CDNOW INC, 424B1, 1998-02-11

CDNOW INC
424B1, 1998-02-11
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AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON FEBRUARY 9, 1998
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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AMENDMENT NO. 3
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. [_]

CALCULATION OF REGISTRATION FEE
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<TABLE>
<CAPTION>
TITLE OF EACH CLASS OF PROPOSED MAXIMUM AMOUNT OF
SECURITIES TO BE REGISTERED AGGREGATE OFFERING PRICE(1) REGISTRATION FEE(2)
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<S> <C> <C>
Common Stock, no par value.... 73,600,000 21,712
</TABLE>
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(1) Estimated solely for the purpose of calculating the registration fee in
accordance with Rule 457(o) under the Securities Act of 1933.
(2) Includes $17,700 paid by the Registrant on November 28, 1997.
--------------
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>

4,100,000 SHARES

[LOGO OF CDNOW APPEARS HERE]

COMMON STOCK

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All of the 4,100,000 shares of Common Stock offered hereby will be sold by
CDnow, Inc. ("CDnow" or the "Company"). Prior to the Offering, there has been
no public market for the Common Stock. For factors considered in determining
the initial public offering price, see "Underwriting." Immediately upon
completion of the Offering, the officers and directors of the Company and
entities that employ certain directors collectively will beneficially own
approximately 67.2% of the outstanding Common Stock. The Common Stock has been
approved for quotation on the Nasdaq National Market under the symbol "CDNW."

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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
TO DISCOUNTS AND TO
PUBLIC COMMISSIONS(1) COMPANY(2)
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<S> <C> <C> <C>
Per Share............................... $16.00 $1.12 $14.88
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Total(3)................................ $65,600,000 $4,592,000 $61,008,000
</TABLE>
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(1) See "Underwriting" for information relating to indemnification of the
Underwriters.
(2) Before deducting expenses for this Offering, payable by the Company,
estimated at $800,000.
(3) The Company and certain shareholders of the Company (the "Selling
Shareholders") have granted the Underwriters a 30-day option to purchase
up to 461,250 and 153,750 additional shares of Common Stock, respectively,
solely to cover over-allotments, if any. To the extent that the option is
exercised, the Underwriters will offer the additional shares at the Price
to Public shown above. If the option is exercised in full, the total Price
to Public, Underwriting Discounts and Commissions and Proceeds to Company
will be $75,440,000, $5,280,800 and $67,871,400, respectively, and the
selling stockholders would receive aggregate net proceeds of $2,287,800.
The Company will not receive any of the proceeds from the sale of shares
by the Selling Shareholders. See "Underwriting."

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The shares of Common Stock are offered by the several Underwriters, subject
to prior sale, when, as and if delivered to and accepted by them, and subject
to the right of the Underwriters to reject any order in whole or in part. It
is expected that delivery of the shares of Common Stock will be made at the
offices of BT Alex. Brown Incorporated, Baltimore, Maryland, on or about
February 13, 1998.

BT ALEX.BROWN NATIONSBANC MONTGOMERY
SECURITIES LLC

THE DATE OF THIS PROSPECTUS IS FEBRUARY 9, 1998
<PAGE>

[ARTWORK APPEARS HERE]

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

2
<PAGE>

PROSPECTUS SUMMARY

The following summary is qualified in its entirety by, and should be read in
conjunction with, the more detailed information and financial statements of the
Company and the notes thereto included elsewhere in this Prospectus. Unless
otherwise indicated, all information presented in this Prospectus assumes (i)
no exercise of the over-allotment option granted by the Company and the Selling
Shareholders to the Underwriters, (ii) the 1.5-for-1 split of the outstanding
Common Stock effective for all holders of record on February 3, 1998, (iii) the
automatic conversion of all outstanding shares of the Company's Series A
Convertible Preferred Stock, no par value (the "Series A Preferred Stock"), and
Series B Convertible Preferred Stock, no par value (the "Series B Preferred
Stock"), into an aggregate of 2,790,131 shares of Common Stock upon the
consummation of this Offering, and (iv) the cashless exercise of a warrant held
by Alan Meltzer, a director of the Company, into 809,237 net shares of Common
Stock upon the consummation of this Offering. Unless the context otherwise
requires, each reference to the "Company" or "CDnow" refers to CDnow, Inc. and
its subsidiaries and each reference to "CDs" refers collectively to compact
discs, cassettes and vinyl records.

THE COMPANY

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

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

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

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<PAGE>

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

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

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

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

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

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

4
<PAGE>

THE OFFERING

Common Stock offered by the Company... 4,100,000 shares

Common Stock to be outstanding after
the Offering....................... 15,545,052 shares(1)

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

Nasdaq National Market symbol......... CDNW
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(1) Includes the cashless exercise of a warrant into 809,237 net shares of
Common Stock. Excludes (i) 721,914 shares of Common Stock issuable upon the
exercise of options outstanding as of January 31, 1998 under the Company's
1996 Equity Compensation Plan (the "Equity Compensation Plan") at a
weighted average exercise price of $2.99 per share, (ii) 878,086 shares
reserved for future grants under the Equity Compensation Plan and (iii)
367,253 shares of Common Stock issuable upon the exercise of warrants
outstanding as of January 31, 1998 at a weighted average exercise price of
$4.05 per share. See "Management--Equity Compensation Plan" and
"Description of Capital Stock."

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

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SUMMARY FINANCIAL AND OPERATING DATA

<TABLE>
<CAPTION>
PERIOD FROM
INCEPTION
(FEBRUARY 12,
1994) TO YEAR ENDED DECEMBER 31,
DECEMBER 31, -----------------------------------------
1994(1) 1995(1) 1996 1997
------------- ----------- ------------ --------------
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Net sales....................... $103,116 $ 2,176,474 $ 6,300,294 $ 17,372,795
Cost of sales................... 92,962 1,844,612 5,363,989 14,541,765
-------- ----------- ----------- ------------
Gross profit................... 10,154 331,862 936,305 2,831,030
Operating expenses:
Operating and development...... 26,946 149,982 523,080 2,179,726
Sales and marketing............ 12,945 200,972 621,454 9,242,179
General and administrative..... 28,712 180,573 563,593 1,968,218
Dispute settlement(2).......... -- -- 1,024,030 --
-------- ----------- ----------- ------------
Total operating expenses....... 68,603 531,527 2,732,157 13,408,123
-------- ----------- ----------- ------------
Operating loss................. (58,449) (199,665) (1,795,852) (10,577,093)
Interest expense, net........... -- (1,248) (14,556) (170,312)
-------- ----------- ----------- ------------
Net loss........................ $(58,449) $ (200,913) $(1,810,408) $(10,747,405)
======== =========== =========== ============
Net loss per share(3)........... $ (1.42)
============
Weighted average number of
common shares outstanding(3)... 7,845,684
============
OPERATING DATA:
Customers(4).................... 1,787 26,953 87,859 296,450
<CAPTION>
DECEMBER 31, 1997
-----------------------------------------
PRO FORMA
ACTUAL PRO FORMA(5) AS ADJUSTED(6)
BALANCE SHEET DATA: ----------- ------------ --------------
<S> <C> <C> <C>
Cash and cash equivalents..................... $10,686,001 $10,686,001 $ 65,116,501
Working capital (deficit)..................... (1,218,005) (1,218,005) 58,700,386
Total assets.................................. 16,448,425 16,448,425 70,791,528
Long-term debt, excluding current portion..... 962,144 962,144 962,144
Redeemable convertible preferred stock........ 9,492,594 -- --
Total shareholders' equity (deficit).......... (9,752,450) (259,856) 59,658,535
</TABLE>

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(1) The business of the Company was established as a sole proprietorship in
February 1994 and commercial operations were commenced in August 1994. The
Company was incorporated in April 1995.
(2) In December 1996, in settlement of a dispute, the Company issued 882,606
shares of Common Stock to certain persons. See "Certain Relationships and
Related Transactions" and Note 7 to Notes to Financial Statements.
(3) See Note 2 to Notes to Financial Statements for an explanation of the
determination of the number of common shares used in computing the per
share amount.
(4) Cumulative number of customers who have purchased products from the Company
from inception of its business in August 1994 through the end of period.
(5) Represents actual data as adjusted to give effect to the conversion of the
outstanding shares of Series A Preferred Stock and Series B Preferred Stock
into 2,790,131 shares of Common Stock upon the consummation of this
Offering. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations," "Certain Relationships and Related
Transactions" and "Principal and Selling Shareholders."
(6) Represents pro forma data as adjusted to give effect to the sale of
4,100,000 shares of Common Stock offered by the Company (after deducting
underwriting discounts and commissions and estimated offering expenses),
the application of the estimated net proceeds therefrom and the write-off
of approximately $290,000 of debt discount and deferred financing costs in
connection with the repayment of the Series A Notes. See "Capitalization"
and "Use of Proceeds."

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RISK FACTORS

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

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

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

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

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

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

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

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

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

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

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

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

8
<PAGE>

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

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

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

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

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

9
<PAGE>

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

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

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

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

10
<PAGE>

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

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

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

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

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

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

11
<PAGE>

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

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

The applicability to the Internet of existing laws in various jurisdictions
governing issues such as property ownership, sales and other taxes, contests
and sweepstakes, libel, personal privacy, rights of publicity, language
requirements and content restrictions, is uncertain and could expose the
Company to substantial liability. The laws of certain foreign countries
provide the owner of copyrighted products with the exclusive right to expose,
through sound and video samples, copyrighted items for sale to the public and
the right to distribute such products. Any new legislation or regulation, or
the application of existing laws and regulations to the Internet could have a
material adverse effect on the Company. For example, major U.S.-based online
services (and personnel) have been challenged by German authorities for making
certain content accessible in Germany. If the Company were alleged to violate
federal, state or foreign, civil or criminal law, even if the Company could
successfully defend such claims, it could have a material, adverse impact on
the Company.

A foreign distribution affiliate of a major record label has sought to
enjoin the sale of music-related products by an Internet retailer in Germany.
Moreover, in February 1998 the Company received correspondence from a foreign
distribution affiliate of another label, demanding that it cease the sale of
two titles in Germany and pay damages. The Company has retained counsel in
this matter and is considering its response. There can be no assurance 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.

12
<PAGE>

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 in defense of potential
claims or to indemnify the Company for all liability that may be imposed. Any
costs or imposition of liability that is not covered by insurance or is in
excess of insurance coverage could have a material adverse effect on the
Company.

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

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

13
<PAGE>

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

Control of the Company. Immediately upon completion of this offering,
approximately 19.3%, 19.3%, 11.1% and 14.9% of the outstanding Common Stock
will be beneficially owned by Jason Olim, the Company's President, Chief
Executive Officer and Chairman of the Board; Matthew Olim, the Company's
Technical Lead and Jason Olim's brother; Alan Meltzer, a director of the
Company; and Grotech Partners, IV, one of the managing directors of which is
Patrick Kerins, a director of the Company. As a result, such persons, acting
together, will have the ability to control all matters submitted to
shareholders of the Company for approval (including the election and removal
of directors and any merger, consolidation or sale of all or substantially all
of the Company's assets) and to control the management and affairs of the
Company. Such concentration of ownership may have the effect of delaying,
deferring or preventing a change in control of the Company, impede a merger,
consolidation, takeover or other business combination involving the Company or
discourage a potential acquirer from making a tender offer or otherwise
attempting to obtain control of the Company, which in turn could have an
adverse effect on the market price of the Company's Common Stock. See
"Principal Shareholders" and "Certain Relationships and Related Transactions."

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

Risks Associated with 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.

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, and the Company's operations may be materially adversely affected to
the extent its customers are unable to use their credit cards due to the Year
2000 issues that are not rectified by their credit card vendors.

Risks Associated with International Sales. For the year ended December 31,
1997, international sales accounted for approximately 29% of the Company's net
sales. While the Company expects that its

14
<PAGE>

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
4,100,000 shares of Common Stock offered hereby (other than shares purchased
by "affiliates" of the Company) will be freely tradeable immediately following
this offering. All of the remaining outstanding shares (the "Restricted
Shares"), have or will become available for sale in the public market during
1998 subject, in certain instances, to the applicable resale limitations of
Rule 144 promulgated under the Securities Act of 1933, as amended (the
"Securities Act"). In addition, the Company intends to file a Registration
Statement on Form S-8 covering up to 1,600,000 shares issuable upon exercise
of stock options under the Equity Compensation Plan. Such shares, upon
issuance, will be immediately available for resale (in the case of holders
that are affiliates of the Company, subject to certain limitations under Rule
144). The Company's officers, directors and certain shareholders, who hold, in
the aggregate, approximately 11,394,884 shares of Common Stock, have agreed
not to sell any shares of Common Stock (excluding shares of Common Stock
offered by this Prospectus or shares purchased in the open market) for a
period of 180 days following the consummation of this offering without the
prior written consent of BT Alex. Brown Incorporated. Thereafter, these shares
may become either freely resalable or eligible for sale pursuant to the
applicable resale limitations of Rule 144. In addition, beneficial owners of
approximately 5,746,307 shares of Restricted Stock have demand and piggyback
registration rights with respect to those shares. Sales of substantial amounts
of Common Stock in the public market or the availability of substantial
amounts of such stock for sale subsequent to this Offering could adversely
affect the prevailing market price of the Common Stock and could impair the
Company's ability to raise capital through the sale of its equity securities.

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

Immediate and Substantial Dilution. The purchasers of the shares of Common
Stock offered hereby will experience immediate and substantial dilution in the
net tangible book value of their shares of Common Stock in the amount of
$12.16 per share (after giving effect to underwriting discounts and
commissions and estimated offering expenses). See "Dilution." In the event the
Company offers additional Common Stock in the future, including shares that
may be issued upon exercise of stock options, purchasers of Common Stock in
this offering may experience further dilution in the net tangible book value
per share of the Common Stock of the Company.

15
<PAGE>

USE OF PROCEEDS

The net proceeds to the Company from the sale of 4,100,000 shares of Common
Stock offered hereby are estimated to be $60.2 million (approximately $67.1
million if the Underwriters' overallotment option is exercised in full) after
deducting underwriting discounts and commissions and estimated offering
expenses.

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

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

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

DIVIDEND POLICY

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

16
<PAGE>

CAPITALIZATION

The following table sets forth, as of December 31, 1997, (i) the actual
capitalization of the Company, (ii) the pro forma capitalization of the
Company after giving effect to the conversion of the outstanding Series A
Preferred Stock and Series B Preferred Stock into 2,790,131 shares of Common
Stock upon the consummation of this offering and the cashless exercise by Alan
Meltzer, a director of the Company, of a warrant for 871,710 shares of common
stock for $1.0 million into 809,237 net shares of Common Stock which is
expected to occur upon the consummation of this offering and (iii) the pro
forma capitalization, as adjusted to reflect the issuance and sale of the
4,100,000 shares of Common Stock offered by the Company hereby, the
application of the estimated net proceeds therefrom and the write-off of
approximately $290,000 of debt discount and deferred financing costs in
connection with the repayment of the Series A Notes. See "Use of Proceeds."
This table should be read in conjunction with the Financial Statements and the
notes thereto and the other financial information included elsewhere in this
Prospectus.

<TABLE>
<CAPTION>
DECEMBER 31, 1997
-------------------------------------
PRO FORMA
ACTUAL PRO FORMA AS ADJUSTED
----------- ----------- -----------
<S> <C> <C> <C>
Cash.................................... $10,686,001 $10,686,001 $65,116,501
=========== =========== ===========
Series A Notes.......................... $ 5,575,288 $ 5,575,288 $ --
=========== =========== ===========
Long-term debt, excluding current
portion................................ $ 962,144 $ 962,144 $ 962,144
----------- ----------- -----------
Redeemable Series A and Series B
Convertible Preferred Stock............ 9,492,594 -- --
----------- ----------- -----------
Shareholders' equity (deficit):
Preferred Stock, no par value;
20,000,000 shares authorized; 254,582
shares Series A Convertible Preferred
Stock and 1,605,505 shares of Series
B Convertible Preferred Stock issued
and outstanding actual; no shares
issued and outstanding pro forma and
pro forma as adjusted................ -- -- --
Common Stock, no par value; 50,000,000
shares authorized; 7,845,684 shares
issued and outstanding actual(1);
11,445,052 shares issued and
outstanding pro forma(1)(2);
15,545,052 shares issued and
outstanding pro forma as
adjusted(1)(2)....................... 579,549 10,072,143 70,280,143
Additional paid-in capital............ 1,325,817 1,325,817 1,325,817
Deferred compensation................. (434,776) (434,776) (434,776)
Accumulated deficit................... (11,223,040) (11,223,040) (11,512,649)
----------- ----------- -----------
Total shareholders' equity (defi-
cit)............................... (9,752,450) (259,856) 59,658,535
----------- ----------- -----------
Total capitalization.............. $ 702,288 $ 702,288 $60,620,679
=========== =========== ===========
</TABLE>
- ---------------------
(1) Excludes (i) 721,914 shares of Common Stock issuable upon the exercise of
options outstanding as of January 31, 1998 under the Company's 1996 Equity
Compensation Plan (the "Equity Compensation Plan") at a weighted average
exercise price of $2.99 per share, (ii) 878,086 shares of Common Stock
reserved for future grants under the Equity Compensation Plan and (iii)
367,253 shares of Common Stock issuable upon the exercise of warrants
outstanding as of January 31, 1998 at a weighted average exercise price of
$4.05 per share. See "Management--Equity Compensation Plan" and
"Description of Capital Stock."
(2) Includes the cashless exercise of a warrant into 809,237 net shares of
Common Stock, as discussed above.

17
<PAGE>

DILUTION

At December 31, 1997, the pro forma net tangible book value of the Company
was a deficit of approximately $(473,000) or $(0.04) per share of Common Stock
after giving effect to the conversion of the outstanding Series A Preferred
Stock and Series B Preferred Stock into 2,790,131 shares of Common Stock and
the cashless exercise, by Alan Meltzer, a director of the Company, of a
warrant into 809,237 net shares of Common Stock upon the consummation of this
Offering. Pro forma net tangible book value per share is equal to the
Company's total tangible assets less its total liabilities, divided by the
total number of shares of Common Stock outstanding on a pro forma basis for
the period immediately prior to this offering. After giving effect to the sale
by the Company of 4,100,000 shares of Common Stock offered hereby and after
deducting underwriting discounts and commissions and estimated offering
expenses and the write-off of $290,000 of debt discount and deferred financing
costs in connection with the repayment of the Series A Notes, the pro forma
net tangible book value of the Company at December 31, 1997 would have been
$59.7 million or approximately $3.84 per share. This represents an immediate
increase in the pro forma net tangible book value of $3.88 per share to
existing shareholders and immediate dilution of $12.16 per share to new
investors purchasing shares of Common Stock in this offering. The following
table illustrates this per share dilution:

<TABLE>
<S> <C> <C>
Initial public offering price per share..................... $16.00
Pro forma net tangible book value per share as of December
31, 1997................................................. $(0.04)
Increase in pro forma combined net tangible book value per
share attributable to new investors...................... 3.88
------
Pro forma net tangible book value per share after this
offering................................................... 3.84
------
Dilution per share to new investors......................... $12.16
======
</TABLE>

The following table sets forth, on an adjusted basis as of December 31,
1997, the number of shares of Common Stock purchased from the Company
(assuming the conversion of the Series A Preferred Stock and Series B
Preferred Stock into 2,790,131 shares of Common Stock and the cashless
exercise of a warrant for 809,237 net shares of Common Stock which is expected
to occur upon the consummation of this offering), the total cash consideration
paid and the average price per share paid by the existing holders of Common
Stock and by new investors, before deducting estimated underwriting discounts
and commissions and expenses payable by the Company:

<TABLE>
<CAPTION>
SHARES PURCHASED TOTAL CONSIDERATION
------------------ ------------------- AVERAGE PRICE
NUMBER PERCENT AMOUNT PERCENT PER SHARE
---------- ------- ----------- ------- -------------
<S> <C> <C> <C> <C> <C>
Existing shareholders.. 11,445,052 73.6% $12,583,787 16.1% $ 1.10
New investors.......... 4,100,000 26.4% 65,600,000 83.9% 16.00
---------- ----- ----------- -----
Total................ 15,545,052 100.0% $78,183,787 100.0%
========== ===== =========== =====
</TABLE>

The foregoing tables exclude (i) 721,914 shares of Common Stock issuable
upon the exercise of options outstanding as of January 31, 1998 under the
Equity Compensation Plan at a weighted average exercise price of $2.99 per
share, (ii) 878,086 shares of Common Stock reserved for future grants under
the Equity Compensation Plan and (iii) 367,253 shares of Common Stock issuable
upon the exercise of warrants outstanding as of January 31, 1998 at a weighted
average exercise price of $4.05 per share. See "Management--Equity
Compensation Plan," "Description of Common Stock" and Note 8 to Notes to
Financial Statements. The exercise of outstanding options and warrants having
an exercise price less than the initial public offering price would increase
the dilution to new investors illustrated by the foregoing tables.

18
<PAGE>

SELECTED FINANCIAL AND OPERATING DATA

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

<TABLE>
<CAPTION>
PERIOD FROM
INCEPTION
(FEBRUARY 12,
1994) TO YEAR ENDED DECEMBER 31,
DECEMBER 31, -------------------------------------
1994(1) 1995(1) 1996 1997
------------- ---------- ----------- ------------
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS
DATA:
Net sales................ $103,116 $2,176,474 $ 6,300,294 $ 17,372,795
Cost of sales............ 92,962 1,844,612 5,363,989 14,541,765
-------- ---------- ----------- ------------
Gross profit............ 10,154 331,862 936,305 2,831,030
Operating expenses:
Operating and develop-
ment................... 26,946 149,982 523,080 2,179,726
Sales and marketing..... 12,945 200,972 621,454 9,242,179
General and administra-
tive................... 28,712 180,573 563,593 1,986,218
Dispute settlement(2)... -- -- 1,024,030 --
-------- ---------- ----------- ------------
Total operating ex-
penses................. 68,603 531,527 2,732,157 13,408,123
-------- ---------- ----------- ------------
Operating loss.......... (58,449) (199,665) (1,795,852) (10,577,093)
Interest expense, net.... -- (1,248) (14,556) (170,312)
-------- ---------- ----------- ------------
Net loss................. $(58,449) $ (200,913) $(1,810,408) $(10,747,405)
======== ========== =========== ============
Net loss per share(3).... $ (1.42)
============
Weighted average number
of common shares
outstanding(3).......... 7,845,684
============
OPERATING DATA:
Customers(4)............. 1,787 26,953 87,859 296,450
<CAPTION>
DECEMBER 31,
---------------------------------------------------
1994 1995 1996 1997
------------- ---------- ----------- ------------
<S> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash and cash
equivalents............. $ 2,008 $ 43,812 $ 775,865 $ 10,686,001
Working capital
(deficit)............... (42,206) (235,478) 231,455 (1,218,005)
Total assets............. 25,765 268,468 1,575,459 16,448,425
Long-term debt, excluding
current portion......... -- 9,519 91,133 962,144
Redeemable convertible
preferred stock......... -- -- -- 9,492,594
Total shareholders'
equity (deficit)........ (18,449) (99,362) 514,017 (9,752,450)
</TABLE>
- ---------------------
(1) The business of the Company was established as a sole proprietorship in
February 1994 and commercial operations were commenced in August 1994. The
Company was incorporated in April 1995.
(2) In December 1996, in settlement of a dispute, the Company issued 882,606
shares of Common Stock to certain persons. See "Certain Relationships and
Related Transactions" and Note 7 to Notes to Financial Statements.
(3) See Note 2 to Notes to Financial Statements for an explanation of the
determination of the number of common shares used in computing the per
share amount.
(4) Cumulative number of customers who have purchased products from the
Company from inception of its business in August 1994 through the end of
period.

19
<PAGE>

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

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

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

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

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

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

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

20
<PAGE>

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

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

RESULTS OF OPERATIONS

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

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

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

Net Sales. Net sales primarily reflect the sales of CDs and related
merchandise, net of estimated returns, and include outbound shipping and
handling charges. Net sales increased by $11.1 million, or 176%, to $17.4
million for the year ended December 31, 1997 compared to $6.3 million for the
year ended

21
<PAGE>

December 31, 1996. This increase is primarily attributable to the significant
growth of the Company's customer base and repeat purchases from the Company's
existing customers, who have typically purchased more units per order than new
customers. International sales represented approximately 29% and 40% of net
sales for the years ended December 31, 1997 and December 31, 1996,
respectively. The Company believes that this decrease in international sales
as a percentage of net sales is due to the substantial increase in the
Company's domestic marketing and advertising expenditures. At December 31,
1997, the Company had approximately 296,000 customer accounts compared to
approximately 88,000 customer accounts at December 31, 1996.

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

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

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

General and Administrative Expense. General and administrative expense
consists of payroll and related expenses for executive, accounting and
administrative personnel, recruiting, professional fees and

22
<PAGE>

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

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

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

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

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

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

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

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

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

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

23
<PAGE>

QUARTERLY RESULTS OF OPERATIONS AND SEASONALITY

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

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

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

24
<PAGE>

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

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

LIQUIDITY AND CAPITAL RESOURCES

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

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

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

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

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

25
<PAGE>

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

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

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

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

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On January 5, 1998, the Company entered into a strategic alliance agreement
(the "GeoCities Agreement") with GeoCities pursuant to which the Company has
been designated as the exclusive music retailer and one of four key commerce
partners that will occupy a premier position on certain pages of the GeoCities
Web site. The Company has also committed to purchase national advertising
during the 1998 Grammy Awards and purchased national advertising during the
1998 American Music Awards. The Company's aggregate commitment under these
arrangements, together with certain other advertising commitments in 1998, is
approximately $3.9 million. In addition, under the GeoCities Agreement, the
Company is required to pay GeoCities additional variable fees based upon the
net sales generated from users that access the CDnow site through links with
GeoCities.

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

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

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

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

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BUSINESS

INTRODUCTION

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

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

INDUSTRY OVERVIEW

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

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

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

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

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

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

STRATEGY

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

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

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

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

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

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

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

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

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

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

THE CDNOW ONLINE RETAIL STORE

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

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

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

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

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

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

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

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

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

MARKETING AND PROMOTION

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

Online and Traditional Advertising

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

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

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

Strategic Alliances

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

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

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

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

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

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

Cosmic Credit Program

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

Direct Marketing

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

CUSTOMER SERVICE

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

DISTRIBUTION AND FULFILLMENT

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

34
<PAGE>

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

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

TECHNOLOGY

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

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

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

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

35
<PAGE>

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

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

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

COMPETITION

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

36
<PAGE>

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

INTELLECTUAL PROPERTY

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

EMPLOYEES

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

FACILITIES

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

LEGAL PROCEEDINGS

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

37
<PAGE>

MANAGEMENT

OFFICERS AND DIRECTORS

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

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

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

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

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

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

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

38
<PAGE>

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

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

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

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

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

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

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

DIRECTOR COMPENSATION

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

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

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

39
<PAGE>

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

EXECUTIVE COMPENSATION

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

SUMMARY COMPENSATION TABLE

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

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

OPTION GRANTS IN LAST FISCAL YEAR

POTENTIAL
INDIVIDUAL GRANTS 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 initial public offering price per share.

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

FISCAL YEAR END OPTION VALUES

<TABLE>
<CAPTION>
VALUE OF UNEXERCISED IN-
NUMBER OF SECURITIES UNDERLYING THE-
UNEXERCISED OPTIONS AT MONEY OPTIONS AT
DECEMBER 31, 1997 DECEMBER 31, 1997(1)
----------------------------------- -------------------------
NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ---- -------------- ----------------- ----------- -------------
<S> <C> <C> <C> <C>
Rod Parker.... -- 120,000 -- $1,760,400
</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 initial public offering price and the applicable exercise price.

40
<PAGE>

EQUITY COMPENSATION PLAN

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

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

As of January 31, 1998, options to purchase a total of 721,899 shares of
Common Stock at a weighted average exercise price per share of $2.99 were
outstanding. Of these options, options to purchase 103,180 shares of Common
Stock were fully vested and exercisable as of January 31, 1998. As of January
31, 1998, the Company had an additional 878,086 shares of Common Stock
available for future grants under the Equity Compensation Plan.

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

41
<PAGE>

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

SERIES A CONVERTIBLE NOTES

In November 1997, the Company issued $5.8 million aggregate principal amount
of Series A Notes to a group of investors, including $1.0 million to Grotech
and $127,500 to the ABS Employees' Venture Fund Limited Partnership ("ABS").
The Series A Notes, which will be repaid upon the consummation of this
offering, bear interest at the rate of 12% per annum. In addition, the Company
issued warrants to these investors to purchase an aggregate of 48,550 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. Most of the warrants issued to ABS will have an exercise
price equal to the initial public offering price as set forth on the cover
page to this Prospectus. See "Underwriting."

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 at a purchase price of $4.91 per share. The
outstanding shares of Series A Preferred Stock will automatically convert upon
the consummation of this Offering into an aggregate of 381,873 shares of
Common Stock. John Regan is a Vice President of the general partner of
Keystone Ventures and was elected to the Company's Board of Directors pursuant
to an agreement among certain shareholders of the Company that terminates upon
the consummation of this Offering. Keystone Ventures received certain
registration rights in connection with this transaction. See "Shares Eligible
for Future Sale--Registration Rights."

SERIES B PREFERRED STOCK

Pursuant to the terms of the Stock Purchase Agreement, as amended by the
Amendment No. 1 to the Stock Purchase Agreement dated as of August 5, 1997 by
and among the Company, Keystone Ventures, Jason Olim, Matthew Olim, Grotech
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
at a purchase price of $5.45 per share, (ii) ABS purchased 62,000 shares of
Series B Preferred Stock at a purchase price of $5.45 per share, (iii) the
Company issued to Grotech Capital a warrant to purchase up to 18,349 shares of
Series B Preferred Stock at an exercise price of $5.45 per share, and (iv) the
Company issued to Alex. Brown & Sons Incorporated, a predecessor-in-interest
to BT Alex. Brown Incorporated ("BT Alex. Brown"), a warrant to purchase up to
103,211 shares of Series B Preferred Stock at an exercise price of $5.45 per
share in partial consideration of its services as the placement agent for the
offering of the Series A and Series B Preferred Stock. The outstanding shares
of Series B Preferred Stock will automatically convert upon the consummation
of this Offering into an aggregate of 2,408,258 shares of Common Stock and
these warrants will automatically become exercisable for an aggregate of
182,341 shares Common Stock upon the consummation of this Offering. Patrick
Kerins is a Managing Director of Grotech Capital, the general partner of
Grotech IV, and was elected to the Company's Board of Directors pursuant to an
agreement among certain shareholders of the Company that terminates upon the
consummation of this Offering. Grotech IV, Grotech Capital, ABS and BT Alex.
Brown received certain registration rights in connection with this
transaction. See "Shares Eligible for Future Sale."

STOCK PURCHASE AND SHAREHOLDERS' AGREEMENT

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

42
<PAGE>

significant cash investment in, and Jason and Matthew Olim would contribute
all of the outstanding capital stock of both Milo and CDnow to, NewCo. The
parties abandoned these discussions and, in August 1996, MBL and Alan Meltzer
instituted a legal action against CDnow, Milo and Jason and Matthew Olim (the
"Legal Action"). On December 6, 1996, the Company entered into a Stock
Purchase and Shareholders' Agreement (the "Stock Purchase and Shareholders
Agreement") with Milo, Jason Olim, Matthew Olim, Alan Meltzer, Jeffrey
McClusky, Anthony Lucenti, William Brennan and MBL pursuant to which (i) Mr.
Meltzer purchased, for an aggregate purchase price of $1,200,000, 921,834
shares of Common Stock and a warrant presently exercisable for 871,710 shares
of Common Stock, and (ii) an aggregate of 882,606 shares of Common Stock were
issued to Messrs. McClusky, Lucenti and Brennan, the sole shareholders of MBL,
in exchange for substantially all of the assets and business of MBL. A primary
inducement for these transactions was the mutual release by all parties to the
Stock Purchase Agreement relating to (i) the Legal Action and (ii) all other
prior agreements and relationships among such parties. At the time of the
settlement, MBL and Music Now were inactive and had no assets or liabilities.
In addition, pursuant to the terms of the Stock Purchase and Shareholders
Agreement, each of Jason and Matthew Olim is generally restricted from
competing with the Company's business for a three-year period ending on the
termination of his relationship (either as an employee, director or
consultant) with the Company. Mr. Meltzer has delivered written notice to the
Company that he intends to effect a cashless exercise of his warrant upon the
consummation of this offering and will receive 809,237 net shares of Common
Stock.

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. The warrants
expire on May 16, 1998 with respect to 59,997 shares of Common Stock and July
16, 1998 with respect to 76,365 shares of Common Stock.

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

43
<PAGE>

PRINCIPAL AND SELLING SHAREHOLDERS

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

<TABLE>
<CAPTION>
BENEFICIAL OWNERSHIP BENEFICIAL OWNERSHIP
PRIOR TO OFFERING AFTER OFFERING#
----------------------- -----------------------
NAME OF BENEFICIAL OWNER SHARES PERCENT SHARES PERCENT
- ------------------------ ------------ ---------- ------------ ----------
<S> <C> <C> <C> <C>
EXECUTIVE OFFICERS AND
DIRECTORS
Jason Olim(1).................. 3,000,000 26.2% 3,000,000 19.3%
Matthew Olim(1)................ 3,000,000 26.2 3,000,000 19.3
Alan Meltzer(2)................ 1,731,071 15.1 1,731,071 11.1
Robert Saltzman(3)............. 37,415 * 37,415 *
Joel Sussman(4)................ 3,000 * 3,000 *
Patrick Kerins(5).............. 1,569 * 1,569 *
Michael Krupit(6).............. -- -- -- --
Rod Parker(7).................. -- -- -- --
John Regan(8).................. -- -- -- --
All executive officers and
directors as a group
(9 persons)(9)................ 7,773,055 67.7 7,773,055 49.9
FIVE PERCENT HOLDERS
Grotech Partners IV, L.P.(10).. 2,315,258 20.2 2,315,258 14.9
POTENTIAL SELLING STOCKHOLDERS
Jeffrey McCluskey.............. 323,622 2.8 323,622 2.1
Anthony Lucenti................ 279,492 2.4 279,492 1.8
William Brennan................ 279,492 2.4 279,492 1.8
</TABLE>
- ---------------------
# Assumes no exercise of the Underwriters' over-allotment option. The Selling
Stockholders have been allocated 25% of the shares subject to such over-
allotment option. In the event such option is exercised in full, the
selling stockholders will sell 153,750 shares allocated among them as
follows: Jason Olim-39,975 shares; Matthew Olim-39,975 shares; Jeffrey
McCluskey-18,450 shares; Anthony Lucenti-18,450 shares; William Brennan-
18,450 shares; and Alan Meltzer-18,450 shares. If the Underwriters' over-
allotment option is only partially exercised, the foregoing persons will
sell that portion of such option that is granted to the Selling
Stockholders, pro-rata, based on the allocation set forth in the preceeding
sentence.
* Less than one percent.
(1) Excludes 41,244 shares owned by Dave Olim, the father of Jason and
Matthew Olim. Jason and Matthew Olim each disclaim beneficial ownership
of these shares. The address of Jason and Matthew Olim is 610 Old York
Road, Suite 300, Jenkintown, Pennsylvania 19046.
(2) Includes 809,237 shares of Common Stock issuable upon the exercise of a
presently exercisable warrant. Mr. Meltzer has notified the Company that
he intends to exercise this warrant upon the consummation of this
Offering. The address of Mr. Meltzer is 944 Park Avenue, New York, New
York 10028.
(3) Represents 32,727 shares of Common Stock obtainable upon conversion of a
presently exercisable warrant held by a trust of which Mr. Saltzman is
the beneficiary and 4,608 shares of Common Stock obtainable upon the
exercise of a stock option granted under the Equity Compensation Plan.
Excludes 70,312 shares of Common Stock that are not exercisable with the
next 60 days under such stock option.
(4) Represents shares of Common Stock obtainable upon the exercise of a stock
option granted under the Equity Compensation Plan. Excludes 75,000 shares
which are not exercisable within the next 60 days under a stock option
granted under such Plan.
(5) Represents 1,569 shares of Common Stock obtainable upon the conversion of
a presently exercisable warrant held by Patrick Kerins. Excludes
2,315,258 shares of Common Stock held by Grotech Partners IV, L.P.
Patrick Kerins is a managing director of Grotech Partners IV, L.P. Mr.
Kerins disclaims beneficial ownership of any shares owned by Grotech
Partners IV L.P.
(6) Excludes 30,000 shares of Common Stock that are not exercisable within
the next 60 days under a stock option granted under the Equity
Compensation Plan.
(7) Represents shares of Common Stock obtainable upon the exercise of a stock
option granted under the Equity Compensation Plan. Excludes 120,000
shares of Common Stock that are not exercisable within the next 60 days
under a stock option granted under such Plan.
(8) Excludes 381,873 shares of Common Stock held by Keystone Ventures IV,
L.P. ("Keystone"). John Regan is a Vice President of the general partner
of Keystone and disclaims beneficial ownership of any shares owned by
Keystone.
(9) Includes an aggregate of 41,984 shares of Common Stock obtainable upon
the exercise of presently exercisable options and warrants.
(10) 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.

44
<PAGE>

DESCRIPTION OF CAPITAL STOCK

The authorized capital stock of the Company consists of 50,000,000 shares of
Common Stock, no par value (the "Common Stock"), and 20,000,000 shares of
Preferred Stock, no par value (the "Preferred Stock"). Immediately after the
sale of the 4,100,000 shares of Common Stock offered hereby, there will be
15,545,052 shares of Common Stock outstanding and no shares of Preferred Stock
outstanding. The following summary is qualified in its entirety by reference
to the Company's Amended and Restated Articles of Incorporation (the "Articles
of Incorporation"), which is included as an exhibit to the Registration
Statement of which this Prospectus is a part.

COMMON STOCK

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

PREFERRED STOCK

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

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

PENNSYLVANIA ANTI-TAKEOVER LAWS

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

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

45
<PAGE>

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

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

TRANSFER AGENT AND REGISTRAR

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

46
<PAGE>

SHARES ELIGIBLE FOR FUTURE SALE

The market price of the Common Stock will be adversely affected by the sale
of substantial amounts of the Common Stock in the public market following this
Offering. Upon completion of this Offering, the Company will have 15,545,052
shares of Common Stock outstanding. Of these shares, the Common Stock sold in
this Offering to persons other than affiliates of the Company, will be freely
tradeable without restriction or further registration under the Act. The
remaining 11,445,052 shares of Common Stock (the "Restricted Shares") were
sold by the Company in reliance on exemptions from the registration
requirements of the Securities Act and are "restricted securities" as defined
in Rule 144 and may not be sold in the absence of registration under the
Securities Act unless an exemption is available, including an exemption
afforded by Rule 144 or Rule 701 under the Securities Act. Subject to the
contractual restrictions described below, approximately 7,845,684 Restricted
Shares will be eligible for sale ninety days after the date of this
Prospectus, subject to certain restrictions imposed by Rule 144. Certain
restrictions apply to any shares of Common Stock purchased in this Offering by
affiliates of the Company, which may be sold subject to volume limitations and
certain other conditions of Rule 144. In addition, 721,914 shares subject to
options issued under the Equity Compensation Plan will be eligible for sale
pursuant to Rule 701 under the Securities Act.

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

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

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

47
<PAGE>

UNDERWRITING

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

<TABLE>
<CAPTION>
UNDERWRITERS NUMBER OF SHARES
------------ ----------------
<S> <C>
BT Alex. Brown Incorporated............................. 1,700,000
NationsBanc Montgomery Securities LLC................... 1,200,000
Donaldson, Lufkin & Jenrette Securities Corporation..... 100,000
Furman Selz LLC......................................... 100,000
Hambrecht & Quist LLC................................... 100,000
Morgan Stanley & Co. Incorporated....................... 100,000
Boenning & Scattergood Inc. ............................ 80,000
Dominick & Dominick, Incorporated....................... 80,000
Fahnestock & Co. Inc.................................... 80,000
Genesis Merchant Group Securities....................... 80,000
Janney Montgomery Scott Inc............................. 80,000
The Ohio Company........................................ 80,000
Parker/Hunter Incorporated.............................. 80,000
Pennsylvania Merchant Group LTD......................... 80,000
Sanders Morris Mundy Inc................................ 80,000
Wessels, Arnold & Henderson, L.L.C...................... 80,000
---------
Total................................................. 4,100,000
=========
</TABLE>

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

The Company and the Selling Shareholders have granted to the Underwriters an
option, exercisable by the Representatives during the 30-day period after the
date of this Prospectus, to purchase up to an aggregate of 615,000 shares of
Common Stock at the same price per share as the initial shares of Common Stock
to be purchased by the Underwriters. The Representative may exercise such
option only to cover over-allotments in the sale of shares of Common Stock. To
the extent that the Representatives exercise such option, the Underwriters
will have a firm commitment, subject to certain conditions, to purchase the
same proportion of such additional shares of Common Stock as the number of
shares of Common Stock to be purchased and offered by such Underwriters in the
above table bears to the total number of shares in the above table.

The Company has been advised by the Representatives that the Underwriters
propose initially to offer the shares of Common Stock to the public at the
offering price set forth on the cover page of this Prospectus, and through the
Representatives to certain dealers at such price less a concession not in
excess of $.64 per share. The Underwriters may allow, and such dealers may
reallow, a concession not in excess of $.10 per share to certain other
dealers. After the Offering, the public offering price and other selling terms
may be changed.

48
<PAGE>

The Company and its officers, directors and certain shareholders have agreed
that, except for shares offered by this Prospectus, the underlying shares sold
by the Company upon the exercise of options or warrants or shares purchased in
the open market, they will not offer, sell, contract to sell, or otherwise
dispose of, directly or indirectly, any shares of Common Stock, or any
interests therein, or any securities convertible into, or exchangeable for,
shares of Common Stock, or rights to acquire the same, for a period of 180 days
from the date of this Prospectus without the prior written consent of the
Representatives, except pursuant to the Underwriting Agreement. Such consent
may be given without any public notice.

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

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

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

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

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

On August 5, 1997 the Company issued to a predecessor-in-interest to BT Alex.
Brown a warrant (the "Warrant") to purchase 103,211 shares of Series B
Preferred Stock at an exercise price of $5.45 per share in partial
consideration of its services as the placement agent for the offering by the
Company of the Series A Preferred Stock and Series B Preferred Stock. On the
same date the ABS Employees' Venture Fund Limited Partnership ("ABS") purchased
62,000 shares of Series B Preferred Stock (the "ABS Shares") at a purchase
price of $5.45 per share. (As a result of the 1.5-for-1 stock split to be
effected prior to the consummation of the offering, the Warrant will instead
become exercisable for 154,817 shares of Common Stock and the ABS Shares will
be convertible into 93,000 shares of Common Stock.) 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 during the 180 day period following the effective date of
the Registration Statement with respect to the Common Stock offered hereby. 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 are
deemed compensation of BT Alex. Brown in connection with this Offering.
Pursuant to such rules and

49
<PAGE>

regulations, the Associated Warrants will have an exercise price equal to the
initial public offering price as set forth on the cover page of this Prospectus
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 during the one year period following the
effective date of the Registration Statement with respect to the Common Stock
offered hereby.

LEGAL MATTERS

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

EXPERTS

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

ADDITIONAL INFORMATION

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

50
<PAGE>

CDNOW, INC.

INDEX TO FINANCIAL STATEMENTS

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

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To CDnow, Inc.:

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

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

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

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

F-2
<PAGE>

CDNOW, INC.

BALANCE SHEETS

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

The accompanying notes are an integral part of these statements.

F-3
<PAGE>

CDNOW, INC.

STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------------
1995 1996 1997
---------- ----------- ------------
<S> <C> <C> <C>
NET SALES.............................. $2,176,474 $ 6,300,294 $ 17,372,795
COST OF SALES.......................... 1,844,612 5,363,989 14,541,765
---------- ----------- ------------
Gross profit......................... 331,862 936,305 2,831,030
---------- ----------- ------------
OPERATING EXPENSES:
Operating and development............. 149,982 523,080 2,179,726
Sales and marketing................... 200,972 621,454 9,242,179
General and administrative............ 180,573 563,593 1,986,218
Dispute settlement (Note 7)........... -- 1,024,030 --
---------- ----------- ------------
531,527 2,732,157 13,408,123
---------- ----------- ------------
Operating loss....................... (199,665) (1,795,852) (10,577,093)
INTEREST INCOME........................ -- -- 201,650
INTEREST EXPENSE....................... (1,248) (14,556) (371,962)
---------- ----------- ------------
NET LOSS............................... (200,913) (1,810,408) (10,747,405)
ACCRETION OF PREFERRED STOCK TO
REDEMPTION VALUE...................... -- -- (410,103)
---------- ----------- ------------
NET LOSS APPLICABLE TO COMMON
SHAREHOLDERS.......................... $ (200,913) $(1,810,408) $(11,157,508)
========== =========== ============
NET LOSS PER COMMON SHARE.............. $ (1.42)
============
WEIGHTED AVERAGE NUMBER OF COMMON
SHARES OUTSTANDING.................... 7,845,684
============
</TABLE>

The accompanying notes are an integral part of these statements.

F-4
<PAGE>

CDNOW, INC.

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

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

The accompanying notes are an integral part of these statements.

F-5
<PAGE>

CDNOW, INC.

STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------------
1995 1996 1997
--------- ----------- ------------
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net loss................................ $(200,913) $(1,810,408) $(10,747,405)
Adjustments to reconcile net loss to net
cash provided by (used in)
operating activities--
Depreciation and amortization.......... 32,999 105,439 1,066,815
Provision for doubtful accounts........ -- 12,000 65,000
Common stock issued in settlement of a
dispute............................... -- 1,024,030 --
Services contributed by the founders... 120,000 117,834 --
Increase in operating assets and
liabilities--
Accounts receivable................... (56,127) (86,310) (258,974)
Prepaid expenses and other............ (26,994) (34,487) (2,401,794)
Accounts payable...................... 109,386 326,296 8,545,748
Accrued expenses...................... 58,124 68,139 450,096
Deferred revenue...................... 4,952 161,155 22,359
Deferred rent liability............... -- -- 56,717
--------- ----------- ------------
Net cash provided by (used in)
operating activities................ 41,427 (116,312) (3,201,438)
--------- ----------- ------------
INVESTING ACTIVITIES:
Purchases of short-term investments..... -- (245,641) (1,005,501)
Sales and maturities of short-term
investments............................ -- -- 248,097
Purchases of property and equipment..... (135,777) (198,985) (912,560)
--------- ----------- ------------
Net cash used in investing
activities.......................... (135,777) (444,626) (1,669,964)
--------- ----------- ------------
FINANCING ACTIVITIES:
Borrowings on term loans payable........ -- -- 218,563
Payments on term loans payable.......... -- -- (28,179)
Borrowings on notes payable............. 100,000 200,000 --
Payments on notes payable............... -- (100,000) (200,000)
Proceeds from sale of common stock and
warrants............................... -- 1,200,000 --
Proceeds from issuance of Series A Notes
and warrants........................... -- -- 5,602,706
Proceeds from sale of preferred stock... -- -- 9,252,491
Proceeds from advances due to related
parties................................ 37,683 6,341 --
Payments on capitalized lease
obligations............................ (1,529) (13,350) (64,043)
--------- ----------- ------------
Net cash provided by financing
activities.......................... 136,154 1,292,991 14,781,538
--------- ----------- ------------
INCREASE IN CASH AND CASH EQUIVALENTS.... 41,804 732,053 9,910,136
CASH AND CASH EQUIVALENTS, BEGINNING
OF PERIOD............................... 2,008 43,812 775,865
--------- ----------- ------------
CASH AND CASH EQUIVALENTS, END
OF PERIOD............................... $ 43,812 $ 775,865 $ 10,686,001
========= =========== ============
</TABLE>

The accompanying notes are an integral part of these statements.

F-6
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS

1. THE COMPANY:

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

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

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

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

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

Management's Use of Estimates

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

Net Loss Per Common Share

The Company has presented net loss per share for 1997 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 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.

Basic loss per share was computed by dividing net loss applicable to common
shareholders by the weighted average number of shares of Common Stock
outstanding during 1997. Diluted loss per share has not been presented, since
the result is anti-dilutive due to the Company's losses.

F-7
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS--(CONTINUED)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED)

Cash and Cash Equivalents

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

Short-Term Investments

At December 31, 1996 and 1997, short-term investments 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 include $87,397 of net deferred
financing costs related to the Series A Notes. Amortization of deferred
financing costs was $87,397 in 1997 and is included in interest expense.

Property and Equipment

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

Internally Developed Systems and Software

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

Revenue Recognition

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

Operating and Development

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

F-8
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS--(CONTINUED)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED)

Sales and Marketing

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

Gift Certificates and Coupons

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

Supplemental Cash Flow Information

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

Recapitalization

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

F-9
<PAGE>

CDNOW, INC.

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

Recently Adopted Accounting Pronouncements

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

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

Recently Issued Accounting Pronouncements

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

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

3. RISKS AND UNCERTAINTIES:

The Company's future results of operations involve a number of risks and
uncertainties. Factors that could affect the Company's future operating
results and cause actual results to vary materially from expectations include,
but are not limited to, dependence on key personnel, uncertain growth of
online commerce, reliance on suppliers of entertainment products, government
regulation, online commerce security risks, substantial competition, reliance
on certain vendors, risk of system failure, absence of redundant facilities,
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%, 72%
and 78% of the cost of sales in 1995, 1996 and 1997, respectively.
Additionally, the Company purchased all of its import music titles from
another vendor. This vendor

F-10
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS--(CONTINUED)
3. RISKS AND UNCERTAINTIES: (CONTINUED)

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

International Sales

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

4. PROPERTY AND EQUIPMENT:

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

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

5. INCOME TAXES:

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

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

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

F-11
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS--(CONTINUED)

5. INCOME TAXES: (CONTINUED)

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

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

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

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

6. DEBT:

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

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

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

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

F-12
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS--(CONTINUED)
consummated by June 30, 1998, the loan will convert into shares of Preferred
Stock at the price per share paid in the next private round of financing, or
at $5.45 per share if such private round is not consummated by June 30, 1998
(the Private Price), and the warrants will enable the investors to purchase
$1,155,000 of the security received upon the above conversion at a price per
share equal to 85% of the Private Price.

7. DISPUTE SETTLEMENT:

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

8. REDEEMABLE CONVERTIBLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY:

Common Stock

In December 1996, the Company sold to an investor 921,834 shares of common
stock and a warrant to purchase an additional 871,710 common shares at $1.15
per share, for aggregate consideration of $1,200,000. Using the Black-Scholes
model, the warrants were valued at $130,750. The remaining amount of the
proceeds of $1,069,250 was allocated to common stock, resulting in a value per
share of $1.16. The warrant expires on June 16, 1998. The investor received
the right to appoint two members of the Company's Board of Directors, each
having one-half vote. This right will terminate upon the consummation of the
Offering. The investor, who is a director of the Company, intends to exercise
the warrant upon consummation of this Offering, by tendering to the Company
62,473 shares received upon exercise to satisfy the $999,561 exercise price
(using an initial public offering price of $16.00 per share). This cashless
exercise will result 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 is convertible into shares of the
Company's common stock at a rate of 1.5 to 1. In addition, effective upon the
closing of the Offering, all shares of Series A and Series B

F-13
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS--(CONTINUED)
8. REDEEMABLE CONVERTIBLE PREFERRED STOCK AND
SHAREHOLDERS' EQUITY: (CONTINUED)

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

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

Equity Compensation Plan

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

Information relative to the Plan is as follows:

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

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

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

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

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

F-14
<PAGE>

CDNOW, INC.

NOTES TO FINANCIAL STATEMENTS--(CONTINUED)

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

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

<TABLE>
<CAPTION>
YEAR
ENDED
DECEMBER 31,
1997
------------
<S> <C>
Net loss 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 Offering, the warrants will convert to warrants to purchase
182,341 shares of common stock at $3.63 per share. Using the Black-Scholes
model, the warrants were valued at $170,000. This amount was recorded as a
reduction in the carrying value of the preferred stock and will be amortized
and included in the accretion to the redemption value of the preferred stock
recorded in each period.

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

9. RELATED-PARTY TRANSACTIONS:

Additional paid-in capital represents the deemed fair value of services
contributed to the Company by the founders in 1994, 1995 and 1996. During this
period, one of the founders served as President and the other was responsible
for the development of the Company's system architecture and transactions
systems. In 1994 and 1995, the founders were paid no compensation and in 1996
the founders' compensation was below market. 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 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. 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 became the exclusive retail
music store sponsor of the www.yahoo.com Web site. The Yahoo Agreement
consists of two one-year terms. The initial term began in October 1997 and
will expire on October 5, 1998. The Company can terminate the contract after
the first year by providing Yahoo with notice, as defined, and paying a
termination fee. During the first one-year term, the Company is required to
pay Yahoo $3,900,000 (of which $900,000 was paid in 1997, ) in exchange for a
specified number of page views. The Company expects to amortize the costs
associated with the Yahoo Agreement over the contract term, with the
amortization method primarily based on the rate of delivery of a guaranteed
number of impressions to be received during the contract term. The Company
will continue to evaluate the realizability of this asset and, if necessary,
write down the asset to realizable value. In connection with the Yahoo
Agreement, the Company paid Yahoo an additional $600,000 for advertising in
August and September 1997, which amount was charged to expense.

Excite Agreement

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

Other Agreements

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

F-16
<PAGE>

CDNOW, INC.

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

Leases

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

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

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

Legal Actions

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

F-17
<PAGE>

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

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

TABLE OF CONTENTS

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

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

UNTIL MARCH 6, 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.

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- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
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4,100,000 Shares

[LOGO OF CDNOW APPEARS HERE]

Common Stock

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

PROSPECTUS

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

BT ALEX. BROWN

NATIONSBANC MONTGOMERY SECURITIES LLC

February 9, 1998

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