 12.8
Sales and marketing............... 9.2 9.9 52.6 20.2 82.2
General and administrative........ 8.3 8.9 11.3 13.4 7.9
Dispute settlement................ -- 16.3 -- -- --
----- ----- ----- ----- -----
Total operating expenses.......... 24.4 45.7 78.5 48.2 102.9
----- ----- ----- ----- -----
Operating loss.................... (9.2) (28.5) (60.9) (27.8) (86.9)
Interest income (expense), net...... -- (0.2) (1.0) (0.1) 3.3
----- ----- ----- ----- -----
Net loss............................ (9.2)% (28.7)% (61.9)% (27.9)% (83.6)%
===== ===== ===== ===== =====
</TABLE>

Beginning in 1998, the Company determined to include royalties paid on CD
sales in return for licensing of ratings, reviews and other information
("Information Royalties") in operating and development expenses rather than in
cost of sales, as was previously the case. This change was made based on
management's determination that including Information Royalties in operating
and development expense was more consistent with the treatment of such
expenses by retailers generally. The financial information in this Prospectus
related to the Company's results of operations for periods prior to 1998 has
been restated to reflect this change. Information Royalties were $146,200,
$225,737, $97,562, and $137,119 during the years ended December 31, 1996 and
1997 and the six months ended June 30, 1997 and 1998, respectively. There were
no Information Royalties paid in 1995. If Information Royalties were included
in cost of sales, gross profit margins would have been 14.9%, 16.3%, 18.7%,
and 15.4% during the years ended December 31, 1996 and 1997 and the six months
ended June 30, 1997 and 1998, respectively.

SIX MONTHS ENDED JUNE 30, 1998 COMPARED TO THE SIX MONTHS ENDED JUNE 30, 1997

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 $16.1 million, or 290%, to $21.6
million for the six months ended June 30, 1998 compared to $5.5 million for
the six months ended June 30, 1997. Net sales were $11.8 million in the six
months ended December 31, 1997. The increase is attributable to continued
growth of the Company's customer base and repeat purchases from existing
customers. Net sales were favorably affected by increased advertising and
promotional activities, including the Company's Grammy Awards promotion and
March 1998 storewide sale, as well as the continued implementation of its
strategic alliances. In the six months ended June 30, 1998, the Company added
approximately 273,000 new customers, bringing the total number of customers
since

21
<PAGE>

inception to 569,000 from 296,000 at December 31, 1997. International sales
represented 22% and 35% of net sales for the six months ended June 30, 1998
and June 30, 1997, respectively. The Company believes that the decrease in
international sales as a percentage of net sales is due to a proportionally
larger increase in domestic sales resulting from the substantial increase in
domestic marketing and advertising expenditures. Nevertheless, international
sales increased to $4.7 million for the six months ended June 30, 1998 from
$1.9 million in the six months ended June 30, 1997.

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.
Cost of sales increased by $13.8 million, or 311%, to $18.2 million for the
six months ended June 30, 1998 compared to $4.4 million for the six months
ended June 30, 1997. Cost of sales was $9.9 million for the six months ended
December 31, 1997. The Company's gross profit margin decreased to 16.0% for
the six months ended June 30, 1998 compared to 16.3% and 20.4% for the six
months ended December 31, 1997 and June 30, 1997, respectively. The decline in
gross margin was attributable to more aggressive pricing of recent releases
and popular titles, as well as increased sales discounts offered by the
Company in connection with its Grammy Awards promotion and March 1998
storewide sale. Gross margin for the quarter ended June 30, 1998 was 17.3%
compared to 14.6% for the quarter ended March 31, 1998; this increase was
attributable to selective price increases, reductions in internal shipping
costs and higher margin revenue from the sale of strategic sponsorships.

Operating and Development Expense. Operating and development expense
consists primarily of payroll and related expenses for store management,
design, development and network operations personnel, systems and
telecommunications infrastructure, and royalties paid by the Company on CD
sales in return for licensing of ratings, reviews, sound samples and other
information. Store development costs are charged to expense as incurred.
Operating and development expense increased by $2.0 million, or 240%, to $2.8
million for the six months ended June 30, 1998 compared to $812,000 for the
six months ended June 30, 1997. The increase is attributable to increased
staffing and associated costs related to enhancing the features and
functionality of the Company's Web site and transaction-processing systems, as
well as increased investment in store content, systems and telecommunications
infrastructure. As a percentage of net sales, operating and development
expense decreased to 12.8% for the six months ended June 30, 1998 compared to
14.6% for the six months ended June 30, 1997 as operating and development
expenses were spread over a larger revenue base.

Sales Marketing Expense. Sales and marketing expense consists primarily of
payments related to advertising, promotion and strategic alliances as well as
payroll and related expenses for personnel engaged in marketing, selling and
customer service activities. Sales and marketing expense increased by $16.7
million to $17.8 million for the six months ended June 30, 1998 compared to
$1.1 million for the six months ended June 30, 1997. As a percentage of net
sales, sales and marketing expense grew to 82.2% for the six months ended June
30, 1998 compared to 20.2% for the six months ended June 30, 1997. The
increase in both absolute dollars and as a percentage of net sales was
primarily attributable to increased online and traditional advertising,
including advertising costs incurred in connection with the Company's Grammy
Awards and American Music Awards promotions, costs associated with the
Company's strategic alliances, and promotional and public relations
expenditures. The Company increased its advertising expense to $14.0 million
for the six months ended June 30, 1998 compared to $490,000 for the six months
ended June 30, 1997. In addition, the Company incurred increased staffing and
related costs in connection with the implementation of its marketing strategy
and customer service activities necessary to support its increased customer
base. The Company expects the dollar amount of sales and marketing expense
generally, and advertising expense in particular, to continue to increase
significantly in future periods. While the Company is hopeful that its net
sales will also increase in future periods so that its sales and marketing
expense will not continue to represent an increasing 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 expense
will not increase as a percentage of net sales.

22
<PAGE>

General and Administrative Expense. General and administrative expense
consists of payroll and related expenses for executive, accounting and
administrative personnel, insurance, professional fees and other general and
corporate expenses. General and administrative expense increased by $1.0
million, or 133%, to $1.7 million for the six months ended June 30, 1998
compared to $743,000 for the six months ended June 30, 1997. The increase in
general and administrative expense was primarily due to the hiring of
additional personnel and increases in professional fees, as well as the costs
associated with becoming a public company. As a percentage of net sales,
general and administrative expense decreased to 7.9% for the six months ended
June 30, 1998 from 13.4% for the six months ended June 30, 1997, as the
Company's fixed costs were spread over a larger revenue base.

Net Loss. The Company's net loss was $18.1 million for the six months ended
June 30, 1998, an increase of $16.6 million, compared to $1.5 million for the
six months ended June 30, 1997.

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

Net Sales. Net sales increased by $11.1 million, or 176%, to $17.4 million
for the year ended December 31, 1997 from $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 increased by $9.1 million, or 174%, to $14.3
million for the year ended December 31, 1997 from $5.2 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 17.6%
for the year ended December 31, 1997 compared to 17.2% 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
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
increased by $1.9 million to $2.5 million for the year ended December 31, 1997
from $669,000 for the year ended December 31, 1996. As a percentage of net
sales, these expenses were 14.6% for the year ended December 31, 1997 and
10.6% 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.

Sales and Marketing Expense. Sales and marketing expense increased by $8.5
million to $9.1 million for the year ended December 31, 1997 from $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 52.6% 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.

General and Administrative Expense. General and administrative expense
increased by $1.4 million to $2.0 million for the year ended December 31, 1997
from $564,000 for the year ended December 31, 1996. As a percentage of net
sales, these expenses increased to 11.3% for the year ended December

23
<PAGE>

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's net loss increased by $8.9 million to a loss of
$10.7 million for the year ended December 31, 1997 from 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 88,000 customer accounts compared to approximately
27,000 customer accounts at December 31, 1995.

Cost of Sales. Cost of sales increased 183% to $5.2 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 increased to 17.2% 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 $669,000 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 10.6% 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 from a net loss of $201,000 for
the year ended December 31, 1995.

24
<PAGE>

QUARTERLY RESULTS OF OPERATIONS AND SEASONALITY

The following table sets forth certain unaudited quarterly statement of
operations data for the ten quarters ended June 30, 1998. This unaudited
quarterly information has been derived from unaudited consolidated 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, MAR. 31,
1996 1996 1996 1996 1997 1997 1997 1997 1998
-------- -------- --------- -------- -------- -------- --------- -------- --------
(IN THOUSANDS)
<S> <C> <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 $10,014
Cost of sales........... 944 1,137 1,373 1,764 2,050 2,363 3,167 6,736 8,555
------ ------ ------ ------- ------ ------- ------- ------- -------
Gross profit............ 184 215 256 427 532 601 740 1,184 1,459
Operating expenses:
Operating and
development........... 101 138 185 246 322 489 632 1,099 1,081
Sales and marketing..... 91 127 174 229 417 707 2,234 5,781 8,786
General and
administrative........ 81 115 157 210 339 404 523 687 850
Dispute settlement...... -- -- -- 1,024 -- -- -- -- --
------ ------ ------ ------- ------ ------- ------- ------- -------
Total operating
expenses............... 273 380 516 1,709 1,078 1,600 3,389 7,567 10,717
------ ------ ------ ------- ------ ------- ------- ------- -------
Operating loss.......... (89) (165) (260) (1,282) (546) (999) (2,649) (6,383) (9,258)
Interest income
(expense), net........ (2) (3) (6) (3) 2 (6) 69 (235) 60
------ ------ ------ ------- ------ ------- ------- ------- -------
Net loss................ $ (91) $ (168) $ (266) $(1,285) $ (544) $(1,005) $(2,580) $(6,618) $(9,198)
====== ====== ====== ======= ====== ======= ======= ======= =======
<CAPTION>
AS A PERCENTAGE OF NET SALES
----------------------------------------------------------------------------------------------
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31,
1996 1996 1996 1996 1997 1997 1997 1997 1998
-------- -------- --------- -------- -------- -------- --------- -------- --------
<S> <C> <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% 100.0%
Cost of sales........... 83.7 84.1 84.3 80.5 79.4 79.7 81.1 85.1 85.4
------ ------ ------ ------- ------ ------- ------- ------- -------
Gross profit............ 16.3 15.9 15.7 19.5 20.6 20.3 18.9 14.9 14.6
Operating expenses:
Operating and
development............ 9.0 10.2 11.4 11.2 12.4 16.5 16.2 13.9 10.8
Sales and marketing..... 8.1 9.4 10.7 10.5 16.2 23.9 57.2 73.0 87.7
General and
administrative......... 7.1 8.5 9.6 9.6 13.1 13.6 13.3 8.6 8.6
Dispute settlement...... -- -- -- 46.7 -- -- -- -- --
------ ------ ------ ------- ------ ------- ------- ------- -------
Total
operating expenses..... 24.2 28.1 31.7 78.0 41.7 54.0 86.7 95.5 107.1
------ ------ ------ ------- ------ ------- ------- ------- -------
Operating loss.......... (7.9) (12.2) (16.0) (58.5) (21.1) (33.7) (67.8) (80.6) (92.5)
Interest income
(expense), net......... (0.2) (0.2) (0.3) (0.1) -- (0.2) 1.8 (3.0) 0.6
------ ------ ------ ------- ------ ------- ------- ------- -------
Net loss................ (8.1)% (12.4)% (16.3)% (58.6)% (21.1)% (33.9)% (66.0)% (83.6)% (91.9)%
====== ====== ====== ======= ====== ======= ======= ======= =======
<CAPTION>
JUNE 30,
1998
----------
<S> <C>
Net sales............... $11,610
Cost of sales........... 9,600
----------
Gross profit............ 2,010
Operating expenses:
Operating and
development........... 1,684
Sales and marketing..... 8,984
General and
administrative........ 884
Dispute settlement...... --
----------
Total operating
expenses............... 11,552
----------
Operating loss.......... (9,542)
Interest income
(expense), net........ 673
----------
Net loss................ $(8,869)
==========
<CAPTION>
JUNE 30,
1998
----------
<S> <C>
Net sales............... 100.0%
Cost of sales........... 82.7
----------
Gross profit............ 17.3
Operating expenses:
Operating and
development............ 14.5
Sales and marketing..... 77.4
General and
administrative......... 7.6
Dispute settlement...... --
----------
Total
operating expenses..... 99.5
----------
Operating loss.......... (82.2)
Interest income
(expense), net......... 5.8
----------
Net loss................ (76.4)%
==========
</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

25
<PAGE>

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, (x)
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.

LIQUIDITY AND CAPITAL RESOURCES

At June 30, 1998 the Company's cash and cash equivalents were $47.3 million,
compared to $269,000 at June 30, 1997. In February 1998, the Company
consummated its initial public offering, selling an aggregate of 4,561,250
shares of Common Stock and raising net proceeds of approximately $67.1
million. Prior to February 1998, the Company 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 of $23.6 million for the six months
ended June 30, 1998 was primarily attributable to a net loss of $18.1 million,
a decrease of $5.5 million in accounts payable and an increase of $1.6 million
in prepaid expenses partially offset by a $903,000 increase in accrued
expenses and depreciation and amortization of $751,000. For the six months
ended June 30, 1997, cash used in operating activities of $522,000 resulted
primarily from a net loss of $1.5 million largely offset by increases in
accounts payable and other accrued expenses.

Net cash used in investing activities was $1.1 million for the six months
ended June 30, 1998, and consisted of purchases of equipment of $1.6 million
and $424,000 of cash for the purchase of superSonic Boom, Inc. partially
offset by the sale of short-term investments of $1.0 million. Net cash used in
investing activities of $87,000 for the six months ended June 30, 1997 was
attributable to purchases of equipment of $333,000 partially offset by sales
and maturities of short-term investments of $246,000.

Net cash provided by financing activities of $61.2 million for the six
months ended June 30, 1998 was primarily attributable to the net proceeds of
approximately $67.1 million from the Company's initial public offering
partially offset by the retirement of $5.8 million of the Company's Series A
Notes.

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).

26
<PAGE>

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 Preferred Stock
automatically converted in February 1998 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. The outstanding
shares of Series B Preferred Stock automatically converted in February 1998
into an aggregate of 2,408,258 shares of Common Stock. See "Certain
Relationships and Related Transactions."

On August 21, 1997, the Company entered into an Advertising and Promotion
Agreement with Yahoo! Inc. (the "Yahoo! Agreement") which extends until
October 1999. 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 $2.8
million was paid through June 30, 1998, and $1.1 million is due in periodic
installments through October 1998. The Company will be required to pay Yahoo!
certain additional fees during the second year of the term 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.

On September 30, 1997, the Company and Excite entered into a two-year
Linking Agreement (the "Excite Agreement") with respect to Excite's 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 June 30, 1998, the Company had paid Excite $2.0 million. 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.

In November 1997, the Company issued $5.8 million aggregate principal amount
of Series A Notes to a group of investors, including Grotech. These Notes,
which bore interest at 12% per annum, were retired in February 1998. The
Company issued warrants to these investors to purchase an aggregate of 48,550
shares of Common Stock at an exercise price of $11.90 per share.

On March 26, 1998, the Company entered into a three-year Linking Agreement
with Lycos (the "Lycos Agreement"). The Company is required to pay Lycos $4.5
million, $5.5 million and $6.5 million in

27
<PAGE>

fixed fees during the first, second and third years, respectively, of the
Lycos Agreement. As of June 30, 1998, the Company had paid Lycos $1.5 million.
The Company is also required to pay Lycos certain variable fees based on the
number of new customers that access, and new Cosmic Credit sites that are
enrolled, through links with the Lycos and Tripod Web sites. In addition, the
Company issued 61,665 shares of Common Stock to Lycos.

On April 2, 1998, the Company entered into a three-year linking agreement
with Lycos Bertelsmann (the "Lycos Bertelsmann Agreement"). The Company is
required to pay Lycos Bertelsmann $1.4 million, $1.9 million and $2.2 million
in fixed fees during the first, second and third years, respectively, of the
Lycos Bertelsmann Agreement. As of June 30, 1998, the Company had paid Lycos
Bertelsmann $880,000. The Company is also required to pay Lycos Bertelsmann
certain variable fees based on the number of new customers acquired, and new
Cosmic Credit sites enrolled, through links with the Lycos Bertelsmann Web
sites.

On May 18, 1998, the Company entered into a binding memorandum of terms with
MTV/VH1 (the "MTV/VH1 Agreement"). Under the MTV/VH1 Agreement, the Company is
required to pay MTV/VH1 $5.2 million, $6.8 million, $7.3 million and $121,000
in fixed fees during the remaining six months of 1998 and the years ending
December 31, 1999, 2000 and 2001, respectively. As additional consideration,
the Company has agreed to issue MTV/VH1 a warrant to purchase 226,892 shares
of Common Stock at an exercise price of $23.28 per share.

The Company is required to pay aggregate minimum fixed fees of $3.1 million,
$2.9 million, $2.4 million and $766,000 during the remaining six months of
1998 and the years ending December 31, 1999, 2000 and 2001, respectively,
under the Company's other strategic alliances.

The Company expects to fund its future payment obligations under its
strategic alliances from its cash and cash equivalents, including a portion of
the net proceeds from the Offering. See "Use of Proceeds" and "Business--
Marketing and Promotion."

As of June 30, 1998, the Company had $47.3 million of cash and cash
equivalents. As of that date, the Company's principal commitments consisted of
obligations under its strategic alliances as well as obligations outstanding
under capital and operating leases. Although the Company has no material
commitments for capital expenditures, it anticipates substantial increases 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 2011.
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 Consolidated Financial Statements.

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

28
<PAGE>

The Company does not believe that it has material exposure to the Year 2000
issue with respect to its own information systems since its existing systems
correctly define the year 2000. The Company intends to conduct an analysis in
1998 to determine the extent to which its major suppliers' systems (insofar as
they relate to the Company's business) are subject to the Year 2000 issue. The
Company is currently unable to predict the extent to which the Year 2000 issue
will affect its suppliers, or the extent to which it would be vulnerable to
the suppliers' failure to remediate any Year 2000 issues on a timely basis.
The failure of a major supplier subject to the Year 2000 to convert its
systems on a timely basis or a conversion that is incompatible with the
Company's systems could have a material adverse effect on the Company. In
addition, most of the purchases from the Company's store are made with credit
cards via the Internet, and the Company's operations may be materially
adversely affected to the extent its customers are unable to use their credit
cards or access the Internet due to the Year 2000 issues that are not
rectified by their credit card vendors or by those organizations responsible
for maintaining and providing access to the Internet.

29
<PAGE>

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 300,000 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
325,000 sound samples and 125,000 product notes, reviews and related articles,
including articles from Rolling Stone, MTV/VH1 and CDnow's editorial staff.
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 569,000
customers who have made purchases from inception through June 30, 1998,
273,000 made their initial purchases during the six month period ended June
30, 1998. Average daily visits to the CDnow store have grown from
approximately 12,000 in January 1996 to approximately 173,000 in June 1998 .
The Company's net sales grew to $11.6 million for the second quarter of 1998
compared to $10.0 million and $3.0 million for the first quarter of 1998 and
the second quarter of 1997, respectively. The Company has also generated
significant customer loyalty. Despite the Company's rapid acquisition of new
customers, repeat customers accounted for approximately 58% of net sales in
the second quarter of 1998.

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 69
million by the end of 1997 and will grow to approximately 320 million by 2002.
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 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 $12.4 billion in 1997, and
will increase to approximately $426 billion by 2002.

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 1997 were approximately $38.1 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 $47
million in 1997 to $1.6 billion in 2002.

30
<PAGE>

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
300,000 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 48% of sales, or approximately $5.9 billion, in
1997. 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 325,000 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 300,000 items. The Company
continually evaluates the feasibility and marketability of new products and
services. With its acquisition of superSonic Boom, Inc., the Company has begun
to offer custom compilation discs which contain individual songs selected
online by the customer.

31
<PAGE>

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.

. Strategic Alliances. 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 and global music-oriented media
companies. Since February 1998, the Company has broadened its strategic
alliance with Yahoo! to include Yahoo! Mail and Yahoo!'s music chat
space. The Company has also entered into new strategic alliances with
Lycos and Tripod, Lycos Bertelsmann, Rolling Stone Network and MTV/VH1.
In addition, CDnow has preexisting alliances with GeoCities and Excite's
WebCrawler service. CDnow's alliances generally provide for the Company
to be the premier online recorded music retailer on certain of the sites
of these providers 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 alliance with Rolling Stone Network also entitles CDnow to use
the Rolling Stone brand name in conjunction with the display of cover
art and excerpts of feature stories, record reviews, artist biographies
and music news from current and past editions of Rolling Stone magazine.
Under the MTV/VH1 alliance, the Company is the premier online retailer
of recorded music on the MTV and VH1 cable television channels with
preferred advertising rights with respect to special events and
promotions, including exclusive online sponsorship of the 1998 Video
Music Awards. The alliance with MTV/VH1 also entitles CDnow to use the
MTV and VH1 brand names in conjunction with the display of MTV and VH1
content, music reviews and music news and provides CDnow with integrated
links from the MTV and VH1 Web sites.

. 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 AltaVista,
Infoseek and Microsoft Network, 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".
CDnow's traditional advertising efforts have included radio advertising
in major markets, such as advertising on the Howard Stern program, and
print advertising in music-related publications, including Spin and
Variety. In the first quarter of 1998, the Company initiated television
advertising, including national advertising during the Grammy Awards and
the American Music Awards. The Company intends to increase its use of
television advertising, including through its alliance with MTV/VH1, and
has purchased advertising on such programs as MTV's 1998 Video Music
Awards, VH1's Flashback Week and the 1999 Grammy Awards.

. Cosmic Credit Program. Through its Cosmic Credit program, CDnow has
arrangements with over 52,000 small Web sites, typically fan sites
devoted to particular musical artists. Approximately 42,000 of these
sites have enrolled since December 31, 1997. The Company provides Cosmic
Credit sites with embedded hyperlinks through which potential customers
can immediately be connected to the CDnow site. These highly-focused,
music-oriented sites are a significant source of traffic and new
customers for the Company.

. 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 Company
also targets e-mail campaigns to specific customer and prospect segments
based upon their recent activity at the CDnow store. The

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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 569,000 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.

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, who accounted for approximately 58% of net sales
during the quarter ended June 30, 1998. 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 one business day
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 respond to customer
inquiries within 24 hours of receipt. The Company also maintains ongoing
customer contact through its customized e-mail newsletter, The CDnow Update.

Enhance International Capabilities. The Company believes that there is a
substantial opportunity to increase its sales to international customers.
International music sales in 1997 were estimated to be approximately twice
that of the U.S. and many products offered by CDnow are not available in these
markets. In April 1998, the Company entered into a strategic alliance with
Lycos Bertelsmann, a European Internet content and service provider, under
which the Company has been designated as the exclusive music retailer for
Lycos Bertelsmann's Web services in various European countries. The Company
has also entered into a letter of intent with MSI of Miami, Inc. ("MSI") under
which MSI would provide an additional 150,000 international titles and create
a fulfillment center in the Netherlands to serve European markets commencing
in mid-1998. The Company has nine foreign language versions of its Web site
that contain translations of account registration and ordering instructions.
CDnow supports its international sales efforts with customer service
representatives fluent in these languages.

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 250,000 CDs, 40,000 movies and
10,000 music videos as well as t-shirts, music books, DVDs and CD-ROMs. On
June 2, 1998, the Company acquired superSonic Boom, Inc.
(www.supersonicboom.com), which offers customized CDs on the Internet. To
encourage purchases, the Company features various promotions on a rotating
basis throughout the store. The Company also launched its Album Advisor in
January 1998, an online recommendation service utilizing artificial
intelligence technology. The Company adjusts pricing

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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. CDnow
recently upgraded its search engine using Verity, Inc.'s K2 search technology
to allow for successful searches even with incomplete or misspelled artists'
names. By clicking on the album title, 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
325,000 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. Since
February 1998, the Company has entered into agreements with MTV/VH1, Rolling
Stone Network, College Media, Inc. ("CMJ"), publisher of the CMJ New Music
Report and CMJ New Music Monthly, and Billboard magazine to enhance the
content available in the CDnow store. The alliance with MTV/VH1 entitles CDnow
to use the MTV and VH1 brand names in conjunction with the display of MTV and
VH1 content, music reviews and music news. The agreement with Rolling Stone
Network entitles CDnow to use Rolling Stone's brand name in conjunction with
the display of cover art and excerpts of feature stories, record reviews,
artist biographies and music news from current and past editions of Rolling
Stone magazine. The agreement with CMJ provides the Company with access to
more than 25,000 reviews from this publication.

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 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. 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.

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Multilingual Capabilities. Approximately 22% of the Company's sales for the
quarter ended June 30, 1998 were generated from international markets. The
Company offers Spanish, French, German, Italian, Portuguese, Japanese, Dutch,
Norwegian 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 may introduce additional foreign language
versions in the 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 strategic alliances, online and
traditional advertising, 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.

Strategic Alliances

The Company believes that strategic alliances with major Internet service
and content providers and global music-oriented media companies can be a
source of a significant number of new customers. The Company has entered into
the following agreements and arrangements, which are listed in chronological
order.

Yahoo! The Company and Yahoo! have entered into the Yahoo! Agreement, under
which CDnow has been granted exclusivity on 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 term of the Yahoo! Agreement expires in October 1999. The
Company and Yahoo! recently amended the Yahoo! Agreement to include
Yahoo!'s e-mail service, Yahoo! Mail, and music chat space for a period
ending in December 1998.

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.

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 in
February 1999, subject to the Company's option to renew the GeoCities
agreement for a 12 month renewal term.

Lycos. The Company and Lycos have entered into the Lycos Agreement, under
which the Company has been designated as the exclusive music retailer for
the Lycos and Tripod Web sites, and has been

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<PAGE>

granted the exclusive right to sponsor targeted links, relevant content and
promotions throughout the Lycos and Tripod Web sites. In addition, the
Company was granted a right-of-first-refusal regarding any music retail
opportunities on the Lycos and Tripod Web sites. The Lycos Agreement
requires Lycos and Tripod to deliver a minimum number of CDnow-branded page
views during each year of the term, and precludes Lycos and Tripod from
entering into new agreements regarding advertising for other music
retailers throughout the Lycos and Tripod Web sites. The Lycos Agreement
expires in July 2001.

Lycos Bertelsmann. The Company and Lycos Bertelsmann have entered into the
Lycos Bertelsmann Agreement under which the Company has been designated as
the exclusive music retailer for Lycos Bertelsmann's Web services in
various European countries and has been granted the exclusive right to
sponsor targeted links, advertising banners, specific keywords, and
relevant content on the Lycos Bertelsmann sites. In addition, the Company
was granted a right-of-first-refusal regarding any opportunities which
Lycos Bertelsmann offers to any other entity which principally sells music
products. The Lycos Bertelsmann Agreement requires Lycos Bertelsmann to
deliver a minimum number of page views during each year of the term. The
term of the Lycos Bertelsmann Agreement expires in April 2001.

Rolling Stone Network. The Company and Rolling Stone Network have entered
into an agreement under which the Company has been designated the exclusive
World Wide Web-based music retailer that may use the Rolling Stone brand
name in conjunction with the display of cover art and excerpts of feature
stories, record reviews, artist biographies and music news from current and
past editions of Rolling Stone magazine. In addition, the Company will be
the exclusive online music retailer on the JAMtv and Rolling Stone Network
Web sites with the exclusive right to sponsor targeted links, relevant
content and promotions. The Rolling Stone Agreement also requires the
delivery of a minimum number of page views on the JAMtv and Rolling Stone
Network Web sites during each year of the agreement. The Company has also
agreed to purchase targeted print, radio broadcast and other promotional
advertising from JAMtv and Straight Arrow, the publisher of Rolling Stone
magazine.

MTV/VH1. Under the MTV/VH1 alliance, the Company is the premier online
retailer of recorded music on the MTV and VH1 cable television channels
with preferred advertising rights with respect to special events and
promotions, including exclusive online sponsorship of the 1998 Video Music
Awards. The alliance with MTV/VH1 entitles CDnow to use the MTV and VH1
brand names in conjunction with the display of MTV and VH1 content, music
reviews and music news and provides CDnow with integrated links from the
MTV and VH1 Web sites. The Company has also been granted certain rights of
first refusal to be the exclusive online music retailer of the 1999 and
2000 Video Music Awards with a portion of its minimum annual payments
applicable, at the Company's option, to such sponsorship.

Other Alliances. The Company has established relationships with other major
Internet content and service providers, including America Online ("AOL")
with respect to its Love@AOL service, 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 AOL are parties to an agreement
whereby CDnow is the exclusive music retailer on the Love@AOL service. The
Company and ABC News Starwave Partners are parties to an agreement 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 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
under which, in addition to purchasing commercial advertising time during
the 1998 and 1999 Grammy Awards, the Company has been designated as the
exclusive online music retailer on the CBS Web site.

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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 AltaVista, Infoseek and Microsoft Network, 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 promoting widespread
brand awareness and attracting traditional retail consumers to the Company's
Web site, including consumers with little or no history of online purchases.
CDnow's traditional advertising efforts have included radio advertising in
major markets, such as advertising on the Howard Stern program, and print
advertising in music-related publications, including Spin and Variety. In the
first quarter of 1998, the Company initiated television advertising, including
national advertising during the Grammy Awards and the American Music Awards.
The Company intends to increase its use of television advertising, including
through its alliance with MTV/VH1, and has purchased advertising on such
programs as MTV's 1998 Video Music Awards, VH1's Flashback Week and the 1999
Grammy Awards.

Cosmic Credit Program

Through its Cosmic Credit Program, CDnow has entered into arrangements with
over 52,000 small Web sites, typically fan sites devoted to particular music
artists. Approximately 42,000 of these sites have enrolled since December 31,
1997. The Company provides Cosmic Credit 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. These highly focused, music-oriented sites are a significant source of
traffic and new customers for the Company. 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. In addition, the Company targets e-mail
communications to persons who have registered at the CDnow store but who have
not actually purchased, to new customers and to customers who have not made
purchases in recent periods. Through these customized programs, the Company
hopes to further stimulate demand, increase repeat purchases, build customer
loyalty, and better understand customer preferences. The Internet allows rapid
and effective experimentation analysis and 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 24 hours a day on

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weekdays and 10:00 AM to 6:00 PM Eastern Time on weekends to provide
assistance via e-mail, phone or fax. The Company strives to answer all
inquiries within 24 hours. The Company currently has approximately 45 customer
service representatives, including representatives fluent in nine 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 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.

Since August 1994, the Company has primarily used Valley Record Distributors
to fulfill orders for CDs, cassettes and vinyl records produced in the U.S.
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 two business days 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 quarter ended June 30, 1998 and the year ended December
31, 1997, payments to Valley accounted for approximately 82% and 78%,
respectively 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.

Since May 1997, the Company has used MSI to fulfill orders for CDs produced
by non-U.S. labels. The Company has also entered into a letter of intent for
MSI to provide an additional 150,000 international titles and create a
fulfillment center in the Netherlands to serve European markets commencing in
mid-1998.

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.

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Many of the software components, and the pages of the Web site, 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 Web site
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
Online Marketing group 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.

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 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 both commercial and proprietary firewalls
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.
Online recommendation technology is made available to all CDnow shoppers
through the Album Advisor feature, introduced 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

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<PAGE>

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, price, effectiveness of advertising
and other customer acquisition efforts, variety of value-added services, ease
of use, site content, quality of service and technical expertise. 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 adopted 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
a diminished brand franchise.

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 June 30, 1998, the Company had 151 full-time and 10 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
and approximately 8,000 square feet under an amendment to such lease that
expires in January 1999.

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The Company has signed a lease for a nearby facility, which contains
approximately 60,000 square feet, that expires in 2006. The Company intends to
move its offices to this nearby facility in late 1998 and sublease the space
in Jenkintown. 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 is not
currently engaged in litigation. See "Risk Factors--Government Regulation and
Legal Uncertainties" for information regarding a demand by certain foreign
distributors that the Company cease the sale of certain titles in Germany.

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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.............. 29 President, Chief Executive Officer and Chairman of the Board of Directors
Matthew Olim............ 29 Technical Lead, Secretary, Treasurer and Director
Rod Parker.............. 55 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
David Capozzi........... 42 Vice President and General Counsel
Steve Dong.............. 39 Vice President of Operations
Alan Meltzer(2)......... 53 Director
Patrick Kerins(1)(2).... 43 Director
John Regan(1)(2)........ 39 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 a 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 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.

42
<PAGE>

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 1997. From 1987 to 1995, Mr. Saltzman held various sales and
marketing positions with Unisys Corporation.

David Capozzi has been a Vice President and General Counsel since April
1998. From February 1996 to April 1998, Mr. Capozzi was an attorney with the
law firm of Morgan, Lewis & Bockius LLP. Mr Capozzi also has over 14 years of
experience in varying capacities in software design and development, including
seven years with Marriott Corporation. Mr. Capozzi holds a Juris Doctorate
from The American University, Washington College of Law, a Masters in Business
Administration from the Katz Graduate School of Business of the University of
Pittsburgh and a Bachelor of Science in Computer Science from the University
of Pittsburgh.

Steve Dong has been the Vice President of Operations since May 1998. Mr.
Dong served as the Director of Operations at Egghead Computer from July 1995
to May 1998. From January 1994 to July 1995, Mr. Dong was Chief Operating
Officer of Mac's Place, a wholly owned subsidiary of Egghead Computer. From
1987 to 1994, Mr. Dong held various management positions with Egghead Software
including Director of Distribution and Transportation.

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 terminated in February 1998.

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

43
<PAGE>

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 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 Relationships and Related 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
PRNCIPAL POSITIONI 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 16.6% $1.33 5/29/2007 $2,968,000 $4,820,000
</TABLE>
- ---------------------
(1) Based on the Company's initial public offering price of $16.00 on February
9, 1998.

44
<PAGE>

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 -- $1,760,400
</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 Company's initial public offering price of $16.00 on February 9, 1998
and the applicable exercise price.

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 June 30, 1998, options to purchase a total of 905,795 shares of Common
Stock at a weighted average exercise price per share of $8.78 were
outstanding. Of these options, options to purchase 115,991 shares of Common
Stock were fully vested and exercisable as of June 30, 1998. As of June 30,
1998, the Company had an additional 659,892 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.

45
<PAGE>

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

SERIES A PREFERRED STOCK

Pursuant to the terms of the Stock Purchase Agreement dated July 15, 1997 by
and among the Company, 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 for an aggregate purchase price of $1.3 million. The
outstanding shares of Series A Preferred Stock converted into an aggregate of
381,873 shares of Common Stock in February 1998. 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 was terminated in February 1998. Keystone
Ventures received certain registration rights in connection with this
transaction.

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
and 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
for an aggregate purchase price of $8.4 million, (ii) ABS purchased 62,000
shares of Series B Preferred Stock for an aggregate purchase price of
$338,000, (iii) the Company issued to Grotech Capital a warrant to purchase up
to 27,524 shares of Common Stock at an exercise price of $3.63 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 154,817 shares of Common Stock at an exercise price of $3.63
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 converted into an aggregate of 2,408,258
shares of Common Stock in February 1998. 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 was terminated in February 1998. Grotech IV,
Grotech Capital, ABS and BT Alex. Brown received certain registration rights
in connection with this transaction.

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 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 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. Mr. Meltzer effected a cashless exercise of this warrant in
February 1998 and received 809,237 shares. 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

46
<PAGE>

(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.

SHAREHOLDER ADVANCES

The Company had indebtedness due to Dave Olim, the father of Jason and
Matthew Olim, in the amount of $74,740, at December 31, 1995. During 1996,
Dave Olim advanced additional funds to the Company and on August 16, 1996, in
consideration of the cancellation of the $81,923 balance of this debt, the
Company issued 41,244 shares of the Company's Common Stock to Dave Olim. The
exchange ratio used to convert the debt into shares of Common Stock was
negotiated among Jason and Matthew Olim and their father, Dave Olim, and
therefore cannot be considered an arms-length transaction.

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, which warrants
were exercised on or about May 16, 1998.

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.

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 ("ABS").
The Series A Notes, which were repaid in February 1998, bore interest at the
rate of 12% per annum. In addition, the Company issued warrants to these
investors to purchase an aggregate of 48,550 shares of Common Stock at an
exercise price of $11.90 per share, including warrants issued to Grotech and
ABS exercisable for 8,403 and 1,071 shares of Common Stock, respectively. The
warrants issued to ABS have an exercise price equal to $16.00 per share. See
"Underwriting."

47
<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, (iv) all directors and executive officers of
the Company as a group and (v) the Selling Shareholder. 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 SHARES AFTER OFFERING#
----------------------- OFFERED -----------------------
NAME OF BENEFICIAL OWNER SHARES PERCENT HEREBY SHARES PERCENT
- ------------------------ ------------ ---------- ------- ------------ ----------
<S> <C> <C> <C> <C> <C>
EXECUTIVE OFFICERS AND
DIRECTORS
Jason Olim(1)........... 2,960,025 18.2% -- 2,960,025 16.9%
Matthew Olim(1)......... 2,960,025 18.2 -- 2,960,025 16.9
Alan Meltzer(2)......... 1,712,621 10.5 -- 1,712,621 9.8
Robert Saltzman(3)...... 42,102 * -- 42,102 *
Joel Sussman(4)......... 33,000 * -- 33,000 *
Rod Parker(4)........... 30,000 * -- 30,000 *
Michael Krupit(4)....... 4,500 * -- 4,500 *
Patrick Kerins(5)....... 1,569 * -- 1,569 *
John Regan(6)........... -- -- -- -- --
All executive officers
and directors as a
group (9 persons)(7)... 7,743,842 47.3 -- 7,743,842 43.9
FIVE PERCENT HOLDERS
Grotech Partners IV,
L.P.(8)................ 2,315,258 14.2 -- 2,315,258 13.2
<CAPTION>
SELLING SHAREHOLDER
<S> <C> <C> <C> <C> <C>
Jeffrey McCluskey....... 305,172 1.9 80,000 225,172 1.3
</TABLE>
- ---------------------

# Assumes no exercise of the Underwriter's over-allotment option.
* 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) 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 and 9,375 shares of Common Stock obtainable upon the
exercise of a stock option granted under the Equity Compensation Plan.
(4) Represents shares of Common Stock presently obtainable, or obtainable
within the next 60 days, upon the exercise of a stock option granted
under the Equity Compensation 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 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.

(7) Includes an aggregate of 111,171 shares of Common Stock obtainable upon
the exercise of presently exercisable options and warrants.
(8) The address of Grotech Partners IV, L.P. is 9690 Deereco Road, Timonium,
Maryland 21093. Grotech Partners IV, L.P. disclaims beneficial ownership
of any shares beneficially owned by Patrick Kerins.

48
<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 1,330,000 shares of Common Stock offered hereby, there will be
17,516,397 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.

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 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

49
<PAGE>

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.

TRANSFER AGENT AND REGISTRAR

The Transfer Agent and Registrar with respect to the Common Stock is
StockTrans, Inc., Ardmore, Pennsylvania.

50
<PAGE>

UNDERWRITING

Subject to the terms and conditions set forth in the underwriting agreement
(the "Underwriting Agreement"), the Company has agreed to sell to BT Alex.
Brown Incorporated (the "Underwriter"), and the Underwriter has agreed to
purchase from the Company and the Selling Shareholder an aggregate of
1,330,000 shares of Common Stock at the public offering price less the
underwriting discounts and commissions set forth on the cover page of this
Prospectus.

In the Underwriting Agreement, the Underwriter has 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.

The Company has granted to the Underwriter an option, exercisable during the
30-day period after the date of this Prospectus, to purchase up to 199,500
shares of Common Stock at the same price per share as the initial shares of
Common Stock to be purchased by the Underwriter. The Underwriter may exercise
such option only to cover over-allotments in the sale of shares of Common
Stock. To the extent that the Underwriter exercises such option, the
Underwriter will have a firm commitment, subject to certain conditions, to
purchase such additional shares of Common Stock.

The Company and its officers, directors and certain shareholders (including
the Selling Shareholder) 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 period of 45 days from the date of this
Prospectus without the prior written consent of the Underwriter. Such consent
may be given without any public notice.

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

To facilitate the offering of the Common Stock, the Underwriter may engage
in transactions that stabilize, maintain or otherwise affect the market price
of the Common Stock. Specifically, the Underwriter may over-allot shares of
the Common Stock in connection with this Offering, thereby creating a short
position in the Underwriter's syndicate account. Additionally, to cover such
over-allotments or to stabilize the market price of the Common Stock, the
Underwriter may bid for, and purchase, shares of the Common Stock at a level
above that which might otherwise prevail in the open market. The Underwriter
is not required to engage in these activities, and, if commenced, any such
activities may be discontinued at any time.

In connection with this Offering, the Underwriter, who is a qualified
registered market maker on the Nasdaq Stock Market, may engage in passive
market making on Nasdaq in accordance with Rule 103 of Regulation M under the
Exchange Act during the one business day period before the commencement of the
offers or sales of the Common Stock. The passive market making transactions
must comply with applicable volume and price limits and be identified as such.
In general, a passive market maker may display its bid at a price not in
excess of the highest independent bid for such security; if all independent
bids are lowered before the passive market maker's bid, however, such bid must
then be lowered when certain purchase limits are exceeded. Passive market
making may stabilize the market price of the Common Stock at a level above
that which might otherwise prevail and, if commenced, may be discontinued at
any time.

51
<PAGE>

The Underwriter has informed the Company that it does not intend to confirm
sales of Common Stock offered hereby for accounts over which it exercises
discretionary authority.

On August 5, 1997 the Company issued to a predecessor-in-interest to BT
Alex. Brown a warrant (the "Warrant") to purchase 154,817 shares of Common
Stock at an exercise price of $3.63 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") for an aggregate purchase price of
$338,000. Pursuant to the terms of an Investor Rights Agreement dated July 15,
1997 among BT Alex. Brown, ABS, Grotech, Keystone Ventures and certain holders
of Common Stock, the shares of Common Stock owned by ABS and the Warrant and
the shares of Common Stock receivable by BT Alex. Brown through exercise of
the Warrant may not be sold or otherwise transferred prior to August 9, 1998.
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. Pursuant to the rules and
regulations of the National Association of Securities Dealers, Inc., the
Associated Warrants beneficially held by current BT Alex. Brown employees have
been deemed compensation of BT Alex. Brown in connection with the Company's
February 1998 initial public offering. Pursuant to such rules and regulations,
the Associated Warrants have an exercise price equal to $16.00 per share, the
initial public offering price in the Company's initial public offering, and
the Associated Warrants and the Common Stock receivable by ABS upon exercise
of the Associated Warrants may not be sold or otherwise transferred, assigned,
pledged or hypothecated until February 9, 1999.

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
Underwriter 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.

52
<PAGE>

CDNOW, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

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

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To CDnow, Inc.:

We have audited the accompanying consolidated balance sheets of CDnow, Inc.
(a Pennsylvania Corporation) and Subsidiaries as of December 31, 1996 and
1997, and the related consolidated 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. and
Subsidiaries as of December 31, 1996 and 1997, and the results of their
operations and their cash flows for each of the three years in the period
ended December 31, 1997, in conformity with generally accepted accounting
principles.

Arthur Andersen llp

Philadelphia, Pa.,
January 14, 1998 (except for the
stock split discussed in Note 2,
as to which the date is February
3, 1998)

F-2
<PAGE>

CDNOW, INC.

CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
DECEMBER 31,
----------------------- JUNE 30,
1996 1997 1998
---------- ----------- -----------
(UNAUDITED)
<S> <C> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents............... $ 775,865 $10,686,001 $47,290,625
Short-term investments.................. 245,641 1,003,045 --
Accounts receivable, net of reserve of
$12,000, $77,000 and $140,846.......... 130,437 324,411 326,830
Prepaid expenses and other.............. 49,821 2,457,958 5,423,757
---------- ----------- -----------
Total current assets................... 1,201,764 14,471,415 53,041,212
PROPERTY AND EQUIPMENT, net.............. 362,035 1,884,296 3,855,871
OTHER ASSETS............................. 11,660 92,714 3,863,069
---------- ----------- -----------
$1,575,459 $16,448,425 $60,760,152
========== =========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
(DEFICIT)
CURRENT LIABILITIES:
Notes payable........................... $ 200,000 $ 5,575,288 $ --
Current portion of term loans payable... -- 54,091 60,315
Current portion of capitalized lease
obligations............................ 35,942 307,471 478,810
Accounts payable........................ 435,682 8,981,430 3,510,308
Accrued expenses........................ 129,317 579,413 1,482,007
Deferred revenues....................... 166,107 188,466 83,200
Advances due to related parties......... 3,261 3,261 --
---------- ----------- -----------
Total current liabilities.............. 970,309 15,689,420 5,614,640
---------- ----------- -----------
TERM LOANS PAYABLE....................... -- 136,293 104,930
---------- ----------- -----------
CAPITALIZED LEASE OBLIGATIONS............ 91,133 825,851 994,005
---------- ----------- -----------
DEFERRED RENT LIABILITY.................. -- 56,717 145,883
---------- ----------- -----------
REDEEMABLE SERIES A AND B CONVERTIBLE
PREFERRED STOCK......................... -- 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,
7,845,684, and 16,266,397 shares issued
and outstanding at December 31, 1996,
1997 and June 30, 1998................. 579,549 579,549 79,281,341
Additional paid-in capital.............. -- 1,325,817 4,325,817
Deferred compensation................... -- (434,776) (300,959)
Accumulated deficit..................... (65,532) (11,223,040) (29,405,505)
---------- ----------- -----------
Total shareholders' equity (deficit)... 514,017 (9,752,450) 53,900,694
---------- ----------- -----------
$1,575,459 $16,448,425 $60,760,152
========== =========== ===========
</TABLE>

The accompanying notes are an integral part of these statements.

F-3
<PAGE>

CDNOW, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
SIX MONTHS ENDED
YEAR ENDED DECEMBER 31, JUNE 30,
------------------------------------- -------------------------
1995 1996 1997 1997 1998
---------- ----------- ------------ ----------- ------------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
NET SALES............... $2,176,474 $ 6,300,294 $ 17,372,795 $ 5,546,203 $ 21,624,030
COST OF SALES........... 1,844,612 5,217,789 14,316,028 4,412,843 18,154,598
---------- ----------- ------------ ----------- ------------
Gross profit.......... 331,862 1,082,505 3,056,767 1,133,360 3,469,432
---------- ----------- ------------ ----------- ------------
OPERATING EXPENSES:
Operating and
development........... 149,982 669,280 2,541,434 812,284 2,765,714
Sales and marketing.... 200,972 621,454 9,139,348 1,121,960 17,769,619
General and
administrative........ 180,573 563,593 1,953,078 743,385 1,734,159
Dispute settlement
(Note 7).............. -- 1,024,030 -- -- --
---------- ----------- ------------ ----------- ------------
531,527 2,878,357 13,633,860 2,677,629 22,269,492
---------- ----------- ------------ ----------- ------------
Operating loss........ (199,665) (1,795,852) (10,577,093) (1,544,269) (18,800,060)
INTEREST INCOME......... -- -- 201,650 1,390 1,228,051
INTEREST EXPENSE........ (1,248) (14,556) (371,962) (6,805) (494,914)
---------- ----------- ------------ ----------- ------------
NET LOSS................ (200,913) (1,810,408) (10,747,405) (1,549,684) (18,066,923)
ACCRETION OF PREFERRED
STOCK TO REDEMPTION
VALUE.................. -- -- (410,103) -- (115,542)
---------- ----------- ------------ ----------- ------------
NET LOSS APPLICABLE TO
COMMON SHAREHOLDERS.... $ (200,913) $(1,810,408) $(11,157,508) $(1,549,684) $(18,182,465)
========== =========== ============ =========== ============
NET LOSS PER COMMON
SHARE.................. $ (1.42) $ (.20) $ (1.29)
============ =========== ============
WEIGHTED AVERAGE NUMBER
OF COMMON SHARES
OUTSTANDING............ 7,845,684 7,845,684 14,044,939
============ =========== ============
</TABLE>

The accompanying notes are an integral part of these statements.

F-4
<PAGE>

CDNOW, INC.

CONSOLIDATED 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,
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)
Mandatory conversion of
Redeemable Series A
Convertible Preferred
Stock to Common Stock
(unaudited)........... (9,608,136) 2,790,131 9,608,136 -- -- -- 9,608,136
Issuance of common
stock from
consummation of IPO,
net of offering costs
(unaudited)........... -- 4,561,250 67,077,862 -- -- -- 67,077,862
Issuance of common
stock (unaudited)..... -- 96,296 2,134,198 -- -- -- 2,134,198
Issuance of warrants
(unaudited)........... -- -- -- 3,000,000 -- -- 3,000,000
Cashless exercise of
warrants (unaudited).. -- 905,996 -- -- -- -- --
Exercise of warrants
(unaudited)........... -- 32,727 59,890 -- -- -- 59,890
Exercise of options
(unaudited)........... -- 34,313 80,706 -- -- -- 80,706
Remeasurement of value
of shares issued to
Lycos (Note 10)
(unaudited)........... -- -- (259,000) -- -- -- (259,000)
Amortization of
Deferred Compensation
(unaudited)........... -- -- -- -- 133,817 -- 133,817
Accretion of preferred
stock to redemption
value (unaudited)..... 115,542 -- -- -- -- (115,542) (115,542)
Net Loss (unaudited)... -- -- -- -- -- (18,066,923) (18,066,923)
----------- ---------- ----------- ---------- --------- ------------ ------------
BALANCE, JUNE 30, 1998
(unaudited)........... $ -- 16,266,397 $79,281,341 $4,325,817 $(300,959) $(29,405,505) $ 53,900,694
=========== ========== =========== ========== ========= ============ ============
</TABLE>

The accompanying notes are an integral part of these statements.

F-5
<PAGE>

CDNOW, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, SIX MONTHS ENDED JUNE 30,
------------------------------------ --------------------------
1995 1996 1997 1997 1998
--------- ----------- ------------ ------------ ------------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
OPERATING ACTIVITIES:
Net loss................. $(200,913) $(1,810,408) $(10,747,405) $(1,549,684) $(18,066,923)
Adjustments to reconcile
net loss to net cash
provided by (used in)
operating activities--
Depreciation and
amortization........... 32,999 105,439 1,066,815 129,000 750,610
Provision for returns
and doubtful accounts.. -- 12,000 65,000 -- 142,846
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) 5,266 (140,185)
Prepaid expenses and
other................. (26,994) (34,487) (2,401,794) (160,648) (1,597,421)
Accounts payable....... 109,386 326,296 8,545,748 722,118 (5,549,024)
Accrued expenses....... 58,124 68,139 450,096 339,604 902,594
Deferred revenue....... 4,952 161,155 22,359 (7,442) (105,266)
Deferred rent
liability............. -- -- 56,717 -- 89,166
--------- ----------- ------------ ------------ ------------
Net cash provided by
(used in)
operating activities.. 41,427 (116,312) (3,201,438) (521,781) (23,573,603)
--------- ----------- ------------ ------------ ------------
INVESTING ACTIVITIES:
Purchases of short-term
investments............. -- (245,641) (1,005,501) -- --
Sales and maturities of
short-term investments.. -- -- 248,097 245,641 1,003,045
Purchases of property and
equipment............... (135,777) (198,985) (912,560) (332,965) (1,637,206)
Acquisition of a
business................ -- -- -- -- (423,694)
--------- ----------- ------------ ------------ ------------
Net cash used in
investing
activities........... (135,777) (444,626) (1,669,964) (87,324) (1,057,855)
--------- ----------- ------------ ------------ ------------
FINANCING ACTIVITIES:
Borrowings on term loans
payable................. -- -- 218,563 190,170 --
Payments on term loans
payable................. -- -- (28,179) (6,478) (25,139)
Borrowings on notes
payable................. 100,000 200,000 -- 50,000 --
Payments on notes
payable................. -- (100,000) (200,000) (110,000) --
Proceeds from sale of
common stock and
warrants................ -- 1,200,000 -- -- --
Proceeds from issuance
(repayment of) of Series
A Notes and warrants.... -- -- 5,602,706 -- (5,777,500)
Proceeds from sale of
preferred stock......... -- -- 9,252,491 -- --
Proceeds from (repayment
of) advances due to
related parties......... 37,683 6,341 -- -- (3,261)
Payments on capitalized
lease obligations....... (1,529) (13,350) (64,043) (21,012) (176,476)
Proceeds from issuance of
common stock, net....... -- -- -- -- 67,077,862
Proceeds from warrants
exercised............... -- -- -- -- 59,890
Proceeds from options
exercised............... -- -- -- -- 80,706
--------- ----------- ------------ ------------ ------------
Net cash provided by
financing
activities........... 136,154 1,292,991 14,781,538 102,680 61,236,082
--------- ----------- ------------ ------------ ------------
INCREASE (DECREASE) IN
CASH AND
CASH EQUIVALENTS......... 41,804 732,053 9,910,136 (506,425) 36,604,624
CASH AND CASH EQUIVALENTS,
BEGINNING OF PERIOD...... 2,008 43,812 775,865 775,865 10,686,001
--------- ----------- ------------ ------------ ------------
CASH AND CASH EQUIVALENTS,
END OF PERIOD............ $ 43,812 $ 775,865 $ 10,686,001 $ 269,440 $ 47,290,625
========= =========== ============ ============ ============
</TABLE>

The accompanying notes are an integral part of these statements.

F-6
<PAGE>

CDNOW, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(INFORMATION AS OF JUNE 30, 1998 AND FOR THE SIX MONTHS ENDED JUNE 30, 1997
AND 1998 IS UNAUDITED)

1. THE COMPANY:

CDnow, Inc. and Subsidiaries (the "Company") is an online retailer of
compact discs ("CDs") and other music-related products. 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 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 June 30 , 1998 had accumulated losses of $30.9 million. For
the year ended December 31, 1997, and the six months ended June 30, 1998 the
Company's net loss was $10.7 million and $18.1 million, respectively. The
Company intends to invest heavily in marketing and promotion, strategic
alliances, 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.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

Principles of Consolidation

The consolidated financial statements include the accounts of CDnow, Inc.
and its wholly owned subsidiaries. All intercompany balances and transactions
have been eliminated in consolidation.

Interim Financial Statements

The consolidated financial statements for the six month periods ended
June 30, 1997 and 1998 are unaudited and, in the opinion of management,
include all adjustments (consisting only of normal and recurring adjustments)
necessary for a fair presentation of results for these interim periods. The
results of operations for the six month ended June 30, 1998 are not
necessarily indicative of the results expected for the entire year.

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.

Net Loss Per Common Share

The Company has presented net loss per common share for 1997 and for the six
months ended June 30, 1997 and 1998 pursuant to Statement of Financial
Accounting Standards (SFAS) No. 128 "Earnings per Share" and the Securities
and Exchange Commission Staff Accounting Bulletin No. 98. Net loss per common
share has not been presented for any period prior to 1997, since such amounts
are not considered meaningful as a result of the Company's S Corporation
status during those periods.

F-7
<PAGE>

CDNOW, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED)

Basic loss per common share was computed by dividing net loss applicable to
common shareholders by the weighted average number of shares of Common Stock
outstanding during 1997 and the six months ended June 30, 1997 and 1998.
Diluted loss per common share has not been presented, since the impact on loss
per share using the treasury stock method is anti-dilutive due to the
Company's losses.

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, $10,005,132, and $47,290,625 at December 31,
1996 and 1997 and June 30, 1998, respectively, included money market funds,
government mortgage-backed bonds and highly rated corporate securities.

Short-Term Investments

At December 31, 1996 and 1997, short-term investments represented government
mortgage-backed bonds maturing in less than a year and each was classified as
available-for-sale. Pursuant to 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, amortized cost approximated fair value
and unrealized gains and losses were immaterial. Gross unrealized holding
gains and losses were immaterial in 1995, 1996 and 1997. The gross proceeds
from sales and maturities of short-term investments were $248,097 in 1997. No
short-term investments were sold or matured prior to 1997. Gross realized
gains and losses were immaterial. For the purpose of determining gross
realized gains and losses, the cost of the securities sold is based upon
specific identification.

Prepaid Expenses

At December 31, 1997 prepaid expenses included $87,397 of net deferred
financing costs related to the Series A Notes. Amortization of deferred
financing costs was $87,397 in 1997 and $87,397 in the six month period ended
June 30, 1998 and is included in interest expense. Prepaid expenses included
$2,000,000 and $3,615,000 at December 31, 1997 and June 30, 1998,
respectively, related to linking agreements and strategic alliances (see Note
10). At June 30, 1998, Other Assets included $2,731,000 related to linking
agreements and strategic alliances.

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.

F-8
<PAGE>

CDNOW, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED)

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.

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, $6,834,000,
$490,486, and $13,992,087 for the years ended December 31, 1995, 1996, 1997
and for the six months ended June 30, 1997 and 1998 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, and the six months
ended June 30, 1997 and 1998, the Company paid interest of $2,329, $19,467,
$284,565, $13,100, and $397,618 respectively. In addition, the Company
incurred $15,000, $126,954, $1,070,290, $43,284 and $515,969 in capitalized
lease obligations for the years ended December 31, 1995, 1996 and 1997, and
the six months ended June 30, 1997 and 1998, respectively. 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 consolidated financial statements to the number of shares
and to per share amounts have been retroactively restated to reflect all of
these changes.

Comprehensive Income

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. The Company has adopted
SFAS 130 in the first quarter of 1998. The Company has had no other
comprehensive income items to report.

F-9
<PAGE>

CDNOW, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED)

Initial Public Offering

On February 13, 1998 the Company consummated an initial public offering of
its Common Stock (the "Initial Public Offering"). The company sold 4,561,250
shares of its common stock, no par value, at an initial public offering price
of $16.00 per share. After deducting the underwriters' discount and other
offering expenses, the net proceeds to the company were approximately
$67,077,862.

Recently Issued Accounting Pronouncements

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 consolidated
financial statements.

Reclassification

The statement of operations for 1996 and 1997 and the six months ended June
30, 1997 have been reclassified to conform with the presentation of June 30,
1998. Beginning in 1998, the Company determined to include royalties paid on
CD sales in return for licensing of ratings, reviews, sound samples and other
information ("Information Royalties") in operating and development expenses
rather than in cost of sales, as was previously the case. This change was made
based on Management's determination that including Information Royalties in
operating and development expense was more consistent with the treatment of
such expenses by retailers generally. The financial information for periods
prior to 1998 has been restated to reflect this change. Information Royalties
were $146,200, $225,737, $97,562, and $137,119 during the years ended December
31, 1996 and 1997 and the six months ended June 30, 1997 and 1998,
respectively. There were no Information Royalties paid in 1995.

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,
risks associated with the Year 2000, 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%, 74%,
78%, 74% and 82% of the cost of sales for the years ended 1995, 1996 and 1997
and the six months ended June 30, 1997 and 1998 respectively. Additionally,
the Company

F-10
<PAGE>

CDNOW, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

3 RISKS AND UNCERTAINTIES: (CONTINUED)

purchased all of its import music titles from another vendor. This vendor
accounted for 21%, 14% and 11% of the cost of sales in 1995, 1996 and the six
months ended June 30, 1997, respectively. 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 and the six months ended June 30, 1998.

International Sales

The Company derived 22%, 40%, 29%, 35% and 22% of revenues for the years
ended 1995, 1996 and 1997, and for the six months ended June 30, 1997 and
1998, 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/ --------------------- JUNE 30,
LEASE TERM 1996 1997 1998
------------ --------- ---------- -----------
(UNAUDITED)
<S> <C> <C> <C> <C>
Computers and equipment.... 3 years $ 387,348 $2,090,144 $4,196,975
Office furniture and
equipment................. 5 years 117,876 397,930 779,876
--------- ---------- ----------
505,224 2,488,074 4,976,851
Less--Accumulated
depreciation and
amortization.............. (143,189) (603,778) (1,120,980)
--------- ---------- ----------
$ 362,035 $1,884,296 $3,855,871
========= ========== ==========
</TABLE>

Depreciation and amortization expense for the years ended 1995, 1996 and
1997 and the six months ended June 30, 1997 and 1998 was $32,999, $105,439,
$460,589, $129,000 and $544,404, respectively. Total property and equipment
under capital leases was $141,954, $1,217,130 and $1,733,099 less accumulated
amortization of $25,659, $252,988, and $498,841, at December 31, 1996 and 1997
and at June 30, 1998.

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 begin to expire in 2011.

F-11
<PAGE>

CDNOW, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

5. INCOME TAXES: (CONTINUED)

The 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 Company's history of operating losses the realization of the
deferred tax asset is uncertain. The Company has, therefore, provided a full
valuation allowance against the deferred tax asset.

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 per share. 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 were 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 and $202,212 in the six months ended June 30, 1998.
The notes were repaid in February 1998.

F-12
<PAGE>

CDNOW, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

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 investor received the right to appoint two members of the
Company's Board of Directors, each having one-half vote. This right terminated
upon the consummation of the Company's Initial Public Offering. The investor,
who is a director of the Company, exercised the warrant upon consummation of
the Initial Public Offering, by tendering to the Company 62,473 shares
received upon exercise to satisfy the $999,561 exercise price. This cashless
exercise resulted in 809,237 net shares of common stock being received by the
investor.

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 converted into shares of the
Company's common stock upon the consummation of the Initial Public Offering in
February 1998, on a 1.5-for-1 basis.

F-13
<PAGE>

CDNOW, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

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

Beginning January 1, 2003, the Series A and B Preferred would have been
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 were being accreted to their redemption values for
accounting purposes. The holders of Series A and B Preferred were entitled to
receive cumulative dividends of 8% per share per year, when and if declared by
the Company; no dividends could have been declared or paid on common stock
unless all cumulative dividends were declared and paid on the preferred stock.
The Series A and Series B Preferred had 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
Granted................... 229,499 $14.00-$35.50 5,909,108 $25.75
Exercised................. (34,313) $ 1.33-$ 3.00 (80,706) $ 2.35
Cancelled................. (11,305) $ 1.33-$10.00 (35,930) $ 3.18
------- ------------- ---------- ------
Outstanding June 30,
1998..................... 905,795 $ 1.33-$35.50 $7,950,152 $ 8.78
======= ============= ========== ======
</TABLE>

As of June 30, 1998, there were options to purchase 115,991 shares of common
stock exercisable with a weighted average exercise price of $1.33 per share.
In addition, as of June 30, 1998, there were options to purchase and 659,892
shares of 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
and $133,817 was charged to compensation expense for the year ended December
31, 1997 and the six months ended June 30, 1998 respectively.

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 CONSOLIDATED 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 applicable to common shareholders:
As reported................................................. $(11,157,508)
============
Pro forma................................................... $(11,265,003)
============
Net loss per common share:
As reported................................................. $ (1.42)
============
Pro forma................................................... $ (1.45)
============
</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 Initial Public Offering, the warrants converted 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 was 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. The fair value of services
contributed by the founders was determined by the Company's Board of
Directors. In determining the value, the Board considered the founders' level
of experience, position in the Company, the compensation level of other
employees, the Company's financial resources and the status of the Company's
development.

F-15
<PAGE>

CDNOW, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
9. RELATED-PARTY TRANSACTIONS: (CONTINUED)

The Company had a $3,261 advance due to a founder at December 31, 1996 and
1997. This advance was repaid in the six months ended June 30, 1998. At
December 31, 1995 the Company had advances due to a founder and his father of
$4,103 and $74,740, respectively. During 1996, the father advanced additional
funds to the Company and, 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. The exchange ratio used to convert the
debt into shares of common stock was negotiated between the founders and their
father and cannot be considered arms-length.

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 was granted exclusivity on
music-related pages on the www.yahoo.com Web site. The term began in October
1997 and will expire on October 5, 1999. During the first year of the 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. During the second year
of the term, the Company will be required to pay Yahoo an amount, not to be
less than $4,500,000, calculated using the number of impressions delivered
during August and September of 1998. 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. 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.

Lycos Agreement

On March 26, 1998, the Company entered into an agreement with Lycos, Inc.
(the "Lycos Agreement"), pursuant to which the Company became the exclusive
retail music store sponsor of the www.Lycos.com and www.Tripod.com Web sites.
The Lycos Agreement has a term of three years which will commence on the
launch date, as defined. The Company has agreed to pay Lycos $4,500,000,
$5,500,000 and $6,500,000 during the first, second and third years,
respectively of the contract term in exchange for a specified number of page
views. In addition, the Company has issued 61,665 shares (the "Lycos Shares")
of common stock to Lycos. The Lycos Shares vest as Lycos delivers certain
required minimum page views, as defined. The Company has the right to
repurchase any of the Lycos shares that do not become vested at a price of
$0.01 per share. The Company will measure the stock granted as it

F-16
<PAGE>

CDNOW, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
10. COMMITMENTS AND CONTINGENCIES: (CONTINUED)

vests. If Lycos is unable to deliver a number of guaranteed minimum
impressions the Company will not be required to make all of the minimum
payments and all of the Lycos shares may not vest. The Company expects to
amortize the costs associated with the Lycos 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.

Lycos Bertelsmann Agreement

On April 2, 1998, the Company entered into an agreement with Lycos
Bertelsmann GMBH & Co. KG (the "Lycos Bertelsmann Agreement), pursuant to
which the Company became the exclusive music retailer on certain Lycos branded
Web services, as defined, in Europe. The Lycos Bertelsmann Agreement has a
three year term which will commence on the launch date, as defined. The
Company has agreed to pay Lycos Bertelsmann $1,420,000, $1,880,000 and
$2,200,000 during the first, second and third years of the contract term. The
Company expects to amortize the costs associated with the Lycos Bertelsmann
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.

MTV Agreement

On May 18, 1998, the Company entered into a binding memorandum of terms for
a three year advertising and promotion agreement with MTV Networks, a
subsidiary of Viacom International, Inc., pursuant to which the Company
committed to purchase advertising on certain MTV and VH1 programming and
obtained the right to use certain MTV and VH1 content. The Company has agreed
to pay MTV Networks $5,200,000, $6,789,000, $7,336,000 and $121,000 during the
remainder of 1998 and during the years ending December 31, 1999, 2000, and
2001, respectively. In addition, the Company has granted MTV Networks a
warrant to purchase 226,892 shares of the Company's common stock at an
exercise price of $23.28 per share. The warrant will vest annually over the
three years of the contract term. The warrant was valued at $3,000,000 using
the Black-Scholes model, and will be charged to expense ratably over the term
of the agreement.

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. The Company has
committed to make payments under advertising and linking agreements with
Rolling Stone Network, America Online with respect to the Love@AOL service,
and with certain other parties and has expanded its agreement with Yahoo. The
Company's aggregate commitment under these arrangements is approximately
$3,088,000, $2,927,000, $2,435,000 and $766,000 in the remaining six months of
1998, and in the years ending December 31, 1999, 2000 and 2001, respectively.

Many of the Company's agreements including the Yahoo, Excite, Lycos and
Lycos Bertelsmann Agreements contain provisions which may require additional
payments to be made by the Company based on factors such as click-throughs and
new customers generated. No such payments have been incurred to date. Such
payments will be expensed as incurred. The Company will continue to evaluate
the realizability of assets recorded, if any, related to the Yahoo, Excite,
Lycos, Lycos Bertelsmann and other agreements, and, if necessary, write down
the assets to realizable value.

F-17
<PAGE>

CDNOW, INC.

NOTES TO CONSOLIDATED 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>
1998.................... $ 291,033 $ 464,103
1999.................... 302,044 453,629
2000.................... 343,784 388,761
2001.................... 316,775 146,407
2002.................... 226,037 --
---------- ----------
Total minimum lease
payments............... $1,479,673 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, $207,724, $49,457
and $253,900 for the years ended 1995, 1996 and 1997 and for the six months
ended June 30, 1997 and 1998, 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-18
<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 UN-
LAWFUL. 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>
Additional Information................................................... 2
Prospectus Summary....................................................... 3
Risk Factors............................................................. 7
Price Range of Common Stock.............................................. 16
Use of Proceeds.......................................................... 17
Dividend Policy.......................................................... 17
Capitalization........................................................... 18
Dilution................................................................. 18
Selected Financial and Operating Data.................................... 19
Management's Discussion and Analysis of Financial Condition and Results
of Operations............................................................ 20
Business................................................................. 30
Management............................................................... 42
Certain Relationships and Related Transactions........................... 46
Principal and Selling Shareholders....................................... 48
Description of Capital Stock............................................. 49
Underwriting............................................................. 51
Legal Matters............................................................ 52
Experts.................................................................. 52
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.

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

1,330,000 Shares

LOGO

Common Stock

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

PROSPECTUS

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

BT ALEX. BROWN

, 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................................................... $ 22,374
NASD filing fee.................................................... 8,084
Transfer agent and registrar fees.................................. 5,000
Printing and engraving............................................. 100,000
Legal fees......................................................... 100,000
Blue Sky fees and expenses......................................... 5,000
Nasdaq National Market listing fee................................. 17,500
Accounting fees.................................................... 100,000
Miscellaneous...................................................... 142,042
Total.............................................................. $500,000
========
</TABLE>

ITEM 14. INDEMNIFICATION OF DIRECTORS AND OFFICERS.

Chapter 17, Subchapter D of the Pennsylvania Business Corporation Law of
1988, as amended (the "PBCL") contains provisions permitting indemnification
of officer and directors of a business corporation in Pennsylvania. Sections
1741 and 1742 of the PBCL provide that a business corporation may indemnify
directors and officers against liabilities and expenses they may incur as such
in connection with any threatened, pending or completed civil, administrative
or investigative proceeding, provided that the particular person acted in good
faith and in a manner he or she reasonably believed to be in, or not opposed
to, the best interests of the corporation, and, with respect to any criminal
proceeding, had no reasonable cause to believe his or her conduct was
unlawful. In general, the power to indemnify under these sections does not
exist in the case of actions against a director or officer by or in the right
of the corporation if the person otherwise entitled to indemnification shall
have been adjudged to be liable to the corporation unless it is judicially
determined that, despite the adjudication of liability but in view of all the
circumstances of the case, the person is fairly and reasonably entitled to
indemnification for specified expenses. Section 1743 of the PBCL provides that
the corporation is required to indemnify directors and officers against
expenses they may incur in defending actions against them in such capacities
if they are successful on the merits or otherwise in the defense of such
actions.

Section 1746 of the PBCL grants a corporation broad authority to indemnify
its directors and officers for liabilities and expenses incurred in such
capacity, except in circumstances where the act or failure to act giving rise
to the claim for indemnification is determined by a court to have constituted
willful misconduct or recklessness.

Section 1747 of the PBCL permits a corporation to purchase and maintain
insurance on behalf of any person who is or was a director or officer of the
corporation, or is or was serving at the request of the corporation as a
representative of another corporation or other enterprise, against any
liability asserted against such person and incurred by him or her in any such
capacity, or arising out of his or her status as such, whether or not the
corporation would have the power to indemnify the person against such
liability under Chapter 17, Subchapter D of the PBCL.

II-1
<PAGE>

Section 8.01 of the Bylaws provides that the Registrant will indemnify any
director or officer of the Registrant or any other person designated by the
Board of Directors of the Registrant (which may, but need not, include any
person serving at the request of the Registrant as a director or officer,
employee, agent, fiduciary or trustee of another corporation, partnership,
joint venture, trust, employee benefit plan or other entity or enterprise)
against 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) incurred in connection with any proceeding
in which such person may be involved as a party or otherwise by reason of the
fact that such person is or was serving in such capacity, including, without
limitation, liabilities resulting from any actual or alleged breach of duty,
error, misstatement or misleading statement, negligent, gross negligence or
act giving rise to strict or products liability. Notwithstanding the
foregoing, the Registrant shall not indemnify any person for any act or
failure to act which is (i) prohibited by applicable law or (ii) finally
determined to have constituted willful misconduct or recklessness or to be
based upon or attributable to the receipt by such person of a personal benefit
to which such person is not legally entitled. Section 8.03 of the Bylaws
provides for the advancement of expenses to an indemnified party upon receipt
of an undertaking by the party to repay those amounts if it is ultimately
determined that the indemnified party is not entitled to indemnification.

Section 8.04 of the Bylaws authorizes the Registrant to use any mechanism or
arrangement, as determined by the Board of Directors, to further effect,
satisfy or secure its indemnification obligations, including purchasing and
maintaining insurance, obtaining a letter of credit, creating a reserve,
trust, escrow or other fund or account, entering into indemnification
agreements or granting security interests.

Section 8.08 of the Bylaws mandates indemnification against expenses
(including attorney's fees and disbursements) actually and reasonably incurred
by any authorized representative of the Registrant who 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 PBCL.

Section 8.09 of the Bylaws provides that the rights of indemnification under
the Bylaws will be deemed a contract between the Registrant and each person
entitled to indemnification.

Section 8.10 of the Bylaws states that the indemnification authorized by the
Bylaws will not be exclusive of any other rights to which persons seeking
indemnification or advancement of expenses may be entitled.

The Registrant maintains, on behalf of its directors and officers, insurance
protection against certain liabilities arising out of the discharge of their
duties.

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.

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.

6. On March 26, 1998, the Company issued 61,665 shares of Common Stock to
an accredited investor as a partial inducement to enter into an agreement
with the Company.

II-2
<PAGE>

7. On May 18, 1998, the Company issued a warrant exercisable for 226,892
shares of Common Stock to an accredited investor as a partial inducement to
enter into a strategic alliance with 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.#
3.3 Amendment No. 1 to 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 Amendment 1998-1 to the CDNow, Inc. 1996 Equity Compensation Plan.#
10.13+ Linking Agreement dated March 26, 1998 between the Registrant and
Lycos, Inc.**
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 5.1 hereto).*
24.1 Power of Attorney (included on signature page to this Registration
Statement).@
27.1 Financial Data Schedule.*
</TABLE>
- ---------------------
*Filed herewith.

**Incorporated by reference to Exhibit 10.13 to the Registrant's Form 10-Q/A
for the three months ended March 31, 1998 filed with the Commission on June 4,
1998.

#Incorporated by reference to the Registrant's Registration Statement on Form
S-1 (File No. 333-41241).

@Previously filed.
+Portions of this Exhibit were omitted and filed separately with the Secretary
of the Commission pursuant to an application for confidential treatment filed
with the Commission pursuant to Rule 406 under the Securities Act.

II-3
<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-4
<PAGE>

SIGNATURES

PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1933, AS AMENDED, THE
REGISTRANT HAS DULY CAUSED THIS REGISTRATION STATEMENT TO BE SIGNED ON ITS
BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, IN JENKINTOWN,
PENNSYLVANIA ON JULY 24, 1998.

CDnow, Inc.

/s/ Jason Olim
By: _________________________________
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

NAME CAPACITY DATE

/s/ Jason Olim President, Chief
- ------------------------------------- Executive Officer July 24, 1998
JASON OLIM and Chairman of the
Board (principal
executive officer)

/s/ Joel Sussman Vice President and
- ------------------------------------- Chief Financial July 24, 1998
JOEL SUSSMAN Officer (principal
financial and
accounting officer)

* Director
- ------------------------------------- July 24, 1998
MATTHEW OLIM

* Director
- ------------------------------------- July 24, 1998
ALAN MELTZER

* Director
- ------------------------------------- July 24, 1998
PATRICK KERINS

* Director
- ------------------------------------- July 24, 1998
JOHN REGAN

/s/ Joel Sussman
*By:_________________________________
JOEL SUSSMAN,
Attorney-in-Fact

II-5
<PAGE>

EXHIBIT INDEX

<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.#
3.3 Amendment No. 1 to 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 Amendment 1998-1 to the CDnow, Inc. 1996 Equity Compensation Plan.#
10.13+ Linking Agreement dated March 26, 1998 between the Registrant and
Lycos, Inc.**
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 5.1 hereto).*
24.1 Power of Attorney (included on the signature page to this Registration
Statement).@
27.1 Financial Data Schedule.*
</TABLE>
- ---------------------
* Filed herewith.

**Incorporated by reference to Exhibit 10.13 to the Registrant's Form 10-Q/A
for the three months ended March 31, 1998 filed with the Commission on June 4,
1998.

# Incorporated by reference to the Registrant's Registration Statement on Form
S-1 (File No. 333-41241).

@ Previously filed.
+ Portions of this Exhibit were omitted and filed separately with the
Secretary of the Commission pursuant to an application for confidential
treatment filed with the Commission pursuant to Rule 406 under the Securities
Act.

<PAGE>

EXHIBIT 1.1
____________ Shares

CDNOW, INC.

Common Stock

UNDERWRITING AGREEMENT

______________, 1998

BT ALEX. BROWN INCORPORATED
1 South Street
Baltimore, Maryland 21202

Dear Sirs:

1. INTRODUCTORY. CDnow, Inc., a Pennsylvania corporation (the
"Company") and the selling stockholders named in Schedule A hereto (the "Selling
Stockholders") propose to sell to BT Alex. Brown Incorporated ("Alex. Brown" or
the "Underwriter"), an aggregate of __________ shares of Common Stock, no par
value share (the "Common Stock"), of the Company of which __________ will be
sold by the Company and ___________ by the Selling Stockholders. The aggregate
of __________ shares so proposed to be sold is hereinafter referred to as the
"Firm Stock." At the Underwriter's option the Company proposes to sell to the
Underwriter up to an additional ___________ shares of Common Stock
(collectively, the "Option Stock"). The Firm Stock and the Option Stock are
hereinafter collectively referred to as the "Stock."

2. (a) REPRESENTATIONS AND WARRANTIES OF THE COMPANY. The Company
represents and warrants to the Underwriter that:

(i) A registration statement on Form S-1 (File No. 333-
52367), with respect to the Stock, including any prospectuses included
therein, copies of which have heretofore been delivered to you, has been
prepared by the Company and has been filed under the Securities Act of
1933, as amended (the "Securities Act"), and the rules and regulations (the
"Rules and Regulations") of the Securities and Exchange Commission (the
"Commission") thereunder; one or more preeffective amendments to such
registration statement, including in each case an amended preeffective
prospectus, copies of which filings have heretofore been delivered to you,
have also been so prepared and filed. Such registration statement at the
time which it became or becomes effective is referred to hereinafter as the
"Registration Statement." If it is contemplated, at the time this Agreement
is executed, that a post-effective amendment to the Registration Statement
will be filed and
<PAGE>

must be declared effective before the offering of the Stock may commence,
the term "Registration Statement" as used in this Agreement means the
Registration Statement as amended by said post-effective amendment. The
term "Registration Statement" as used in this Agreement shall also include
any registration statement relating to the Stock, in the form in which it
is filed, that is filed and declared effective pursuant to Rule 462(b)
under the Securities Act. The term "Prospectus" as used in this Agreement
means the prospectus in the form included in the Registration Statement,
or, if the prospectus included in the Registration Statement omits
information in reliance on Rule 430A under the Securities Act and such
information is included in a prospectus filed with the Commission pursuant
to Rule 424(b) under the Securities Act, the term "Prospectus" as used in
this Agreement means the prospectus in the form included in the
Registration Statement as supplemented by the addition of the Rule 430A
information contained in the prospectus filed with the Commission pursuant
to Rule 424(b). The term "Preeffective Prospectus" as used in this
Agreement means the prospectus subject to completion in the form included
in the Registration Statement at the time of the initial filing of the
Registration Statement with the Commission, and as such prospectus shall
have been amended from time to time prior to the date of the Prospectus.

(ii) The Commission has not issued or, to the knowledge of
the Company, threatened to issue any order preventing or suspending the use
of any Preeffective Prospectus, and, at the time when it became or becomes
effective, the Registration Statement conformed or will conform in all
material respects to the requirements of the Securities Act. If the
Registration Statement was declared effective prior to the execution and
delivery of this Agreement, on the date the Registration Statement was
declared effective, the Registration Statement conformed in all material
respects with the requirements of the Securities Act and did not include
any untrue statement of a material fact or omit to state any material fact
required to be stated therein or necessary to make the statements therein
not misleading and, at the time of the filing of the Prospectus pursuant to
Rule 424(b), the Prospectus will conform in all material respects to the
requirements of the Securities Act and will not include any untrue
statement of a material fact or omit to state any material fact required to
be stated therein or necessary to make the statements therein, in light of
the circumstances under which they are made, not misleading. If the
Registration Statement is declared effective subsequent to the execution
and delivery of this Agreement, on the date the Registration Statement
becomes effective, the Registration Statement and the Prospectus will
conform in all material respects to the requirements of the Securities Act,
and on the date the Registration Statement is declared effective, neither
the Registration Statement nor the Prospectus will include any untrue
statement of a material fact or will omit to state any material fact
required to be stated therein or necessary to make the statements therein
not misleading; provided, however, that the foregoing representations,
warranties and agreements shall not apply to information contained in or
omitted from the Registration Statement or the Prospectus or any amendment
or supplement thereto in reliance upon, and in conformity with, written
information furnished to the Company by or on behalf of the Underwriter,
specifically for use in the preparation thereof; there is no permit, lease,
contract, agreement or document required to be described in the
Registration Statement or Prospectus or to be filed as an exhibit to the
Registration Statement which is not described or filed therein as

-2-
<PAGE>

required; and all descriptions of any such permits, leases, contracts,
agreements or documents contained in the Registration Statement fairly
presents in all material respects the information called for by the
Securities Act and the Rules and Regulations with respect to such permits,
leases, contracts, agreements or documents and fairly summarize in all
material respects the matters referred to therein.

(iii) Subsequent to the respective dates as of which
information is given in the Registration Statement and Prospectus, and
except as set forth or contemplated in the Prospectus, neither the Company
nor any of its subsidiaries has incurred any material liabilities or
obligations, direct or contingent, not in the ordinary course of business,
nor entered into any material transactions not in the ordinary course of
business, and there has not been any material adverse change in the
condition (financial or otherwise), properties, business affairs,
management, business prospects or results of operations of the Company and
its subsidiaries considered as a whole, or any change in the capital stock
(other than pursuant to the exercise of outstanding stock options or
warrants) of the Company and its subsidiaries which is material to the
Company and its subsidiaries considered as a whole.

(iv) The financial statements, together with the related
notes and schedules, set forth in the Prospectus and elsewhere in the
Registration Statement fairly present in all material respects, on the
basis stated in the Registration Statement, the financial position and the
results of operations and cash flows of the Company at the respective dates
or for the respective periods therein specified. Such statements and
related notes and schedules have been prepared in accordance with generally
accepted accounting principles applied on a consistent basis except as may
be set forth in the Prospectus. The selected financial and statistical data
set forth in the Prospectus under the captions "Selected Financial And
Operating Data" are in conformity with the Rules and Regulations. The pro
forma financial information included in the Registration Statement and the
Prospectus has been prepared in accordance with the applicable published
rules and regulations of the Commission with respect to pro forma financial
information and the assumptions used in preparing such information are
reasonable.

(v) Arthur Andersen LLP, who has expressed its opinion on
the audited financial statements and related schedules included in the
Registration Statement and the Prospectus, are independent public
accountants as required by the Securities Act and the Rules and
Regulations.

(vi) The Company has and each of its subsidiaries has been
duly organized and is validly existing and in good standing (validly
subsisting with respect to the Company) as a corporation under the laws of
its jurisdiction of incorporation, with corporate power and corporate
authority to own or lease its properties and to conduct its businesses as
described in the Prospectus; except as described in the Prospectus, the
Company is and each of its subsidiaries is in possession of and operating
in compliance with all material grants, authorizations, licenses, permits,
easements, consents, certificates and orders required for the conduct of
their respective businesses, all of which are, to the Company's knowledge,
valid and in full force and effect; and, except as described in the
Prospectus, the Company is and

-3-
<PAGE>

each of its subsidiaries is duly qualified to do business and in good
standing as a foreign corporation in all other jurisdictions where its
ownership or leasing of properties or the conduct of its businesses
requires such qualification, except where the failure to be so qualified
and in good standing would not have a material adverse effect on the
Company and its subsidiaries taken as a whole (a "Material Adverse
Effect"). The Company has and each of its subsidiaries has all necessary
consents, approvals, authorizations, orders, registrations, qualifications,
licenses and permits of and from all public regulatory or governmental
agencies and bodies to own, lease and operate their respective properties
and conduct their respective businesses as now being conducted and as
described in the Registration Statement and the Prospectus except where the
failure to have any such consent, approval, authorization, order,
registration, qualification, license and permit would not have a Material
Adverse Effect, and no such consent, approval, authorization, order,
registration, qualification, license or permit contains a materially
burdensome restriction not adequately disclosed in the Registration
Statement and the Prospectus. The Company owns 100% of the capital stock of
CDnow Investments, Inc and CDnow Trademarks, Inc., in each case, free and
clear of any liens, encumbrances, equities or claims. Other than the
ownership of not more than 5% of the securities of any publicly traded
corporation, the Company does not directly or indirectly own or control any
other corporations or entities.

(vii) The Company's authorized and outstanding capital
stock is on the date hereof, and will be on the Closing Dates (as defined
below), as set forth under the heading "Capitalization" in the Prospectus;
the outstanding shares of common stock (including the outstanding shares of
Stock) of the Company conform to the description thereof in the Prospectus
and have been duly authorized and validly issued and are fully paid and
nonassessable; have been duly authorized for quotation on the Nasdaq
National Market, subject to official notice of issuance; have been issued
in compliance with all federal and state securities laws; and have not been
issued in violation of (other than violations subsequently cured and
waived) or subject to any preemptive rights or similar rights to subscribe
for or purchase securities. Except as disclosed in and or contemplated by
the Prospectus, neither the Company nor its subsidiaries have outstanding
any options or warrants to purchase, or any preemptive rights or other
rights to subscribe for or to purchase any securities or obligations
convertible into capital stock, or any contracts or commitments to issue or
sell shares of its capital stock or any such options, rights, convertible
securities or obligations. The description of the options or other rights
granted or exercised under the Company's 1996 Equity Compensation Plan (the
"Plan") or other arrangements as set forth in the Prospectus, fairly
present in all material respects the information required to be shown with
respect to such options and rights. All outstanding shares of capital stock
of each subsidiary of the Company have been duly authorized and validly
issued, and are fully paid and non-assessable.

(viii) The shares of Stock to be issued and sold by the
Company to the Underwriter hereunder have been duly authorized and, when
issued and delivered against payment therefor as provided herein, will be
validly issued, fully paid and nonassessable and free of any preemptive or
similar rights and will conform to the description thereof in the
Prospectus.

-4-
<PAGE>

(ix) Except as set forth in the Prospectus, there are no
legal or governmental proceedings pending to which the Company or any of
its subsidiaries or affiliates is a party or of which any property of the
Company or any subsidiary or affiliate is subject, that are required to be
described in the Registration Statement or the Prospectus that are not so
described. Neither the Company nor any of its subsidiaries is a party or
subject to the provisions of any material injunction, judgment, decree or
order of any court, regulatory body or other governmental agency or body
that is not described in the Prospectus.

(x) The execution, delivery and performance of this
Agreement by the Company and the consummation of the transactions herein
contemplated by the Company will not result in a breach or violation of any
of the terms or provisions of, or constitute a default under, any
indenture, mortgage, deed of trust, note agreement or other material
agreement or instrument to which the Company or any of its subsidiaries is
a party or by which it or any of them or any of their properties is or may
be bound, the Articles of Incorporation or By-laws of the Company or any of
its subsidiaries, or any law, order, rule or regulation of any court or
governmental agency or body having jurisdiction over the Company or any of
its subsidiaries or any of its properties or will result in the creation of
a materially burdensome lien on any of the properties of the Company or any
of its subsidiaries.

(xi) No consent, approval, authorization or order of any
court or governmental agency or body or self-regulatory body is required
for the consummation by the Company of the transactions contemplated by
this Agreement, except such as may be required by the Commission or the
National Association of Securities Dealers, Inc. (the "NASD") or under the
securities or "Blue Sky" laws of any jurisdiction in connection with the
purchase and distribution of the Stock by the Underwriters.

(xii) The Company has the full corporate power and
corporate authority to enter into this Agreement and to perform its
obligations hereunder (including to issue, sell and deliver the Stock), and
this Agreement has been duly and validly authorized, executed and delivered
by the Company and is a valid and binding obligation of the Company,
enforceable against the Company in accordance with its terms, except to the
extent that rights to indemnity and contribution hereunder may be limited
by federal or state securities laws or the public policy underlying such
laws and except as the enforcement hereof may be limited by applicable
bankruptcy, insolvency, moratorium, fraudulent conveyance or similar laws
affecting creditors' rights generally, or by general equitable principles
regardless of whether considered in a proceeding at law or in equity.

(xiii) Subject to such qualifications as are set forth in
the Prospectus, the Company is and its subsidiaries are in all material
respects in compliance with, and are currently conducting their businesses
in conformity with, all applicable federal, state, local and foreign laws,
rules and regulations of each court or governmental agency or body having
jurisdiction over the Company and its subsidiaries except where the failure
to be in compliance or to so conduct their businesses would not have a
material adverse effect on the

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<PAGE>

Company and its subsidiaries, taken as a whole; to the knowledge of the
Company, except as set forth in the Registration Statement and the
Prospectus, no prospective change in any of such federal or state laws,
rules or regulations has been adopted which, when made effective, would
have a material adverse effect on the operations of the Company and its
subsidiaries.

(xiv) The Company and its subsidiaries have filed all
necessary federal, state, local and foreign income, payroll, franchise and
other tax returns and have paid all taxes shown as due thereon or with
respect to any of their properties, except for those taxes (i) for which
the Company has established adequate reserves in its financial statements
or (ii) that, in the aggregate, the Company's failure to pay would not have
a Material Adverse Effect.

(xv) No person or entity has the right to require
registration of shares of Common Stock or other securities of the Company
because of the filing or effectiveness of the Registration Statement,
except for persons and entities who have expressly waived such right or who
have been given proper notice and have failed to exercise such right within
the time or times required under the terms and conditions of such right.

(xvi) Neither the Company nor, to its knowledge, any of its
officers, directors or affiliates has taken or will take, directly or
indirectly, any action designed or intended to stabilize or manipulate the
price of any security of the Company, or which caused or resulted in, or
which might in the future reasonably be expected to cause or result in,
stabilization or manipulation of the price of any security of the Company.

(xvii) Except as described in the Prospectus, the Company
and its subsidiaries own, possess or have a valid right to use all
trademarks, trademark registrations, service marks, service mark
registrations, tradenames, copyrights, licenses, inventions, trade secrets
and rights described in the Prospectus as being owned by them or any of
them or necessary for the conduct of their respective businesses. To the
Company's knowledge, except as described in the Prospectus, no claim has
been made against the Company or its subsidiaries alleging the infringement
by the Company or its subsidiaries of any patent, trademark, service mark,
tradename, copyright, trade secret, license in or other intellectual
property right or franchise right of any person. Except as set forth in the
Prospectus (including, without limitation, uncertainties relating to making
content available in Germany and the possibility that distributors in
foreign countries may seek to enjoin the sale of music-related items by an
Internet retailer), the Company's business as now conducted and as proposed
to be conducted does not and, to its knowledge, will not infringe or
conflict with any patents, trademarks, service marks, trade names,
copyrights, trade secrets, licenses or other intellectual property or
franchise right of any person.

(xviii) The Company and its subsidiaries have performed all
material obligations required to be performed by them under any indenture,
mortgage, deed of trust, note agreement or other material agreement or
instrument to which they are a party or by which they or any of their
properties may be bound, and neither the Company nor any of its

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<PAGE>

subsidiaries nor, to the Company's knowledge, any other party to such
indenture, mortgage, deed of trust, note agreement or other agreement or
instrument is in default under or in breach of any such obligations which
default or breach would reasonably be expected to have a material adverse
effect on the Company and its subsidiaries taken as a whole. Neither the
Company nor any of its subsidiaries has received any notice of such default
or breach.

(xix) The Company is not involved in any labor dispute nor
to the Company's knowledge is any such dispute threatened. The Company is
not aware that (A) any executive, key employee or significant group of
employees of the Company or any subsidiary plans to terminate employment
with the Company or any such subsidiary or (B) any such executive or key
employee is subject to any noncompete, nondisclosure, confidentiality,
employment, consulting or similar agreement that would be violated by the
present or proposed business activities of the Company and its
subsidiaries. Neither the Company nor any subsidiary has or expects to have
any liability for any prohibited transaction or funding deficiency or any
complete or partial withdrawal liability with respect to any pension,
profit sharing or other plan which is subject to the Employee Retirement
Income Security Act of 1974, as amended ("ERISA"), to which the Company or
any subsidiary makes or ever has made a contribution and in which any
employee of the Company or any subsidiary is or has ever been a
participant. With respect to such plans, the Company and each subsidiary
are in compliance in all material respects with all applicable provisions
of ERISA.

(xx) The real property and buildings held under lease by
the Company and its subsidiaries are held by them under valid and binding
leases with such exceptions as would not have a material adverse effect on
the Company and its subsidiaries considered as a whole or as are described
in the Prospectus.

(xxi) Other than as contemplated by this Agreement, there
is no broker, finder or other party that is entitled to receive from the
Company any brokerage or finder's fee or other fee or commission as a
result of any of the transactions contemplated by this Agreement.

(xxii) The Company and each of its subsidiaries maintain a
system of internal accounting controls sufficient to provide reasonable
assurances that (i) transactions are executed in accordance with
management's general or specific authorization; (ii) transactions are
recorded as necessary to permit preparation of financial statements in
conformity with generally accepted accounting principles and to maintain
accountability for assets; (iii) access to assets is permitted only in
accordance with management's general or specific authorization; and (iv)
the recorded accountability for assets is compared with existing assets at
reasonable intervals and appropriate action is taken with respect to any
differences.

(xxiii) To the Company's knowledge, neither the Company nor
any of its subsidiaries nor any employee or agent of the Company or any of
its subsidiaries has made any payment of funds of the Company or any of its
subsidiaries or received or retained

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<PAGE>

any funds in violation of any law, rule or regulation, which payment,
receipt or retention of funds is of a character required to be disclosed in
the Prospectus.

(xxiv) Neither the Company nor any of its subsidiaries is
an "investment company," as such term is defined in the Investment Company
Act of 1940, as amended.

(b) REPRESENTATIONS AND WARRANTIES AND AGREEMENTS OF THE SELLING
STOCKHOLDERS. Each Selling Stockholder severally represents and warrants to the
Underwriter that such Selling Stockholder:

(i) Now has, and on the First Closing Date (as hereinafter
defined) will have, valid title to the Stock to be sold by such Selling
Stockholder, free and clear of any "Adverse Claim" within the meaning of
the Uniform Commercial Code as in effect in the Commonwealth of
Pennsylvania ("Adverse Claim") and has full legal right and capacity to
enter into this Agreement, the Power of Attorney and the Custody Agreement
(each as hereinafter defined).

(ii) Now has, and on the First Closing Date will have, upon
delivery of and payment for each share of Stock being sold by such Selling
Stockholder hereunder, full legal right and capacity required by law to
sell, transfer, assign and deliver such shares, and no consent, approval,
authorization or order of any court or governmental agency or body or self-
regulatory body is required for the consummation by such Selling
Stockholder of the transactions contemplated by this Agreement, except such
as may be required by the Commission or the National Association of
Securities Dealers, Inc. (the "NASD") or under the securities or "Blue Sky"
laws of any jurisdiction in connection with the purchase and distribution
of the Stock by the Underwriter; and, upon delivery and payment for such
shares as contemplated hereby, the Underwriter will acquire valid title to
such shares, free and clear of any Adverse Claim.

(iii) Has duly executed and delivered a power of attorney
in substantially the form heretofore delivered to the Underwriter (the
"Power of Attorney"), appointing Jason Olim and Joel Sussman, and each of
them, as attorney-in-fact (the "Attorneys-in-fact") with authority to
execute and deliver this Agreement on behalf of such Selling Stockholder,
to authorize the delivery of the shares of Stock to be sold by such Selling
Stockholder hereunder and otherwise to act on behalf of such Selling
Stockholder in connection with the transactions contemplated by this
Agreement.

(iv) Has duly executed and delivered a custody agreement in
substantially the form heretofore delivered to the Representatives (the
"Custody Agreement"), with StockTrans, Inc., as custodian (the
"Custodian"), pursuant to which certificates in negotiable form for the
shares of Stock to be sold by such Selling Stockholder hereunder have been
placed in custody for delivery under this Agreement.

-8-
<PAGE>

(v) Has, by execution and delivery of each of this
Agreement, the Power of Attorney and the Custody Agreement, created valid
and binding obligations of such Selling Stockholder, enforceable against
such Selling Stockholder in accordance with its terms, except to the extent
that rights to indemnity and contribution hereunder may be limited by
federal or state securities laws or the public policy underlying such laws
and except as the enforcement hereof may be limited by applicable
bankruptcy, insolvency, fraudulent conveyance, moratorium or similar laws
affecting creditors' rights generally, or by general equitable principles
regardless of whether considered in a proceeding at law or in equity.

(vi) The performance of this Agreement, the Custody
Agreement and the Power of Attorney, and the consummation of the
transactions contemplated hereby and thereby will not result in a breach or
violation by such Selling Stockholder of any of the terms or provisions of,
or constitute a default by such Selling Stockholder under, any indenture,
mortgage, deed of trust, trust, loan agreement, lease, franchise, license
or other material agreement or material instrument to which such Selling
Stockholder is a party or by which such Selling Stockholder or any of its
properties is bound, or any judgment of any court or governmental agency or
body applicable to such Selling Stockholder or any of its properties, or to
such Selling Stockholder's knowledge, any statute, decree, order, rule or
regulation of any court or governmental agency or body applicable to such
Selling Stockholder or any of his properties.

(vii) The information pertaining to such Selling
Stockholder under the caption "Principal and Selling Stockholders" in the
Prospectus fairly presents in all material respects the information called
for by Item 507 of Regulation S-K of the Rules and Regulations with respect
to such Selling Stockholder.

(viii) Such Selling Stockholder has not taken and will not
take, directly or indirectly, any action designed to, or which has
constituted, or which might reasonably be expected to cause or result in
the stabilization or manipulation of the price of the Common Stock of the
Company and, other than as permitted by the Securities Act, the Selling
Stockholder will not distribute any prospectus or other offering material
in connection with the offering of the Shares.

Each Selling Stockholder agrees that the shares of Stock represented
by the certificates held in custody under the Custody Agreement are coupled with
and subject to the interests of the Underwriter, the Company and the other
Selling Stockholders hereunder, and that the arrangement for such custody and
the appointment of the Attorneys-in-fact are to that extent irrevocable other
than as set forth in the Power of Attorney and the Custody Agreement; that the
obligations of such Selling Stockholder hereunder shall not be terminated by
operation of law, whether by death or incapacity of such Selling Stockholder, or
any other event, that if such Selling Stockholder should die or become
incapacitated or any other such event occurs, before the delivery of the Stock
hereunder, certificates for the Stock to be sold by such Selling Stockholder
shall be delivered on behalf of such Selling Stockholder in accordance with the
terms and conditions of this Agreement and the Custody Agreement, and action
taken by the Attorneys-in-fact or any of them under the Power of Attorney shall
be as valid as if such death, incapacity or other such event had not

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<PAGE>

occurred, whether or not the Custodian, the Attorneys-in-fact or any of them
shall have notice of such death, incapacity or such other event.

3. PURCHASE BY, AND SALE AND DELIVERY TO, UNDERWRITER--CLOSING
DATES. The Company and the Selling Stockholders agree to sell to the
Underwriter the Firm Stock on the basis of the representations, warranties,
covenants and agreements herein contained, but subject to the terms and
conditions herein set forth, the Underwriter agrees, to purchase the Firm Stock
from the Company and the Selling Stockholders.

The purchase price per share to be paid by the Underwriter to the
Company and the Selling Stockholders will be $______ per share (the "Purchase
Price").

The Company will deliver the number of shares of Firm Stock set forth
in paragraph 1 hereof and the Attorneys-in-fact and Custodian will deliver the
number of shares of Firm Stock set forth in Paragraph 1 hereof to the
Underwriter for the account of the Underwriter (in the form of definitive
certificates, issued in such names and in such denominations as the Underwriter
may direct by notice in writing to the Company and the Custodian not later than
the second full business day preceding the First Closing Date (as defined below)
against payment of the aggregate Purchase Price therefor by wire transfer of
same-day funds, payable to the order of the Company, all, as selected by Alex.
Brown, at the offices of (x) Alex. Brown, Baltimore, Maryland or (y) Morgan,
Lewis & Bockius LLP, Philadelphia, Pennsylvania. The time and date of the
delivery and closing shall be at 10:00 A.M., Baltimore Time), on July ___, 1998.
The time and date of such payment and delivery are herein referred to as the
"First Closing Date". The First Closing Date and the location of delivery of,
and the form of payment for, the Firm Stock may be varied by agreement among the
Company and Alex. Brown.

The Company, the Custodian and the Attorneys-in-fact shall make the
certificates for the Stock available to the Underwriter for examination not
later than 10:00 A.M., Baltimore Time, on the business day preceding the First
Closing Date at the offices of (x) Alex. Brown, Baltimore, Maryland or (y)
Morgan, Lewis & Bockius LLP, Philadelphia, Pennsylvania, as selected by Alex.
Brown.

The Underwriter agrees to make a public offering of the Firm Stock at
the public offering price as set forth in the Prospectus as soon after the
effectiveness of the Registration Statement as in their judgment is advisable.
The Representatives shall promptly advise the Company of the making of the
initial public offering.

For the purpose of covering any over-allotments in connection with the
distribution and sale of the Firm Stock as contemplated by the Prospectus, the
Selling Stockholders and the Company hereby grants to the Underwriters an option
to purchase up to __________ shares. The price per share to be paid for the
Option Stock shall be the Purchase Price. The option granted hereby may be
exercised as to all or any part of the Option Stock at any time prior to or
after the First Closing Date (with oral or written notice of such exercise to be
made at least two business days prior to the closing date for the sale of the
Option Stock), but may not be exercised more than once and such exercise must
occur not more than thirty (30) days subsequent to the effective date of this

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<PAGE>

Agreement. No Option Stock shall be sold and delivered unless the Firm Stock
previously has been, or simultaneously is, sold and delivered. The right to
purchase the Option Stock or any portion thereof may be surrendered and
terminated at any time upon notice by the Underwriter to the Company.

The option granted hereby may be exercised by the Underwriter by
giving written notice to the Company setting forth the number of shares of the
Option Stock to be purchased by it and the date and time for delivery of and
payment for the Option Stock. Each date and time for delivery of and payment
for the Option Stock (which may be the First Closing Date, but not earlier) is
herein called the "Option Closing Date" and shall in no event be earlier than
two (2) business days nor later than ten (10) business days after oral or
written notice is given. (The Option Closing Date and the First Closing Date
are herein called the "Closing Dates.") Upon exercise of the option by the
Underwriter, the Company shall sell to the Underwriter the number of shares of
Option Stock set forth in the written notice of exercise and the Underwriter
agrees, subject to the terms and conditions herein set forth, to purchase the
number of such shares determined as aforesaid.

The Company will deliver the Option Stock to the Underwriter (in the
form of definitive certificates, issued in such names and in such denominations
as the Underwriter may direct by notice to the Company no later than the second
full business day preceding the Option Closing Date, against payment of the
aggregate Purchase Price therefor by wire transfer of same-day funds, payable as
directed by the Company, all at the offices of (x) Alex. Brown, Baltimore,
Maryland or (y) Morgan, Lewis & Bockius LLP, Philadelphia, Pennsylvania, as
selected by Alex. Brown. The Company shall make the certificates for the Option
Stock available to the Underwriter for examination not later than 10:00 A.M.,
Baltimore Time, on the business day preceding the Option Closing Date at the
offices of (x) Alex. Brown, Baltimore, Maryland or (y) Morgan, Lewis & Bockius
LLP, Philadelphia, Pennsylvania, as selected by Alex. Brown. The Option Closing
Date and the location of delivery of, and the form of payment for, the Option
Stock may be varied by agreement between the Company and Alex. Brown.

If on the First Closing Date, any Selling Stockholder fails to sell
the Stock which such Selling Stockholder has agreed to sell on such date as set
forth in Schedule A hereto, the Company agrees that it will sell or arrange for
the sale of that number of shares of Common Stock to the Underwriter which
represents Stock which such Selling Stockholder has failed to so sell, as set
forth in Schedule A hereto, or such lesser number as may be requested by the
Underwriter.

4. COVENANTS AND AGREEMENTS OF THE COMPANY AND THE SELLING
STOCKHOLDERS. The Company covenants and agrees with the Underwriter that:

The Company will (i) if the Company and the Underwriter have determined not to
proceed pursuant to Rule 430A, use its reasonable commercial efforts to cause
the Registration Statement to become effective, (ii) if the Company and the
Underwriter have determined to proceed pursuant to Rule 430A, use its reasonable
commercial efforts to comply with the provisions of and make all requisite
filings with the Commission pursuant to Rule 430A and Rule 424 of the Rules and
Regulations and (iii) if the Company and the Underwriter have determined to
deliver Prospectuses pursuant to Rule 434 of the Rules and Regulations, to use
its reasonable commercial efforts to comply with all the

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<PAGE>

applicable provisions thereof. The Company will advise the Underwriter promptly
as to the time at which the Registration Statement becomes effective, if it has
not yet become effective, will advise the Underwriter promptly of the issuance
by the Commission of any stop order suspending the effectiveness of the
Registration Statement or of the institution of any proceedings for that
purpose, and in the event of the institution of such proceedings, will use its
reasonable commercial efforts to prevent the issuance of any such stop order and
to obtain as soon as is reasonably practicable the lifting thereof, if issued.
The Company will advise the Underwriter promptly of the receipt of any comments
of the Commission or any request by the Commission for any amendment of or
supplement to the Registration Statement or the Prospectus or for additional
information and will not at any time file any amendment to the Registration
Statement or supplement to the Prospectus which shall not previously have been
submitted to the Underwriter a reasonable time prior to the proposed filing
thereof or to which the Underwriter shall reasonably object in writing within a
reasonable time or which is not in compliance with the Securities Act and the
Rules and Regulations.

If at any time after the effective date of the Registration Statement when a
prospectus relating to the Stock is required to be delivered under the
Securities Act any event relating to or affecting the Company or any of its
subsidiaries occurs as a result of which the Prospectus or any other prospectus
as then in effect would include an untrue statement of a material fact, or omit
to state any material fact necessary to make the statements therein, in light of
the circumstances under which they were made, not misleading, or if it is
necessary at any time to amend the Prospectus to comply with the Securities Act,
the Company will promptly notify the Representatives thereof and will prepare an
amended or supplemented prospectus which will correct such statement or
omission; and in case the Underwriter is required to deliver a prospectus
relating to the Stock nine (9) months or more after the effective date of the
Registration Statement, the Company upon the request of the Underwriter and at
the expense of the Underwriter will prepare promptly such prospectus or
prospectuses as may be necessary to permit compliance with the requirements of
Section 10(a)(3) of the Securities Act.

The Company will deliver to the Underwriter, at or before the First Closing
Date, (4) signed copies of the Registration Statement, as originally filed with
the Commission, and all amendments thereto including all financial statements
and exhibits thereto, and will deliver to the Underwriter such number of copies
of the Registration Statement, including such financial statements but without
exhibits, and all amendments thereto, as the Underwriter may reasonably request.
The Company will deliver or mail to or upon the reasonable order of the
Underwriter, from time to time until the effective date of the Registration
Statement, as many copies of the Preeffective Prospectus as the Underwriter may
reasonably request. The Company will deliver or mail to or upon the reasonable
order of the Underwriter on the date of the public offering, and thereafter from
time to time during the period when delivery of a prospectus relating to the
Stock is required under the Securities Act, as many copies of the Prospectus, in
final form or as thereafter amended or supplemented as the Underwriter may
reasonably request; provided, however, that the expense of the preparation and
delivery of any prospectus required for use nine (9) months or more after the
effective date of the Registration Statement shall be borne by the Underwriter.

The Company will cooperate with the Underwriter to enable the Stock to be
registered or qualified for offering and sale by the Underwriter and by dealers
under the securities laws of such jurisdictions in the United States as the
Underwriter may designate and at the request of the Underwriter will

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<PAGE>

make such applications and furnish such consents to service of process or other
documents as may be required of it as the issuer of the Stock for that purpose;
provided, however, that the Company shall not be required to qualify to do
business, to file a general consent to service of process or subject itself to
taxation in any such jurisdiction where it is not now so subject nor shall the
Company or any stockholder of the Company be required to escrow or forfeit any
shares that they currently hold. The Company will advise the Underwriter
promptly after the Company becomes aware of the suspension of the qualifications
or registration of (or any such exception relating to) the Common Stock of the
Company for offering, sale or trading in any jurisdiction or of any initiation
or threat of any proceeding for any such purpose, and in the event of the
issuance of any orders suspending such qualifications, registration or
exception, the Company will, with the cooperation of the Underwriter (which the
Underwriter covenants to provide), use its reasonable commercial efforts to
obtain the withdrawal hereof.

The Company will furnish to its stockholders annual reports containing financial
statements certified by independent public accountants. During the period of
five (5) years from the date hereof, the Company will deliver to the
Underwriter, as soon as they are available, copies of each annual report of the
Company containing the balance sheet of the Company as of the close of such
fiscal year and statements of income, stockholders' equity and cash flows for
the year then ended and the opinion thereon of the Company's independent public
accountants and will deliver to the Underwriter, (i) as soon as they are
available, copies of any other reports or communication (financial or other)
which the Company shall make available to any of its stockholders generally as
such and (ii) as soon as they are available, copies of any reports and financial
statements furnished to or filed with the Commission, or the NASD or any
national securities exchange. Similar reports shall be furnished for all
subsidiaries whose accounts are not consolidated but which at the time are
significant subsidiaries as defined in the Rules and Regulations.

The Company has received approval for listing the Stock, subject to official
notice of issuance, on the Nasdaq National Market.

The Company will maintain a transfer agent and a registrar (if required by its
jurisdiction of incorporation) for its Common Stock.

The Company will not offer, sell, assign, transfer, encumber, contract to sell,
grant an option to purchase or otherwise dispose of any shares of Common Stock,
securities convertible into or exercisable or exchangeable for Common Stock or
other derivative securities whose value is derived form the value of the Common
Stock during the 90 days following the date of the Prospectus, other than the
Company's sale of Common Stock hereunder and the Company's issuance of Common
Stock upon the exercise of warrants and of stock options which are presently
outstanding and described in the Prospectus or pursuant to employee benefit
plans described in the Prospectus.

Except to the extent arising from conditions beyond the control of the Company,
the Company will apply the net proceeds from the sale of the Stock as set forth
in the description under "Use of Proceeds" in the Prospectus.

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<PAGE>

The Company will supply you with copies of all correspondence to and from, and
all documents issued to and by, the Commission in connection with the
registration of the Stock under the Securities Act.

Prior to the Closing Dates the Company will furnish to you, as soon as they have
been prepared, copies of any unaudited interim consolidated financial statements
of the Company and its subsidiaries for any periods subsequent to the periods
covered by the financial statements appearing in the Registration Statement and
the Prospectus.

The Company shall not invest, or otherwise use the proceeds received by the
Company from its sale of the Stock in such a manner as would require the Company
to register as an investment company under the Investment Company Act of 1940,
as amended (the "1940 Act").

The Company will not take, directly or indirectly, any action designed to cause
or result in, or that has constituted or might reasonably be expected to
constitute, the stabilization or manipulation of the price of any securities of
the Company.

Each of the Selling Stockholders covenants and agrees with the
Underwriter that:

(i) Without the prior written consent the Underwriter he
will not, directly or indirectly (a) offer, sell, pledge, contract to sell
(including any short sale), grant any option to purchase or otherwise dispose of
any shares of common stock of the Company ("Shares") which may be deemed to be
beneficially owned by him on the date hereof in accordance with the rules and
regulations of the Securities and Exchange Commission and Shares which may be
issued to him upon exercise of a stock option or warrant owned by him other than
Shares purchased in the open market, or (b) enter into any Hedging Transaction
(as defined below) relating to such Shares (each of the foregoing clauses (a)
and (b) are hereinafter referred to as a "Disposition") for a period of 45 days
after the effective date of the Registration Statement (the "Lock-Up Period").
The foregoing restriction is expressly intended to preclude each Selling
Stockholder from engaging in any Hedging Transaction or other transaction which
is designed to or reasonably expected to lead to or result in a Disposition by
him during the Lock-Up Period even if the securities would be disposed of by
someone other than him. "Hedging Transaction" means any short sale (whether or
not against the box) or any purchase, sale or grant of any right (including,
without limitation, any put or call option) with respect to any security (other
than a broad-based market basket or index) that includes, relates to or derives
any significant part of its value from the Shares; provided that the exercise of
an option or warrant to purchase Shares or the conversion of any convertible
securities into Shares shall not be a Hedging Transaction. Notwithstanding the
foregoing, a Selling Stockholder may transfer by gift, will or intestacy any or
all of the Shares beneficially owned by him; provided, however, that in any such
case it shall be a condition to the transfer that the transferee execute an
agreement stating that the transferee is receiving and holding such Shares
subject to the provisions of this Section 4(i) and there shall be no further
transfer of such Shares except in accordance with this Section 4(i).

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<PAGE>

(ii) Each of the Selling Stockholders agrees to deliver to
you prior to or at the Closing Date a properly completed and executed
United States Treasury Department Form W-8 or W-9, as applicable.

(iii) Such Selling Stockholder will not take, directly or
indirectly, an action designed to cause or result in, or that might
reasonably be expected to constitute, the stabilization or manipulation of
the price of any securities of the Company.

5. PAYMENT OF EXPENSES.

The Company will pay (directly or by reimbursement) all costs, expenses and fees
incident to the performance of the Company and the Selling Stockholders under
this Agreement, including the following: the fees and expenses of the Company's
independent public accountants; the fees and disbursements of counsel for the
Company and the Selling Stockholders (except as expressly provided below with
respect to counsel to be paid for by the Selling Stockholders and except as
provided in Sections 4(b) and (c) hereof); the filing fees of the Commission;
the costs of preparing stock certificates (including printing and engraving
costs); all fees and expenses of the registrar and transfer agent for the Common
Stock; all necessary transfer and other stamp taxes in connection with the
issuance and sale of the Stock by the Company to the Underwriter hereunder; the
cost of printing and delivering to, or as requested by, the Underwriter copies
of the Registration Statement, Preliminary Prospectus, Prospectus and any
supplements or amendments thereto except as provided in Sections 4(b) and (c)
hereof; the NASD filing fees incident to securing any required review by the
NASD of the terms of the sale of the Stock; the listing fee of the Nasdaq
National Market; and the expenses, including the reasonable and ordinary fees
and disbursements of counsel for the Underwriters incurred in connection with
review by the NASD of the terms of the sale of the Stock and exemptions from
qualifying or registering (or obtaining qualification or registration of) all or
any part of the Stock for offer or sale under the Blue Sky or other securities
laws of such jurisdictions within the United States as the Underwriter may
designate. To the extent, if at all, that any Selling Stockholder engages
special legal counsel to represent such Selling Stockholder in connection with
this offering, the fees and expenses of such counsel shall be borne by such
Selling Stockholder. The Company shall not, however, be required to pay for any
of the Underwriters' expenses (other than the fees ordinary incident to securing
any required review by the NASD and those related to qualification under state
securities or "blue sky" laws), except as provided in Section 11 hereof.

Each Selling Stockholder will pay (directly or by reimbursement) all fees and
expenses incident to the performance of such Selling Stockholder's obligations
under this Agreement which are not otherwise specifically provided for herein,
including but not limited to any fees and expenses of counsel for such Selling
Stockholder, and all transfer, stamp and other taxes incident to the sale and
delivery of the Stock to be sold by such Selling Stockholder to the Underwriter
hereunder.

6. INDEMNIFICATION AND CONTRIBUTION.

The Company and each Selling Stockholder, severally and not jointly, agree to
indemnify and hold harmless the Underwriter and each person, if any, who
controls the Underwriter within the meaning

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<PAGE>

of the Securities Act and the respective officers, directors, partners,
employees, representatives and agents of the Underwriter (collectively, the
"Underwriter Indemnified Parties" and, each, an "Underwriter Indemnified
Party"), against any losses, claims, damages, liabilities or expenses
(including, except as set forth below with respect to counsel fees, the
reasonable cost of investigating and defending against any claims therefor and
counsel fees incurred in connection therewith) which may be based upon the
Securities Act, or any other statute or at common law, on the ground or alleged
ground that any Preeffective Prospectus, the Registration Statement or the
Prospectus (or the Registration Statement or the Prospectus as amended or
supplemented) includes an untrue statement of a material fact or omits to state
a material fact required to be stated therein or necessary in order to make the
statements therein, in light of the circumstances under which they were made,
not misleading, unless such statement or omission was made in reliance upon, and
in conformity with, written information furnished to the Company or any
subsidiary by the Underwriter specifically for use in the preparation thereof;
provided, however, that neither the Company nor any Selling Stockholder will not
be liable to any Underwriter Indemnified Party with respect to any loss, claim,
damage, expense or liability arising out of or based upon any untrue statement
or alleged untrue statement or omission or alleged omission to state a material
fact in the Preeffective Prospectus which is corrected in the Prospectus if the
person asserting such loss, claim, damage, expense or liability was not sent or
given a copy of the Prospectus at or prior to the written confirmation of the
sale of Stock to such person. In no event shall the liability of any Selling
Stockholder to the Underwriter Indemnified Parties under this Agreement
(including, without limitation liabilities arising with respect to such Selling
Stockholder's representations hereunder) exceed the proceeds, net of
underwriting discounts and commissions, received by such Selling Stockholder
from the Underwriter in the offering of the Stock and net of any damages that
the Selling Stockholder was otherwise required to pay by reason of such untrue
or allegedly untrue statement or omission. The Company or such Selling
Stockholder will be entitled to participate at its own expense in the defense
or, if the Company so elects, the Company will be entitled to assume the defense
of any suit brought to enforce any such liability, but if the Company elects to
assume the defense, such defense shall be conducted by counsel chosen by it. In
the event the Company elects to assume the defense of any such suit and retain
such counsel, any Underwriter Indemnified Parties, defendant or defendants in
the suit, may retain additional counsel but shall bear the fees and expenses of
such counsel unless (i) the Company shall have specifically authorized the
retaining of such counsel or (ii) the parties to such suit include any such
Underwriter Indemnified Parties, and the Company and such Underwriter
Indemnified Parties have been advised by counsel to the Underwriter that one or
more legal defenses may be available to it or them which may not be available to
the Company, in which case the Company shall not be entitled to assume the
defense of such suit notwithstanding its obligation to bear the fees and
expenses of such counsel. It is understood that the Company Indemnified Parties
and Stockholder Indemnified Parties shall not, collectively in connection with
any proceeding or related proceedings in the same jurisdiction, be liable for
the reasonable fees and expenses of more than one separate firm for all
Underwriter Indemnified Parties. The Company and the Selling Stockholders
against whom indemnity may be sought shall not be liable to indemnify any person
for any settlement of any such claim effected without the consent of the Company
or such Selling Stockholder, as applicable. In no case is the Company or any
Selling Stockholder to be liable with respect to any claims made against any
Underwriter Indemnified Party against whom the action is brought unless such
Indemnified Party shall have notified the Company and the Selling Stockholder in
writing within a reasonable time after the summons or other first legal process
giving information

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<PAGE>

of the nature of the claim shall have been served upon the Underwriter
Indemnified Party, but failure to notify the Company and the Selling
Stockholders of such claim shall not relieve them from any liability which they
may have to any Underwriter Indemnified Party otherwise then on account of its
indemnity agreement contained in this paragraph. This indemnity agreement is not
exclusive and will be in addition to any liability which the Company or any
Selling Stockholder might otherwise have.

The Underwriter, agrees to indemnify and hold harmless the Company, each of its
directors, each person named as a prospective director in the Registration
Statement, each of its officers who have signed the Registration Statement and
each person, if any, who controls the Company within the meaning of the
Securities Act (collectively, the "Company Indemnified Parties"), and the
Selling Stockholders and each person, if any, who controls any Selling
Stockholder within the meaning of the Securities Act (collectively, the
"Stockholder Indemnified Parties") against any losses, claims, damages,
liabilities or expenses (including, the reasonable cost of investigating and
defending against any claims therefor and, except as set forth below, counsel
fees incurred in connection therewith), joint or several, which arise out of or
are based in whole or in part upon the Securities Act, the Exchange Act or any
other federal, state, local or foreign statute or regulation, or at common law,
on the ground or alleged ground that any Preeffective Prospectus, the
Registration Statement or the Prospectus (or the Registration Statement or the
Prospectus, as amended or supplemented) includes an untrue statement of a
material fact or omits to state a material fact required to be stated therein or
necessary in order to make the statements therein, in light of the circumstances
in which they were made, not misleading, but only insofar as any such statement
or omission was made in reliance upon, and in conformity with, written
information furnished to the Company by such Underwriter specifically for use in
the preparation thereof; provided, however, that in no case is the Underwriter
to be liable with respect to any claims made against any Company Indemnified
Party or Stockholder Indemnified Party against whom the action is brought unless
such Company Indemnified Party or Stockholder Indemnified Party shall have
notified the Underwriter in writing within a reasonable time after the summons
or other first legal process giving information of the nature of the claim shall
have been served upon the Company Indemnified Party or Stockholder Indemnified
Party, but failure to notify the Underwriter of such claim shall not relieve it
from any liability which it may have to any Company Indemnified Party or
Stockholder Indemnified Party otherwise than on account of its indemnity
agreement contained in this paragraph. The Underwriter shall be entitled to
participate at its own expense in the defense, or, if it so elects, to assume
the defense of any suit brought to enforce any such liability, but, if the
Underwriter elects to assume the defense, such defense shall be conducted by
counsel chosen by it. In the event that the Underwriter elects to assume the
defense of any such suit and retain such counsel, the Company Indemnified
Parties or Stockholder Indemnified Parties or controlling person or persons,
defendant or defendants in the suit, shall bear the fees and expenses of any
additional counsel retained by them, respectively, unless (i) the Underwriter
shall have specifically authorized the retaining of such counsel or (ii) the
parties to such suit includes any such Company Indemnified Parties or Selling
Stockholder Indemnified Parties and the Underwriter, and the Underwriter or such
Company Indemnified Parties have been advised by counsel to the Company (in the
case of the Company Indemnified Parties) or the Selling Stockholders (in the
case of the Selling Stockholder Indemnified Parties) that one or more legal
defenses may be available to it or them which may not be available to the
Underwriter, in which case the Underwriter shall not be entitled to assume the
defense of such suit notwithstanding

-17-
<PAGE>

its obligation to bear the fees and expenses of such counsel. It is understood
that the Underwriter Indemnified Parties shall not, in connection with any
proceeding or related proceedings in the same jurisdiction, be liable for the
reasonable fees and expenses of more than one separate firm for all Company
Indemnified Parties and Stockholder Indemnified Parties. The Underwriter shall
not be liable to indemnify any person for any settlement of any such claim
effected without the Underwriter's consent. This indemnity agreement is not
exclusive and will be in addition to any liability which the Underwriter might
otherwise have and shall not limit any rights or remedies which may otherwise be
available at law or in equity to any Company Indemnified Party or Stockholder
Indemnified Party.

If the indemnification provided for in this Section 6 is unavailable or
insufficient to hold harmless an indemnified party under subsection (a) or (b)
above in respect of any losses, claims, damages, liabilities or expenses (or
actions in respect thereof) referred to herein, then each indemnifying party
shall contribute to the amount paid or payable by such indemnified party as a
result of such losses, claims, damages, liabilities or expenses (or actions in
respect thereof) in such proportion as is appropriate to reflect the relative
benefits received by the Company and the Selling Stockholders on the one hand,
and the Underwriter on the other, from the offering of the Stock. If, however,
the allocation provided by the immediately preceding sentence is not permitted
by applicable law, then each indemnifying party shall contribute to such amount
paid or payable by such indemnified party in such proportion as is appropriate
to reflect not only such relative benefits but also the relative fault of the
Company and the Selling Stockholders on the one hand and the Underwriter on the
other in connection with the statements or omissions which resulted in such
losses, claims, damages, liabilities or expenses (or actions in respect
thereof), as well as any the relevant equitable considerations. The relative
benefits received by the Company and the Selling Stockholders on the one hand
and the Underwriter on the other shall be deemed to be in the same proportion as
the total net proceeds from the offering (before deducting expenses) received by
the Company and the Selling Stockholders bear to the total underwriting
discounts and commissions received by the Underwriter, in each case as set forth
in the table on the cover page of the Prospectus. The relative fault shall be
determined by reference to, among other things, whether the untrue or alleged
untrue statement of a material fact or the omission or alleged omission to state
a material fact relates to information supplied by the Company, the Selling
Stockholders or the Underwriter and the parties' relative intent, knowledge,
access to information and opportunity to correct or prevent such statement or
omission. The Company, the Selling Stockholders and the Underwriter agree that
it would not be just and equitable if contribution were determined by pro rata
allocation or by any other method of allocation which does not take account of
the equitable considerations referred to above. The amount paid or payable by
an indemnified party as a result of the losses, claims, damages, liabilities or
expenses (or actions in respect thereof) referred to above shall be deemed to
include any legal or other expenses reasonably incurred by such indemnified
party in connection with investigating, defending, settling or compromising such
claim. Notwithstanding the provisions of this subsection (c), the Underwriter
shall not required to contribute any amount in excess of the amount by which the
total price at which the shares of the Stock underwritten by it and distributed
to the public were offered to the public exceeds the amount of any damages which
the Underwriter has otherwise been required to pay by reason of such untrue or
alleged untrue statement or omission or alleged omission and no person guilty of
fraudulent misrepresentation (within the meaning of Section 11(f) of the
Securities Act)

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<PAGE>

shall be entitled to contribution from any person who was not guilty of such
fraudulent misrepresentation.

Notwithstanding anything in this Agreement to the contrary, (i) the liability of
any Selling Stockholder to the Underwriter Indemnified Parties pursuant to this
Section 6 or as a result of the breach of any representation, warranty, covenant
or agreement of such Selling Stockholder set forth in this Agreement shall be
limited to the proceeds received by such Selling Stockholder from the
Underwriter in the Offering of the Stock, net of underwriting discounts and
commissions, and net of any damages the Selling Stockholder has otherwise been
required to pay by reason of any untrue or alleged untrue statement in any
Preeffective Prospectus, the Registration Statement or the Prospectus, or by
reason of any omission or alleged omission therefrom and (ii) no Selling
Stockholder shall be required by this Section 6 to make any payment to any
Underwriter Indemnified Party until such time as such Underwriter Indemnified
Party has asserted a claim for such payment against the Company and such claim
cannot be satisfied by the Company in accordance with the provisions of this
Section 6.

7. SURVIVAL OF INDEMNITIES, REPRESENTATIONS, WARRANTIES, ETC. The
respective indemnities, covenants, agreements, representations, warranties and
other statements of the Company, the Selling Stockholders and the Underwriter,
as set forth in this Agreement or made by them respectively, pursuant to this
Agreement, shall remain in full force and effect, regardless of any
investigation made by or on behalf of the Underwriter, the Selling Stockholders,
the Company or any of their officers or directors or any controlling persons,
and shall survive delivery of and payment for the Stock.

8. CONDITIONS OF UNDERWRITER'S OBLIGATIONS. The obligations of the
Underwriter hereunder shall be subject to the accuracy, in all material respects
at and (except as otherwise stated herein) as of the date hereof and at and as
of the Closing Dates (except that representations and warranties qualified by
materiality shall be true and correct in all respects), of the representations
and warranties made herein by the Company and the Selling Stockholders, and to
compliance in all respects at and as of the Closing Dates by the Company and the
Selling Stockholders with their covenants and agreements herein contained, and
to the following additional conditions:

The Registration Statement, if not heretofore effective, shall have become
effective and no stop order suspending the effectiveness thereof shall have been
issued and no proceedings for that purpose shall have been initiated or, to the
knowledge of the Company or the Underwriter, shall be threatened by the
Commission, and any request for additional information on the part of the
Commission (to be included in the Registration Statement or the Prospectus or
otherwise) shall have been complied with to the reasonable satisfaction of the
Underwriter. Any filings of the Prospectus, or any supplement thereto, required
pursuant to Rule 424(b) or Rule 434 of the Rules and Regulations, shall have
been made in the manner and within the time period required by Rule 424(b) and
Rule 434 of the Rules and Regulations, as the case may be.

Neither the Registration Statement nor the Prospectus, or any amendment or
supplement thereto, shall contain an untrue statement of fact which in the
reasonable opinion of counsel to the

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<PAGE>

Underwriter is material or omits to state a fact which in the reasonable opinion
of the Underwriter is material, required to be stated therein or necessary to
make the statements therein not misleading.

At the time of execution of this Agreement, the Underwriter shall have received
from Arthur Andersen LLP, independent certified public accountants, a letter,
dated the date hereof, in form and substance satisfactory to the Underwriter.

The Underwriter shall have received from Arthur Andersen LLP, independent
certified public accountants, a letter, dated the Closing Dates, to the effect
that such accountants reaffirm, as of the Closing Dates, and as though made on
the Closing Dates, the statements made in the letter furnished by such
accountants pursuant to paragraph (c) of this Section 8.

The Underwriter shall have received from Morgan Lewis & Bockius LLP, counsel for
the Company, an opinion, dated the Closing Dates, to the effect set forth in
Exhibit I hereto.

The Underwriter shall have received from Schnader Harrison Segal & Lewis LLP,
counsel for the Underwriter, their opinion or opinions dated the Closing Dates
with respect to the incorporation of the Company, the validity of the Stock, the
Registration Statement and the Prospectus and such other related matters as
Underwriter may reasonably request, and the Company and the Selling Stockholders
shall have furnished to such counsel such documents as they may reasonably
request for the purpose of enabling them to pass upon such matters.

The Underwriter shall have received a certificate, dated the Closing Dates, of
the Company signed on its behalf by the president and the chief financial
officer of the Company in which such officers shall state to the effect that:

(i) No stop order suspending the effectiveness of the
Registration Statement has been issued, and, to the knowledge of the
signers, no proceedings for that purpose have been instituted or are
pending or contemplated under the Securities Act;

(ii) As of the date of such certificate, the Prospectuses, as
amended or supplemented through such date, does not include any untrue
statement of a material fact or omit to state any material fact required to
be stated therein or necessary to make the statements therein, in light of
the circumstances under which they were made, not misleading;

(iii) Subsequent to the respective dates as of which information
is given in the Registration Statement and the Prospectus, and except as
set forth or contemplated in the Prospectus, neither the Company nor any of
its subsidiaries has incurred any material liabilities or obligations,
direct or contingent not in the ordinary course of business, nor entered
into any material transactions not in the ordinary course of business and
there has not been any material adverse change in the condition (financial
or otherwise), properties, business affairs, management, business
prospects or results of operations of the Company and its subsidiaries
considered as a whole, or any change in the capital stock (other than
pursuant to the exercise of outstanding stock options or warrants or
conversion of

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<PAGE>

preferred stock) of the Company and its subsidiaries which is material to
the Company and its subsidiaries considered as a whole;

(iv) The representations and warranties of the Company in this
Agreement are true and correct in all material respects (except that
representations and warranties qualified by materiality shall be true and
correct in all respects) at and as of the Closing Dates, and the Company
has complied in all material respects with all the agreements and performed
or satisfied all the conditions on its part to be performed or satisfied at
or prior to the Closing Dates.

The Underwriter shall have received a certificate or certificates, dated the
First Closing Date, of each Selling Stockholder to the effect that as of the
First Closing Date such Selling Stockholder's representations and warranties in
this Agreement are true and correct in all material respects as if made on and
as of such Closing Date (except that representations and warranties qualified by
materiality shall be true and correct in all respects), and that he has
performed in all material respects all his obligations and satisfied all the
conditions on such Selling Stockholder's part to be performed or satisfied at or
prior to such Closing Date.

Each officer, director and employee of the Company has furnished to you, on or
prior to the date of this agreement, a letter or letters (the "Lock-up Letters")
in substantially the form attached as Exhibit B hereto.

The Nasdaq National Market shall have approved the Stock for inclusion, subject
only to official notice of issuance.

All opinions, certificates, letters and other documents will be in compliance
with the provisions hereunder only if they are satisfactory in form and
substance to the Underwriter in his reasonable judgment. The Company will
furnish to the Underwriter conformed copies of such opinions, certificates,
letters and other documents as the Underwriter shall reasonably request. If any
of the conditions hereinabove provided for in this Section shall not have been
satisfied when and as required by this Agreement unless such failure to satisfy
results from any default or omission on the part of the Underwriter, this
Agreement may be terminated by the Underwriter by notifying the Company of such
termination in writing or by telegram at or prior to the First Closing Date, but
the Underwriter shall be entitled to waive any of such conditions.

9. EFFECTIVE DATE. This Agreement shall become effective
immediately.

10. TERMINATION. This Agreement may be terminated by the Underwriter
by notice to the Company and the Selling Stockholders, (i) if at or prior to the
First Closing Date trading in securities on any of the New York Stock Exchange
or Nasdaq National Market, shall have been suspended or minimum or maximum
prices shall have been established on any such exchange or market, or a banking
moratorium shall have been declared by New York State or United States
authorities; (ii) trading of any securities of the Company shall have been
suspended on any exchange or on the Nasdaq National Market; (iii) if following
the date of this Agreement and prior to the First Closing Date there shall have
been (A) an outbreak or escalation of hostilities between the United

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<PAGE>

States and any foreign power or of any other insurrection or armed conflict
involving the United States or (B) any material adverse change in financial
markets or any calamity or crisis which, in the reasonable judgment of the
Underwriter, make it impractical or inadvisable to offer or sell the Stock on
the terms contemplated by the Prospectus; (iv) if there shall have been any
development or prospective development involving particularly the business or
properties or securities of the Company or any of its subsidiaries or the
transactions contemplated by this Agreement, which is material and adverse and
in the reasonable judgment of the Underwriter, makes it impracticable or
inadvisable to offer or deliver the Stock on the terms contemplated by the
Prospectus; or (v) pursuant to Section 8.

11. REIMBURSEMENT OF UNDERWRITER. Notwithstanding any other
provisions hereof, if this Agreement shall be terminated by the Underwriter
under Section 8 or Section 10 (other than a termination due to any failure,
refusal or inability by the Company or any Selling Stockholder to perform any
covenant or satisfy any condition of this Agreement on their part to be
performed or satisfied which is due to the default or omission of the
Underwriter or any Selling Stockholder), the Company will bear and pay the
expenses specified in Section 5 hereof and, in addition to its obligations
pursuant to Section 6 hereof, the Company will reimburse the reasonable out-of-
pocket expenses of the Underwriter (including reasonable fees and disbursements
of counsel for the Underwriter) incurred in connection with this Agreement and
the proposed purchase of the Stock, and promptly upon demand the Company will
pay such amounts to you; provided, that the Company shall not in be liable to
any of the Underwriter for damages on account of loss of anticipated profits
from the sale by them of the Stock.

12. NOTICES. All communications hereunder shall be in writing and,
(i) if sent to the Underwriter shall be mailed, delivered or telegraphed and
confirmed to you, at 1 South Street, Baltimore, Maryland 21202, Attention: Jay
S. Eastman, Principal, with copies to BT Alex. Brown Incorporated, 1 South
Street, Baltimore, Maryland 21202, Attention: General Counsel and Alan H.
Lieblich, Esquire, Schnader Harrison Segal & Lewis LLP, 1600 Market Street,
Suite 3600, Philadelphia, Pennsylvania 19103, (ii) if sent to the Company or any
Selling Stockholder, shall be mailed, delivered or telegraphed and confirmed c/o
CDnow, Inc., 610 Old York Road, Suite 300, Jenkintown, Pennsylvania 19046,
Attention: David Capozzi, General Counsel.

13. SUCCESSORS. This Agreement shall inure to the benefit of and be
binding upon the Underwriter, the Company and the Selling Stockholders and their
respective successors and legal representatives. Nothing expressed or mentioned
in this Agreement is intended or shall be construed to give any person other
than the persons mentioned in the preceding sentence any legal or equitable
right, remedy or claim under or in respect of this Agreement, or any provisions
herein contained, this Agreement and all conditions and provisions hereof being
intended to be and being for the sole and exclusive benefit of such persons and
for the benefit of no other person; except that the representations, warranties,
covenants, agreements and indemnities of the Company and the Selling
Stockholders contained in this Agreement shall also be for the benefit of the
person or persons, if any, who control the Underwriter within the meaning of
Section 15 of the Securities Act or Section 20 of the Exchange Act, and the
indemnities of the Underwriter shall also be for the benefit of each director of
the Company, each of its officers who has signed the Registration

-22-
<PAGE>

Statement and the person or persons, if any, who control the Company or any
Selling Stockholders within the meaning of Section 15 of the Securities Act or
Section 20 of the Exchange Act.

14. APPLICABLE LAW. This Agreement shall be governed by and
construed in accordance with the laws of the State of Maryland without giving
effect to the choice of law principles thereof.

15. AUTHORITY OF THE ATTORNEYS-IN-FACT. Any action taken under this
Agreement by any of the Attorneys-in-fact will be binding on the Selling
Stockholders.

16. PARTIAL UNENFORCEABILITY. The invalidity or unenforceability of
any Section, paragraph or provision of this Agreement shall not affect the
validity or enforceability of any other Section, paragraph or provision hereof.
If any Section, paragraph or provision of this Agreement is for any reason
determined to be invalid or unenforceable, there shall be deemed to be made such
minor changes (and only such minor changes) thereto as are necessary to make it
valid and enforceable.

17. GENERAL. This Agreement constitutes the entire agreement of the
parties to this Agreement and supersedes all prior written or oral and all
contemporaneous oral agreements, understandings and negotiations with respect to
the subject matter hereof.

In this Agreement, the masculine, feminine and neuter genders and the
singular and the plural include one another. The section headings in this
Agreement are for the convenience of the parties only and will not affect the
construction or interpretation of this Agreement. This Agreement may be amended
or modified, and the observance of any term of this Agreement may be waived,
only by a writing signed by the Company, the Selling Stockholders and the
Underwriter.

The Company, the Selling Stockholders and the Underwriter acknowledge
and agree that the only information furnished or to be furnished by the
Underwriter to the Company for inclusion in any Prospectus or the Registration
Statement consists of the information set forth in the last paragraph on the
front cover page (insofar as such information relates to the Underwriter),
legends required by Item 502(d) of Regulation S-K under the Exchange Act and the
information under the caption "Underwriting" in the Prospectus.

The reimbursement, indemnification and contribution agreements
contained in this Agreement and the representations, warranties and covenants in
this Agreement shall remain in full force and effect regardless of (a) any
termination of this Agreement, (b) any investigation made by or on behalf of the
Underwriter or controlling person thereof, or by or on behalf of the Company or
its directors or officers and (c) delivery of and payment for the Stock under
this Agreement.

18. COUNTERPARTS. This Agreement may be signed in two (2) or more
counterparts, each of which shall be an original, with the same effect as if the
signatures thereto and hereto were upon the same instrument.

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<PAGE>

Any person executing and delivering this Agreement as Attorney-in-fact
for the Selling Stockholders represents by so doing that he has been duly
appointed as Attorney-in-fact by such Selling Stockholder pursuant to a validly
existing and binding Power of Attorney which authorizes such Attorney-in-fact to
take such action.

If the foregoing correctly sets forth our understanding, please
indicate your acceptance thereof in the space provided below for that purpose,
whereupon this letter and your acceptance shall constitute a binding agreement
between us.

Very truly yours,

CDNOW, INC.

By:______________________________

SELLING STOCKHOLDERS LISTED
IN SCHEDULE A

By:___________________________
Attorney-in-fact

By:__________________________________
Attorney-in-fact
Acting on his own behalf and on
behalf of the Selling Stockholders
listed in Schedule A.

Accepted and delivered
as of the date first above
written.

By: BT ALEX. BROWN INCORPORATED

By:_________________________
Title:

-24-
<PAGE>

SCHEDULE A

Number of shares
of Option Stock
Seller to be sold
- ------ ---------------------

Jeffrey McCluskey

TOTAL

-25-

<PAGE>

EXHIBIT 5.1

Morgan, Lewis & Bockius LLP

2000 One Logan Square
Philadelphia, Pennsylvania 19103-6993
(215) 963-5000 (telephone)
(215) 963-5299 (facsimile)

July 24, 1998

CDnow, Inc.
Jenkins Court, Suite 300
610 Old York Road
Jenkintown, PA 19046

Re: CDnow, Inc. -- Registration Statement on Form S-1 (No. 333-52367)
-----------------------------------------------------------------

Ladies and Gentlemen:

We have acted as counsel to CDnow, Inc., a Pennsylvania corporation (the
"Company"), in connection with the preparation of the above-referenced
Registration Statement on Form S-1 (the "Registration Statement"), relating to
the offering of up to 1,330,000 shares of the Company's common stock, no par
value (the "Common Shares"), of which 1,250,000 shares of authorized but
unissued Common Shares are being sold by the Company and 80,000 shares of
presently issued and outstanding Common Shares are being sold by a selling
shareholder named in the Registration Statement (the "Selling Shareholder"). The
Registration Statement also relates to 199,500 shares of authorized but unissued
Common Shares that may be sold by the Company upon exercise of the Underwriter's
over-allotment option pursuant to the terms of the Underwriting Agreement.

In rendering the opinion set forth below, we have reviewed (a) the Registration
Statement and the exhibits thereto; (b) the Company's Amended and Restated
Articles of Incorporation; (c) the Company's Amended and Restated Bylaws; (d)
certain records of the Company's corporate proceedings as reflected in its
minute and stock books; (e) a draft of the Underwriting Agreement pertaining to
the proposed offering subject to the Registration Statement; and (f) such other
documents as we have deemed relevant. In our examination, we have assumed the
genuineness of all signatures, the authenticity of all documents submitted to us
as originals and the conformity with the original of all documents submitted to
us as copies thereof.

Based upon the foregoing, we are of the opinion that:

1. the Common Shares to be issued by the Company to the Underwriter as
described in the Registration Statement, when and to the extent
purchased by the Underwriter in accordance with the Underwriting
Agreement, will be legally issued, fully paid and non-assessable; and

2. the Common Shares to be sold by the Selling Shareholder to the
Underwriter as described in the Registration Statement have been
legally issued and are fully paid and non-assessable.
<PAGE>

Our opinions set forth above are limited to the laws of the Commonwealth of
Pennsylvania.

We hereby consent to the use of this opinion as Exhibit 5.1 to the Registration
Statement. In giving such opinion, we do not thereby admit that we are acting
within the category of persons whose consent is required under Section 7 of the
Act or the rules or regulations of the Securities and Exchange Commission
thereunder.

Very truly yours,

/s/ Morgan, Lewis & Bockius LLP

<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.
July 24, 1998

<PAGE>

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