<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
[ X ] Annual report pursuant to section 13 or 15(d) of the Securities
Exchange Act of 1934
For the fiscal year ended DECEMBER 31, 1998
----------------------------
or
[ ] Transition report pursuant to section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ____________ to ___________
COMMISSION FILE NUMBER 0-23753
CDNOW, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER.)
Pennsylvania 23-2813867
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1005 Virginia Drive
Fort Washington, Pennsylvania 19034
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: 215-619-9900
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
Title of each class: Name of each exchange on which registered:
None None
- -------------------------- -------------------------------------
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
Common Stock, no par value
----------------------------------------------------
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days: YES X NO ______
----
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
The aggregate market value of the voting stock held by non-affiliates of the
registrant is approximately $170,239,936. Such aggregate market value was
computed by reference to the closing price of the Common Stock as reported on
the National Market of The Nasdaq Stock Market on March 11, 1999. For purposes
of this calculation only, the registrant has defined affiliates as including all
directors and executive officers. In making such calculation, registrant is not
making a determination of the affiliate or non-affiliate status of any holders
of shares of Common Stock.
The number of shares of the registrant's Common Stock outstanding as of March
11, 1999 was 17,799,167.
DOCUMENTS INCORPORATED BY REFERENCE
None.
<PAGE>
CDNOW, INC.
FORM 10-K ANNUAL REPORT
For Fiscal Year Ended December 31, 1998
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PART I Page
----
<S> <C>
Item 1. Business.................................................................................... 1
Item 2. Properties.................................................................................. 14
Item 3. Legal proceedings........................................................................... 14
Item 4. Submission of Matters to a Vote of Security Holders......................................... 15
PART II
Item 5. Market for registrant's common equity and related stockholder matters....................... 16
Item 6. Selected financial data..................................................................... 17
Item 7. Management's discussion and analysis of financial condition and results of operations....... 18
Item 7A. Qualitative and quantitative disclosure about market risk................................... 25
Item 8. Financial statements and supplementary data................................................. 25
Item 9. Changes in and disagreements with accountants on accounting and financial disclosure........ 25
PART III
Item 10. Directors and executive officers of the registrant.......................................... 26
Item 11. Executive compensation...................................................................... 27
Item 12. Security ownership of certain beneficial owners and management.............................. 30
Item 13. Certain relationships and related transactions.............................................. 31
PART IV
Item 14. Exhibits, financial statement schedules, and reports on form 8-K............................ 33
</TABLE>
-i-
<PAGE>
This document contains certain forward-looking statements that are subject to
risks and uncertainties. Forward-looking statements include certain information
relating to outsourcing trends as well as other trends in the telemarketing
industry and the overall domestic economy, the Company's business strategy
including the markets in which it operates, the services it provides, its
ability to attract new clients and the customers it targets, the benefits of
certain technologies the Company has acquired or plans to acquire and the
investment it plans to make in technology, the Company's plans regarding
international expansion, the implementation of quality standards, the
seasonality of the Company's business, variations in operating results and
liquidity, as well as information contained elsewhere in this Report where
statements are preceded by, followed by or include the words "believes,"
"expects,""anticipates" or similar expressions. For such statements, the Company
claims the protection of the safe harbor for forward-looking statements
contained in the Private Securities Litigation Reform Act of 1995. The forward-
looking statements in this document are subject to risks and uncertainties that
could cause the assumptions underlying such forward-looking statements and the
actual results to differ materially from those expressed in or implied by the
statements.
PART I
ITEM 1. BUSINESS
--------
CDnow, Inc. is a leading retailer of CDs and other music-related products.
CDnow's online store offers broad selection, information, easy-to-use navigation
and search capabilities, a high level of customer service, competitive pricing
and personalized merchandising. Customers may choose from more than 390,000 CDs
and other merchandise. CDnow believes that it offers customers an online
selection of readily available products that is five to ten times greater than a
typical music retailer maintains in store. The CDnow store also assists music
buyers with approximately 430,000 music samples and 160,000 product notes,
reviews, editorials and related articles, including reviews and articles from
Rolling Stone, MTV/VH1, CMJ and CDnow's editorial staff. The CDnow store is open
24 hours a day, seven days a week and offers its customers convenient and timely
product delivery, including an overnight delivery option.
CDnow has grown rapidly since its launch in 1994. More than 983,000
customers have made purchases from 1994 through December 31, 1998. More than
686,000 of these customers made their first purchases during the year ended
December 31, 1998. Average daily visits to the CDnow store increased from
approximately 12,000 in January 1996 to approximately 308,000 in December 1998.
CDnow's net sales grew to $20.9 million for the fourth quarter of 1998 compared
to $13.9 million for the third quarter of 1998 and $7.9 million for the fourth
quarter of 1997.
CDnow believes it has a significant number of loyal customers. Despite the
rapid increase in new customers, sales to existing customers accounted for
approximately 56% of net sales in the fourth quarter of 1998.
CDnow began as a sole proprietorship in February 1994 and became a
Pennsylvania corporation in April 1995. CDnow's principal offices are located
at:
CDnow, INC.
1005 Virginia Avenue
Fort Washington, Pennsylvania 19034
(215) 619-9900
RECENT DEVELOPMENTS
Proposed Merger with N2K Inc. On October 22, 1998, CDnow and N2K Inc., a
Delaware corporation, entered into an Agreement and Plan of Merger which was
amended and restated on January 29, 1999. The parties will create a new public
company to be initially named CDnow/N2K, Inc. ("CDnow/N2K"). The merger
agreement provides for the merger of wholly-owned subsidiaries of CDnow/N2K into
each of CDnow and N2K Inc. CDnow and N2K will each survive the merger and become
wholly-owned subsidiaries of CDnow/N2K. In the merger, each outstanding share of
common stock of CDnow will be converted into one share of CDnow/N2K and each
outstanding share of common stock of N2K will be converted into .83 shares of
CDnow/N2K. There is no collar on the exchange ratio. As a result, the
shareholders of CDnow would own approximately 60% of the combined company and
the stockholders of N2K Inc. would own approximately 40% of the combined
company. The closing stock prices on October 22, 1998, were $9.4375
-1-
<PAGE>
for CDnow and $5.50 for N2K Inc. The consummation of the merger is subject to
many conditions and no assurance can be given that the Merger will be
consummated. A copy of the merger agreement, as amended, is attached as Appendix
I to the Company's Definitive Proxy Statement filed on February 17, 1999.
INDUSTRY OVERVIEW
CDnow believes that a significant opportunity exists for the online retail
sale of music on the Internet. According to the International Federation of the
Phonographic Industry, worldwide sales of pre-recorded music and music videos in
1997 were approximately $38.1 billion, of which one-third was in North America.
Online music retailers currently account for a small but growing portion of
total sales. Jupiter Communications estimates that sales of pre-recorded music
over the Internet will grow on a worldwide basis from approximately $47 million
in 1997 to $1.6 billion in 2002.
A number of characteristics of online music retailing make the online sale
of pre-recorded music particularly attractive relative to traditional retail
stores. The online environment 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. Online
retailers can more easily obtain extensive 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,
online 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, we believe that a typical music store may carry up to 12,000 merchandise
units and a megaspore may carry up to 50,000 merchandise units compared to the
more than 375,000 merchandise units offered 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 Sounds can, 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.
CDnow 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 1996 to
approximately 48% of sales, or approximately $5.9 billion, in 1997. CDnow
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.
THE CDNOW ONLINE RETAIL STORE
CDnow strives to make the CDnow store informative and authoritative.
Customers may easily learn about, discover and purchase CDs and other music-
related products. CDnow designed its store to be intuitive and easy to use.
CDnow's store, allows customers to find and order a CD with a minimum of effort.
CDnow offers many attractive features for music shoppers. Customers can
focus their searches, browse among top sellers and other featured titles, read
reviews, listen to music samples, participate in promotions and check order
status. New users may access an information page that CDnow specifically
designed to give shoppers a quick understanding of the site and its many
features.
-2-
<PAGE>
Merchandising CDnow currently offers:
. more than: additional products, including
. 325,000 CDs, . T-shirts,
. 40,000 movies, . DADS and
. 10,000 music videos and . CD-ROMS.
To encourage purchases, CDnow features various promotions on a rotating
basis throughout the store. CDnow adjusts pricing strategies and tactics as
necessary to maintain competitiveness. CDnow generally prices recent releases
and popular titles aggressively. CDnow reduces shipping costs for larger orders
to encourage customers to purchase multiple titles.
Personalization. CDnow launched its My CDnow service in September 1998 to
provide customers with customized and personalized features. CDnow believes that
these features will increase customer retention, likelihood of purchases and
average order sizes. CDnow provides customers with:
. recommendations using artificial intelligence technology;
. the ability to rate albums the customer owns;
. a "wish list" capability to keep track of albums the customer intends
to purchase at a later date;
. a "gift registry" that allows visitors to purchase albums as gifts for
participating customers;
. automatic log in;
. one-click order feature;
. a "favorite artists" list;
. order history; and
. frequent buyer points and credit information.
Searching. Through CDnow's "Fast find" search engine, customers can quickly
and easily navigate the store to find CDs and other products of interest.
Customers can search for products based on artist, album title, song title,
record label, musical genre or release date for new releases. CDnow recently
upgraded its search engine using Verity, Inc.'s K. search technology. This
technology helps customers make successful searches even with incomplete or
misspelled artists' names. By clicking on the album title, a visitor can browse
among CDnow's database of reviews, cover art, sound samples and album notes.
Through CDnow's "Lexicon" feature, customers can browse alphabetical lists based
on artists, types of products, record labels and album cover art.
Content and Music Discovery. CDnow believes that effective use of content
encourages purchases by customers who may be browsing the site without a
specific title in mind. CDnow's online store contains music samples, extensive
information with regard to titles, reviews, editorials, ratings and articles on
music topics and other information. To help customers browse and discover CDs,
the CDnow store is organized into seven music spaces:
. Rock/Pop . Country/Folk . Children
. Jazz/Blues . World/New Age . Classical
. Urban/Electronic
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 music samples and purchase CDs recommended by CDnow.
Since February 1998, to enhance the attractiveness of its online store to
customers, CDnow has entered into agreements with:
. MTV/VH1-CDnow may use the MTV and VH1 brand names in conjunction with
the display of MTV and VH1 content, music reviews and music news.
-3-
<PAGE>
. Rolling Stone Network-CDnow may use Rolling Stone's brand name in
conjunction with the display of cover art and excerpts of feature
stories, record reviews, artist biographies and music news from
current and past editions of Rolling Stone magazine.
. The CMJ New Music Report and CMJ New Music Monthly-CDnow has access to
more than 30,000 reviews from CMJ.
. Billboard magazine top seller music charts.
Custom Compilations. CDnow offers customized CDs through its stores as a
result of its acquisition of supersonic Boom, Inc. Customers can build full-
length CDs from a collection of individual songs from major artists. CDnow
manufactures and ships each custom CD from its Fort Washington facility. The
customer can choose from a catalogue of more than 60,000 songs to build his or
her custom CD. CDnow is currently offering a Valentine's Day collection, and
intends to offer more collections in the future. In addition, CDnow sells custom
CDs in volume to other companies for use by such companies in promotions they
run from time to time.
Purchasing. Once a customer selects a CD, he or she simply clicks on the
price to add products, including advance orders of yet-to-be released products,
to their virtual shopping carts. Customers can add and remove products from
their shopping carts as they browse, prior to making a final purchase. The
shopping cart page displays each item that has been placed in the cart,
including title, price and any applicable discount. To purchase, customers
select the shipping and payment methods, if desired, gift wrapping and a
personalized message. Then the customer clicks on the "Place Order" button.
Customers can also create a wish list of products they may want to purchase on
future visits. The wish list is a special section of the My CDnow service where
items may be stored between visits.
Payment. Customers may pay for orders with credit cards, personal checks or
money orders. For convenience, CDnow enables customers to store credit card
information on CDnow's secure server, thereby avoiding the need to re-enter this
information when making future purchases. CDnow offers customers a variety of
shipping options, including overnight delivery. CDnow automatically confirms
each order by e-mail within minutes after the final order is placed and
subsequently confirms shipment of each order by e-mail. CDnow offers a money-
back return policy.
Distribution and Filling Orders. CDnow's inventory is owned and held by
outside vendors who ship directly to CDnow's 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. CDnow electronically transmits orders
to its outside vendors at least once daily. These vendors ship orders using a
CDnow label and invoice, in most cases within a day after an order is placed
with CDnow.
Multilingual Capabilities. CDnow generated approximately 22% of its net
sales from international markets for the year ended December 31, 1998. CDnow
offers foreign 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.
CDnow currently offers versions of its online store in the following foreign
languages:
. Spanish . Portuguese
. French . Japanese
. German . Dutch
. Italian
MARKETING AND PROMOTION
CDnow designed its marketing and promotion strategy to broaden awareness of
the CDnow brand, increase customer traffic to CDnow's Web site and encourage new
and repeat purchases. CDnow markets and promotes its brand using marketing
agreements, online and traditional advertising, CDnow's Cosmic Credit Program,
and direct marketing. CDnow believes that using these multiple marketing
channels reduces reliance on any one source of customers, maximizes brand
awareness and lowers average customer acquisition cost.
-4-
<PAGE>
MARKETING AGREEMENTS
CDnow believes that marketing agreements with major Internet service and
content providers and global music-oriented media companies can be a significant
source of new customers. CDnow has the following marketing agreements and
arrangements:
Yahoo! On September 2, 1998, the CDnow entered into a global merchant
agreement with Yahoo! Inc., extending and expanding upon earlier agreements with
Yahoo! of August 1997 and March 1998. Under the Yahoo! agreement:
. CDnow continues to be granted music-retail exclusivity on music-related
search results pages on Yahoo!'s main directory, www.yahoo.com;
. CDnow is integrated into other areas of the Yahoo! Service, including
Yahoo! Mail;
. CDnow becomes the premier music retailer on many of Yahoo!'s
international sites;
. the term of the Yahoo! agreement ends on December 31, 2000. CDnow may
terminate the Yahoo! agreement earlier upon payment of a specified
termination fee; and
. coincident with the Yahoo! agreement, Yahoo! agreed to purchase up to $2
million in newly issued shares of CDnow common stock, of which $1
million was invested in September 1998, and the remainder is to be
invested as of December 31, 1999.
WebCrawler. CDnow and Excite have entered into an agreement under which
CDnow is designated as the exclusive online music retailer within Excite's
WebCrawler service. Excite has granted CDnow the exclusive right to sponsor
targeted links, advertising banners and specific keywords for online retail
music purchases within WebCrawler. The 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 Excite's ability to include advertising for other
music retailers on the WebCrawler service.
GeoCities. CDnow and GeoCities, Inc. have entered into an agreement under
which CDnow is 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 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 CDnow's Web site. The initial term of the agreement expired in February 1999,
and has been extended for two months while the companies discuss terms for
renewing the agreement.
Lycos. CDnow and Lycos have entered into an agreement designating CDnow as
the exclusive music retailer for the Lycos and Tripod Web sites. Lycos has
granted CDnow the exclusive right to sponsor targeted links, relevant content
and promotions throughout the Lycos and Tripod Web sites. In addition, CDnow has
a right-of-first-refusal regarding any music retail opportunities on the Lycos
and Tripod Web sites. The agreement requires Lycos and Tripod to deliver a
minimum number of CDnow-branded page views during each year of the term, and
precludes Lycos and Tripod from entering into new agreements regarding
advertising for other music retailers throughout the Lycos and Tripod Web sites.
The agreement expires in August 2001.
Lycos Bertelsmann. CDnow and Lycos Bertelsmann have entered into an
agreement designating CDnow as the exclusive music retailer for Lycos
Bertelsmann's Web services in various European countries, and CDnow has been
granted the exclusive right to sponsor targeted Links, advertising banners,
specific keywords, and relevant content on the Lycos Bertelsmann sites. In
addition, CDnow has a right-of-first-refusal regarding any opportunities that
Lycos Bertelsmann offers to any other entity that principally sells music
products. The agreement requires Lycos Bertelsmann to deliver a minimum number
of page views during each year of the term. The term of the agreement expires in
April 2001.
Rolling Stone Network. CDnow and Rolling Stone Network have entered into an
agreement designating CDnow as the only World Wide Web-based music retailer that
may use the Rolling Stone brand name in conjunction
-5-
<PAGE>
with the display of cover art and excerpts of feature stories, record reviews ,
artist biographies and music news from current and past editions of Rolling
Stone magazine. In addition, CDnow is the exclusive online music retailer on the
JAMtv and Rolling Stone Network Web sites with the exclusive right to sponsor
targeted links, relevant content and promotions. The agreement also requires the
delivery of a minimum number of page views on the JAMtv and Rolling Stone
Network Web sites during each year of the agreement. CDnow has also agreed to
purchase targeted print, radio broadcast and other promotional advertising from
JAMtv and Straight Arrow, the publisher of Rolling Stone magazine.
MTV/VH1. Under the MTV/VH1 alliance, CDnow is the premier online retailer
of recorded music on the MTV and VH1 cable television channels with preferred
advertising rights with respect to special events and promotions, including
exclusive online sponsorship of the 1998 Video Music Awards. The alliance with
MTV/VH1 entitles CDnow to use the MTV and VH1 brand names in conjunction with
the display of MTV and VH1 content, music reviews and music news and provides
CDnow with integrated links from the MTV and VH1 Web sites. CDnow also has
certain rights of first refusal to be the exclusive online music retailer of the
1999 and 2000 Video Music Awards with a portion of its minimum annual payments
applicable, at CDnow's option, to such sponsorship.
ONLINE AND TRADITIONAL ADVERTISING
CDnow promotes its brand using a combination of online and traditional
advertising. CDnow advertises on the sites of major internet content and service
providers, including Alta Vista, Microsoft Network and targeted music-related
sites such as Billboard Magazine's online site. As part of these arrangements,
CDnow 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 CDnow to quickly adjust its advertising
plans in response to seasonal and promotional activities.
CDnow believes that traditional advertising is a key ingredient in building
brand recognition and promoting the benefits of online retail shopping.
Traditional advertising can be an effective means of promoting widespread brand
awareness and attracting traditional retail consumers to CDnow's online store
including consumers with little or no history of online purchases. CDnow's
traditional advertising efforts have included radio advertising in major
markets, print advertising in music-related publications and television
advertising. CDnow has purchased television advertising on such programs as
MTV's 1998 Video Music Awards, VH1's Flashback Week and the 1998 and 1999 Grammy
Awards.
COSMIC CREDIT PROGRAM
Through its Cosmic Credit Program, as of December 31, 1998, CDnow has
arrangements with over 145,000 small Web sites, typically fan sites devoted to
particular music artists. Approximately 135,000 of these sites have enrolled
since December 31, 1997. CDnow provides Cosmic Credit sites with embedded
hyperlinks through which potential customers can immediately be connected to the
CDnow site. CDnow pays Cosmic Credit participants commissions in store credit or
cash based upon the dollar amount of purchases made by persons using the link.
These highly focused, music-oriented sites are a significant source of traffic
and new customers for CDnow. Cosmic Credit participants sign up online and are
listed inside the CDnow store to assist CDnow's customers in finding these
sites. CDnow rewards the best Cosmic Credit sites with special incentives.
DIRECT MARKETING
CDnow uses direct marketing techniques to target new and existing customers
with communications and promotions. CDnow sends a personalized e-mail
newsletter, The CDnow Update, to its customers. This e-mail newsletter includes
purchase recommendations based on demonstrated customer preferences and prior
purchases. The newsletter also includes more general information concerning new
releases and promotions. In addition, CDnow targets e-mail communications to
persons who have registered at the CDnow store but have not made purchases, to
new customers and to customers who have not made recent purchases. Through these
customized programs, CDnow hopes to further stimulate demand, increase repeat
purchases, build customer loyalty, and better understand customer preferences.
CUSTOMER SERVICE
-6-
<PAGE>
CDnow believes that a high level of customer service and support is
critical to retaining and expanding its user base. CDnow customer service
representatives are available 24 hours a day on weekdays and from 10:00 a.m. to
6:00 p.m. Eastern Time on weekends to provide assistance via e-mail, phone or
fax. CDnow strives to answer all inquiries within 24 hours. CDnow currently has
approximately 75 customer service representatives, including representatives
fluent in nine foreign languages. Customer service representatives handle
questions about orders, assist customers in finding CDs and other music-related
products and register a customer's credit card information over the telephone.
Customer service representatives are a valuable source of feedback regarding
user satisfaction.
DISTRIBUTION AND FILLING ORDERS
CDnow does not carry an inventory and relies exclusively on third party
vendors for distribution and filling orders. CDnow believes that this
distribution strategy allows it to offer extensive selection while avoiding the
high fixed costs and capital requirements associated with owning and warehousing
product inventory and the significant operational effort associated with same-
day shipment. CDnow has experienced a return rate of approximately one percent
of all merchandise sold.
Since August 1994, CDnow has primarily used Valley Media to fill orders for
CDs, cassettes and vinyl records produced in the U.S. CDnow transmits data to
Valley through a secure network to ensure customer security and data integrity.
Valley picks, packs and ships customer orders and charges CDnow for merchandise,
shipping and handling. In most cases, products are shipped within two business
days after an order is placed with CDnow. CDnow performs customer billing
through a third-party credit card processor. To date, Valley has satisfied
CDnow's requirements on a timely basis. For the twelve months ended December 31,
1998, payments to Valley accounted for approximately 85% of CDnow's cost of
sales. For the year ended December 31, 1997, payments to Valley accounted for
approximately 81% of CDnow's cost of sales. CDnow's agreement with Valley
expires in June 1999. Valley may terminate its existing agreement with CDnow
upon 30 days' written notice, if Valley discontinues filling orders for all of
its online service customers.
Since May 1997, CDnow has used MSI to fill orders for CDs produced by non-
U.S. labels. Beginning in July 1998, CDnow has also utilized MSI to provide an
additional 60,000 international titles from a fulfillment center in the
Netherlands servicing primarily European markets.
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, CDnow 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. CDnow uses Oracle 7.3.3 and 7.3.4 as the technology for database
management. In December 1997, CDnow 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. CDnow'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 CDnow online store, 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 changes to the CDnow online store and
minimizing the engineering required to maintain a growing amount of items and
content. CDnow's technology also enables other internet sites with different
formats to integrate CDnow store elements such as search, artist and 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 CDnow has
-7-
<PAGE>
developed marketing arrangements and to Cosmic Credit sites. These technologies
and tools and the switchboard system and linking interface allow the linking of
external internet sites, banners, and promotions to items and functions
contained in the CDnow store. CDnow's Online Marketing group uses proprietary
tools to manage the marketing and Cosmic Credit relationships in an efficient
manner. CDnow has developed similar systems and tools for its Customer Service
department. The ability to manage customer accounts and orders enables CDnow's
Customer Service department to add capacity effectively and communicate
efficiently, thereby responding to most inquiries within 24 hours. These systems
automate many routine communications and allow customers to better manage their
accounts and orders.
Fault Tolerance and Scalability. CDnow's hardware servers, storage systems,
internet connections and networks allow its online systems to operate
continuously and enable it to maintain a 24-hour-a-day, seven-day-a-week retail
store. CDnow runs its Oracle databases and Web servers on a series of Sun
Enterprise 4000 servers which are able to respond to software or hardware
failure. CDnow maintains dedicated connections to the internet lines provided by
multiple internet service providers. This technology, combined with the
architecture of the systems, allows CDnow to increase capacity by adding new
components or servers while maintaining performance and cost effectiveness.
CDnow uses both proprietary and commercially available tools to monitor and
manage these systems with minimal operator participation.
Security. CDnow employs both commercial and proprietary firewalls
integrated into the architecture of its system to keep its internet connections
secure. CDnow uses the Netscape SSL Commerce Server for secure electronic
transactions over the internet and uses proprietary electronic data interchange
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. CDnow continually evaluates emerging technologies
and new developments in many areas including electronic commerce, database
management and networking. CDnow is currently evaluating technologies that allow
for the digital distribution of music recordings. Since April 1997, CDnow has
been using collaborative filtering to make personal music recommendations in its
customer newsletter, The CDnow Update. CDnow makes online recommendation
technology available to its shoppers through the Album Advisor feature, which
was introduced in January 1998.
COMPETITION
The online commerce market is new, rapidly evolving and intensely
competitive. CDnow expects competition to further intensify. Barriers to entry
are minimal, and a competitor can launch a new site at a relatively low cost. In
addition, the broader retail music industry is intensely competitive. CDnow
currently competes with a variety of companies, including:
. online vendors of music, music videos and other related products;
. online service providers which offer music products directly or in
cooperation with other retailers;
. traditional retailers of music products, including specialty music
retailers;
. other retailers that offer music products, including mass merchandisers,
superstores and consumer electronic stores; and
. non-store retailers such as music clubs. Many of these traditional
retailers also support dedicated Web sites that compete directly with
CDnow.
CDnow believes that the principal competitive factors in its online market
are brand recognition, selection, price, effectiveness of advertising and other
customer acquisition efforts, variety of value-added services, ease of use, site
content, quality of service and technical expertise. Many of CDnow's current and
potential competitors have longer operating histories, larger customer bases,
greater brand recognition and significantly greater financial, marketing and
other resources than CDnow. CDnow is aware that certain of its competitors have
adopted and may continue to adopt aggressive pricing or inventory availability
policies and devote substantially more resources to Web site and systems
development than CDnow. Increased competition may result in reduced operating
margins, loss of market share and a diminished brand franchise.
There can be no assurance that CDnow 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
-8-
<PAGE>
CDnow. 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 CDnow. In addition, many companies that allow access
to transactions through network access or Web browsers promote CDnow's
competitors and could charge CDnow a substantial fee for inclusion.
INTELLECTUAL PROPERTY
CDnow regards its trademarks, trade secrets and similar intellectual
property as valuable to its business, and CDnow relies on trademark and
copyright law, trade secret protection and confidentiality and/or license
agreements with its employees, partners and third parties to protect its
proprietary rights. There can be no assurance that the steps taken by CDnow will
be adequate to prevent misappropriation or infringement of its intellectual
property.
CDnow has licensed in the past, and expects that it may license in the
future, some of its proprietary rights, such as trademarks or copyrighted
material, to third parties. While CDnow 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 CDnow's proprietary rights or reputation, which could have a material adverse
effect on CDnow. See "Risk Factors-We may not be able to protect our proprietary
rights and may infringe on the proprietary rights of others, both of which would
have a material adverse effect on our business."
EMPLOYEES
As of December 31, 1998, CDnow had 191 full-time and 20 part-time
employees. CDnow also employs independent contractors and other temporary
employees in its editorial, operations and administrative functions. None of
CDnow's employees is represented by a labor union under a collective bargaining
agreement. CDnow considers its employee relations to be good. Competition for
qualified personnel in CDnow's industry is intense, particularly among software
development and other technical staff. CDnow believes that its future success
will depend in part on its continued ability to attract, hire and retain
qualified personnel. See "Risk Factors-Our success is dependent on our key
personnel, who may decide not to continue to work for CDnow/N2K, and we may not
be able to hire enough qualified personnel to meet our hiring needs."
RISK FACTORS
WE HAVE A HISTORY OF LOSSES AND WE EXPECT FUTURE LOSSES.
CDnow has incurred significant losses since inception. We cannot assure
that we will ever be profitable. CDnow had net losses of $10.7 million for the
year ended December 31, 1997 and $43.8 million for the year ended December 31,
1998. As of December 31, 1998, CDnow had accumulated losses of $55.1 million. We
anticipate that we will continue to incur substantial expenses for the following
purposes:
. marketing and promotion, including agreements with internet content and
service providers;
. web site development and enhancement; and
. reorganization and development of our combined administrative organization.
We hope that the combination of our business with N2K Inc., pursuant to our
proposed merger, will enable us to reduce our combined expenses so that they are
significantly less than the sum of the expenses we would incur if we continue as
separate entities. However, we cannot assure that we will be successful in our
effort to reduce our combined expenses. Even if we are able to realize these
cost savings as a result of the merger, we expect to incur substantial operating
losses for the foreseeable future. Moreover, because our products have low gross
margins, we must generate substantially increased net sales to achieve
profitability.
IF CUSTOMERS DO NOT ACCEPT ELECTRONIC COMMERCE, WE WILL BE MATERIALLY ADVERSELY
AFFECTED.
Customers may not accept the use of electronic commerce. If electronic
commerce does not continue to grow or grows more slowly than expected, we will
be materially adversely affected. Our long term success is dependent on
widespread consumer acceptance of electronic commerce. There are a number of
factors that could prevent or delay consumer acceptance, including the
following:
-9-
<PAGE>
. electronic commerce is at an early stage of acceptance;
. the necessary network infrastructure for substantially increased purchase
volumes may not be adequately developed;
. increased government regulation may adversely impact the viability of
electronic commerce;
. insufficient availability of telecommunications services or changes in
telecommunication services could result in slower response times, which
could adversely impact electronic commerce; and
. adverse publicity and consumer concern about the security of electronic
commerce transactions could discourage its acceptance and growth.
WE COMPETE WITH AMAZON.COM AND OTHER ONLINE RETAILERS AND TRADITIONAL MUSIC
RETAILERS WHO MAY BE MORE SUCCESSFUL THAN WE ARE IN ATTRACTING AND RETAINING
CUSTOMERS.
Competition in our business is intense. We will be materially adversely
affected if we cannot compete successfully.
Barriers to entry in our business are minimal and a competitor can launch a
new site at relatively low cost. We have always confronted a large number of
online competitors. In June 1998, Amazon.com launched an online music business
and, based on its announced third quarter 1998 revenue, became the largest
online retailer of music and music related products although our combined
revenues would have made us larger for this period. Other large entities,
including Tower Records, Columbia House and Best Buy, have launched online music
retailing efforts. Moreover, competition in the broader retail music industry
also affects our business. Among our competitors are the following:
. online vendors of music, music videos and other related products;
. online service providers that offer music directly or in cooperation with
other retailers;
. traditional retailers of music products, including specialty music
retailers;
. other retailers that offer music products, including mass merchandisers,
superstores, discount stores and consumer electronic stores;
. non-store retailers such as music clubs; and
. record companies and other entities who may make available digitally
downloaded music.
Many of our competitors have much greater financial, marketing and other
resources than ours. This may place us at a disadvantage in responding to our
competitors' pricing strategies, technological advances, advertising campaigns
and other initiatives. In addition, recently developed technologies have
increased competitive pressures on CDnow. For example, applications that can
indicate which online site has the lowest price for a particular title could
direct customers to our competitors' sites. We cannot assure that we will
compete successfully in this environment.
WE RELY ON MARKETING AGREEMENTS AND ONLINE AND TRADITIONAL ADVERTISING WHICH MAY
NOT GENERATE THE ANTICIPATED NUMBER OF NEW CUSTOMERS EVEN THOUGH WE MUST MAKE
SUBSTANTIAL PAYMENTS UNDER THESE AGREEMENTS.
If we are unable to further develop and successfully administer our
marketing agreements and advertising campaigns, we will be materially adversely
affected. To attract customers, we entered into agreements with online search
and other internet service providers. We also utilize online advertising and
traditional advertising. If these alliances and advertising campaigns, in which
we make significant investments, do not generate the expected number of new
customers or if we are unable to renew on successful terms marketing agreements,
we will be materially adversely affected.
We may enter into additional marketing agreements in the future. The
success of these relationships depends on the amount of increased traffic we
receive from the internet sites of these online search and other internet
service providers. We cannot assure that these arrangements will generate the
expected number of new customers. Moreover, we may not be able to renew on
successful terms marketing agreements or enter into new agreements with others.
In addition, we cannot assure that our advertising campaigns will be successful.
-10-
<PAGE>
WE RELY ON VALLEY MEDIA, INC. TO FILL OUR CUSTOMERS' ORDERS. IF WE ARE UNABLE TO
MAINTAIN THIS RELATIONSHIP OR FIND A REPLACEMENT ON THE SAME OR BETTER TERMS,
THEN OUR ABILITY TO DISTRIBUTE TO OUR CUSTOMERS IN A COST EFFICIENT MANNER WILL
BE IMPEDED.
If our relationship with Valley Media, Inc. is unexpectedly terminated, we
could be materially adversely affected, particularly if the termination occurs
during the fourth quarter of the calendar year, a period when a high percentage
of music sales are made. Orders for recorded music items for CDnow are primarily
filled by Valley Media. We cannot fill customers' orders on our own. Therefore,
our business is dependent on maintaining the relationship with Valley Media or
on establishing new relationships with companies who provide similar services.
We cannot assure that we will maintain the relationship with Valley Media or
find a replacement vendor capable of filling our customers' orders on
satisfactory terms.
CDnow's agreement with Valley Media terminates in June 1999. Also, if
Valley Media decides to stop providing services to all of its online customers,
Valley Media may terminate its agreements with us on 30 days' written notice. To
date, Valley Media has satisfied our requirements on a timely basis. However, if
Valley Media is unable to satisfy our increasing requirements on a timely basis,
or terminates or chooses not to renew its current agreements with us, we will be
materially adversely affected.
We also rely on single vendors to fill orders with respect to
internationally manufactured recorded music items and other product lines that
we carry. If we lose any one vendor, our sales of the product line serviced by
the vendor could be materially adversely affected. While we attempt to negotiate
multi-year contracts with vendors to ensure the availability of merchandise, we
cannot assure that our vendors will continue to sell merchandise to us on
acceptable terms. Moreover, we cannot assure that, if necessary, we could
establish relationships with suitable vendors on a timely basis and on
acceptable commercial terms. If we are unable to maintain suitable relationships
with vendors, we will be materially adversely affected.
WE COULD EXPERIENCE SYSTEM FAILURES AND CAPACITY CONSTRAINTS WHICH WOULD
INTERFERE WITH ACCESS TO OUR ONLINE STORE.
Any system interruptions that cause our online stores to be unavailable or
that reduce our ability to process transactions could materially adversely
affect us. Further, if we do not appropriately expand and upgrade our systems
and infrastructure, we will suffer a material adverse affect. Our business
depends on the efficient and uninterrupted operation of our computer and
communications hardware systems. Interruptions could result from natural
disasters as well as power loss, telecommunications failure and similar events.
We have had system interruptions in the past and expect further interruptions in
the future. We do not have fully redundant systems or a formal disaster recovery
plan. Additionally, we may not carry sufficient business interruption insurance
to compensate us for losses that may occur.
As traffic in our online stores continues to increase, we must expand and
upgrade our technology, transaction processing systems, network infrastructure
and customer service capabilities. We may not be able to accurately project the
rate of increase in our online stores. In addition, we may not be able to expand
and upgrade our systems and infrastructure and customer service capabilities to
accommodate increased use of our online stores.
WE MAY BE NEGATIVELY AFFECTED BY SECURITY BREACHES WHICH COULD AFFECT OUR
ABILITY TO MAINTAIN SECURITY OF OUR CUSTOMERS' INFORMATION AND OUR ABILITY TO
ATTRACT AND RETAIN CUSTOMERS.
If security breaches of our customer information or other information
occurs, we may be materially adversely affected. The security of proprietary
information is a concern in our business. If we are unable to protect our
customer or other information, concern regarding the security of confidential
information may deter consumers from shopping with us or engaging in online
commerce, and we could be materially adversely affected. We believe that concern
regarding the security of confidential information transmitted over the
internet, such as credit card numbers, prevents many potential customers from
engaging in online transactions.
To protect confidential information, we rely on encryption technology,
which transforms information into a "code" designed to be unreadable by third
parties and authentication technology which utilizes passwords and other
-11-
<PAGE>
information to prevent unauthorized persons from accessing a customer's
information. These measures cannot guarantee that physical or electronic break-
ins, viruses or similar problems will not occur. If a person circumvents our
security measures, he or she could misappropriate proprietary information or
cause interruptions in our operations. Security breaches that result in access
to confidential information could damage our reputation and expose us to a risk
of loss or liability. We may be required to make significant expenditures and
expend considerable personnel effort to protect against security breaches or
remedy problems caused by these breaches. We cannot assure that our security
measures will prevent such breaches.
WE RELY ON INTERNALLY AND EXTERNALLY DEVELOPED SOFTWARE, WHICH IF NOT
CONTINUALLY UPDATED WILL MATERIALLY ADVERSELY AFFECT OUR ABILITY TO RETAIN AND
ATTRACT CUSTOMERS.
If we do not continually improve our internally and externally developed
software, we will be materially adversely affected because our competitors may
provide superior services to our current and potential customers. We use
internally and externally developed software for our online stores, search
engines and almost all aspects of our transaction processing and order
management systems. As our business grows, we will have to modify internally
developed software and upgrade or acquire externally developed software to
accommodate increased traffic in our online stores or increased volume in our
transaction processing order management systems. If we fail to make
modifications when needed, we may experience any one or more of the following
undesirable effects:
. unanticipated system disruptions;
. slower response time;
. impaired quality and speed of filling orders;
. degradation in customer service; or
. delays in reporting accurate financial information.
Any of these events could have a material adverse effect on us.
WE MAY BE MATERIALLY ADVERSELY AFFECTED BY RAPID TECHNOLOGICAL CHANGE IF WE ARE
UNABLE TO RESPOND TIMELY AND EFFECTIVELY.
If we are not able to successfully respond to online commerce's rapid
technological change, we will be materially adversely affected. Our success will
depend upon our ability to respond to such developments in a timely and cost-
effective manner. For example, new technology which could be used for the
illegal electronic distribution of recordings and other material could have a
detrimental effect on our business by reducing the market for our products.
Although the Recording Industry Association of America, in concert with various
recording and technology companies, has launched an initiative to develop a
technology for the digital distribution of music, this initiative may not
succeed in reducing the risk of illegal distribution of recordings in digital
form or in any form. Similarly, technological developments could provoke
significant changes to the way in which recorded music is produced and
distributed, thereby requiring us to acquire, implement and adopt new technology
and distribution systems.
WE MAY NOT BE ABLE TO PROTECT OUR PROPRIETARY RIGHTS AND MAY INFRINGE ON THE
PROPRIETARY RIGHTS OF OTHERS, BOTH OF WHICH WOULD HAVE A MATERIAL ADVERSE EFFECT
ON OUR BUSINESS.
Our efforts to establish and protect our proprietary rights may be
inadequate to prevent misappropriation or infringement of our proprietary
property. Some of our proprietary rights are licensed to third parties. There is
a risk that these licensees will take actions that materially adversely affect
the value of our proprietary rights or reputation.
It is possible that we may be the subject of infringement claims because of
our relationship with the CDnow Cosmic Credit sites and use of unlicensed
information. CDnow established a network of links with numerous small online
sites through its Cosmic Credit program. These online sites, which typically are
fan sites devoted to popular musical artists, permit customers to connect to
CDnow's site through an embedded hyperlink. CDnow gives Cosmic Credit
participants commissions in store credit or cash based upon the dollar amount of
purchases made by persons using the link. Many of the Cosmic Credit sites are
not officially sanctioned by the artists on whom the sites are focused.
Moreover, many of the sites do not have licenses for the use of any proprietary
intellectual property which they display on their sites. In addition, CDnow's
primary provider of artist and music-related information, including photographs,
articles and reviews advised CDnow that it may not have a license to distribute
some of this information.
-12-
<PAGE>
From time to time, we have been subject to claims alleging infringement of
intellectual property of others. To date, we have not suffered material harm
from these claims. However, such claims could have a material adverse effect on
us in the future, particularly if we are unsuccessful in defending against them.
WE ARE SUBJECT TO GOVERNMENT REGULATION AND LEGAL LIABILITIES WHICH MAY BE
COSTLY AND MAY INTERFERE WITH OUR ABILITY TO CONDUCT BUSINESS.
If we become subject to claims that we have violated U.S. or foreign laws,
we could be materially adversely affected even if we successfully defend against
these claims. Moreover, new laws that impose restrictions on our ability to
follow current business practices or increase our costs of doing business could
also materially adversely affect us. Laws and regulations directly applicable to
online commerce or internet communications are becoming more prevalent. These
laws and regulations could expose us to substantial liability.
The most recent session of Congress and the European Union have recently
enacted laws and regulations concerning the internet, and there is uncertainty
regarding their marketplace impact. In addition, various jurisdictions already
have enacted laws covering intellectual property, privacy, libel and taxation
that are not specifically directed to online commerce but that could impact our
business.
Legal rights to use some content on the internet are not clearly settled.
Our ability to rely on exemptions or defenses under copyright law is uncertain.
We believe that our use of third party material in our online stores is
permitted under current provisions of copyright law. It is possible that the law
could develop in a fashion that would prohibit us from having rights to
downloadable music samples as well as artist, record and other information. We
could be materially adversely affected if we are no longer able to use this
information.
In addition, the growth of the internet, coupled with publicity regarding
internet fraud, may lead to the enactment of more stringent consumer protection
laws. These laws may impose additional burdens on our business.
WE MAY BE SUBJECT TO LEGAL LIABILITY FOR PUBLISHING OR DISTRIBUTING CONTENT OVER
THE INTERNET WHICH MAY BE COSTLY FOR US TO DEFEND.
We may be subject to legal claims relating to the content in our online
stores, or the downloading and distribution of the content. For example, persons
may bring claims against us if material deemed inappropriate for viewing by
young children can be accessed from our online stores. Claims could also involve
matters such as defamation, invasion of privacy and copyright infringement.
Online services have been sued in the past (sometimes successfully) based on the
content of material on the internet. Our insurance may not cover claims of this
type, or may not provide sufficient coverage. We could suffer a material adverse
effect if costs resulting from these claims are not covered or significantly
exceed our coverage.
WE MAY BE SUBJECT TO LIABILITY FOR SALES AND OTHER TAXES.
We could suffer a material adverse effect if sales and similar taxes are
imposed on our business, or if penalties are assessed on us for past nonpayment
of these taxes. We do not collect sales or other similar taxes in most states.
Recently adopted legislation provides that, prior to October 2001, a state
cannot impose sales taxes on products sold on the internet unless such taxes
could be charged on non-internet transactions involving these products. During
this moratorium, it is possible that taxing mechanisms may be developed that
would, following the moratorium, impose increasing sales and similar tax burdens
on us. If these burdens are placed on us, we could suffer a material adverse
effect. In addition, foreign jurisdictions may claim that we are subject to
taxation because we conduct transactions with their citizens.
OUR SUCCESS IS DEPENDENT ON OUR KEY PERSONNEL, WHO MAY DECIDE NOT TO CONTINUE TO
WORK FOR CDNOW, AND WE MAY NOT BE ABLE TO HIRE ENOUGH QUALIFIED PERSONNEL TO
MEET OUR HIRING NEEDS.
We will be materially adversely affected if we cannot hire and retain
suitable executive management team members and personnel. We believe that our
success will depend on continued employment of the executive management team
designated to serve following the merger with N2K Inc. If one or more members of
our management team become unable or unwilling to continue in their present
positions, we could be materially adversely affected. In
-13-
<PAGE>
addition, our success also depends upon continued service by key sales,
marketing and support personnel and our ability to hire additional personnel as
our business grows.
OUR COMPUTER SYSTEMS AND THOSE OF OUR KEY SUPPLIERS AND SERVICE PROVIDERS MAY
NOT BE YEAR 2000 COMPLIANT WHICH MAY CAUSE SYSTEM FAILURES AND DISRUPTIONS OF
OPERATIONS.
The Year 2000 issue 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 which may materially adversely affect us. To date, we have
experienced very few problems related to Year 2000 problems and we do not
believe that we have material exposure to the Year 2000 issue with respect to
our information systems as these systems correctly define the Year 2000.
We are currently conducting an analysis to determine the extent to which
the systems of third parties raise Year 2000 issues may affect us. However, we
cannot assure that the primary provider we use to fill our orders for direct-to-
consumer music products, Valley Media, will, in fact be year 2000 compliant on a
timely basis. Generally, we are unable to predict the extent to which the Year
2000 issue will effect our suppliers, or the extent to which we would be
vulnerable to our suppliers' failure to remediate any Year 2000 issues on a
timely basis. The failure of a major supplier subject to the Year 2000 issue to
convert its systems on a timely basis or a conversion that is incompatible with
our systems could have a material adverse effect on us, which is not currently
quantifiable. In addition, most of the purchases from our online stores are made
with credit cards, and our operations may be materially adversely affected to
the extent our customers are unable to use their credit cards due to Year 2000
issues that are not rectified by credit card providers.
ITEM 2. PROPERTIES
----------
CDnow's executive offices are located in, and substantially all of its
operating activities are conducted from, leased office space located in Fort
Washington, Pennsylvania. CDnow has leased this facility, which contains
approximately 60,000 square feet, under a lease that expires in 2006. CDnow does
not own any real estate.
ITEM 3. LEGAL PROCEEDINGS
-----------------
From time to time, the Company is involved in litigation incidental to its
business. In the opinion of management, no litigation to which the Company is
currently a party is likely to have a material adverse effect on the Company's
results of operations, financial condition or liquidity, if decided adversely to
the Company.
CDnow has been named a party in an action entitled Rubin v. Rosen et al.
(Docket No. 16743 NC, filed in the Chancery Court of Delaware for the County of
New Castle). CDnow believes that the claims are without merit and intends to
defend the action vigorously. As of the date hereof, CDnow has not been served
with notice that it will appear in court to defend the action. From time-to-
time, CDnow may be involved in litigation relating to claims arising out of its
ordinary course of business.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
---------------------------------------------------
None.
-14-
<PAGE>
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
---------------------------------------------------------------------
The Company's Common Stock trades on the National Market segment of the
Nasdaq Stock Market under the symbol "CDNW." The following table sets forth,
for the periods indicated, the high and low sales prices as quoted on the Nasdaq
Stock Market.
<TABLE>
<CAPTION>
Period High Low
------ ---- ---
<S> <C> <C>
Fiscal 1998:
First Quarter (beginning February 10, 1998)...... $27.25 $18.25
Second Quarter................................... $39.00 $16.00
Third Quarter.................................... $27.50 $ 7.00
Fourth Quarter................................... $39.25 $ 7.06
</TABLE>
As of March 11, 1999 there were 171 holders of record of the Company's
Common Stock. On March 11, 1999, the closing sale price of the Common Stock as
reported by the Nasdaq Stock Market was $16.94.
The Company has never declared or paid any cash dividends on its capital
stock. The Company currently intends to retain its earnings to finance future
growth and working capital needs and therefore does not anticipate paying any
cash dividends in the foreseeable future.
-15-
<PAGE>
ITEM 6. SELECTED FINANCIAL DATA
-----------------------
The following selected financial data are derived from the financial
statements of the Company. The data should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" in Item 7 and the consolidated financial statements and related
notes thereto included in Item 8.
<TABLE>
<CAPTION>
PERIOD FROM
INCEPTION
(FEBRUARY 12,
1994) TO
DECEMBER 31, YEAR ENDED DECEMBER 31,
-------------------------------------------------------
1994 1995 1996 1997 1998
------------- ----------- ------------- ------------ ------------
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Net sales.............................. $ 103,116 $2,176,474 $ 6,300,294 $ 17,372,795 $ 56,394,606
Cost of sales.......................... 92,962 1,815,672 5,074,087 13,847,773 45,250,328
------------- ----------- ----------- ------------ ------------
Gross profit........................... 10,154 360,802 1,226,207 3,525,022 11,144,278
Operating expenses:
Operating and development.............. 26,946 149,982 669,280 2,541,434 8,000,023
Sales and marketing.................... 12,945 229,912 765,156 9,607,603 44,572,304
General and administrative............. 28,712 180,573 563,593 1,953,078 4,446,995
Dispute settlement..................... -- -- 1,024,030 -- --
------------- ----------- ----------- ------------ ------------
Total operating expenses............... 68,603 560,467 3,022,059 14,102,115 57,019,322
------------- ----------- ----------- ------------ ------------
Operating loss......................... (58,449) (199,665) (1,795,852) (10,577,093) (45,875,044)
Interest income (expense), net......... -- (1,248) (14,556) (170,312) 2,106,123
------------- ----------- ------------ ------------ ------------
Net loss............................... (58,449) (200,913) (1,810,408) (10,747,405) (43,768,921)
Accretion of preferred stock to
redemption value.................. -- -- -- (410,103) (115,542)
------------- ----------- ----------- ------------ ------------
Net loss applicable to common
shareholders...................... $ (58,449) $ (200,913) $(1,810,408) $(11,157,508) $(43,884,463)
============= =========== =========== ============ ============
Net loss per common share.............. $ (0.01) $ (0.03) $ (0.29) $ (1.42) $ (2.79)
============= =========== =========== ============ ============
Weighted average number of common
shares outstanding................ 6,000,000 6,000,000 6,139,072 7,845,684 15,712,857
============= =========== =========== ============ ============
<CAPTION>
AS OF DECEMBER 31,
------------------------------------------------------------------------
1994 1995 1996 1997 1998
--------------- ----------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents.............. $ 2,008 $ 43,812 $ 775,865 $ 10,686,001 $ 49,041,370
Working capital (deficit).............. (42,206) (235,478) 231,455 (1,218,005) 42,408,170
Total assets........................... 25,765 268,468 1,575,459 16,448,425 69,043,043
Long-term debt, excluding current
portion............................ -- 9,519 91,133 962,144 1,750,892
Redeemable convertible preferred stock -- -- -- 9,492,594 --
Total shareholders' equity (deficit)... (18,449) (99,362) 514,017 (9,752,450) 51,138,937
</TABLE>
-16-
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
-----------------------------------------------------------------------
OF OPERATIONS
-------------
OVERVIEW
CDnow 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. CDnow continuously seeks to expand its
customer base through multiple marketing channels, which include:
. pursuing an aggressive marketing campaign using a combination of online and
traditional marketing;
. establishing marketing agreements with major internet and proprietary
online content and service providers;
. entering into linking arrangements with other Web sites as part of its
Cosmic Credit Program; and
. using direct marketing techniques to target new and existing customers with
personalized communications. CDnow entered into marketing agreements and
business alliances with Yahoo!, Excite and GeoCities in August 1997,
September 1997 and January 1998, respectively, and has accelerated its
marketing campaign since CDnow's initial public offering in February 1998
by expanding its relationship with Yahoo! and entering into additional
alliances with Lycos, Lycos Bertelsmann, Rolling Stone Network, CMJ and
MTV/VH1.
Since its inception, CDnow has incurred significant net losses and, as of
December 31, 1998, had accumulated losses of $56.6 million. As it seeks to
expand aggressively, CDnow believes that its operating expenses will
significantly increase as a result of the financial commitments related to the
development of marketing channels, future business relationships, and
improvements to its Web site and other capital expenditures. CDnow 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. As CDnow has
relatively low product gross margins, the ability of CDnow 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
CDnow's marketing efforts, CDnow will be materially adversely affected. There
can be no assurance that CDnow 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, 1998 and the year ended December 31, 1997,
international sales accounted for approximately 21% and 29%, respectively, of
net sales. While CDnow expects that net sales from international markets will
continue to represent a significant portion of total net sales, CDnow believes
that the percentage of its net sales from international markets may decrease in
future periods due to the substantial increase in CDnow's domestic marketing and
advertising expenditures.
-17-
<PAGE>
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 1998
------- -------- ------ --------
<S> <C> <C> <C> <C>
Net sales................................ 100.0% 100.0% 100.0% 100.0%
Cost of sales............................ 83.4 80.5 79.7 80.2
------- -------- ------ ------
Gross profit........................ 16.6 19.5 20.3 19.8
Operating expenses:
Operating and development........... 6.9 10.6 14.6 14.2
Sales and marketing................. 10.6 12.1 55.3 79.0
General and administrative.......... 8.3 9.0 11.3 7.9
Dispute settlement.................. -- 16.3 -- --
------- -------- ------ ------
Total operating expenses............ 25.8 48.0 81.2 101.1
------- -------- ------ ------
Operating loss...................... (9.2) (28.5) (60.9) (81.3)
Interest income (expense), net........... -- (0.2) (1.0) 3.7
------- -------- ------ ------
Net loss................................. (9.2)% (28.7)% (61.9)% (77.6)
======= ======== ====== ======
</TABLE>
Reclassifications
This year, CDnow determined to include Information Royalties in operating
and development expenses rather than in cost of sales, as was previously the
case. Information Royalties are royalties paid on CD sales in return for
licensing of ratings, reviews and other information. In addition, CDnow
determined to include credit card processing fees in sales and marketing
expenses, rather than in costs of sales as was previously the case. CDnow made
these changes based on management's determination that the changes are
consistent with the treatment of these expenses generally. We have restated
CDnow's results of operations to reflect this change for all periods.
The table below shows the amount of Information Royalties and Credit Card
Processing Fees for the years ended December 31, 1995, 1996, 1997, and 1998.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------------------
1995 1996 1997 1998
------------ -------- --------- -----------
<S> <C> <C> <C> <C>
Information Royalties........... $ -- $146,200 $225,737 $ 469,770
Credit Card Processing Fees..... 28,940 143,702 468,225 1,451,324
</TABLE>
If CDnow included Information Royalties and Credit Card Processing Fees in
costs of sales, gross profit margins would have been:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------------
1995 1996 1997 1998
-------- ------- -------- -------
<S> <C> <C> <C>
15.2% 14.9% 16.3% 16.4%
</TABLE>
Year Ended December 31, 1998 Compared to the Year Ended December 31, 1997
Net Sales. Net sales primarily reflect the sales of CDs and related
---------
merchandise, net of estimated returns, and include outbound shipping and
handling charges. Net sales were $56.4 million for the year ended December 31,
1998, representing an increase of 225% over the year ended December 31, 1997.
The increase is attributable to continued growth of CDnow's customer base and
repeat purchases from existing customers who have typically purchased more units
per order than new customers. Net sales were favorably affected by increased
advertising and promotional activities, including CDnow's purchase of
advertising during the 1998 Grammy Awards and 1998 MTV Video Music Awards, as
well as the continued implementation of its marketing agreements. For the year
ended December 31, 1998, CDnow added approximately 686,000 new customers,
bringing the total number of customers since inception to 983,000 as of December
31, 1998, compared to 209,000 new customers that were added during the year
ending December 31, 1997. International sales represented 21% of net sales for
the year ended December 31, 1998 compared to 29% for the year ended December 31,
1997. CDnow believes that the decrease in international sales as a percentage
-18-
<PAGE>
of net sales is due to a proportionally larger increase in domestic sales
resulting from the substantial increase in domestic marketing and advertising
expenditures. Nevertheless, international sales increased to $11.7 million for
the year ended December 31, 1998, from $5.0 million in the year ended December
31, 1997.
Cost of Sales. Cost of sales consists primarily of the cost of merchandise
-------------
sold to customers, including the costs of filling orders and outbound shipping
and handling. Cost of sales increased by $31.4 million, or 227%, to $45.3
million for the year ended December 31, 1998, compared to $13.8 million for the
year ended December 31, 1997. CDnow's gross profit decreased to 19.8% for the
year ended December 31, 1998 from 20.3% for the year ended December 31, 1997.
The decline in gross margin was attributable to more aggressive pricing of
recent releases and popular titles, as well as increased sales discounts offered
by CDnow.
Operating and Development Expense. Operating and development expense
----------------------------------
consists primarily of payroll and related expenses for store management, design,
development and network operations personnel, systems and telecommunications
infrastructure and royalties paid by CDnow on CD sales in return for licensing
of ratings, reviews, sound samples and other information. Store development
costs are charged to expense as incurred. Operating and development expense
increased by $5.5 million or 215% to $8.0 million for the year ended December
31, 1998 compared to $2.5 million for the year ended December 31, 1997. The
increase is attributable to increased staffing and associated costs related to
enhancing the features and functionality of CDnow's Web site and transaction-
processing systems, as well as increased investment in store content, systems
and telecommunications infrastructure. As a percentage of net sales, operating
and development expense remained relatively constant, to 14.2% for the year
ended December 31, 1998, compared to 14.6% for the year ended December 31, 1997.
Sales and Marketing Expense. Sales and marketing expense consists primarily
---------------------------
of payments related to advertising, promotion and marketing agreements as well
as payroll and related expenses for personnel engaged in marketing, selling and
customer service activities and credit card fees. Sales and marketing expense
increased by $35.0 million to $44.6 million for the year ended December 31, 1998
compared to $9.6 million for the year ended December 31, 1997. As a percentage
of net sales, sales and marketing expense grew to 79.0% for the year ended
December 31, 1998 compared to 55.3% for the year ended December 31, 1997. The
increase in both absolute dollars and as a percentage of net sales was primarily
attributable to increased online and traditional advertising, including CDnow's
purchase of advertising during the 1998 Grammy Awards and the 1998 MTV Video
Music Awards, costs associated with CDnow's marketing agreements and promotional
and public relations expenditures. CDnow increased its advertising expense to
$32.9 million for the year ended December 31, 1998, compared to $6.7 million for
the year ended December 31, 1997. In addition, CDnow incurred increased staffing
and related costs in connection with the implementation of its marketing
strategy and customer service activities necessary to support its increased
customer base and increased credit card processing fees related to the growth of
revenues. CDnow expects the dollar amount of sales and marketing expense
generally and advertising expense in particular to continue to increase in
future periods. While CDnow is hopeful that its net sales will also increase in
future periods so that its sales and marketing expense will not continue to
represent an increasing percentage of net sales, CDnow 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 CDnow will achieve increased net sales or that sales
and marketing expense will not 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, insurance, professional fees and other general and
corporate expenses. General and administrative expense increased by $2.5
million, or 128% to $4.4 million for the year ended December 31, 1998 compared
to $2.0 million for the year ended December 31, 1997. The increase in general
and administrative expense was primarily due to the hiring of additional
personnel and increases in professional fees as well as the costs associated
with becoming a public company. As a percentage of net sales, general and
administrative expense decreased to 7.9% for the year ended December 31, 1998
compared to 11.3% for the year ended December 31, 1997 as general and
administrative expenses were spread over a large revenue base.
Net Loss. CDnow's net loss was $43.8 million for the year ended December
---------
31, 1998 compared to $10.7 million for the year ended December 31, 1997.
Year Ended December 31, 1997 Compared to the Year Ended December 31, 1996
Net Sales. Net sales increased by $11.1 million or 176% to $17.4 million
----------
for the year ended December
-19-
<PAGE>
31, 1997 from $6.3 million for the year ended December 31, 1996. This increase
is primarily attributable to the significant growth of CDnow's customer base and
repeat purchases from CDnow'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. CDnow believes that this decrease in
international sales as a percentage of net sales is due to the substantial
increase in CDnow's domestic marketing and advertising expenditures. At December
31, 1997, CDnow had approximately 296,000 customer accounts compared to
approximately 88,000 customer accounts at December 31, 1996.
Cost of Sales. Cost of sales increased by $8.7 million or 173% to $13.8
--------------
million for the year ended December 31, 1997 from $5.1 million for the year
ended December 31, 1996. This increase is primarily attributable to CDnow's
increased sales volume. CDnow's gross profit margin was 20.3% for the year ended
December 31, 1997 compared to 19.5% 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 CDnow's suppliers and a change to a lower-price supplier for
imported music and music-related products. CDnow's gross profit margin declined
in the fourth quarter of 1997 due to increased sales promotions during the
holiday season.
Operating and Development Expense. Operating and development expense
----------------------------------
increased by $1.9 million to $2.5 million for the year ended December 31, 1997
from $669,000 for the year ended December 31, 1996. As a percentage of net
sales, these expenses were 14.6% for the year ended December 31, 1997 and 10.6%
for the year ended December 31, 1996. This increase was due to increased
staffing and associated costs related to enhancing the features, content and
functionality of CDnow's online store and transaction-processing systems, as
well as increased investments in systems and telecommunications infrastructure.
Sales and Marketing Expense. Sales and marketing expense increased by $8.8
----------------------------
million to $9.6 million for the year ended December 31, 1997 from $765,000 for
the year ended December 31, 1996 with $6.0 million of this expense incurred in
the fourth quarter. As a percentage of net sales, these expenses increased to
55.3% for the year ended December 31, 1997 from 12.1% for the year ended
December 31, 1996. This increase was due to the significant expansion of CDnow's
advertising expenditures, costs associated with marketing agreements with Yahoo!
and Excite and the increased staffing and associated costs related to
implementing CDnow's marketing strategy and supporting CDnow's increased
customer base. CDnow increased its advertising expense to $6.8 million for the
year ended December 31, 1997 compared to $61,000 for the year ended December 31,
1996.
General and Administrative Expenses. General and administrative expense
------------------------------------
increased by $1.4 million to $2.0 million for the year ended December 31, 1997
from $564,000 for the year ended December 31, 1996. As a percentage of net
sales, these expenses increased to 11.3% for the year ended December 31, 1997
compared to 9.0% 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. CDnow's net loss increased by $8.9 million to a loss of $10.7
---------
million for the year ended December 31, 1997 from a net loss of $1.8 million for
the year ended December 31, 1996.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 1998 CDnow's cash and cash equivalents were $49.0 million
compared to $11.7 million at December 31, 1997. In July 1998, CDnow consummated
a follow-on public offering, selling an aggregate of 1,250,000 shares of common
stock and raising net proceeds of approximately $21.7 million. In February 1998,
CDnow consummated its initial public offering, selling an aggregate of 4,561,250
shares of common stock which included 461,250 shares sold in March 1998 upon the
exercise of the underwriters' overallotment option and raising net proceeds of
approximately $67.0 million. Prior to February 1998, CDnow 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
-20-
<PAGE>
. certain other short-term loans.
Net cash used in operating activities of $40.4 million for the year ended
December 31, 1998 was primarily attributable to a net loss of $43.8 million and
an increase of $3.7 million in prepaid expenses partially offset by a $5.2
million increase in accounts payable, accrued expenses and depreciation and
amortization of $2.1 million.
Net cash used by investing activities was $3.8 million for the year ended
December 31, 1998, and consisted of purchases of equipment and leasehold
improvements of $4.4 million and $424,000 for the acquisition of superSonicBoom,
Inc., partially offset by the sale of short-term investments of $1.0 million.
Net cash used in investing activities of $1.7 million for the year ended
December 31, 1997 was attributable to purchases of equipment of $413,000 and to
purchases of short-term investments of $1.0 million, partially offset by sales
and maturities of short-term investments of $248,000. Net cash provided by
financing activities was $82.6 million for the year ended December 31, 1998, and
consisted largely of net proceeds of approximately $88.6 million from CDnow's
1998 public offerings, offset by the retirement of $5.8 million of CDnow's
Series A Notes.
CDnow is required to pay aggregate minimum fixed fees of $24.2 million,
$24.3 million and $7.2 million during the years ending December 31, 1999, 2000
and 2001, respectively, under CDnow's marketing agreements.
CDnow expects to fund its 1999 payment obligations under its marketing
agreements from its cash and cash equivalents, and its future payment
obligations from cash generated from future operations and financing activities.
As of December 31, 1998, CDnow had $49.0 million of cash and cash equivalents.
As of that date, CDnow's principal commitments consisted of obligations under
its marketing agreements as well as obligations outstanding under capital and
operating leases. Although CDnow has no material commitments for capital
expenditures, it anticipates substantial increases in its capital expenditures
and lease commitments consistent with anticipated growth in operations,
infrastructure and personnel.
SEASONALITY
CDnow expects that it will experience seasonality in its business,
reflecting a combination of seasonal fluctuations in sales via electronic
commerce 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, CDnow's limited operating history and rapid growth
make it difficult to ascertain the effects of seasonality on its business. CDnow
believes that period-to-period comparisons of CDnow's historical results are not
necessarily meaningful and should not be relied upon as an indication of future
results.
FACTORS AFFECTING CDNOW'S BUSINESS AND PROSPECTS
CDnow expects to experience significant fluctuations in its future
quarterly operating results due to a variety of factors, many of which are
outside CDnow's control. Factors that may affect CDnow's quarterly operating
results include:
. ability to retain existing customers, attract new customers and
maintain customer satisfaction;
. introduction of new or enhanced Web pages, services, products and
marketing agreements by CDnow and its competitors;
. price competition or higher wholesale prices;
. level of use of the internet and consumer acceptance of the internet
for the purchase of recorded music;
. seasonality of recorded music sales;
. ability to upgrade and develop its systems and infrastructure and
attract qualified personnel;
. technical difficulties, system downtime or internet blackouts and
brownouts;
-21-
<PAGE>
. amount and timing of operating costs and capital expenditures relating
to expansion of CDnow's business, operations and infrastructure;
. timing of Company promotions and sales programs;
. level of merchandise returns experienced by CDnow;
. government regulation; and
. general economic conditions and economic conditions specific to
electronic commerce and the music industry.
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. To date, we have experienced very few problems related to Year 2000
testing and those requiring immediate modification have been fixed in our day to
day operating environment. CDnow does not believe that there is material
exposure to the Year 2000 issue with respect to its electronic commerce
transaction processing and online store systems since these systems correctly
define the Year 2000.
CDnow is currently conducting an analysis to determine the extent to which
others have Year 2000 issues. These include CDnow's major suppliers' systems,
including the systems of credit card processors, telecommunications providers,
product distributors and companies with whom CDnow has marketing agreements.
CDnow's primary distributor for direct-to-consumer music products, Valley Media,
has indicated that it has begun its remediation efforts and expects to be in
compliance before the year 2000. CDnow is currently unable to predict the extent
to which the Year 2000 issue will affect Valley's suppliers, or the extent to
which Valley would be vulnerable to its suppliers' failure to remediate any Year
2000 issues on a timely basis. The failure of a major supplier subject to the
Year 2000 issue to convert its systems on a timely basis or a conversion that is
incompatible with CDnow's systems could have a material adverse effect on CDnow.
In addition, most of the purchases from CDnow's online stores are made with
credit cards, and our operations may be materially adversely affected to the
extent customers are unable to use their credit cards due to Year 2000 issues
that are not rectified by their credit card providers.
CDnow incurred $20,000 of expense related to Year 2000 compliance during
the year ended December 31, 1998 and expects to expend $55,000 in 1999 to
support Year 2000 compliance initiatives.
CDnow intends to actively work with and encourage its suppliers to minimize
the risks of business disruptions resulting from Year 2000 issues and develop
contingency plans where necessary. Such plans may include, but are not limited
to, using alternative suppliers and establishing contingent supply arrangements.
CDnow expects to have such plans in place by June 30, 1999.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
See Note 2 "Recently Issued Accounting Pronouncements" on page F-10 to
Consolidated Financial Statements of CDnow. CDnow Management's Discussion and
Analysis of Financial Condition and Results of Operations
ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK
---------------------------------------------------------
FOREIGN CURRENCY RISK
Currently, all of our revenues and expenses are denominated in United
States Dollars. Therefore, our only current exposure to foreign currency risk
relates to our International sales. International sales represented 22% and 29%
of revenues in the years ended December 31, 1998 and 1997. To the extent that
the value of a United States Dollar increases relative to foreign currencies,
the amount of foreign currency needed to obtain United States Dollars to make
-22-
<PAGE>
purchases will increase, and it will be more costly for international customers
to make purchases. Therefore changes in exchange rates may impact the amount of
our international sales.
INTEREST RATE RISK
Our exposure to market risk related changes in interest rates relates
primarily to our investment portfolio. We invest in instruments that meet high
credit quality standards, as specified in our investment policy. The policy
also limits the amount of credit exposure to any one issue, issuer and type of
investment.
As of December 31, 1998, all of our funds were cash equivalents. Due to
the average maturity and conservative nature of our investment portfolio, a
sudden change in interest rates would not have a material effect on the value of
the portfolio. Management estimates that had the average yield of the Company's
investments decreased by 100 basis points, the Company's interest income for the
year ended December 31, 1998 would have decreased by less than $500,000. This
estimate assumes that the decrease occurred on the first day of 1998 and reduced
the yield of each investment instrument by 100 basis points. The impact on the
Company's future interest income, of future changes in investment yields will
depend largely on the gross amount of the Company's investments, see "Liquidity
and Capital Resources".
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
-------------------------------------------
The financial statements of the Company are filed under this Item 8,
beginning on page F-1 of this report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
---------------------------------------------------------------
FINANCIAL DISCLOSURE
--------------------
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
--------------------------------------------------
OFFICERS AND DIRECTORS
The executive officers and directors of the Company are as follows:
<TABLE>
<CAPTION>
Name Age Position
---- --- --------
<S> <C> <C>
Jason Olim................ 29 President, Chief Executive Officer and Chairman of the Board of Directors
Matthew Olim.............. 29 Technical Lead, Secretary, Treasurer and Director
Rod Parker................ 55 Senior Vice President of Product Management and Marketing
Joel Sussman.............. 50 Vice President and Chief Financial Officer
Michael Krupit............ 34 Vice President of Technology
Robert Salzman............ 46 Vice President of Strategic Business Development
David Capozzi............. 42 Vice President and General Counsel
Steve Dong................ 39 Vice President of Operations
Patrick Kerins/(1)(2)/... 43 Director
John Regan/(l)(2)/........ 39 Director
</TABLE>
_________________________
(1) Member of the Audit Committee of the Company's Board of Directors.
(2) Member of the Compensation Committee of the Company's Board of Directors.
Jason Olim co-founded the Company in February 1994 and has been its
President since the Company's inception and its Chief Executive Officer since
November 1997. Previously, Mr. Olim was employed in the
-23-
<PAGE>
Professional Services group of Soft-Switch, Inc. where he designed and built
software systems for routing mail and documents for domestic and international
clients. Mr. Olim has a Bachelor of Arts degree in Computer Science from Brown
University.
Matthew Olim co-founded the Company in February 1994 and has been
responsible for the development of the Company's system architecture and
transactions systems. Mr. Olim has a Bachelor of Arts degree in Astrophysics
from Columbia University.
Rod Parker has been the Senior Vice President of Product Management and
Marketing since June 1997. Mr. Parker served as the Vice President of
Interactive Merchandising at Time Warner Cable Programming from September 1995
to June 1997; General Manager of Catalog I, a joint venture between Time Warner
and Spiegel, Inc., from October 1993 to September 1995; and in various other
positions with Spiegel, Inc. (including Vice President, New Media and Vice
President, Creative Division) from April 1987 to September 1995. Mr. Parker
spent more than twenty years in the advertising industry, including service as a
Senior Vice President in account management with Ogilvy and Mather.
Joel Sussman has been a Vice President and Chief Financial Officer since
September 1997. From June 1995 to September 1997, Mr. Sussman was an
independent financial management consultant and served as Interim Chief
Financial Officer of a number of companies, including CDnow. From July 1994 to
June 1995. Mr. Sussman was Vice President, Finance and Administration, and
Chief Financial Officer of Personnel Data Systems, Inc. From January 1991 to
December 1994, Mr. Sussman was Vice President of Finance and Chief Financial
Officer of The Devereux Foundation. Prior to January 1991, Mr. Sussman served
for 10 years as Treasurer of Decision Data, Inc. and six years in commercial
banking and leasing. Mr. Sussman is a Certified Public Accountant and Certified
Management Accountant and holds a Masters degree in Business Administration from
the Wharton School of the University of Pennsylvania.
Michael Krupit has been the Vice President of Technology since October 1997
and was the Director of Technology from April 1997 to October 1997. Mr. Krupit
was the Director of Technology and Product Development at Infonautics, Inc., a
provider of searching, viewing, and retrieval applications for the Internet,
from February 1994 to March 1997. Mr. Krupit was the Development Manager at
Verity, Inc., a provider of online information and archive services, from
October 1989 to November 1993.
Robert Salzman has been the Vice President of Strategic Business
Development since December 1997. Mr. Salzman served as the Director of Business
Development at Bell Atlantic Network Integration from November 1995 to December
1997. From 1987 to 1995, Mr. Saltzman held various sales and marketing
positions with Unisys Corporation.
David Capozzi has been a Vice President and General Counsel since April
1998. From February 1996 to April 1998, Mr. Capozzi was an attorney with the
law firm of Morgan, Lewis & Bockius LLP. Mr Capozzi also has over 14 years of
experience in varying capacities in software design and development, including
seven years with Marriott Corporation. Mr. Capozzi holds a Juris Doctorate from
The American University, Washington College of Law, a Masters in Business
Administration from the Katz Graduate School of Business of the University of
Pittsburgh and a Bachelor of Science in Computer Science from the University of
Pittsburgh.
Steve Dong has been the Vice President of Operations since May 1998. Mr.
Dong served as the Director of Operations at Egghead Computer from July 1995 to
May 1998. From January 1994 to July 1995, Mr. Dong was Chief Operating Officer
of Mac's Place, a wholly owned subsidiary of Egghead Computer. From 1987 to
1994, Mr. Dong held various management positions with Egghead Software including
Director of Distribution and Transportation.
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. Mr. Kerins is a director of Pathnet, Inc., a publicly traded company.
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
-24-
<PAGE>
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, a former
director, 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.
ITEM 11. EXECUTIVE COMPENSATION
----------------------
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 Committee was formed in August 1997. The members
of the Compensation Committee are Patrick Kerins and John Regan. Mr. Kerins is
a Managing Director of Grotech Capital, the general partner of Grotech Capital
Partners IV, L.P., a significant shareholder of the Company. See "Certain
Relationships and Related Transactions." Prior to August 1997, decisions
concerning the compensation of the Company's employees, including its executive
officers, were made by the Company's Board of Directors, which included Jason
Olim and Matthew Olim.
EXECUTIVE COMPENSATION
The following table provides information concerning compensation paid or
accrued in the year ended December 31, 1998 with respect to the Company's
President and Chief Executive Officer and the four other most highly compensated
executive officers of the Company.
-25-
<PAGE>
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG TERM
COMPENSATION
----------------
ANNUAL COMPENSATION AWARDS
------------------------------ ----------------
SECURITIES
FISCAL OTHER ANNUAL UNDERLYING ALL OTHER
NAME AND PRINCIPAL POSITION YEAR SALARY BONUS COMPENSATION OPTIONS COMPENSATION
- ---------------------------- -------- --------- ---------- -------------- ----------- ----------------
<S> <C> <C> <C> <C> <C> <C>
Jason Olim
President, Chief Executive
Officer and Chairman of the 1998 $ 147,858 -- -- -- $ 2,286(5)
Board of Directors ....... 1997 89,583 -- -- -- 1,272
1996 26,083 -- -- -- --
Rod Parker
Senior Vice President (1) 1998 $ 212,412 $ 55,000 $ 37,218 (4) -- $ 2,525(5)
1997 130,730 -- 3,879 120,000 1,335
Matthew Olim
Technical Lead, Secretary
and Treasurer............. 1998 $ 147,852 -- -- -- $ 1,333(5)
1997 89,583 -- -- -- 1,272
1996 26,083 -- -- -- --
Joel Sussman
Vice President (2)...... 1998 $ 149,327 -- -- -- --
1997 34,792 -- -- 78,000 --
Robert Salzman
Vice President (3)...... 1998 $ 147,998 -- -- -- --
1997 10,301 -- -- 75,000 --
</TABLE>
_____________________
(1) Mr. Parker commenced employment with us in June, 1997.
(2) Mr. Sussman commenced employment with us in December, 1997.
(3) Mr. Salzman commenced employment with us in September, 1997.
(4) Other Annual Compensation for Mr. Parker includes reimbursement for
apartment in Pennsylvania and travel expenses. Mr. Parker's residence is in
Connecticut.
(5) Represents CDnow contribution to 401(k) Plan.
The Company did not grant stock options to any of the executive officers
named in the Summary Compensation Table in 1998.
The following table sets forth information regarding stock options held as
of December 31, 1998 by executive officers named in the Summary Compensation
Table during 1998.
-26-
<PAGE>
FISCAL YEAR-END OPTION VALUES
<TABLE>
<CAPTION>
Number of Securities Underlying Value of Unexercised In-The-Money
Exercised Options at December 31, 1998 Options at December 31, 1998
------------------------------------------- ------------------------------------
Name Exercisable Unexercisable Exercisable Unexercisable
- ------------------- --------------------- -------------------- ----------------- -----------------
<S> <C> <C> <C> <C>
Rod Parker......... 30,000 90,000 $500,100 $1,500,300
Joel Sussman....... 10,750 47,250 $162,503 $ 712,508
Robert Salzman..... 18,750 56,250 $150,000 $ 450,000
</TABLE>
(1) Based on closing sales price per share on December 31, 1998 as reported on
the Nasdaq National Market. The closing price per share on that date was
$18.00.
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. 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 March 8, 1999, options to purchase a total of 905,795 shares of
Common Stock at a weighted average exercise price per share of $8.78 were
outstanding. Of these options, options to purchase 124,222 shares of Common
Stock were fully vested and exercisable as of March 8, 1999. As of March 8,
1999, the Company had an additional 659,892 shares of Common Stock available for
future grants under the Equity Compensation Plan.
The option price per share of Common Stock under the Equity Compensation
Plan is determined by the Committee at the time of each grant, provided,
however, that the option price per share for any ISO may not be less than the
fair market value of the Common Stock at the time of the grant. In addition, if
a person who owns 10 percent or more of the Company's Common Stock (a "10%
Shareholder") is granted an ISO, the exercise price for such ISO may not be less
than 110% of the fair market value on the date of grant. The term of each stock
option may not exceed ten years; in the case of a 10% shareholder, the term may
not exceed five years. Payment for the exercise of an option may be made by
cash, check or other instrument as the Committee may accept, including, in the
discretion of the Committee, unrestricted Common Stock of the Company. The
Committee may also allow an option holder to surrender all or a portion of a
stock option and receive a number of shares of Common Stock with a value equal
to the excess of the fair market value over the option price of the surrendered
stock option or portion of the stock option.
-27-
<PAGE>
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
--------------------------------------------------------------
The following table sets forth information regarding the beneficial ownership of
the CDnow common stock:
. Each person known to us to . The chief executive officer
own beneficially more than and four other most highly
5% of the outstanding compensated executive
shares of the CDnow officers of each of CDnow
common stock.
. Each director of CDnow . All directors and executive
officers of CDnow as a group.
Unless otherwise indicated, to our knowledge, 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.
<TABLE>
<CAPTION>
BENEFICIAL OWNERSHIP
OF CDNOW COMMON STOCK
-----------------------------------------------
OPTIONS/
NAME OF BENEFICIAL OWNER SHARES WARRANTS TOTAL PERCENT
- ---------------------------------------------------- -------- ---------- ------- ---------
<S> <C> <C> <C> <C>
EXECUTIVE OFFICERS AND
DIRECTORS
Jason Olim(1).................................... 2,960,025 -- 2,960,025 16.6%
Matthew Olim(1).................................. 2,960,025 -- 2,960,025 16.6
Rod Parker(2).................................... -- 30,000 30,000 *
Patrick Kerins(3)................................ 1,000 1,569 2,569 *
John Regan(4).................................... -- -- -- --
Joel Sussman(5).................................. -- 20,500 20,500 *
All executive officers and directors of CDnow
as a group (7 persons).......................... 5,921,050 91,069 6,012,119 33.5
FIVE PERCENT HOLDERS
Grotech Partners IV, L.P.(6)..................... 1,638,258 8,403 1,646,661 9.2
</TABLE>
____________________
* 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 1005 Virginia Drive, Fort
Washington, Pennsylvania 19034.
(2) Includes shares presently obtainable, or obtainable within the next 60
days, upon the exercise of stock options.
(3) Excludes 1,646,661 shares held by Grotech Partners IV, L.P., of which Mr.
Kerins is a managing director. Mr. Kerins disclaims beneficial ownership of
any shares owned by Grotech Partners IV, L.P.
(4) Excludes 181,873 shares held by Keystone Ventures IV, L.P., a partnership
of which Mr. Regan is a Vice President of the general partner. Mr. Regan
disclaims beneficial ownership of any shares owned by Keystone Ventures IV,
L.P.
-28-
<PAGE>
(5) Includes shares presently obtainable, or obtainable within the next 60
days, upon the exercise of stock options.
(6) 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.
COMPLIANCE WITH SECTION 16(A) OF THE SECURITIES EXCHANGE ACT OF 1934
Section 16(a) of the Securities Exchange Act of 1934 requires the
Company's directors and executive officers and persons who beneficially own more
than 10% of the Company's common stock to file reports of ownership and changes
in ownership with the Securities and Exchange Commission (the "SEC"). Such
directors, executive officers and greater than 10% stockholders are required by
SEC regulation to furnish to the Company copies of all Section 16(a) forms they
file.
CDnow believes that for fiscal year 1998, all Section 16(a) filing
requirements were satisfied on a timely basis.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
----------------------------------------------
SERIES A PREFERRED STOCK
Pursuant to the terms of the Stock Purchase Agreement dated July 15, 1997
by and among the Company, Keystone Ventures, Jason Olim and Matthew Olim (the
"Stock Purchase Agreement"), Keystone Ventures purchased 254,582 shares of
Series A Convertible Preferred Stock, no par value (the "Series A Preferred
Stock"), of the Company for an aggregate purchase price of $1.3 million. The
outstanding shares of Series A Preferred Stock converted into an aggregate of
381,873 shares of Common Stock in February 1998. John Regan is a Vice President
of the general partner of Keystone Ventures and was elected to the Company's
Board of Directors pursuant to an agreement among certain shareholders of the
Company that was terminated in February 1998. Keystone Ventures received certain
registration rights in connection with this transaction.
SERIES B PREFERRED STOCK
Pursuant to the terms of the Stock Purchase Agreement, as amended by the
Amendment No. 1 to the Stock Purchase Agreement dated as of August 5, 1997 by
and among the Company, Keystone Ventures, Jason Olim, Matthew Olim, Grotech and
ABS, (i) Grotech purchased 1,543,505 shares of Series B Convertible Preferred
Stock, no par value (the "Series B Preferred Stock"), of the Company for an
aggregate purchase price of $8.4 million, (ii) ABS purchased 62,000 shares of
Series B Preferred Stock for an aggregate purchase price of $338,000, (iii) the
Company issued to Grotech Capital a warrant to purchase up to 27,524 shares of
Common Stock at an exercise price of $3.63 per share, and (iv) the Company
issued to Alex. Brown & Sons Incorporated, a predecessor-in-interest to BT Alex.
Brown Incorporated ("BT Alex. Brown"), a warrant to purchase up to 154,817
shares of Common Stock at an exercise price of $3.63 per share in partial
consideration of its services as the placement agent for the offering of the
Series A and Series B Preferred Stock. The outstanding shares of Series B
Preferred Stock converted into an aggregate of 2,408,258 shares of Common Stock
in February 1998. Patrick Kerins is a Managing Director of Grotech Capital, the
general partner of Grotech IV, and was elected to the Company's Board of
Directors pursuant to an agreement among certain shareholders of the Company
that was terminated in February 1998. Grotech IV, Grotech Capital, ABS and BT
Alex. Brown received certain registration rights in connection with this
transaction.
NOTES PAYABLE
In November 1997, the Company issued $5.8 million aggregate principal
amount of Series A Notes to a group of investors, including $1.0 million to
Grotech and $127,500 to the ABS Employees' Venture Fund Limited Partnership
("ABS"). The Series A Notes, which were repaid in February 1998, bore interest
at the rate of 12% per annum. In addition, the Company issued warrants to these
investors to purchase an aggregate of 48,550 shares of Common Stock at an
exercise price of $11.90 per share, including warrants issued to Grotech and
ABS exercisable for 8,403 and 1,071 shares of Common Stock, respectively. The
warrants issued to ABS have an exercise price equal to $16.00 per share.
-29-
<PAGE>
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
----------------------------------------------------------------
Financial Statements and Financial Statement Schedules
- ------------------------------------------------------
See Index to Financial Statements at page F-1.
Reports on Form 8-K
- -------------------
The following report on Form 8-K have been filed by the Registrant during
the quarter ended December 31, 1998:
Current Report on Form 8-K dated October 22, 1998
Item 5 and 7.
Exhibits
- --------
The following is a list of exhibits filed as part of this annual report on
Form 10-K. Where so indicated by footnote, exhibits which were previously filed
are incorporated by reference. For exhibits incorporated by reference, the
location of the exhibit in the previous filing is indicated parenthetically
except for in those situations where the exhibit number was the same as set
forth below.
-30-
<PAGE>
Exhibit
Number Description
- ------- -----------
2.1* Amended and Restated Agreement and Plan of Merger dated as of January
29, 1999, as amended, among CDnow/N2K, Inc., CDnow, Inc. and N2K Inc.
2.2* Stock Option Agreement between N2K Inc and CDnow, Inc. dated as of
October 22, 1998
2.3* Stock Option Agreement between CDnow, Inc and N2K, Inc. dated as of
October 22, 1998
2.4* Shareholder Support Agreement by Jason Olim dated as of October 22,
1998
3.1** Amended and Restated Articles of Incorporation
3.2** Amended and Restated Bylaws
10.1** Stock Purchase Agreement dated as of July 15, 1997 by CDnow, Inc. and
certain shareholders of CDnow, Inc.
10.2** Amendment No. 1 to Stock Purchase Agreement dated as of August 5, 1997
by CDnow, Inc. and certain shareholders of CDnow, Inc.
10.3** Investors' Rights Agreement dated as of July 15, 1997 by CDnow, Inc.
and certain shareholders of CDnow, Inc.
10.4** CDnow, Inc. 1996 Equity Compensation Plan+
10.5** Amendment 1997-1 to the CDnow, Inc. 1996 Equity Compensation Plan+
10.6** Warrant dated August 5, 1997 issued by CDnow, Inc. to Grotech Capital
Group, IV, LLP
10.7* Lease Agreement between CDnow, Inc. and Delaware Avenue Associates,
dated June 12, 1998
10.8* Amendment Number 1 to Lease Agreement between CDnow, Inc. and Delaware
Avenue Associates, dated October 17, 1998
21 List of Subsidiaries
23 Consent of Independent Public Accountants
27 Financial Data Schedule
* Filed as an Exhibit to CDnow/N2K, Inc. Registration Statement on Form S-4
(File No. 333-72463).
** Filed as an Exhibit to CDnow, Inc.'s Registration Statement on Form S-1
(File No. 333-41241).
+ Denotes executive compensation plan or arrangement.
-31-
<PAGE>
CDNOW, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<S> <C>
Report of Independent Public Accountants ........................................................... F-2
Consolidated Balance Sheets ........................................................................ F-3
Consolidated Statements of Operations .............................................................. F-4
Consolidated Statements of Redeemable Convertible Preferred Stock and Shareholders' Equity
(Deficit) ....................................................................................... F-5
Consolidated Statements of Cash Flows .............................................................. F-6
Notes to Consolidated Financial Statements ......................................................... F-7
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To CDnow, Inc.:
We have audited the accompanying consolidated balance sheets of CDnow, Inc. (a
Pennsylvania Corporation) and Subsidiaries as of December 31, 1997 and 1998, and
the related consolidated statements of operations, redeemable convertible
preferred stock and shareholders' equity (deficit) and cash flows for each of
the three years in the period ended December 31, 1998. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of CDnow, Inc. and Subsidiaries as
of December 31, 1997 and 1998, and the results of their operations and their
cash flows for each of the three years in the period ended December 31, 1998, in
conformity with generally accepted accounting principles.
/s/ Arthur Andersen LLP
Philadelphia, Pa.,
February 17, 1999
F-2
<PAGE>
CDNOW, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
December 31,
------------------------------------------
1997 1998
---- ----
ASSETS
CURRENT ASSETS:
<S> <C> <C>
Cash and cash equivalents........................................ $ 10,686,001 $ 49,041,370
Short-term investments........................................... 1,003,045 --
Accounts receivable, net of reserve of $77,000
and $299,991................................................ 324,411 839,672
Prepaid expenses and other....................................... 2,457,958 8,322,889
------------ ------------
Total current assets......................................... 14,471,415 58,203,931
PROPERTY AND EQUIPMENT, net....................................... 1,884,296 6,643,995
OTHER ASSETS...................................................... 92,714 4,195,717
------------ ------------
$ 16,448,425 $ 69,043,643
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES:
Notes payable.................................................... $ 5,575,288 $ --
Current portion of long-term debt................................ 361,562 822,043
Accounts payable................................................. 8,981,430 10,306,323
Accrued expenses................................................. 579,413 4,455,515
Deferred revenue................................................. 191,727 211,880
------------ ------------
Total current liabilities.................................... 15,689,420 15,795,761
------------ ------------
LONG-TERM DEBT.................................................... 962,144 1,750,892
------------ ------------
DEFERRED RENT LIABILITY........................................... 56,717 358,053
------------ ------------
REDEEMABLE SERIES A AND B CONVERTIBLE
PREFERRED STOCK.................................................. 9,492,594 --
------------ ------------
COMMITMENTS AND CONTINGENCIES (Note 10)
SHAREHOLDERS' EQUITY (DEFICIT):
Preferred stock, no par value, 20,000,000 shares authorized,
254,582 Redeemable Series A Convertible shares and
1,605,505 Redeemable Series B Convertible shares issued
and outstanding at December 31, 1997 no shares issued and
outstanding at December 31, 1998.............................. -- --
Common stock, no par value, 50,000,000 shares authorized,
7,845,684, and 17,842,975 shares issued and
outstanding at December 31, 1997, and 1998..................... 579,549 102,137,536
Additional paid-in capital....................................... 1,325,817 4,325,817
Deferred compensation............................................ (434,776) (216,913)
Accumulated deficit.............................................. (11,223,040) (55,107,503)
------------ ------------
Total shareholders' equity (deficit)........................... (9,752,450) 51,138,937
------------ ------------
$ 16,448,425 $ 69,043,643
============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
F-3
<PAGE>
CDNOW, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
Year Ended December 31,
-------------------------------------------------------
1996 1997 1998
--------------- ------------------ ------------------
<S> <C> <C> <C>
NET SALES.............................. $ 6,300,294 $ 17,372,795 $ 56,394,606
COST OF SALES.......................... 5,074,087 13,847,773 45,250,328
----------- ------------ ------------
Gross profit......................... 1,226,207 3,525,022 11,144,278
----------- ------------ ------------
OPERATING EXPENSES:
Operating and development.......... 669,280 2,541,434 8,000,023
Sales and marketing................... 765,156 9,607,603 44,572,304
General and administrative............ 563,593 1,953,078 4,446,995
Dispute settlement (Note 7)........... 1,024,030 -- --
----------- ------------ ------------
3,022,059 14,102,115 57,019,322
----------- ------------ ------------
Operating loss.................... (1,795,852) (10,577,093) (45,875,044)
INTEREST INCOME........................ -- 201,650 2,742,581
INTEREST EXPENSE....................... (14,556) (371,962) (636,458)
----------- ------------ ------------
NET LOSS............................... (1,810,408) (10,747,405) (43,768,921)
ACCRETION OF PREFERRED
STOCK TO REDEMPTION
-- (410,103) (115,542)
VALUE................................. ----------- ------------ ------------
NET LOSS APPLICABLE TO
COMMON SHAREHOLDERS................... $(1,810,408) $(11,157,508) $(43,884,463)
=========== ============ ============
NET LOSS PER COMMON
SHARE................................. $(0.29) $(1.42) $(2.79)
=========== ============ ============
WEIGHTED AVERAGE NUMBER
OF COMMON SHARES
OUTSTANDING........................... 6,139,702 7,845,684 15,712,857
=========== ============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
F-4
<PAGE>
CDNOW, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND
SHAREHOLDERS' EQUITY (DEFICIT)
<TABLE>
<CAPTION>
Redeemable Shareholders Equity (Deficit)
-------------------------------------------------------
Convertible Additional
Preferred Common Stock Paid-in Deferred
----------------------------
Stock Shares Amount Capital Compensation
------------ ---------- -------------- ------------ -------------
<S> <C> <C> <C> <C> <C>
BALANCE, DECEMBER 31, 1995.............................. $ -- 6,000,000 $ -- $ 160,000 $ --
Sale of common stock and warrants .................... -- 921,834 1,069,250 130,750 --
Issuance of common stock in
settlement of a dispute (Note 7)...................... -- 882,606 1,024,030 -- --
Issuance of common stock to repay
advances due to a related party....................... -- 41,244 81,923 -- --
Services contributed by the founders
(Note 9).............................................. -- -- -- 117,834 --
Termination of S Corporation status.................... -- -- (1,595,654) (408,584) --
Net loss.............................................. -- -- -- -- --
----------- ---------- ------------ ---------- ------------
BALANCE, DECEMBER 31, 1996.............................. -- 7,845,684 579,549 -- --
Sale of Redeemable Series A and B
Convertible Preferred Stock, net of
expenses and value of warrants
issued................................................ 9,082,491 -- -- 170,000 --
Value of warrants issued with Series A
Convertible Notes..................................... -- -- -- 404,425 --
Grant of common stock option below
deemed fair value for accounting
purposes.............................................. -- -- -- 751,392 (751,392)
Amortization of deferred
compensation.......................................... -- -- -- -- 316,616
Accretion of preferred stock to
redemption value...................................... 410,103 -- -- -- --
Net loss.............................................. -- -- -- -- --
----------- ---------- ------------ ---------- ------------
BALANCE, DECEMBER 31, 1997.............................. 9,492,594 7,845,684 579,549 1,325,817 (434,776)
Accretion of preferred stock to
redemption value...................................... 115,542 -- -- -- --
Mandatory conversion of Redeemable
Series A Convertible Preferred
Stock to Common....................................... (9,608,136) 2,790,131 9,608,136 -- --
Issuance of common stock from
consummation of IPO, net of
offering costs........................................ -- 4,561,250 67,077,862 -- --
Issuance of common stock from
secondary offering, net of offering
costs................................................. -- 1,250,000 21,473,044 -- --
Issuance of common stock............................... -- 222,952 3,634,198 -- --
Cashless exercise of warrants.......................... -- 1,039,673 -- -- --
Exercise of warrants................................... -- 32,727 59,890 -- --
Exercise of options.................................... -- 100,558 224,896 -- --
Remeasurement of value of shares
issued to Lycos (Note 10)............................. -- -- (520,039) -- --
Amortization of Deferred
Compensation.......................................... -- -- -- -- 217,863
Issuance of warrants................................... -- -- -- 3,000,000 --
Net Loss............................................... -- -- -- -- --
----------- ---------- ------------ ---------- ------------
BALANCE, DECEMBER 31, 1998.............................. $ -- 17,842,975 $102,137,536 $4,325,817 $(216,913)
=========== ========== ============ ========== ============
</TABLE>
<TABLE>
<CAPTION>
SHAREHOLDERS EQUITY (DEFICIT)
------------------------------
Accumulated
Deficit Total
-------------- --------------
<S> <C> <C>
BALANCE, DECEMBER 31, 1995.............................. $ (259,362) $ (99,362)
Sale of common stock and warrants .................... -- 1,200,000
Issuance of common stock in
settlement of a dispute (Note 7)...................... -- 1,024,030
Issuance of common stock to repay
advances due to a related party....................... -- 81,923
Services contributed by the founders
(Note 9).............................................. -- 117,834
Termination of S Corporation status.................... 2,004,238 --
Net loss.............................................. (1,810,408) (1,810,408)
------------ ------------
BALANCE, DECEMBER 31, 1996.............................. (65,532) 514,017
Sale of Redeemable Series A and B
Convertible Preferred Stock, net of
expenses and value of warrants
issued................................................ -- 170,000
Value of warrants issued with Series A
Convertible Notes..................................... -- 404,425
Grant of common stock option below
deemed fair value for accounting
purposes.............................................. -- --
Amortization of deferred
compensation.......................................... -- 316,616
Accretion of preferred stock to
redemption value...................................... (410,103) (410,103)
Net loss.............................................. (10,747,405) (10,747,405)
------------ ------------
BALANCE, DECEMBER 31, 1997.............................. (11,223,040) (9,752,450)
Accretion of preferred stock to
redemption value...................................... (115,542) (115,542)
Mandatory conversion of Redeemable
Series A Convertible Preferred
Stock to Common....................................... -- 9,608,136
Issuance of common stock from
consummation of IPO, net of
offering costs........................................ -- 67,077,862
Issuance of common stock from
secondary offering, net of offering
costs................................................. -- 21,473,044
Issuance of common stock............................... -- 3,634,198
Cashless exercise of warrants.......................... -- --
Exercise of warrants................................... -- 59,890
Exercise of options.................................... -- 224,896
Remeasurement of value of shares
issued to Lycos (Note 10)............................. -- (520,039)
Amortization of Deferred
Compensation.......................................... -- 217,863
Issuance of warrants................................... 3,000,000
Net Loss............................................... (43,768,921) (43,768,921)
------------ ------------
BALANCE, DECEMBER 31, 1998.............................. $(55,107,503) $ 51,138,937
============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
F-5
<PAGE>
CDNOW, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
Year Ended December 31,
-------------------------------------------------------
1996 1997 1998
---------------- ----------------- ------------------
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net loss............................................................. $(1,810,408) $(10,747,405) $(43,768,921)
Adjustments to reconcile net loss to net cash used
in operating activities--
Depreciation and amortization....................................... 105,439 1,066,815 2,129,703
Provision for returns and doubtful accounts......................... 12,000 65,000 222,991
Common stock issued in settlement of a dispute...................... 1,024,030 -- --
Services contributed by the founders................................ 117,834 -- --
Increase in operating assets and liabilities--
Accounts receivable................................................. (86,310) (258,974) (733,172)
Prepaid expenses and other.......................................... (34,487) (2,401,794) (3,676,843)
Accounts payable.................................................... 326,296 8,545,748 1,246,991
Accrued expenses.................................................... 68,139 450,096 3,876,102
Deferred revenue.................................................... 161,155 22,359 20,153
Deferred rent liability............................................. -- 56,717 301,336
----------- ------------ ------------
Net cash used in operating activities.............................. (116,312) (3,201,438) (40,381,660)
----------- ------------ ------------
INVESTING ACTIVITIES:
Purchases of short-term investments.................................. (245,641) (1,005,501) --
Sales and maturities of short-term investments....................... -- 248,097 1,003,045
Purchases of property and equipment.................................. (198,985) (912,560) (4,407,477)
Acquisition of a business............................................ -- -- (423,694)
----------- ------------ ------------
Net cash used in investing activities.............................. (444,626) (1,669,964) (3,828,126)
----------- ------------ ------------
FINANCING ACTIVITIES:
Borrowings on term loans payable..................................... -- 218,563 --
Payments on term loans payable....................................... -- (28,179) (54,194)
Borrowings on notes payable.......................................... 200,000 -- --
Payments on notes payable............................................ (100,000) (200,000) --
Proceeds from sale of common stock and warrants...................... 1,200,000 -- --
Proceeds from issuance (repayment) of Series A Notes and
warrants............................................................ -- 5,602,706 (5,777,500)
Proceeds from sale of preferred stock................................ -- 9,252,491 --
Proceeds from advances due to related parties........................ 6,341 -- --
Payments on capitalized lease obligations............................ (13,350) (64,043) (438,843)
Proceeds from issuance of common stock, net.......................... -- -- 88,550,906
Proceeds from warrants exercised..................................... -- -- 59,890
Proceeds from options exercised...................................... -- -- 224,896
----------- ------------ ------------
Net cash provided by financing activities.......................... 1,292,991 14,781,538 82,565,155
----------- ------------ ------------
INCREASE IN CASH AND CASH EQUIVALENTS................................. 732,053 9,910,136 38,355,369
CASH AND CASH EQUIVALENTS, BEGINNING OF
YEAR................................................................. 43,812 775,865 10,686,001
----------- ------------ ------------
CASH AND CASH EQUIVALENTS, END OF YEAR................................ $ 775,865 $ 10,686,001 $ 49,041,370
=========== ============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
F-6
<PAGE>
CDNOW, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. THE COMPANY
CDnow, Inc. and Subsidiaries (the "Company") is an online retailer of compact
discs ("CDs") and other music-related products. The Company's revenues are
almost entirely derived from the sale of pre-recorded music and music-related
products. The Company contracts with outside vendors for fulfillment services to
deliver its products to customers and therefore maintains no inventories.
Since inception (February 12, 1994), the Company has incurred significant
losses, and as of December 31, 1998 had accumulated losses of $56.6 million. For
the years ended December 31, 1997, and 1998 the Company's net losses were $10.7
million and $43.8 million, respectively. The Company intends to invest heavily
in marketing and promotion, strategic alliances, Web site development and
technology, and development of its administration organization. As a result, the
Company believes that it will incur substantial operating losses for the
foreseeable future. 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. However,
the Company believes that its current cash and cash equivalents will be
sufficient to sustain its operations through December 31, 1999. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations".
On October 23, 1998, the Company and N2K, Inc. ("N2K") issued a joint press
release announcing the execution of a definitive merger agreement. N2K is an
online retailer of CDs and other music related products. The merger will be
effected through the formation of a new publicly traded company, initially to be
called CDnow/N2K, Inc. ("Newco"). The agreement provides for each existing
Company shareholder to receive one share of common stock in Newco for each
Company share owned by such party and for each existing N2K stockholder to
receive 0.83 shares of common stock in Newco for each N2K share owned by such
party. The consummation of the merger is subject to many conditions, including
obtaining shareholder approval, and no assurance can be given that the merger
will be consummated.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of CDnow, Inc. and
its wholly owned subsidiaries. All intercompany balances and transactions have
been eliminated in consolidation.
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.
F-7
<PAGE>
Net Loss Per Common Share
The Company has presented net loss per common share pursuant to Statement of
Financial Accounting Standards ("SFAS") No. 128 "Earnings per Share" and the
Securities and Exchange Commission Staff Accounting Bulletin No. 98.
Basic loss per common share was computed by dividing net loss applicable to
common shareholders by the weighted average number of shares of Common Stock
outstanding. Diluted loss per common share has not been presented, since the
impact on loss per share using the treasury stock method is anti-dilutive due to
the Company's losses.
Cash and Cash Equivalents
Cash equivalents are carried at cost plus accrued interest, which approximates
fair value. The Company considers all highly liquid investments with an original
maturity date of three months or less to be cash equivalents. Cash equivalents
of $10,005,132, and $49,041,370 at December 31, 1997 and 1998, respectively,
included money market funds, government mortgage-backed bonds and highly rated
corporate securities.
Short-Term Investments
At December 31, 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, 1997,
amortized cost approximated fair value and unrealized gains and losses were
immaterial. Gross unrealized holding gains and losses were immaterial in 1996
and 1997. The gross proceeds from sales and maturities of short-term investments
were $248,097 and $1,003,045 in 1997 and 1998, respectively. No short-term
investments were sold or matured prior to 1997. Gross realized gains and losses
were immaterial. For the purpose of determining gross realized gains and losses,
the cost of the securities sold is based upon specific identification.
Prepaid Expenses
At December 31, 1997 prepaid expenses included $87,397 of net deferred financing
costs related to the Series A Notes (see Note 6). Amortization of deferred
financing costs was $87,397 in 1997 and $87,397 in 1998 and is included in
interest expense. Prepaid expenses included $2,000,000 and $7,278,116 at
December 31, 1997 and 1998, respectively, related to linking agreements and
strategic alliances (see Note 10). At December 31, 1998, Other Assets included
$2,208,036 related to linking agreements and strategic alliances.
The Company follows the American Institute of Certified Public Accountants
Statement of Position 93-7 "Reporting for Advertising Costs" ("SOP 93-7") to
account for its linking agreements. Under SOP 93-7, the Company amortizes the
costs associated with its linking agreements over the contract terms, with the
amortization method primarily based on the rate of delivery of a guaranteed
number of impressions to be received during the contract term. To the extent
additional payments are required to be made based on factors such as click-
throughs and new customers generated, such payments will be charged to expense
as incurred.
F-8
<PAGE>
Property and Equipment
Property and equipment are stated at cost. Depreciation and amortization are
provided using the straight-line method 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, have been charged to
expense as incurred.
Revenue Recognition
Net sales, which consist primarily of recorded music sold via the Internet,
include shipping and handling charged to customers 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 expense consists primarily of payroll and related
expenses for store management, design, development and network operations
personnel, systems and telecommunications infrastructure and royalties paid by
CDnow on CD sales in return for licensing of ratings, reviews, sound samples and
other information.
Sales and Marketing
Advertising costs are included in sales and marketing expenses and are charged
to expense as incurred. Such costs were $61,432, $6,834,000, and $33,703,301 for
the years ended December 31, 1996, 1997 and 1998, respectively. The Company
gives merchandise credit to the providers of various small Web sites through its
Cosmic Credit Program. Expenses related to this program are included in sales
and marketing expenses. 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
The Company paid interest of $19,467, $284,565 and $636,458 for the years ended
December 31, 1996, 1997, and 1998, respectively. In addition, the Company
incurred $126,954, $1,070,290, and $1,742,266 in capitalized lease obligations
for the years ended December 31, 1996 and 1997, and 1998, respectively. In 1996
the Company issued 41,244 shares of common stock to retire $81,923 of advances
due to a related party (see Note 9).
F-9
<PAGE>
Recapitalization
In April 1996, the Company amended its Articles of Incorporation to effect a
10,000-for-1 split of its common shares and to change the number of authorized
common shares to 5,000,000. In July 1997, the Company amended its Articles of
Incorporation to effect a 4-for-1 split of its common shares, to change the
number of authorized common shares to 50,000,000, and to authorize 20,000,000
shares of preferred stock. In January 1998, the Company amended its Articles of
Incorporation to effect a 1.5-for-1 split of its common shares. All references
in the consolidated financial statements to the number of shares and to per
share amounts have been retroactively restated to reflect all of these changes.
Comprehensive Income
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income"
("SFAS 130"). This statement requires companies to classify items of other
comprehensive income by their nature in a financial statement and display the
accumulated balance of other comprehensive income separately from retained
earnings and additional paid-in capital in the equity section of a statement of
financial position. SFAS 130 is effective for financial statements issued for
fiscal years beginning after December 15, 1997. The Company has adopted SFAS 130
in the first quarter of 1998. The Company has had no other comprehensive income
items to report.
Public Offerings
On February 13, 1998 the Company consummated an initial public offering of its
Common Stock (the "Initial Public Offering"). The company sold 4,561,250 shares
of its common stock, no par value, at an initial public offering price of $16.00
per share. After deducting the underwriters' discount and other offering
expenses, the net proceeds to the company were approximately $67,077,862.
On July 28, 1998 the Company consummated a secondary public offering of its
Common Stock (the "Secondary Offering"). The company sold 1,250,000 shares of
its common stock, no par value, at a public offering price of $18.50 per share.
After deducting the underwriters' discount and other offering expenses, the net
proceeds to the company were $21,473,044.
Recently Issued Accounting Pronouncements
In June 1997, the FASB issued SFAS No. 131, "Disclosure About Segments of an
Enterprise and Related Information" ("SFAS 131"). This statement establishes
additional standards for segment reporting in the financial statements and is
effective for fiscal years beginning after December 15, 1997. Management has
prepared these financial statements in accordance with SFAS 131.
In June 1998, the FASB issues SFAS No. 133," Accounting for Derivative
Instruments and Hedging Activities" ("SFAS 133"). This Statements establishes
accounting and reporting standards for derivative instruments, including certain
derivative instruments embedded in other contacts and for hedging activities and
is effective for all fiscal quarters of fiscal years beginning after June 15,
1999. Management believes that SFAS 133 will have no impact on the Company's
consolidated financial statements.
F-10
<PAGE>
In March 1998, the American Institute of Certified Public Accountants issued
Statement of Position 98-1 "Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use" ("SOP 98-1"), SOP 98-1 provides guidance
on accounting for the costs of computer software developed or obtained for
internal use. Management has not determined the impact, if any, the adoption of
SOP 98-1 will have on the Company.
Reclassifications
The statement of operations for 1996 and 1997 have been reclassified to conform
with the presentation of 1998.
Beginning in 1998, the Company determined to include royalties paid on CD sales
in return for licensing of ratings, reviews, sound samples and other information
("Information Royalties") in operating and development expenses rather than in
cost of sales, as was previously the case. This change was made based on
Management's determination that including Information Royalties in operating and
development expense was more consistent with the treatment of such expenses by
retailers generally. The financial information for periods prior to 1998 has
been restated to reflect this change. Information Royalties were $146,200,
$225,737, and $469,770 during the years ended December 31, 1996, 1997 and 1998,
respectively.
During 1998, the Company determined to include credit card processing fees
("Credit Card Fees") in sales and marketing expenses rather than in cost of
sales, as was previously the case. This change was made based on Management's
determination that including Credit Card Fees in sales and marketing expense was
more consistent with the treatment of such expenses by retailers generally. The
financial information for periods prior to 1998 has been restated to reflect
this change. Credit Card Fees were $143,702, $468,255, and $1,451,324 during the
years ended December 31, 1996, 1997 and 1998, respectively.
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.
Dependence on Suppliers
The Company's primary provider of order fulfillment for recorded music titles is
Valley Media, Inc. ("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
another fulfillment operation. 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 76%, 81%, and 85% of the cost of sales for the years ended
December 31, 1996, 1997 and 1998, respectively. Additionally, in 1996 the
Company purchased all of its imported music
F-11
<PAGE>
titles from another vendor. This vendor accounted for 14% of the cost of sales
in 1996. The Company replaced this vendor during the year ended December 31,
1997 and neither the current nor the former import vendor accounted for more
than 10% of cost of sales in the years ended December 31, 1997 and 1998.
International Sales
The Company derived 40%, 29%, and 21% of revenues for the years ended December
31, 1996, 1997, and 1998, respectively, from customers outside the United
States. All international sales are paid in U.S. dollars.
4. PROPERTY AND EQUIPMENT
<TABLE>
<CAPTION>
December 31,
Useful Life/ --------------------------
Lease Term 1997 1998
------------ ------------ ------------
<S> <C> <C> <C>
Computers and equipment................................................ 3 years $2,090,144 $ 6,910,547
Office furniture and equipment and leasehold improvements.............. 5 years 397,930 1,782,185
---------- -----------
2,488,074 8,692,732
Less--Accumulated depreciation and amortization........................ (603,778) (2,048,737)
----------- -----------
$1,884,296 $ 6,643,995
========== ===========
</TABLE>
Depreciation and amortization expense for the years ended 1996, 1997 and 1998
was $105,439, $460,589, and $1,506,828 respectively. Total property and
equipment under capital leases at December 31, 1997 and 1998 was $1,217,130 and
$2,959,396 less accumulated amortization of $252,988, and $949,076 respectively.
5. INCOME TAXES
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, 1998, the Company had a net operating loss carryforward for
federal income tax purposes of approximately $53,000,000. The net operating loss
carryforward will begin to expire in 2011.
The Company's utilization of its loss carryforward will be limited pursuant to
the Tax Reform Act of 1986, due to cumulative changes in ownership in excess of
50%.
F-12
<PAGE>
The approximate income tax effect of each type of temporary difference and the
loss carryforward is as follows:
<TABLE>
<CAPTION>
December 31,
------------------------------------
1997 1998
----------------- -----------------
<S> <C> <C>
Accruals and reserves not currently deductible................... $ 198,772 $ 409,407
Benefit of net operating loss carryforward....................... 3,584,327 18,126,168
Development expenses not currently deductible.................... 142,278 124,493
Deferred revenues................................................ 64,078 420,144
Other............................................................ (132,095) (315,425)
---------------- ----------------
3,857,360 18,764,787
Valuation allowance.............................................. (3,857,360) (18,764,787)
---------------- ----------------
$ - $ -
================ ================
</TABLE>
Due to the Company's history of operating losses the realization of the deferred
tax asset is uncertain. The Company has, therefore, provided a full valuation
allowance against the deferred tax asset.
6. DEBT
On December 31, 1995, the Company issued a note for $100,000 to a private
investor who at the time was 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 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 $62,296 in 1999, $48,833 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 bore interest at an annual rate of 12% and were due upon
consummation of the Initial Public Offering. In connection with the sale of the
Series A Notes, the Company issued warrants to these investors. The warrants
allow the investors to purchase 48,550 shares of common stock at an exercise
price of $11.90 per share. The warrants were valued using the Black-Scholes
model, and the Series A Notes were recorded net of the value of $404,425
assigned to the warrants. The notes were amortized to their face amount over
their estimated term, with $202,213 of amortization included in interest expense
for the year ended December 31, 1997 and $202,212 in the year ended December 31,
1998. The notes were repaid in February 1998.
F-13
<PAGE>
7. DISPUTE SETTLEMENT
In May 1995, MILO Productions, Inc. ("MILO"), which was owned by the Company's
then shareholders, entered into a partnership with MBL Entertainment, Inc.
("MBL") called Music Now. In December 1995, MBL, an investor and the Company's
then shareholders entered into nonbinding discussions for the purpose of
creating a new company ("NewCo") which would merge with Music Now. These
discussions contemplated, among other things, that the private investor would
make a significant cash investment in, and the Company's then shareholders would
contribute all of the outstanding capital stock of both MILO and the Company, to
NewCo. The parties abandoned these discussions in August 1996, and MBL and the
private investor subsequently instituted a legal action against the Company,
MILO and the Company's then shareholders. On December 6, 1996, the Company and
all parties involved in this dispute negotiated a settlement pursuant to which
(i) the private investor made an investment in the Company (see Note 8) and (ii)
the shareholders of MBL were issued an aggregate of 882,606 shares of common
stock. The shares issued to the shareholders of MBL were valued at $1,024,030
based on the sale of common stock to the investor, which valued the common stock
at $1.16 per share (see Note 8), with the related charge recorded as an expense
in the accompanying statement of operations for the year ended December 31,
1996. At the time of the settlement, MBL and Music Now were inactive and had no
assets or liabilities.
8. REDEEMABLE CONVERTIBLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY
Common Stock
In December 1996, the Company sold to an investor 921,834 shares of common stock
and a warrant to purchase an additional 871,710 common shares at $1.15 per
share, for aggregate consideration of $1,200,000. Using the Black-Scholes model,
the warrants were valued at $130,750. The remaining amount of the proceeds of
$1,069,250 was allocated to common stock, resulting in a value per share of
$1.16. The investor received the right to appoint two members of the Company's
Board of Directors, each having one-half vote. This right terminated upon the
consummation of the Company's Initial Public Offering. The investor, who was a
director of the Company, exercised the warrant upon consummation of the Initial
Public Offering, by tendering to the Company 62,473 shares received upon
exercise to satisfy the $999,561 exercise price. This cashless exercise resulted
in 809,237 net shares of common stock being received by the investor.
Preferred Stock
As of December 31, 1997, the Company had 20,000,000 shares of preferred stock
authorized, of which 254,582 were designated, issued and outstanding as no par
value Redeemable Series A Convertible Preferred Stock ("Series A Preferred") and
1,605,505 were designated, issued and outstanding as no par value Redeemable
Series B Convertible Preferred Stock ("Series B Preferred"). The Series A
Preferred was sold to an investor in July 1997 for $4.91 per share, resulting in
proceeds to the Company of $1,152,186, net of expenses. The Series B Preferred
was sold to investors in August 1997 for $5.45 per share, resulting in proceeds
to the Company of $8,100,305, net of expenses.
Each share of Series A and B Preferred converted into shares of the Company's
common stock upon the consummation of the Initial Public Offering in February
1998, on a 1.5-for-1 basis.
F-14
<PAGE>
The Series A and B Preferred were being accreted to their redemption values for
accounting purposes. The holders of Series A and B Preferred were entitled to
receive cumulative dividends of 8% per share per year, when and if declared by
the Company.
Equity Compensation Plan
On June 1, 1996, the Company adopted the Equity Compensation Plan (the "Plan").
Under the Plan, incentive and nonqualified stock options, restricted stock and
stock appreciation rights may be granted to employees, officers, employee
directors and independent contractors and consultants. An aggregate of 1,600,000
shares of common stock have been reserved for issuance under the Plan. No stock
options, restricted stock or stock appreciation rights were granted in 1996.
Information relative to the Plan is as follows:
<TABLE>
<CAPTION>
Weighted
Average
Range of Aggregate Exercise
Shares Exercise Prices Exercise Price Price
------------- --------------- --------------- ---------
<S> <C> <C> <C> <C>
Outstanding January 1, 1997............................... -- -- -- --
Granted................................................... 721,914 $1.33-$ 10.00 $ 2,157,680 $ 2.99
--------- ------------- ----------- ------
Outstanding December 31, 1997............................. 721,914 $1.33-$ 10.00 2,157,680 $ 2.99
Granted................................................... 454,891 $8.50-$ 35.50 9,539,892 $20.97
Exercised................................................. (100,557) $ 1.33-$ 3.00 (224,896) $ 2.24
Cancelled................................................. (32,518) $1.33-$ 19.50 (237,566) $ 7.31
--------- ------------- ----------- ------
Outstanding December 31, 1998............................. 1,043,730 $1.33-$ 35.50 $11,235,110 $10.76
========= ============= =========== ======
</TABLE>
As of December 31, 1998, there were options to purchase 230,219 shares of common
stock exercisable with a weighted average exercise price of $2.69 per share. In
addition, as of December 31, 1998, there were options to purchase 455,713 shares
of common stock available for grant under the Plan.
The Company accounts for its option grants under APB Opinion No. 25 and related
interpretations. Accordingly, compensation has been recorded for the Plan based
on the intrinsic value of the stock option at the date of grant (i.e., the
difference between the exercise price and the fair value of the Company's
stock). Compensation, if any, is deferred and recorded as expense over the
vesting period. For the year ended December 31, 1997, deferred compensation of
$751,392 was recorded for options granted, of which $316,616 and $217,863 was
charged to compensation expense for the year ended December 31, 1997 and 1998
respectively.
In 1995, the FASB issued SFAS No. 123 "Accounting for Stock Based Compensation"
(SFAS 123). SFAS 123 establishes a fair value based method of accounting for
stock-based compensation plans.
This statement also applies to transactions in which an entity issues its equity
instruments to acquire goods or services from non-employees. SFAS 123 requires
that an employer's financial statements include certain disclosures about stock-
based employee compensation arrangements regardless of the method 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 years ended December 31, 1997 and
1998 would have been as follows:
F-15
<PAGE>
<TABLE>
<CAPTION>
Year Ended Year Ended
December 31, December 31,
1997 1998
---------------- ------------------
<S> <C> <C>
Net loss applicable to common shareholders:
As reported $(11,157,508) $(43,884,463)
============ ============
Pro forma $(11,265,003) $(45,080,868)
============ ============
Net loss per common share:
As reported $ (1.42) $ (2.79)
============ ============
Pro forma $ (1.45) $ (2.88)
============ ============
</TABLE>
The weighted average fair value of the stock options granted during the years
ended December 31, 1997 and 1998 was $2.63 and $14.53, respectively. 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 5.9% to 6.8% based on the rates in effect
on the date of grant, a volatility of 60% for options granted subsequent to the
filing date of the Company's registration statement, no expected dividend yield,
and an expected life of eight years for the options.
Warrants
In August 1997, the Company issued warrants to purchase 121,560 shares of Series
B Preferred at an exercise price of $5.45 per share in connection with the
Series B Preferred financing. The warrants were issued to one of the investors
in the Series B Preferred and to the agent who represented the Company in that
financing. These warrants expire in August 2002. Upon the closing of the Initial
Public Offering, the warrants converted to warrants to purchase 182,341 shares
of common stock at $3.63 per share. Using the Black-Scholes model, the warrants
were valued at $170,000. This amount was recorded as a reduction in the carrying
value of the preferred stock and was amortized and included in the accretion to
the redemption value of the preferred stock recorded in each period.
As consideration for certain loans, the lenders received warrants to purchase
59,997 and 76,365 shares of common stock at a price of $1.83 per share until May
16, 1998 and July 16, 1998, respectively (see Note 6). Based on the warrants'
18-month term and exercise price, the Black-Scholes model calculated a minimal
value for the warrants.
Information relative to warrants follows:
<TABLE>
<CAPTION>
Grant Date
Shares Exercise Price Fair Value
-------------- ------------------- ------------
<S> <C> <C> <C>
Outstanding warrants, January 1, 1996................................. -- --
Warrants granted to investor (see Note 6)............................. 871,710 $ 1.83 $ 130,750
Warrants granted to lenders........................................... 59,997 $ 1.83 --
---------- -------------
Outstanding warrants, December 31, 1996............................... 931,707 $ 1.83
Warrants granted to lenders........................................... 76,365 $ 1.83 --
Warrants granted to holders of Series B Preferred Stock............... 182,341 $ 3.63 $ 170,000
Warrants granted to Series A Note Holders (See Note 6)................ 48,550 $11.90-$16.00 $ 404,425
---------- -------------
Outstanding warrants, December 31, 1997............................... 1,238,963 $ 1.83-$16.00
Warrants exercised including 1,138,565 shares on a cashless basis..... (1,171,292) $ 1.83-$11.90
Warrants granted to MTV Networks (see Note 10)........................ 226,892 $ 23.28 $3,000,000
---------- -------------
Outstanding warrants, December 31, 1998............................... 294,563 $ 3.63-$23.28
========== =============
</TABLE>
F-16
<PAGE>
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.
The Company had a $3,261 advance due to a founder at December 31, 1996 and 1997.
This advance was repaid in 1998. At December 31, 1995 the Company had advances
due to a founder and his father of $4,103 and $74,740, respectively. During
1996, the father advanced additional funds to the Company and, on August 16,
1996, in consideration of the cancellation of $81,923 debt due to the father,
the Company issued 41,244 shares of the Company's common stock. The exchange
ratio used to convert the debt into shares of common stock was negotiated
between the founders and their father and cannot be considered arms-length.
10. COMMITMENTS AND CONTINGENCIES
Marketing Agreements and Strategic Alliances
Yahoo! Agreement. On September 2, 1998, the Company entered into a global
merchant agreement with Yahoo! Inc. (the "Yahoo! Agreement"), extending and
expanding upon earlier agreements with Yahoo! of August 1997 and March 1998.
Under the Yahoo! Agreement: (i) the Company continues to be granted music-retail
exclusivity on music-related search-results pages on Yahoo!'s main directory,
www.yahoo.com, (ii) is integrated into other areas of the Yahoo! Service,
including Yahoo! Mail and (iii) becomes the premier music retailer on many of
Yahoo!'s international sites. The term of the Yahoo! Agreement ends on December
31, 2000, except for presence on the international sites, which ends in March,
2000. The Company may terminate the Yahoo! Agreement earlier upon payment of a
specified termination fee. Coincident with the Yahoo! Agreement, Yahoo! agreed
to purchase up to $2 million in newly-issued common shares of the Company at
market price, of which $1 million was invested in September 1998, and the
remainder is to be invested on December 31, 1999.
Excite Agreement. On September 30, 1997, the Company entered into an 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 Excite Agreement will expire in
October 2000.
Lycos Agreement. On March 26, 1998, the Company entered into an agreement with
Lycos, Inc. (the "Lycos Agreement"), pursuant to which the Company became the
exclusive retail music store sponsor of the www.lycos.com and www.tripod.com Web
sites. The Lycos Agreement has a term of three years and will expire in August
2001. The Company has issued 82,220 shares (the "Lycos Shares") of common stock
to Lycos. The Lycos Shares vest as Lycos delivers certain required minimum page
views, as defined in the Lycos Agreement. The Company has the right to
repurchase any of the Lycos shares that do not become vested at a price of $0.01
per share. The Company will measure the stock granted as
F-17
<PAGE>
it vests. If Lycos is unable to deliver a number of guaranteed minimum
impressions, some of the Lycos shares may not vest.
Lycos Bertelsmann Agreement. On April 2, 1998, the Company entered into an
agreement with Lycos Bertelsmann GMBH & Co. KG (the "Lycos Bertelsmann
Agreement"), pursuant to which the Company became the exclusive music retailer
on certain Lycos Bertelsmann branded Web services in Europe, as defined in the
Lycos Bertelsmann Agreement. The Lycos Bertelsmann Agreement has a three year
term expiring in April 2001.
MTV Agreement. On May 18, 1998, the Company entered into a binding memorandum of
terms for a three year advertising and promotion agreement with MTV Networks, a
subsidiary of Viacom International, Inc., pursuant to which the Company
committed to purchase advertising on the MTV and VH1 cable television channels
and obtained the right to use certain MTV and VH1 content. The Company has
granted MTV Networks a warrant to purchase 226,892 shares of the Company's
common stock at an exercise price of $23.28 per share. The warrant will vest
annually over the three years of the contract term.
Other Agreements.
The Company also has committed to make payments under advertising and linking
agreements with Rolling Stone Network, America Online with respect to the
Love@AOL service, GeoCities and with certain other parties.
The Company is required to pay aggregate minimum fixed fees of $24.2 million,
$24.3 million and $7.2 million during the years ending December 31, 1999, 2000
and 2001, respectively, under the Company's marketing agreements and strategic
alliances.
The Company expects to amortize the costs associated with its marketing
agreements and strategic alliances over the contract terms, with the
amortization method primarily based on the rate of delivery of a guaranteed
number of impressions to be received during the contract term.
Many of the Company's agreements, including the Yahoo!, Excite, Lycos and Lycos
Bertelsmann Agreements, contain provisions which may require additional payments
to be made by the Company based on factors such as click-throughs and new
customers generated. To date, the amount of such payments has not been material.
Such payments are charged to expense as incurred. The Company will continue to
evaluate the realizability of assets recorded, if any, related to the Yahoo!,
Excite, Lycos, Lycos Bertelsmann and other agreements, and, if necessary, write
down the assets to realizable value.
F-18
<PAGE>
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, 1998 are as follows:
<TABLE>
<CAPTION>
Operating CAPITAL
----------------- ------------------
<S> <C> <C>
1999 $ 1,210,036 $ 1,038,447
2000 1,456,776 973,580
2001 1,457,769 540,363
2002 1,391,037 115,757
2003 1,257,384 115,757
2004 and thereafter 2,627,616 231,514
----------------- ------------------
Total minimum lease payments $ 9,400,618 3,015,418
=================
Less--Amount representing interest (578,673)
------------------
Present value of minimum capitalized lease payments $ 2,436,745
==================
</TABLE>
Rent expense under operating leases was $16,905, $207,724, and $676,153 for the
years ended 1996, 1997 and 1998, respectively.
Legal Actions
From time-to-time, the Company is 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-19
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
CDNOW, INC.
(Registrant)
Dated: March 16, 1999
By: /s/ Jason Olim
---------------------------------
Jason Olim
Chairman, President and Chief
Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
Signature Title Date
--------- ----- ----
<S> <C> <C>
/s/ Jason Olim Chairman, President, Chief March 16, 1999
- --------------------------
Jason Olim Executive Officer and Director
(principal executive officer)
/s/ Joel Sussman Vice President and Chief Financial Officer March 16, 1999
- --------------------------
Sussman (principal financial and accounting officer)
/s/ Matthew Olim Technical Lead, Secretary, Treasurer and March 16, 1999
- --------------------------
Matthew Olim Director
/s/ Patrick Kerins Director March 16, 1999
- --------------------------
Patrick Kerins
/s/ John Regan Director March 16, 1999
- --------------------------
John Regan
</TABLE>
<PAGE>
EXHIBIT INDEX
Exhibit No. Description
- ---------- -----------
21 List of Subsidiaries
23 Consent of Independent Public Accountants
27 Financial Data Schedule
<PAGE>
EXHIBIT 21
LIST OF SUBSIDIARIES
<TABLE>
<CAPTION>
Percent
Name of Subsidiary Owned State/Country of Incorporation/Organization
- ------------------------- ------- -------------------------------------------
<S> <C> <C>
CDnow Investments, Inc. 100% Delaware
CDnow Trademarks, Inc. 100% Delaware
CDnow/N2K, Inc. 50% Pennsylvania
</TABLE>
<PAGE>
EXHIBIT 23
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
As independent public accountants, we hereby consent to the incorporation of our
report included in this Form 10-K, into the Company's previously filed
Registration Statement on Form S-8 (File No. 333-51191) filed with the
Securities and Exchange Commission on April 18, 1998 and the CDnow/N2K, Inc.'s
previously filed Registration Statement on Form S-4 (File No. 333-72463) filed
with the Securities and Exchange Commission on February 16, 1999.
ARTHUR ANDERSEN LLP
Philadelphia, Pa.
March 12, 1999
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FINANCIAL
STATEMENTS AS OF AND FOR THE YEAR ENDED DECEMBER 31, 1998 AND IS QUALIFIED IN
ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 49,041,370
<SECURITIES> 0
<RECEIVABLES> 1,134,663
<ALLOWANCES> (299,991)
<INVENTORY> 0
<CURRENT-ASSETS> 58,203,931
<PP&E> 8,692,732
<DEPRECIATION> (2,048,737)
<TOTAL-ASSETS> 69,043,643
<CURRENT-LIABILITIES> 15,795,761
<BONDS> 0
0
0
<COMMON> 102,137,536
<OTHER-SE> (50,998,599)
<TOTAL-LIABILITY-AND-EQUITY> 69,043,643
<SALES> 56,394,606
<TOTAL-REVENUES> 56,394,606
<CGS> 42,250,328
<TOTAL-COSTS> 42,250,328
<OTHER-EXPENSES> 57,019,322
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 636,458
<INCOME-PRETAX> (43,768,921)
<INCOME-TAX> 0
<INCOME-CONTINUING> (43,768,921)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (43,768,921)
<EPS-PRIMARY> (2.79)
<EPS-DILUTED> (2.79)
</TABLE>
