CDNOW INC/PA, 10-K, 2000-03-28

CDNOW INC/PA
10-K, 2000-03-28
RECORD & PRERECORDED TAPE STORES

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<PAGE> 1
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, 1999
-----------------
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 23-2979814
(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. [ ]

The aggregate market value of the voting stock held by non-affiliates of the
registrant is approximately $184,478,799. 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 20, 2000. 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
20, 2000 was 32,796,231.

DOCUMENTS INCORPORATED BY REFERENCE

None.

<PAGE> 2

CDNOW, INC.

FORM 10-K ANNUAL REPORT
For Fiscal Year Ended December 31, 1999

TABLE OF CONTENTS
<TABLE>
<CAPTION>
PART I

Page
----
<S> <C>
Item 1. Business..................................................................................3

Item 2. Properties...............................................................................13

Item 3. Legal proceedings........................................................................13

Item 4. Submission of Matters to a Vote of Security Holders......................................14

PART II

Item 5. Market for registrant's common equity and related stockholder matters....................15

Item 6. Selected financial data..................................................................16

Item 7. Management's discussion and analysis of financial condition and results of operations....17

Item 7A. Qualitative and quantitative disclosure about market risk................................22

Item 8. Financial statements and supplementary data..............................................22

Item 9. Changes in and disagreements with accountants on accounting and financial disclosure.....22

PART III

Item 10. Directors and executive officers of the registrant.......................................22

Item 11. Executive compensation...................................................................24

Item 12. Security ownership of certain beneficial owners and management...........................25

Item 13. Certain relationships and related transactions...........................................27

PART IV

Item 14. Exhibits, financial statement schedules, and reports on form 8-K........................ 27
</TABLE>

<PAGE> 3

This document contains certain forward-looking statements that are subject to
risks and uncertainties. Forward-looking statements include certain information
relating to trends in the electronic commerce 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 customers, the
benefits of certain technologies the company has acquired or plans to acquire
and the investments 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, through its Internet site at cdnow.com, is a leading electronic
commerce retailer of pre-recorded music, including compact discs (CDs) and
digital downloads, and other entertainment-related products as well as a source
of entertainment-related content. Its early entry into the online music
retailing industry has helped CDNOW gain a well-recognized brand and a large
customer base. CDNOW strives to combine the advantages of online commerce with
superior customer focus in order to be the authoritative source for the online
purchase of music. CDNOW offers over 500,000 items for sale. CDNOW's Internet
site offers:

- broad selection and informative content;

- easy-to-use navigation and search capabilities;

- a high level of customer service;

- competitive pricing; and

- personalized merchandising and recommendations.

Due to CDNOW's retail focus, revenues are primarily derived from the sale
of pre-recorded music and other entertainment-related products. CDNOW also sells
advertising space and sponsorships on its site to companies interested in
promoting their own goods and services to CDNOW's customer base and the large
number of visitors to CDNOW's Internet site.

On March 17, 1999, CDNOW and N2K Inc. merged. The N2K Internet site,
MusicBlvd.com, which was a major competitor to CDNOW in online retail music
sales, was merged into the CDNOW site.

<PAGE> 4

Approximately 3.2 million customers have made purchases from either CDNOW
or Music Boulevard since the inception of CDNOW in August 1994 through December
31, 1999. Approximately 1.6 million of these customers made their first purchase
during the year ended December 31, 1999. CDNOW's net sales were $147.2 million
for the year ended December 31, 1999.

CDNOW believes it has a significant number of loyal customers. In addition
to the rapid increase in new customers, CDNOW has also generated significant
sales from existing customers. Repeat customer purchases accounted for
approximately 63% of product sales in the year ended December 31, 1999.

CDnow, Inc., a Pennsylvania corporation, was incorporated in October 1998.
A predecessor corporation, also named CDnow, Inc., was incorporated in
Pennsylvania in 1994. CDNOW's principal offices are located at:

1005 Virginia Drive
Fort Washington, Pennsylvania 19034
(215) 619-9900

Recent Developments.

On July 12, 1999, CDNOW entered into an Agreement of Merger and
Contribution with Sony Corporation of America ("Sony") and Time Warner Inc.
("Time Warner") to combine its business with that of Columbia House, which is
owned equally by Sony and Time Warner. On March 13, 2000, Sony, Time Warner and
CDNOW mutually consented to terminate the Merger and Contribution Agreement and
entered into a Termination Agreement. Under the Termination Agreement, Sony and
Time Warner purchased $21 million of CDNOW's common stock (2,405,500 shares), no
par value, on March 16, 2000, and replaced a $30 million short-term loan
commitment with $30 million of long-term convertible debt, which is convertible
at the option of the holder into CDNOW common stock at $10 per share. Sony, Time
Warner, Columbia House and CDNOW also agreed to explore the possibilities of a
number of strategic relationships. Following the execution of the Termination
Agreement, CDNOW retained Allen & Company to explore strategic options and
alternative financing arrangements. On March 14, 2000, CDNOW filed a report with
the Securities and Exchange Commission on Form 8-K concerning the termination of
the proposed merger with Columbia House.

On February 1, 2000, the CDNOW Board of Directors adopted the CDNOW 2000
Equity Compensation Plan to provide grants of options to purchase CDNOW common
stock as well as grants of restricted stock to CDNOW employees. At the next
regular meeting of the shareholders of CDNOW, the Board will submit a proposal
requesting that the shareholders of CDNOW vote to approve the Plan.

On March 20, 2000, CDNOW repriced issued and outstanding options to
purchase its common stock, no par value, held by its employees, including
officers and certain members of its Board of Directors, that were set at an
exercise price greater than the closing price of CDNOW common stock, as listed
on the Nasdaq National Market on March 20, 2000, of $5.625, to this price.

The CDNOW Internet Site.

CDNOW strives to make the CDNOW site informative and authoritative.
Customers can easily learn about, discover and purchase pre-recorded music
products, including CDs, digital downloads, music-related products and other
entertainment-related products. CDNOW offers many attractive features for
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 CDNOW
site and its many features.

<PAGE> 5

Merchandising.

CDNOW currently offers more than 500,000 products including:

- CDs;

- movie and music videos on tape and DVD; and

- other products, including:

- T-shirts;

- music accessories; and

- periodic offers of audio and video equipment, such as CD recorders
and DVD players.

To encourage purchases, CDNOW features various promotions on a rotating
basis throughout its site, adjusts pricing strategies and tactics as necessary
to maintain competitiveness and generally prices recent releases and popular
titles aggressively. CDNOW also reduces shipping costs for larger orders to
encourage customers to purchase multiple titles.

Personalization. CDNOW provides customers with customized and personalized
features through its "My CDNOW" service. CDNOW believes that these features
increase customer retention, likelihood of repeat purchases and average order
size. As part of the "My CDNOW" service, CDNOW offers:

- recommendations using artificial intelligence technology;

- the ability to rate albums the customer has purchased;

- a "wish list" capability to keep track of products the customer
intends to purchase at a later date;

- a gift registry that allows visitors to purchase gifts for
participating customers;

- automatic login to avoid requiring the customer to enter his/her
userid and password each time they access the site;

- a favorite artists list;

- order history; and

- frequent buyer points.

Searching. Through CDNOW's "FastFind" search engine, customers can quickly and
easily navigate the site to find music and other products of interest. Customers
can search for music products based on artist, album title, song title, record
label, or musical genre, and for movie videos based on title, actor or director.
CDNOW's search engine uses Verity, Inc.'s K2 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.

<PAGE> 6

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 site 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 music,
the CDNOW store is organized into genre-specific music spaces. Within each genre
space, customers can browse sale items, new releases, advance orders and charts,
read reviews, listen to music samples and purchase music recommended by CDNOW.

Custom Compilations. CDNOW offers its customers the opportunity to create and
purchase customized CDs. Customers can build full-length CDs from theme-based
collections of music, including holidays (Christmas and Chanukah) and
Valentine's Day collections. Customers select their favorite songs, add a
personalized title and write their own liner notes. CDNOW expects to continue
offering custom CD collections on a regular basis. In addition, CDNOW sells
branded custom CDs to other companies for corporate promotions, in volume as
well as on-demand. CDNOW manufactures and ships custom CDs from its Fort
Washington, Pennsylvania facility and on occasion uses third parties to provide
manufacturing and shipping.

Digital Download. Beginning in July 1999, CDNOW began offering promotional music
tracks that its customers can digitally download directly to their computers. In
August 1999, CDNOW began selling music tracks in digital download format both as
individual songs and albums. CDNOW intends to continue offering various
promotional digital downloads in the future as well as digital downloads that
its customers can purchase as individual songs, albums or CDNOW-defined
compilations.

Video. In December 1999, CDNOW expanded its video store selling movies and music
videos in both VHS and DVD formats. CDNOW expects to continue enhancing the
product offerings and content of its video store.

Purchasing Product. Once a customer selects a product, he or she simply clicks
on the price to add products, including advance orders of yet-to-be released
products, to his or her virtual shopping cart. 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 complete their
purchase, customers select the ship to address, shipping and payment methods,
gift wrapping and a personalized message if desired, 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 can 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 order is placed and subsequently
confirms shipment of each order by e-mail. CDNOW offers a 30-day money-back
return policy.
<PAGE> 7

Inventory 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
offered 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,
often within a day after an order is placed with CDNOW.

Multilingual Capabilities. CDNOW generated approximately 19% of its net sales
from international markets for the year ended December 31, 1999. CDNOW derived
29% of its net revenues in 1997 and 21% in 1998 from international sales. CDNOW
offers foreign language versions of its site that contain translation of account
registration and ordering instructions, and CDNOW supports its international
sales efforts with customer service representatives fluent in these languages.
CDNOW currently offers versions of its site in the following languages:

- Dutch,
- French,
- German,
- Italian,
- Japanese,
- Spanish, and
- Portuguese.

Marketing and Promotion. CDNOW designs its marketing and promotion strategy to
broaden awareness of the CDNOW brand, increase customer traffic to CDNOW's site
and encourage new and repeat purchases. CDNOW markets and promotes its brand
using marketing agreements, online and traditional advertising, affiliate
programs that provide commissions for sales referrals and direct marketing
through e-mails to customers and prospective customers. 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.

Marketing Agreements. CDNOW believes that marketing agreements with Internet
portals and content providers and global entertainment-oriented media companies
can be a significant source of new customers. For example, under an agreement
with America Online, CDNOW and America Online share revenues generated from the
sale of advertising, sponsorships, CDs and related merchandise. CDNOW is
featured as the exclusive online music retailer within America Online's Music
Space channel, receives a featured position on America Online's Shopping
Channel, participates in a variety of banner advertising opportunities and is
assigned specific keywords within the America Online service. CDNOW's marketing
arrangement with America Online continues through August 31, 2000.

Online and Traditional Advertising.

CDNOW promotes its brand using a combination of online and traditional
advertising. CDNOW advertises on the sites of many Internet content and service
providers. As part of these arrangements, CDNOW typically purchases banner
advertisements on Internet sites relevant to CDNOW's products. When a consumer
clicks onto the banner advertisement they are immediately transferred to CDNOW's
site. CDNOW also purchases the right to be displayed on search results pages
that are generated by Internet search engines when a user makes a search using a
specific keyword, such as "jazz." The significant flexibility of online
advertising allows CDNOW to quickly adjust its advertising plans in response to
seasonal and promotional activities.
<PAGE> 8

CDNOW believes that traditional advertising, such as print, radio and
television, is a key ingredient in building brand recognition and promoting the
benefits of online retail shopping. Traditional advertising can be an effective
means of creating widespread brand awareness and attracting traditional retail
consumers to CDNOW's site, 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
programs such as MTV's 1998 Video Music Awards, VH1's Behind the Music and the
1998, 1999 and 2000 Grammy Awards. In addition, CDNOW has been featured in
television and print advertising campaigns of third parties when CDNOW conducts
joint promotions with such parties.

Co-Marketing advertising has also become an important concept in building
brand awareness and driving traffic to CDNOW. In January of 2000, CDNOW launched
a highly integrated promotion with Pizza Hut. Consumers who bought a Big New
Yorker Pizza at Pizza Hut received an access code to make their own custom CD at
cdnow.com. The promotion was offered through in-store advertising, radio spots
and network television commercials, including television commercials that aired
in January and February 2000, and a commercial during the XXXIV Super Bowl,
which aired in January 2000.

Affiliate Programs. Through its affiliate programs, as of December 31, 1999,
CDNOW maintains arrangements with over 230,000 web sites, including many small
fan sites devoted to particular music artists. CDNOW provides these sites with
embedded hyperlinks through which potential customers can immediately be
connected to the CDNOW site. CDNOW pays participants in these programs
commissions in store credit or cash based upon the dollar amount of purchases
made by persons using the link. These sites are a significant source of traffic
and new customers for CDNOW. CDNOW rewards the best sites with special
incentives.

Direct Marketing. CDNOW uses direct marketing techniques to target prospective,
new and existing customers with communications and promotions. CDNOW sends
personalized e-mails to its customers. These e-mails may contain information on
a variety of topics, including purchase recommendations based on demonstrated
customer preferences and prior purchases, information concerning new releases
and other types of promotions and sales. CDNOW also sends directed e-mail
communications to persons who have registered at CDNOW's site but have not made
purchases 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. 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, seven-days-a-week, to
provide assistance via e-mail, phone or fax. CDNOW strives to answer all
inquiries within 24 hours. CDNOW currently has approximately 140 customer
service representatives, including representatives fluent in nine foreign
languages. Customer service representatives handle questions about orders,
assist customers in finding music titles 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.
<PAGE> 9

Inventory and Filling Orders.

CDNOW does not carry inventory, except limited inventories related to its
custom compilation business and specialized products such as audio and video
equipment. CDNOW relies on third party vendors to carry inventory and fill
orders. CDNOW believes that this distribution strategy allows it to offer an
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 order fulfillment and shipment. CDNOW
typically experiences a return rate of between 1% to 2% of all merchandise sold.

CDNOW uses Valley Media as its primary vendor to fill orders. CDNOW
transmits data to Valley Media through a secure network to ensure customer
security and data integrity. Valley Media picks, packs and ships customer orders
and charges CDNOW for the cost of the merchandise, as well as shipping and
handling. In the majority of cases, products are shipped within one business day
after an order is placed. CDNOW processes customer billing through a third party
credit card processor. To date, Valley Media has generally satisfied CDNOW's
requirements on a timely basis. For the year ended December 31, 1999, costs
incurred for products shipped from Valley Media accounted for approximately 85%
of CDNOW's cost of sales. In addition to Valley Media, CDNOW:

- has initiated a relationship with Alliance Group to also fulfill orders
for CDs, cassettes and vinyl records produced in the United States;

- uses MSI of Miami Corp. to fill orders for CDs produced by foreign
labels, including 60,000 international titles from a fulfillment
center in the Netherlands servicing primarily European markets; and

- fulfills orders for videos and DVDs through Baker & Taylor.

Technology.

CDNOW has developed technologies and implemented systems to support
distributed, reliable and expandable 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.

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 CDNOW's store, are developed using a proprietary technology
that extends HTML, the typical computer software language for Internet site
development, 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 look-ups thus
reducing software updates for changes to CDNOW's site and minimizing the
engineering required to maintain a growing amount of items and content.
<PAGE> 10

Interfaces. CDNOW has developed technologies and tools for managing
interfaces with Internet service and content providers. A linking interface is
made available to businesses with which CDNOW has developed marketing
arrangements. These technologies and tools and the linking interface allow the
linking of external Internet sites, banners and promotions to items and
functions contained in CDNOW's site. CDNOW's online marketing group uses
proprietary tools to manage marketing and affiliate programs in an efficient
manner. CDNOW has developed and licensed 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 to
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 databases and web servers on a series of Sun Enterprise
servers. CDNOW uses multiple servers and redundant data storage systems to
minimize store performance degradation or downtime in the event of software or
hardware failures. 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. Since April 1997, CDNOW has been using information
gathered about a customer's preferences and recent purchases to make personal
music recommendations to its customers.

Competition.

Online commerce 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;
<PAGE> 11

- 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; and

- non-store retailers such as music clubs.

Many of these traditional retailers also have 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; and

- quality of service and technical expertise.

Some of CDNOW's current and potential competitors have:

- longer operating histories;

- larger customer bases;

- greater brand recognition; and

- significantly greater financial, marketing, technological and other
resources than CDNOW.

CDNOW is aware that several of its competitors have adopted and may
continue to adopt aggressive pricing or inventory availability policies and
devote substantially more resources to 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 on CDNOW. For
example, applications that compare specific titles from a variety of sites based
on factors such as price may channel customers to online retailers that compete
with CDNOW.
<PAGE> 12

Intellectual Property.

CDNOW regards its trademarks, trade secrets and similar intellectual
property as valuable to its business, and relies on trademark and copyright law,
trade secret protection and confidentiality and/or license agreements with its
employees, partners and third parties to protect its proprietary rights. The
steps taken by CDNOW, however, may not adequately 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, these licensees may take actions that
might significantly decrease the value of CDNOW's proprietary rights or
reputation, which could harm CDNOW.

Seasonality.

CDNOW expects that it will experience seasonality in its business,
reflecting a combination of seasonal fluctuations in Internet usage and
traditional retail seasonality patterns affecting sales of pre-recorded music
and other entertainment-related products. Sales in the traditional retail music
industry are significantly higher in the fourth calendar quarter of each year,
which corresponds to the holiday season, than in the preceding three-quarters.
Additionally, retail music sales are traditionally hits-driven through popular
releases by well-known and emerging artists. The presence or absence of hits in
any one quarter tends to affect music sales.

To date, CDNOW's limited operating history and rapid growth make it
difficult to ascertain the effects of seasonality on its business, especially
with regard to products other than the sale of music CDs. CDNOW believes that
period-to-period comparisons of its historical results are not necessarily
meaningful and should not be relied upon as an indication of future results.

Environmental Compliance. As the lessee of real property, CDNOW is subject to
laws and regulations governing protection of the environment, human health and
safety, and the use, management and disposal of hazardous substances. These laws
can impose significant costs and liabilities, including the costs of cleaning up
contaminated properties. CDNOW believes that it substantially complies with all
applicable environmental laws and regulations.

Financial Information About Geographic Areas. In 1999, CDNOW generated 81% of
its revenues from U.S. purchases and 19% of its revenues from purchases in
foreign countries.

Employees. As of March 20, 2000, CDNOW had 502 full-time and 35 part-time
employees. CDNOW also employs independent contractors and other temporary
employees in its editorial, operations and administrative functions. None of
CDNOW's employees are 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.
<PAGE> 13

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 77,000 square feet, under a lease that expires in 2006. In
addition, CDNOW leases small amounts of office space in New York City, San
Francisco, Los Angeles, London and Yokohama, Japan. CDNOW does not own any real
estate.

ITEM 3. LEGAL PROCEEDINGS

N2K and its directors were defendants in a consolidated purported class
action in the U.S. District Court for the Southern District of New York entitled
In re N2K Inc. Securities Litigation (Docket No. 98 CIV 3304 (HB)). The action
consolidated two purported class actions, entitled Kuhn v. N2K Inc. et al.
(Docket No. 98 CIV 4360 (HB)) and Bender v. Rosen et al. (Docket No. 98 CIV 3304
(HB)) that were previously discussed in N2K's Quarterly Reports on Form 10-Q for
the quarterly periods ended September 30, 1998, June 30, 1998 and March 31,
1998, and CDNOW's Quarterly Report on Form 10-Q for the quarterly periods, ended
March 31, June 30, and September 30, 1999, respectively. The consolidated action
was a purported class action on behalf of common shareholders and seeks to
recover unspecified damages and other relief, as well as costs and expenses,
stemming from alleged violations of the Securities Act of 1933 in connection
with the public offering of the shares of N2K's common stock in April 1998. The
consolidated action alleged that, among other things, the defendants failed to
disclose N2K's first quarter financial results in the registration statement for
the April 1998 public offering. The defendants moved to dismiss the complaint on
August 31, 1998 for failure to state a claim and/or for failure to plead fraud
with the requisite particularity. On May 21, 1999, Judge Baer dismissed the
plaintiff's complaint with prejudice. On June 22, 1999, plaintiffs filed a
Notice of Appeal to the U.S. Court of Appeals for the Second Circuit, which is
located in New York City. On February 7, 2000, the Second Circuit upheld Judge
Baer's dismissal of the plaintiff's complaint.

On or about November 4, 1998, an action entitled Ticketmaster Ticketing Co.
v. N2K Inc. (Docket No. BC200194) was filed against N2K in California Superior
Court for the County of Los Angeles. The Ticketmaster action alleges that N2K
breached a marketing and advertising contract dated April 23, 1998 between
Ticketmaster and N2K, which N2K terminated effective October 31, 1998, based on
alleged breaches of the agreement by Ticketmaster as well as other tortious
conduct. Ticketmaster seeks damages in an amount not less than $8,000,000, plus
pre- and post-judgment interest, as well as fees and costs. N2K filed a
cross-complaint for affirmative relief. The parties are in the process of
conducting discovery in preparation for trial.

N2K and 17 other entities have been named as defendants in a civil action
entitled Interactive Gift Express v. Compuserve, Inc., et al. (Docket 95 CV 6871
(BSJ)), which is pending in the U.S. District Court for the Southern District of
New York. N2K has also been named as defendant in a civil action entitled Parsec
Sight/Sound, Inc. v. N2K Inc. (Docket 98 CV 0118), which is pending in the U.S.
District Court for the Western District of Pennsylvania. The plaintiffs in each
of these actions allege infringement of intellectual property rights, and each
seeks treble damages and costs in an unspecified amount, as well as other
declaratory and injunctive relief. In the Interactive Gift action, the court has
issued a preliminary ruling favorable to defendants. The plaintiffs consented to
entry of judgment against them in order to speed their appeal of the court's
ruling. The parties have appealed the matter to the U.S. Court of Appeals for
the Second Circuit. In the Parsec action, CDNOW has answered the complaint and
discovery is ongoing.

CDNOW and N2K have been named defendants in an action brought by BPW
Rhythmic Records, L.L.C. for breach of contract and other related claims arising
out of a label agreement entered into between N2K Inc. and Rhythmic Records on
March 27, 1998. The plaintiff, Rhythmic Records, seeks direct, punitive and
exemplary damages, costs, including attorney's fees, and a constructive trust
against CDNOW's assets. Plaintiff originally filed the action in a Texas state
court. CDNOW and N2K removed the action to the U.S. District Court for the
Northern District of Texas, and filed a motion to have the case dismissed or
moved to the federal trial court in New York City. Subsequently, the federal
court in Texas transferred the action to the U.S. District Court for the
Southern District of New York in New York City. The parties are in the early
stages of this litigation and have not yet begun formal pre-trial discovery.

On July 14, 1999, CDNOW filed a complaint against Lycos, Inc. and its
wholly-owned subsidiary Tripod, Inc., in the U.S. District Court located in
Philadelphia, Pennsylvania. The complaint alleges that Lycos and Tripod breached
their respective obligations to CDNOW as specified in the linking agreement
entered into among CDNOW, Lycos and Tripod on March 26, 1998. CDNOW seeks
damages in excess of $75,000 and a declaratory judgment terminating the linking
agreement. On November 15, 1999, Lycos and Tripod filed an answer and
counterclaim alleging breach of contract, quantum meruit and restitution, breach
of implied covenant of good faith and fair dealing and unfair and deceptive acts
and practices. Lycos and Tripod seek dismissal of the complaint, attorneys' fees
and damages as established at trial. The parties are in the early stages of this
litigation and have not yet begun formal pre-trial discovery.
<PAGE> 14

CDNOW is a party to other lawsuits and proceedings arising in the ordinary
course of its business, none of which, in CDNOW's opinion, is likely to have a
material adverse effect on operations.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.
<PAGE> 15

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
---------------------------------------------------------------------

CDNOW'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 1999:
- --------------
First Quarter $24.94 $13.63
Second Quarter $22.25 $13.25
Third Quarter $23.27 $11.38
Fourth Quarter $18.13 $9.88

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 20, 2000 there were 354 holders of record of CDNOW's common
stock, although it believes that the number of beneficial holders of its common
stock exceeds twenty thousand. On March 20, 2000, the closing sale price of the
common stock as reported by the Nasdaq Stock Market was $5.625.

CDNOW has never declared or paid any cash dividends on its capital stock.
CDNOW currently intends to retain any earnings it may realize to finance future
growth and working capital needs and, therefore, does not anticipate paying any
cash dividends in the foreseeable future.
<PAGE> 16

ITEM 6. SELECTED FINANCIAL DATA

The following selected financial data are derived from CDNOW's 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>
Year Ended December 31,

1999 1998 1997 1996 1995
---------------- ---------------- ---------------- ---------------- ----------------
<S> <C> <C> <C> <C> <C>
Statement of Operations Data:

Net sales............................ $ 147,189,405 $ 56,394,606 $ 17,372,795 $ 6,300,294 $ 2,176,474
Cost of sales........................ 118,037,621 45,250,328 13,847,773 5,074,087 1,815,672
---------------- ---------------- ---------------- ---------------- ----------------
Gross profit......................... 29,151,784 11,144,278 3,525,022 1,226,207 360,802
Operating expenses:
Operating and development............ 23,421,062 8,000,023 2,541,434 669,280 149,982
Sales and marketing................ 89,734,790 44,572,304 9,607,603 765,156 229,912
General and administrative........... 11,736,503 4,244,194 1,953,078 563,593 180,573
Amortization of goodwill and other
intangibles ..................... 25,786,261 202,801 -- -- --
Dispute settlement................... -- -- -- 1,024,030 --
---------------- ---------------- ---------------- ---------------- ----------------
Total operating expenses............. 150,678,616 57,019,322 14,102,115 3,022,059 560,467
---------------- ---------------- ---------------- ---------------- ----------------
Operating loss....................... (121,526,832) (45,875,044) (10,577,093) (1,795,852) (199,665)
Interest income (expense), net....... 2,297,807 2,106,123 (170,312) (14,556) (1,248)
---------------- ---------------- ---------------- ---------------- ----------------
Net loss............................. (119,229,025) (43,768,921) (10,747,405) (1,810,408) (200,913)
Accretion of preferred stock to
redemption value................ -- (115,542) (410,103) -- --
---------------- ---------------- ---------------- ---------------- ----------------
Net loss applicable to common
shareholders.................... $ (119,229,025) $ (43,884,463) $ (11,157,508) $ (1,810,408) $ (200,913)
================ ================ ================ ================ ================
Net loss per common share............ $ (4.32) $ (2.79) $ (1.42) $ (0.29) $ (0.03)
================ ================ ================ ================ ================
Weighted average number of common
shares outstanding.............. 27,618,917 15,712,857 7,845,684 6,139,072 6,000,000
================ ================ ================ ================ ================

<CAPTION>
1999 1998 1997 1996 1995
Balance Sheet Data: ---------------- ---------------- ---------------- ---------------- ----------------
<S> <C> <C> <C> <C> <C>
Cash and cash equivalents............ $ 20,612,706 $ 49,041,370 $ 10,686,001 $ 775,865 $ 43,812
Working capital (deficit)............ (37,152,771) 42,408,170 (1,218,005) 231,455 (235,478)
Total assets......................... 118,801,757 69,043,043 16,448,425 1,575,459 268,468
Long-term debt, excluding current
portion......................... 2,629,359 1,750,892 962,144 91,133 9,519
Redeemable convertible preferred
stock........................... -- -- 9,492,594 -- --
Total shareholders' equity (deficit). 44,765,289 51,138,937 (9,752,450) 514,017 (99,362)
</TABLE>

<PAGE> 17

ITEM 7.

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

Overview.

CDNOW is a leading electronic commerce retailer of pre-recorded music,
including CDs and digital downloads, and other entertainment-related products.
Its early entry into the online music retailing industry has helped CDNOW gain a
well-recognized brand and a large customer base. CDNOW strives to combine the
advantages of online commerce with superior customer focus in order to be the
authoritative source for the online purchase of music. CDNOW's Internet site,
cdnow.com, offers broad selection, informative content, easy-to-use navigation
and search capabilities, a high level of customer service, competitive pricing
and personalized merchandising and recommendations. Due to CDNOW's retail focus,
revenues are primarily derived from the sale of pre-recorded music and related
products. CDNOW also sells advertising space and sponsorships to companies
interested in promoting their own goods and services to CDNOW's customer base
and the large number of visitors to CDNOW's Internet site.

CDNOW has grown rapidly since its founding in 1994. Since inception,
approximately 3.2 million customers have made purchases from either CDNOW or
from Music Boulevard, the Internet music retail store previously operated by
N2K, which was integrated into the cdnow.com Internet site on May 17, 1999.
Approximately 1.6 million customers made their initial purchase during the year
ended December 31, 1999. CDNOW's net sales grew to $147.2 million during the
year ended December 31, 1999, compared to $56.4 million during the year ended
December 31, 1998.

In addition to the sales generated from Music Boulevard customers as a
result of the acquisition of N2K and the rapid acquisition of new customers,
CDNOW has also generated significant sales from existing customers. Repeat
customers accounted for approximately 63% of net sales during the year ended
December 31, 1999, up from approximately 56% during the year ended December 31,
1998.

CDNOW believes that the key factors affecting its long-term financial
success include its ability to secure financing arrangements, obtain new
customers at reasonable costs, retain customers and encourage repeat purchases.
CDNOW seeks to expand its customer base through multiple marketing channels,
which include (i) marketing campaigns using a combination of online and
traditional offline marketing, consisting of print, television and radio
advertising, (ii) continuing marketing agreements with one or more Internet
content and service providers, (iii) entering into linking arrangements with
other Internet sites as part of its affiliate website programs, and (iv) using
direct marketing techniques to target new and existing customers with
personalized communications. CDNOW periodically enters into marketing agreements
with various Internet portals and online content providers. CDNOW presently has
marketing agreements in place with, among others, AOL, Excite and MTV/VH1.

Since inception, CDNOW has incurred significant net losses and, as of
December 31, 1999, had accumulated losses of $174.3 million. CDNOW expects that
it will continue to incur losses and generate negative cash flow from operations
for the foreseeable future. Since it 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 and/or alternative financing arrangements are not
realized, CDNOW will be materially adversely affected. There can be no assurance
that CDNOW will be able to generate sufficient revenues to achieve or maintain
profitability on a quarterly or annual basis or secure adequate funding to
continue its operations.

Results of Operations.

Year Ended December 31, 1999 Compared to the Year Ended December 31, 1998
-------------------------------------------------------------------------

Net Sales. Net sales primarily reflect the sale of pre-recorded music and other
entertainment-related products, net of estimated returns and promotional
discounts. Net sales include coupons redeemed to purchase merchandise and
outbound shipping and handling charges. Revenues from the sale of both cash and
barter advertising on CDNOW's Internet site are also included in net sales. Net
sales were $147.2 million for the year ended December 31, 1999, representing an
increase of 161% over the year ended December 31, 1998. This increase is
attributable to continued growth of CDNOW's customer base, increased sales from
repeat customers (including former Music Boulevard customers) and increased
advertising revenue. For the year ended December 31, 1999, CDNOW added
approximately 1.6 million new customers, compared to 686,000 new customers that
were added during the year ended December 31, 1998. The addition of

<PAGE> 18
approximately 1.6 million new customers for the year ended December 31, 1999
brings the total number of customers who have made purchases at either CDNOW or
Music Boulevard since each site's respective inception to approximately 3.2
million as of December 31, 1999. During 1999, CDNOW continued to devote a
substantial portion of its marketing efforts to the retention of existing
customers. Repeat customer purchases represented approximately 63% of product
sales for the year ended December 31, 1999, compared to approximately 56% for
the year ended December 31, 1998. Advertising revenue was $8.8 million for the
year ended December 31, 1999, representing an increase of 626% over the year
ended December 31, 1998.

CDNOW includes the amount of coupons redeemed to purchase merchandise in
net sales. As a percentage of net sales, coupons redeemed were 4.9% for the year
ended December 31, 1999 compared to 3.2% for the year ended December 31, 1998.
For the years ended December 31, 1999 and 1998, the total amount of redeemed
coupons included in net sales was approximately $7.2 million and $1.8 million,
respectively. CDNOW also includes the revenue associated with barter advertising
transactions in net sales. As a percentage of net sales, barter revenue was 1.3%
for both the years ended December 31, 1999 and 1998. The total amount of barter
revenue included in net sales was approximately $1.9 million and $753,000 for
the years ended December 31, 1999 and 1998, respectively.

International sales represented 19% of net sales for the year ended
December 31, 1999 compared to 21% for the year ended December 31, 1998. The
decrease in international sales as a percentage of net sales is primarily due to
a proportionally larger increase in U.S. sales resulting from heavily-promoted
shipping discounts for U.S. customers during the fourth quarter of 1999. The
decrease is also due to a proportionally larger increase in U.S. sales from
Music Boulevard customers obtained as a result of the acquisition of N2K, which
derived a smaller percentage of its sales from international customers than
CDNOW. Nevertheless, international sales increased to $27.6 million for the year
ended December 31, 1999, from $11.7 million in the year ended December 31, 1998.

Cost of Sales. Cost of sales consists primarily of the cost of merchandise sold
to customers, including product fulfillment and outbound shipping and handling
charges. Cost of sales increased 161%, to $118.0 million for the year ended
December 31, 1999, from $45.3 million for the year ended December 31, 1998. The
increase in percentage terms is identical to the 161% increase in net sales, and
hence CDNOW's gross margin remained consistent at 19.8% for the years ended
December 31, 1999 and 1998. During 1999, CDNOW pursued more aggressive pricing
policies and promotions than in 1998, but the effects were offset by the
increase in advertising revenue, which has a higher margin than product sales.

Operating and Development Expense. Operating and development expense consist
primarily of payroll and related expenses for store management, design,
development and network operations personnel, systems and telecommunications
infrastructure and fees paid by CDNOW in return for licensing of ratings,
reviews, sound samples and other information. Store maintenance costs are
charged to expense as incurred. Operating and development expense increased by
$15.4 million, or 193%, to $23.4 million for the year ended December 31, 1999
compared to $8.0 million for the year ended December 31, 1998. As a percentage
of net sales, operating and development expense was 15.9% for the year ended
December 31, 1999 compared to 14.2% for the year ended December 31, 1998. The
increase in both dollar and percentage terms is attributable to costs of systems
and telecommunications infrastructure necessary to support increased traffic and
transaction volume on CDNOW's online site, some of which is attributable to the
merger with N2K, to increased staffing and associated costs related to
maintaining the features and functionality of CDNOW's online site and
transaction-processing systems and to increased investments in store content.

Sales and Marketing Expense. Sales and marketing expense includes expenses
related to marketing agreements, advertising and promotions, including barter
advertising and coupon promotions, payroll and related expenses for personnel
engaged in marketing, selling, and customer service activities and credit card
processing fees. Sales and marketing expense increased by $45.1 million to $89.7
million for the year ended December 31, 1999 compared to $44.6 million for the
year ended December 31, 1998. As a percentage of net sales, sales and marketing
expense was 61.0% for the year ended December 31, 1999 compared to 79.0% for the
year ended December 31, 1998. The increase in absolute dollars was primarily
attributable to increased costs associated with CDNOW's marketing agreements,
including those assumed by it as a result of the acquisition of N2K and those
entered into partway through 1998. 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. The increase is also due to increased advertising and
promotional expenditures. The decrease as a percentage of sales is primarily
attributable to the increased percentage of CDNOW's sales from repeat customer
purchases, which are relatively less expensive than the cost of acquiring new
customers, and marketing efficiencies gained from the merger with N2K.

General and Administrative Expense. General and administrative expense consists
of payroll and related expenses for executive and administrative personnel,
insurance, professional fees and other general and corporate expenses. General
and administrative expense increased by $7.5 million, or 177%, to $11.7 million
for the year ended December 31, 1999 compared to $4.2 million for the year ended

<PAGE> 19

December 31, 1998. As a percentage of net sales, general and administrative
expense increased to 8% for the year ended December 31, 1999 compared to 7.5%
for the year ended December 31, 1998. The increase in both dollar and percentage
terms is primarily due to merger-related expenses of approximately $2.4 million
incurred in connection with CDNOW's terminated Merger and Contribution Agreement
to combine its business with Columbia House, the hiring of additional personnel
to support overall growth of CDNOW, and increased professional fees.

Amortization of Goodwill and Other Intangibles. Amortization of goodwill and
other intangibles related to the acquisition of N2K and superSonic Boom, Inc.
were approximately $25.8 million for the year ended December 31, 1999 compared
to $203,000 for the year ended December 31, 1998. As the acquisition of N2K was
completed in March 1999, amortization expense in 1998 only related to the
acquisition of superSonic Boom, Inc.

Net Loss Applicable to Common Shareholders. CDNOW's net loss applicable to
common shareholders was $119.2 million for the year ended December 31, 1999
compared to $43.9 million for the year ended December 31, 1998.

Year Ended December 31, 1998 Compared to the Year Ended December 31, 1997
-------------------------------------------------------------------------

Net Sales. 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,
compared to 209,000 new customers that were added during the year ended December
31, 1997.

For the years ended December 31, 1998 and 1997, the total amount of
redeemed coupons included in net sales was approximately $1.8 million and $0,
respectively. The total amount of barter revenue included in net sales was
approximately $753,000 and $0 for the years ended December 31, 1998 and 1997,
respectively.

International sales represented 21% of net sales for the year ended
December 31, 1998 compared to 29% for the year ended December 31, 1997. The
decrease in international sales as a percentage of net sales is primarily due to
a proportionally larger increase in domestic sales resulting from increased
spending in domestic marketing and advertising programs. 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 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 margin 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.

Operating and Development Expense. 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 costs related to enhancing the features
and functionality of CDNOW's on-line store 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 at 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 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,
and costs associated with its marketing agreements and promotional and public
relations expenditures. CDNOW increased its advertising expense to $33.7 million
for the year ended December 31, 1998, compared to $6.8 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.

<PAGE> 20
General and Administrative Expense. General and administrative expense increased
by $2.3 million, or 117% to $4.2 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 7.5% for the year ended December 31, 1998,
compared to 11.2% for the year ended December 31, 1997, as general and
administrative expenses were spread over a larger revenue base.

Amortization of Goodwill and Other Intangibles. Amortization of goodwill and
other intangibles of approximately $203,000 for the year ended December 31, 1998
relates to the May 1998 acquisition of superSonic Boom, Inc.

Net Loss Applicable to Common Shareholders. CDNOW's net loss applicable to
common shareholders was $43.9 million for the year ended December 31, 1998,
compared to $11.2 million for the year ended December 31, 1997.

Liquidity and Capital Resources.

At December 31, 1999, CDNOW's cash and cash equivalents were $20.6 million
compared to $49.0 million at December 31, 1998. In February 1998, CDNOW
consummated its initial public offering by selling an aggregate of 4,561,250
shares of common stock and raising net proceeds of approximately $67.1 million.
In July 1998, CDNOW consummated a second public offering by selling an aggregate
of 1,250,000 shares of common stock and raising net proceeds of approximately
$21.5 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 Series A Notes in November 1997,
internally-generated cash flows, advances from related parties and certain other
short-term loans.

Net cash used in operating activities of $51.8 million for the year ended
December 31, 1999 was primarily attributable to a net loss of $119.2 million, of
which $31.8 million was a non-cash charge for depreciation and amortization and
$1.1 million was a non-cash charge for accelerated option vesting, options
issued to non-employees, and common stock issued to employees. Additional uses
of cash included a $1.7 million increase in accounts receivable due to an
increase in fourth quarter revenues compared to 1998. These uses of cash were
partially offset by a $7.7 million decrease in prepaid expenses and other assets
primarily due to the expense of prepaid marketing agreements, a net $27.9
million increase in accounts payable and accrued expenses due to an increase in
accrued merchandise costs and accrued advertising expenses, and a $1.8 million
increase in deferred revenue and deferred rent liability. The changes in working
capital exclude the impact of the acquisition of the assets acquired and
liabilities assumed as a result of the acquisition of N2K on March 17, 1999. 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 $5.1 million
increase in accounts payable and accrued expenses, and depreciation and
amortization of $2.1 million.

Net cash provided by investing activities was $23.9 million for the year
ended December 31, 1999, which consisted of $27.8 million in net cash acquired
from the acquisition of N2K, partially offset by purchases of equipment and
leasehold improvements of $3.9 million. Net cash used in 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 financing activities was $526,000 for the year ended
December 31, 1999. During the year ended December 31, 1999, CDNOW made $1.3
million of payments under capital lease and term loan obligations including the
payoff of the capital leases and loans assumed as a result of the acquisition of
N2K. This use of cash was partially offset by the receipt of $819,000 of
proceeds from exercised warrants and options. 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 the company's Series A
Notes.

As of December 31, 1999 CDNOW's principal commitments consisted of
obligations under its marketing agreements and obligations associated with
leased office space and capital financing arrangements. CDNOW is required to pay
aggregate minimum fixed fees under its marketing agreements of $10.9 million and
$2.8 million during the years ended December 31, 2000 and 2001, respectively.

In connection with CDNOW's Merger and Contribution Agreement with Sony and
Time Warner on July 12, 1999, to combine its business with that of Columbia
House, it received a short-term loan commitment from Sony and Time Warner to
provide $30 million in working capital financing, based on certain working
capital minimums, drawable on or after December 16, 1999. On March 13, 2000,
Sony, Time Warner and CDNOW mutually consented to terminate the Merger and

<PAGE> 21
Contribution Agreement and entered into a Termination Agreement. Under the
Termination Agreement, Sony and Time Warner purchased $21 million of CDNOW
common stock and converted the $30 million short-term loan commitment from the
Merger and Contribution Agreement, into long-term convertible debt. As of March
16, 2000, CDNOW has made borrowings under the long-term convertible debt of $20
million. Following execution of the Termination Agreement, the company retained
Allen & Company to explore strategic options and alternative financing
arrangements. CDNOW believes that its current cash and cash equivalents are
sufficient to meet its payment obligations until approximately September 30,
2000. CDNOW is actively seeking third party financing or another merger
transaction. However, CDNOW cannot assure that it will be able to obtain the
financing necessary to continue supporting its business.

Seasonality.

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 its control. Factors that may
affect CDNOW's quarterly operating results include: (i) its ability to secure
alternative financing arrangements, (ii) its ability to retain existing
customers, attract new customers and maintain customer satisfaction, (iii) its
competitors, (iv) price competition or higher wholesale prices, (v) the level of
use of the Internet and consumer acceptance of the Internet for the purchase of
CDNOW's products, (vi) seasonal fluctuations in sales of CDNOW's products, (vii)
its ability to maintain its systems and infrastructure and attract qualified
personnel, (viii) technical difficulties, system downtime or Internet
performance problems not attributable to CDNOW, (ix) the amount and timing of
operating costs relating to the maintenance of CDNOW's business, operations and
infrastructure, (x) the timing of CDNOW promotions and sales programs, (xi) the
level of merchandise returns experienced by CDNOW, (xii) government regulation
and (xiii) general economic conditions and economic conditions specific to the
Internet, the online sale of products and the entertainment 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. CDNOW's computer systems and those of its key suppliers and
service providers may fail, which could result in system failures or
miscalculations causing disruptions to operations, including, among others, a
temporary inability to process transactions, create and send invoices or engage
in similar normal business activities, which may adversely affect it. CDNOW has
developed detailed plans for resolving problems related to the year 2000 issue.
To date, CDNOW has not experienced any Year 2000 problems in computer systems or
operations. However, latent Year 2000 problems could be experienced.

CDNOW actively worked with and encouraged its suppliers to minimize the
risks of business disruptions resulting from Year 2000 issues and developed
contingency plans where necessary.

CDNOW estimates that, as of December 31, 1999, the cost of remediating its
internal systems has been approximately $250,000. These efforts were funded
through normal working capital.

Recently Issued Accounting Pronouncements. See Note 2 "Recently Issued
Accounting Pronouncements" in the Consolidated Financial Statements.
<PAGE> 22

ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK
---------------------------------------------------------

Foreign Currency Risk. CDNOW's revenues and expenses are denominated in United
States dollars, with the exception of revenues and expenses related to its
Japanese internet site. Therefore, the only current exposure to foreign currency
risk relates to international sales. For the years ended December 31, 1999 and
December 31, 1998, international sales accounted for approximately 19% and 21%
of net sales, respectively. To the extent that the value of the United States
dollar increases relative to foreign currencies, it may be more costly for
international customers to make purchases. Therefore, changes in exchange rates
may impact the amount of CDNOW's international sales.

Interest Rate Risk.

CDNOW's exposure to market risk as a result of changes in interest rates
relates primarily to its investment portfolio. CDNOW invests in instruments that
meet high credit quality standards, as specified in its investment policy. This
policy also limits the amount of credit exposure to any one issue, issuer and
type of investment.

As of December 31, 1999, all of CDNOW's funds were cash equivalents. Due to
the average maturity and conservative nature of its 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 CDNOW's
investments decreased by one percent, its interest income for the year ended
December 31, 1999 would have decreased by approximately $350,000. This estimate
assumes that the decrease occurred on the first day of 1999 and reduced the
yield of each investment instrument by one percent. The impact on CDNOW's future
interest income from future changes in investment yields will depend largely on
the gross amount of its investments. (See the "Liquidity and Capital Resources"
section of this report).

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

CDNOW's financial statements 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

CDNOW's executive officers and directors are as follows:
<TABLE>
<CAPTION>
Name Age Position
- ---- --- --------
<S> <C> <C>
Jason Olim................. 30 President and Chief Executive Officer
Jonathan V. Diamond ....... 41 Chairman of the Board of Directors
Matthew Olim............... 30 Technical Lead and Director
Rod Parker (1)............. 56 Senior Vice President of Product Management and Marketing
Joel Sussman............... 51 Vice President and Chief Financial Officer
Michael Krupit............. 36 Chief Operating Officer
Robert Saltzman............ 48 Vice President of Corporate Sales and Development
David Capozzi.............. 43 Vice President, General Counsel and Secretary
Steve Dong (4)............. 41 Vice President of Operations
James E. Coane............. 59 Director
Patrick Kerins (2) (3).... 44 Director
John Regan (2) (3)......... 40 Director
</TABLE>

(1) Mr. Parker resigned in July 1999.
(2) Member of the Audit Committee of the Board of Directors.
(3) Member of the Compensation Committee of the Board of Directors.
(4) Mr. Dong resigned as of March 20, 2000.

Jason Olim co-founded CDNOW in February 1994 and has been President since
inception and Chief Executive Officer since November 1997. Previously, Mr. Olim
was employed in the Professional Services group of Soft-Switch, Inc. where he
designed and built software systems for routing mail and documents for domestic
and international clients. Mr. Olim has a Bachelor of Arts degree in Computer
Science from Brown University.
<PAGE> 23

Jonathon V. Diamond has been CDNOW's Chairman of the Board since the
effective date of the merger with N2K on March 17, 1999. Mr. Diamond served as
Vice Chairman and a director of N2K from February 1996 to March 17, 1999. From
June 1995 to February 1996, Mr. Diamond served as Co-Chairman of New York N2K.
Mr. Diamond was an investor in and director of Telebase Systems, Inc. from
September 1994 to February 1996. Mr. Diamond founded and was Chairman, from 1991
to 1995, of the J. Diamond Group, a holding company which acquired and launched
six media and entertainment companies in the U.S. and the U.K. From 1984 to
1990, Mr. Diamond served as a director and Executive Vice President of GRP, a
jazz record label, where he was responsible for its business and financial
strategy. Prior to his association with GRP, Mr. Diamond founded Diamond
Investments, which acquired or launched companies in the media, entertainment
and broadcasting areas. Mr. Diamond holds a B.A. in Economics and Music from the
Honors College of the University of Michigan and an M.B.A. from Columbia
University's Graduate School of Business.

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

Rod Parker was Senior Vice President of Product Management and Marketing
from June 1997 through July 1999.

Joel Sussman has been a Vice President and CDNOW's 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 was CDNOW's Vice President of Technology from October 1997
through January 31, 2000 and was the Director of Technology from April 1997 to
October 1997. Mr. Krupit was promoted to Chief Operating Officer on February 1,
2000. 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 Saltzman has been the Vice President of Strategic Business
Development since December 1997. Mr. Saltzman served as the Director of Business
Development at Bell Atlantic Network Integration from November 1995 to December
1997. From 1987 to 1995, Mr. Saltzman held various sales and marketing positions
with Unisys Corporation.

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

Steve Dong was Vice President of Operations from May 1998 until March 20,
2000.

James E. Coane has been a member of CDNOW's Board of Directors since the
effective date of the merger with N2K on March 17, 1999. Mr. Coane served as
President, Chief Operating Officer and a director of N2K from February 1996
through March 17, 1999. From April 1987 to February 1996, Mr. Coane served as
President and Chief Executive Officer of N2K and as Chairman of the Board of
Directors from 1993 until February 1996. From 1984 to 1987, Mr. Coane served as
President and Chief Operating Officer of Morris Decision Systems, Inc., a
marketer and supplier of microcomputers and related peripherals. Mr. Coane is a
Phi Beta Kappa graduate of Duke University with an A.B. in Economics and
Business Administration.

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

<PAGE> 24
John Regan has been a director since July 1997. Since February 1995, Mr.
Regan has been a Vice President of Keystone Venture IV Management Company, L.P.
which is the general partner of Keystone Venture IV, L.P. From 1989 to February
1995, he was an associate and then general partner of Apex Management
Partnership, a venture capital partnership.

CDNOW's Amended and Restated Bylaws divide the Board of Directors into
three classes, and each director will serve for a staggered three-year term. 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 date, CDNOW has not assigned its directors to specific classes. 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.

CDNOW's executive officers 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. CDNOW reimburses its directors for out-of-pocket expenses
incurred in connection with their rendering of services as directors. CDNOW
currently does not intend to pay cash fees to directors for attendance at
meetings. Directors who are not currently receiving compensation as CDNOW
officers or employees are eligible to receive options under the CDNOW 1999
Equity Compensation Plan. To date, no such options have been granted to
directors under either of these plans.

Compensation Committee Interlocks and Insider Participation. Since August 1997,
recommendations concerning the aggregate compensation of CDNOW employees were
made to the Compensation Committee by CDNOW's President. The Compensation
Committee was formed in August 1997. The members of the Compensation Committee
are Patrick Kerins and John Regan. Prior to August 1997, decisions concerning
the compensation of CDNOW employees, including its executive officers, were made
by the Board of Directors, which included Jason Olim and Matthew Olim.

Executive Compensation
<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 1999 $193,077 $ -- $ -- $ -- $ 2,822 (6)
President and Chief 1998 147,858 -- -- -- 2,286
Executive Officer 1997 89,583 -- -- -- 1,272
- ------------------------------------------------------------------------------------------------------
Jonathan Diamond
Chairman of the Board 1999 200,384 -- 6,720 (7) -- --
of Directors (1)
- ------------------------------------------------------------------------------------------------------
Rod Parker 1999 153,859 -- 12,574 (3) 10,000 1,154 (6)
Senior Vice President (2) 1998 212,412 55,000 37,218 -- 2,525
1997 130,730 -- 3,879 120,000 1,335
- ------------------------------------------------------------------------------------------------------
Robert Saltzman 1999 152,489 -- -- 60,000 1,333 (6)
Vice President (4) 1998 147,998 -- -- -- --
1997 10,301 -- -- 75,000 --
- ------------------------------------------------------------------------------------------------------
James Coane
Director (5) 1999 151,442 -- 10,094 (7) -- 1,575 (6)
</TABLE>
(1) Mr. Diamond became the Chairman of the Board of Directors on the N2K
merger effective date on March 17, 1999.
(2) Mr. Parker commenced employment with CDNOW in June 1997 and resigned
in July 1999. Mr. Parker has a one-year severance agreement, which
expires in July 2000.
(3) Other Annual Compensation for Mr. Parker includes reimbursement for an
apartment in Pennsylvania and travel expenses. Mr. Parker's residence
is in Connecticut.
(4) Mr. Saltzman commenced employment with CDNOW in December 1997.
(5) Mr. Coane became a member of the CDNOW Board of Directors on the N2K
merger effective date on March 17, 1999.
(6) Represents CDNOW contribution to 401(k) Plan.
(7) Represents automobile allowance.

The following table sets forth information regarding stock options held as
of December 31, 1999 by executive officers named in the Summary Compensation
Table. The dollar values are based on closing sales price per share on December
31, 1999 as reported on the Nasdaq National Market. The closing price per share
on that date was $9.88.
<PAGE> 25

Fiscal Year-End Option Values
<TABLE>
<CAPTION>
Number of Securities
Underlying Unexercised Value of Unexercised In-The-Money
Options at December 31, 1999 Options at December 31, 1999
Shares Value ------------------------------ ---------------------------------
Name Exercised Received Exercisable Unexercisable Exercisable Unexercisable
- ---------------- ----------- ------------ ------------- --------------- -------------- ---------------
<S> <C> <C> <C> <C> <C> <C>
Jonathan Diamond -- -- 310,770 11,428 $ 1,001,011 $ 66,275
Rod Parker 120,000 $1,782,900 5,000 5,000 -- --
Robert Saltzman -- -- 40,625 119,375 -- --
James Coane 5,903 $ 70,723 102,714 -- $ 375,776 --
</TABLE>

Equity Compensation Plans.

CDNOW has adopted the 1996 Equity Compensation Plan (the "1996 Plan") and
the 1999 Equity Compensation Plan (the "1999 Plan") (together the "Plans")
pursuant to which it has awarded stock options to its employees, officers,
non-employee directors and certain independent contractors and consultants.
CDNOW ceased granting stock options pursuant to the 1996 Plan as of March 17,
1999. Since that date, stock options and restricted stock have been granted only
pursuant to the 1999 Plan.

The 1996 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 1999 Plan provides for the issuance to
employees, non-employee directors and eligible independent contractors and
consultants of up to 2,500,000 shares of common stock pursuant to the grant of
ISOs, NQSOs, and restricted stock. Both Plans are administered by the
Compensation Committee of the Board of Directors, which currently consists of
Messrs. Kerins and Regan. Subject to the provisions of the Plans, the
Compensation 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 Plans, the Compensation Committee may also amend the terms
of any outstanding award. Effective upon the CDNOW/N2K merger on March 17, 1999,
CDNOW assumed the equity compensation plans formerly administered by N2K (the
"N2K Plans").

As of March 20, 2000, options to purchase a total of 3,441,080 shares of
common stock were outstanding. Of these options, options to purchase 1,207,853
shares of common stock were fully vested and exercisable as of March 20, 2000.
As of March 20, 2000, the company had an additional 541,908 shares of common
stock available for future grants under the 1996 Plan and an additional 496,460
shares of common stock available for future grants under the 1999 Plan. CDNOW
has made no grants under any of the N2K Plans it assumed and will not be making
any grants in the future under the N2K Plans.

The option price per share of common stock under the Equity Compensation
Plans is determined by the Compensation 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 CDNOW'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 or check.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table sets forth information regarding the beneficial ownership of
CDNOW common stock for the following persons or entities as of March 20, 2000:

- - Each person known to CDNOW to - The chief executive officer
own beneficially more than 5% and four other most highly
of the outstanding shares of compensated executive
CDNOW common stock; officers of CDNOW; and

- - Each director of CDNOW; - All directors and executive
officers of CDNOW as a group.

Unless otherwise indicated, to CDNOW's knowledge, all persons and entities
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.
<PAGE> 26

<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 2,960,025 -- 2,960,025 9.0%
Matthew Olim 2,960,025 -- 2,960,025 9.0%
Jonathan V. Diamond 663,382 335,646 999,028 3.0%
James E. Coane 94,090 97,526 191,616 *
Patrick Kerins 1,000 1,569 2,569 *
John Regan (1) 1,819 -- 1,819 *
Joel Sussman 981 36,750 37,731 *
Steve Dong 729 61,100 61,829 *
Michael Krupit 11,474 18,875 30,349 *
Robert Saltzman 33,508 50,937 84,445 *
All executive officers and directors as a
group (11 persons) 6,725,214 633,440 7,358,654 22.4%

Five Percent Holders
- --------------------
Carlos Slim Helu (2),
Grupo Sanborns, S.A. de C.V. (3),
Grupo Carso, S.A. de C.V. (4), collectively 2,000,000 -- 2,000,000 6.1%
Time Warner Inc. (5) (7) 2,211,100 -- 2,211,100 6.7%
Sony Music Entertainment Inc. (6) (7) 2,211,100 -- 2,211,100 6.7%
</TABLE>

* Less than one percent.

(1) Includes 1,819 shares held by Keystone Ventures IV, L.P., a partnership of
which Mr. Regan is a Vice President of the general partner.
(2) The address of Carlos Slim Helu is Paseo de las Palmas 736, Col. Lomas de
Chapultepec, Mexico, D.F., 11000, Mexico. Mr. Slim and members of his
immediate family, directly and through their ownership of a majority of the
voting and economic interests in a trust, own a majority of the outstanding
voting equity securities of Grupo Carso. Accordingly, Mr. Slim may be
deemed to beneficially own 2,000,000 shares of common stock.
(3) The address of Grupo Sanborns, S.A. de C.V., is Av. San Fernando No. 649,
Col. Pena Pobre, Tlalpan, Mexico, D.F. 14060, Mexico.
(4) The address of Grupo Carso, S.A. de C.V., is Insurgentes Sur No. 3500, Col.
Pena Pobre, Tlalpan, Mexico, D.F. 14060, Mexico. Grupo Carso is the parent
of Grupo Sanborns and therefore beneficially owns 2,000,000 shares of CDNOW
common stock.
(5) The address of Time Warner Inc. is 75 Rockefeller Plaza, New York,
New York 10019.
(6) The address of Sony Music Entertainment, Inc. is 550 Madison Avenue,
New York, New York 10022.
(7) On March 15, 2000 and in connection with the termination of the merger
agreement among CDNOW, Time Warner Inc., Sony Music Entertainment, Inc. and
Columbia House, CDNOW issued 1,202,750 shares of common stock, no par
value, to each of TWI CDNOW Holdings Inc., a wholly owned subsidiary of
Time Warner, Inc., and Sony Music Entertainment Inc. in consideration of
cash payments of $10.5 million each. Additionally, each of Time Warner
Inc. and Sony Music Entertainment Inc. have a right at any time to convert
long-term debt in the amount of $10 million plus accrued interest of
$83,500, as of March 20, 2000, to CDNOW's common stock, no par value, at a
price of $10 per share.

Compliance with Section 16(a) of the Securities Exchange Act of 1934. Section
16(a) of the Securities Exchange Act of 1934 requires a company's directors and
executive officers and persons who beneficially own more than 10% of that
company's common stock to file reports of ownership and changes in ownership
with the Securities and Exchange Commission. These directors, executive officers
and greater than 10% stockholders are required by regulation of the Securities
and Exchange Commission to furnish to the company copies of all Section 16(a)
forms they file. Initial Statements of Beneficial Ownership of Securities on
Form 3 for the following directors and executive officers of CDNOW were not
filed on a timely basis: Patrick Kerins, Michael Krupit, Joel Sussman, David A.
Capozzi, Matthew Olim, Rod Parker, Steven Dong, Jason Olim, John Regan, Robert
Saltzman, Robert David Grusin and James E. Coane. An Initial Statement of
Beneficial Ownership of Securities on Form 3 for Jonathan V. Diamond has not
been filed with the Securities and Exchange Commission. A Form 4 was not filed
on a timely basis for James E. Coane.

<PAGE> 27

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
----------------------------------------------

None.

PART IV
-------

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

Financial Statements and Financial Statement Schedules
- ------------------------------------------------------
1. See Index to Financial Statements at page F-1.

All other schedules have been omitted because the required information is
included in the consolidated financial statements or the notes there to, or
is not applicable or required.

Reports on Form 8-K
- -------------------
None

Exhibits
- --------
None

<PAGE> 28

CDNOW, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<S> <C>
Report of Independent Public Accountants F - 1
Consolidated Balance Sheets F - 2
Consolidated Statements of Operations F - 3
Consolidated Statements of Redeemable Convertible Preferred Stock
and Shareholders' Equity (Deficit) F - 4
Consolidated Statement of Cash Flows F - 5
Notes to Consolidated Financial Statements F - 6
</TABLE>

<PAGE> 29

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To CDnow, Inc.:

We have audited the accompanying consolidated balance sheets of CDnow, Inc. (a
Pennsylvania Corporation) and Subsudiaries as of December 31, 1999 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, 1999. 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 its
subsidiaries as of December 31, 1999 and 1998, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1999, in conformity with generally accepted accounting principles.

The accompanying financial statements have been prepared assuming that the
company will continue as a going concern. As discussed in Note 1 to the
financial statements, the company has suffered recurring losses from operations,
has a working capital deficiency and significant payments due in 2000 related to
marketing agreements that raises substantial doubt about its ability to continue
as a going concern. Management's plans in regard to these matters are also
described in Note 1. The financial statements do not include any adjustments
that might result from the outcome of this uncertainty.

/s/ Arthur Andersen LLP

Philadelphia, Pa.
January 28, 2000 (except with
respect to matters discussed
in Note 1, as to which the
date is March 16, 2000)

F-1
<PAGE> 30

CDNOW, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>

December, 31
--------------------------------------
ASSETS 1999 1998
------ ----------------- -----------------
CURRENT ASSETS:
<S> <C> <C>
Cash and cash equivalents $ 20,612,706 $ 49,041,370
Accounts receivable, net 4,068,700 839,672
Prepaid expenses and other 5,580,241 8,322,889
----------------- -----------------
Total current assets 30,261,647 58,203,931

Property and equipment, net 17,216,980 6,643,995
Goodwill and other intangibles, net 70,121,321 833,735
Other assets 1,201,809 3,361,982
----------------- -----------------
$ 118,801,757 $ 69,043,643
================= =================

LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
CURRENT LIABILITIES:
Current portion of long term debt $ 1,670,838 $ 822,043
Accounts payable 46,431,122 10,306,323
Accrued merger costs 1,384,679 --
Accrued expenses and other current liabilities 17,927,779 4,667,395
----------------- -----------------
Total current liabilities 67,414,418 15,795,761

Long term debt 2,629,359 1,750,892
Common stock subject to put rights 2,999,995 --
Deferred rent liabilities 992,696 358,053

COMMITMENTS AND CONTINGENCIES (Note 10)

STOCKHOLDERS' EQUITY:
Preferred stock, no par value, 50,000,000 and 20,000,000
shares authorized, no shares issued and outstanding -- --
Common stock, no par value, 200,000,000 and 50,000,000
shares authorized, 30,355,948 and 17,842,975 issued
and outstanding 204,573,908 102,137,536
Additional paid-in capital 14,589,814 4,325,817
Deferred compensation (61,905) (216,913)
Accumulated deficit (174,336,528) (55,107,503)
----------------- -----------------
Total stockholders' equity 44,765,289 51,138,937
----------------- -----------------
$ 118,801,757 $ 69,043,643
================= =================
</TABLE>

The accompanying notes are an integral part of these statements.

F-2
<PAGE> 31

CDNOW, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>

December 31,
------------------------------------------------------
1999 1998 1997
---------------- ---------------- ----------------
<S> <C> <C> <C>
Net Sales $ 147,189,405 $ 56,394,606 $ 17,372,795
Cost of Sales 118,037,621 45,250,328 13,847,773
---------------- ---------------- ----------------
Gross profit 29,151,784 11,144,278 3,525,022

OPERATING EXPENSES:
Operating and development 23,421,062 8,000,023 2,541,434
Sales and marketing 89,734,790 44,572,304 9,607,603
General and administrative 11,736,503 4,244,194 1,953,078
Amortization of goodwill and other intangibles 25,786,261 202,801 --
---------------- ---------------- ----------------
Total operating expenses 150,678,616 57,019,322 14,102,115
---------------- ---------------- ----------------
Operating loss (121,526,832) (45,875,044) (10,577,093)

Interest and other Income 2,688,882 2,742,581 201,650
Interest expense (391,075) (636,458) (371,962)
---------------- ---------------- ----------------
NET LOSS (119,229,025) (43,768,921) (10,747,405)

Accretion of preferred stock to redemption value -- (115,542) (410,103)
---------------- ---------------- ----------------
Net loss applicable to common shareholders $ (119,229,025) $ (43,884,463) $ (11,157,508)
================ ================ ================
Basic and diluted loss per common share:
Net loss per common share $ (4.32) $ (2.79) $ (1.42)
================ ================ ================
Weighted average number of shares outstanding 27,618,917 15,712,857 7,845,684
================ ================ ================
</TABLE>

The accompanying notes are an integral part of these statements.

F-3
<PAGE> 32

CDNOW, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF REDEEMABLE PREFERRED STOCK AND

SHAREHOLDERS' EQUITY (DEFICIT)
<TABLE>
<CAPTION>
Shareholders' Equity (Deficit)
-------------------------------------------------------------------------
Redeemable
Convertible Common Stock Additional
Preferred ---------------------- Paid-in Deferred Accumulated
Stock Shares Amount Capital Comp. Deficit Total
----------- ---------- ------------ ----------- ---------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE AT DECEMBER 31, 1996 $ -- 7,845,684 $ 579,549 $ -- $ -- $ (65,532)$ 514,017
Sale of redeemable Series A and B
convertible preferred stock, net of
expenses and value of warrants issued 9,082,491 -- -- 170,000 -- -- 170,000
Value of warrants issued with Series A
convertible notes -- -- -- 404,425 -- -- 404,425
Grant of common stock option below deemed
fair value for accounting purposes -- -- -- 751,392 (751,392) -- --
Amortization of deferred compensation -- -- -- -- 316,616 -- 316,616
Accretion of preferred stock to
redemption value 410,103 -- -- -- -- (410,103) (410,103)
Net loss -- -- -- -- -- (10,747,405) (10,747,405)
----------- ---------- ------------ ----------- ---------- ------------- ------------
BALANCE AT DECEMBER 31, 1997 9,492,594 7,845,684 579,549 1,325,817 (434,776) (11,223,040) (9,752,450)
Accretion of preferred stock to
redemption value 115,542 -- -- -- -- (115,542) (115,542)
Mandatory conversion of redeemable Series
convertible preferred stock to common (9,608,136) 2,790,131 9,608,136 -- -- -- 9,608,136
Issuance of common stock from consummation
of IPO, net of offering costs -- 4,561,250 67,077,862 -- -- -- 67,077,862
Issuance of common stock from secondary
offering, net of offering costs -- 1,250,000 21,473,044 -- -- -- 21,473,044
Issuance of common stock -- 222,952 3,634,198 -- -- -- 3,634,198
Cashless exercise of warrants -- 1,039,674 -- -- -- -- --
Exercise of warrants -- 32,727 59,890 -- -- -- 59,890
Exercise of options -- 100,557 224,896 -- -- -- 224,896
Remeasurement of value of shares issued to
Lycos (Note 10) -- -- (520,039) -- -- -- (520,039)
Amortization of deferred compensation -- -- -- -- 217,863 -- 217,863
Issuance of warrants -- -- -- 3,000,000 -- -- 3,000,000
Net loss -- -- -- -- -- (43,768,921) (43,768,921)
----------- ---------- ------------ ----------- ---------- ------------- ------------
BALANCE AT DECEMBER 31, 1998 -- 17,842,975 102,137,536 4,325,817 (216,913) (55,107,503) 51,138,937
Equity issued in connection with the
purchase of N2K -- 12,159,249 101,833,713 9,281,189 -- -- 111,114,902
Employee compensation -- 6,397 102,335 -- -- -- 102,335
Exercise of warrants -- 2,521 30,000 -- -- -- 30,000
Exercise of options -- 344,806 788,925 -- -- -- 788,925
Compensation expense due to option
acceleration -- -- -- 903,000 -- -- 903,000
Consulting expense related to options
issued -- -- -- 79,808 -- -- 79,808
Remeasurement of value of shares issued to
Lycos (Note 10) -- -- (318,601) -- -- -- (318,601)
Amortization of deferred compensation -- -- -- -- 155,008 -- 155,008
Net loss -- -- -- -- -- (119,229,025)(119,229,025)
----------- ---------- ------------ ----------- ---------- ------------- ------------
BALANCE AT DECEMBER 31, 1999 $ -- 30,355,948 $204,573,908 $14,589,814 $ (61,905)$(174,336,528)$ 44,765,289
=========== ========== ============ =========== ========== ============= ============
</TABLE>

The accompanying notes are an integral part of these statements.
F-4
<PAGE> 33

CDNOW, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>

Year Ended December 31,
--------------------------------------------------------
1999 1998 1997
---------------- ---------------- ----------------
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net loss $ (119,229,025) $ (43,768,921) $ (10,747,405)
Adjustments to reconcile net loss to net cash used in
operating activities
Depreciation and amortization 31,815,364 2,129,703 1,066,815
Accelerated common stock option vesting 903,000 -- --
Common stock issued to employees 102,335 -- --
Common stock options issued to non-employees 79,808 -- --
Increase (decrease) in operating assets and liabilities
Accounts receivable (1,726,926) (510,181) (193,974)
Prepaid expenses and other 7,720,665 (3,676,843) (2,401,794)
Accounts payable 31,083,120 1,246,991 8,545,748
Accrued expenses (3,152,884) 3,896,255 472,455
Deferred rent liability 634,643 301,336 56,717
---------------- ---------------- ----------------
Net cash used in operating activities (51,769,900) (40,381,660) (3,201,438)

INVESTING ACTIVITIES
Net cash acquired in (used in) acquisition 27,783,893 (423,694) --
Purchases of property and equipment (3,916,706) (4,407,477) (912,560)
Sales and maturities of short-term investments -- 1,003,045 248,097
Purchases of short-term investments -- -- (1,005,501)
---------------- ---------------- ----------------
Net cash provided by (used in) investing activities 23,867,187 (3,828,126) (1,669,964)

FINANCING ACTIVITIES
Payments on term loans payable (67,470) (54,194) (28,179)
Payments on capitalized lease obligations (1,277,406) (438,843) (64,043)
Proceeds from options exercised 788,925 224,896 --
Proceeds from warrants exercised 30,000 59,890 --
Proceeds from issuance of common stock, net -- 88,550,906 --
Proceeds from issuance (repayment) of Series A notes -- (5,777,500) 5,602,706
Borrowings on term loans payable -- -- 218,563
Payments on notes payable -- -- (200,000)
Proceeds from sales of preferred stock -- -- 9,252,491
---------------- ---------------- ----------------
Net cash provided by (used in) financing activities (525,951) 82,565,155 14,781,538
---------------- ---------------- ----------------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (28,428,664) 38,355,369 9,910,136
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 49,041,370 10,686,001 775,865
---------------- ---------------- ----------------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 20,612,706 $ 49,041,370 $ 10,686,001
================ ================ ================

</TABLE>
The accompanying notes are an integral part of these statements.

F-5
<PAGE> 34

CDNOW, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. THE COMPANY

CDNOW is a leading electronic commerce retailer of pre-recorded music,
including compact discs (CDs) and digital downloads and other
entertainment-related products. CDNOW's revenues are derived from the sale of
pre-recorded music, other entertainment-related products and advertising on the
cdnow.com site. CDNOW contracts with outside vendors for fulfillment services to
deliver its products to customers.

On October 22, 1998, CDNOW and N2K Inc. ("N2K"), a Delaware corporation,
entered into an Agreement and Plan of Merger. CDNOW and N2K survived the merger
and became wholly-owned subsidiaries of CDnow/N2K, Inc. At the closing of the
merger on March 17, 1999, each outstanding share of common stock of CDNOW was
converted into one share of CDNOW/N2K and each outstanding share of common stock
of N2K was converted into .83 shares of CDNOW/N2K. As a result, the shareholders
of CDNOW owned approximately 60% of the combined company and the stockholders of
N2K owned approximately 40% of the combined company as of March 17, 1999. Also
on that date, CDnow/N2K was renamed CDNOW, Inc.

On July 12, 1999, CDNOW entered into an Agreement of Merger Contribution
with Sony Corporation of America ("Sony") and Time Warner Inc. ("Time Warner")
to combine its business with that of Columbia House, which is owned equally by
Sony and Time Warner. On March 13, 2000, Sony, Time Warner and CDNOW mutually
consented to terminate the Merger and Contribution Agreement and entered into a
Termination Agreement. Under the Termination Agreement, Sony and Time Warner
purchased $21 million of CDNOW's common stock (2,405,500 shares), no par value,
on March 16, 2000, and replaced a $30 million short-term loan commitment with
$30 million of long-term convertible debt, which is convertible at the option of
the holder into CDNOW common stock at $10 per share (see Note 7). Sony, Time
Warner, Columbia House and CDNOW also agreed to explore the possibilities of a
number of strategic relationships. Following execution of the Termination
Agreement, the company retained Allen & Company to explore strategic options and
alternative financing arrangements. CDNOW believes that its current cash and
cash equivalents are sufficient to meet its payment obligations until
approximately September 30, 2000. CDNOW is actively seeking third party
financing or another merger transaction. However, CDNOW can not assure that it
will be able to obtain the financing necessary to continue supporting its
business. On March 14, 2000 CDNOW filed a report on Form 8-K with the Securities
and Exchange Commission concerning the termination of the proposed merger with
Columbia House.

Since inception (February 12, 1994), CDNOW has incurred significant losses,
and as of December 31, 1999 had accumulated losses of $174.3 million. For the
years ended December 31, 1999, 1998 and 1997, CDNOW's net losses applicable to
common shareholders were $119.2 million, $43.9 million and $11.2 million,
respectively. In addition, CDNOW has a working capital deficit of $37.2 million
as of December 31, 1999. CDNOW believes it will continue to incur substantial
operating losses for the foreseeable future. Because CDNOW has relatively low
product gross margins, achieving profitability depends upon its ability to
generate and sustain substantially increased revenue and gross margins. There
can be no assurance that CDNOW will be able to generate sufficient revenues or
gross margins to achieve or sustain profitability in the future. In addition,
CDNOW has significant payments due in 2000 related to marketing agreements.

CDNOW is currently financing its working capital needs with cash derived
from revenues, funds from the equity investment of $21 million by Sony and Time
Warner and the long-term convertible debt facility available from Sony and Time
Warner (see Note 7). CDNOW is actively engaged in pursuing other financing
arrangements. However, CDNOW can not assure that it will be able to obtain the
financing necessary to continue to support its business.

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 inter-company
balances and transactions have been eliminated in consolidation.

Reclassifications. The consolidated financial statements for prior periods have
been reclassified to conform with the current period's presentation.

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, 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-6
<PAGE> 35
Net Loss Per Common Share.

CDNOW has presented net loss per common share amounts for the years ended
December 31, 1999, 1998 and 1997 pursuant to Statement of Financial Accounting
Standards ("SFAS") No. 128 "Earnings Per Share" and the Securities and Exchange
Commission Staff Accounting Bulletin No. 98.

Basic and diluted 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 share is the same amount as basic
earnings per share because the impact on loss per share using the treasury stock
method is anti-dilutive due to CDNOW's losses.

Cash and Cash Equivalents. Cash equivalents are carried at cost plus accrued
interest, which approximates fair value. CDNOW considers all highly liquid
investments with an original maturity date of three months or less to be cash
equivalents. CDNOW's cash and cash equivalents were $20,612,706 and $49,041,370
at December 31, 1999 and 1998, respectively, and primarily included money market
funds.

Short-Term Investments. At December 31, 1999 and 1998, CDNOW had no short-term
investments. The gross proceeds from sales and maturities of short-term
investments were $1,003,045 and $248,097 during the years ended December 31,
1998 and 1997, respectively. These short-term investments consisted of
government mortgage-backed bonds with a maturity date of less than a year. For
the purpose of determining gross realized gains and losses, the cost of the
securities sold was based upon specific identification.

Prepaid Expenses.

CDNOW follows the American Institute of Certified Public Accountants
(AICPA) Statement of Position 93-7 "Reporting for Advertising Costs" ("SOP
93-7") to account for its marketing agreements. Under SOP 93-7, CDNOW amortizes
the costs associated with its marketing 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 are charged to expense
as incurred. CDNOW evaluates the realizability of assets recorded, and if
necessary, writes down the assets to its net realizable value.

Prepaid expenses include $3,888,309 and $7,278,116 at December 31, 1999 and
1998, respectively, related to marketing agreements (see Note 10). Other assets
include the long-term portion of marketing agreements of $803,791 and $2,208,036
at December 31, 1999 and 1998, respectively.

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. CDNOW has adopted Statement of
Position 98-1 "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use" ("SOP 98-1"), effective for fiscal years beginning
after December 15, 1998. Accordingly, the costs of computer software developed
or obtained for internal use have been capitalized and amortized over the
estimated useful life of three years. At December 31, 1999, net capitalized
computer software developed or obtained for internal use was $1,391,961.

Common Stock Subject to Put Rights. America Online, Inc. ("AOL") and N2K, a
predecessor-in-interest to and, as of the merger of CDNOW and N2K, a
wholly-owned subsidiary of CDNOW, entered into an agreement pursuant to which
AOL agreed to purchase at N2K's initial public offering price per share of
$19.00 (less underwriting discounts and commissions) an aggregate amount of
approximately $3.0 million or 169,779 shares of N2K's common stock (the "AOL
Purchase"). Subsequent to the Merger, the price per share converted to $22.89
and the number of shares converted to 140,916 shares of CDNOW common stock. N2K
granted AOL certain shelf and other registration rights with respect to the
shares purchased by AOL, including the right to require N2K to register such
shares for resale, to have such registration statement declared effective on or
before April 16, 1998 and to maintain the effectiveness of such registration
statement for a period of two years from the consummation of the AOL Purchase.
As N2K had not caused such registration statement to be declared effective by
April 16, 1998, AOL has the right to require CDNOW, as a successor-in-interest
to N2K, to repurchase such shares for cash at a price equal to the greater of
the original purchase price or the then-current fair market value. Accordingly,
the value of these shares is not included in stockholders' equity. Presently,
F-7
<PAGE> 36
these shares have not been registered and AOL has not exercised its put right.
The common stock subject to put rights on CDNOW's consolidated balance sheets
will be accreted to its fair market value based upon the price of CDNOW's common
stock at each reporting date. The fair market value will be recorded as a charge
to retained earnings at each reporting date and will reduce earnings available
to common shareholders. The fair market value of CDNOW's common stock as of
December 31, 1999 was $9.88 per common share. As of December 31, 1999, there was
no charge as the market value of CDNOW's common stock was below $22.89 per
common share.

Revenue Recognition.

Net sales, which consist primarily of pre-recorded music and other
entertainment-related products sold via the Internet, include shipping and
handling charged to customers, and are recognized net of promotional discounts
when the products are shipped. CDNOW records a reserve for estimated returns,
which is based on historical return rates. Revenue from the sale of cash and
barter advertising on the cdnow.com site is recognized as the advertising is
run.

CDNOW includes the amount of coupons redeemed to purchase merchandise in
net sales. For the years ended December 31, 1999, 1998 and 1997, the total
amount of redeemed coupons included in net sales was approximately $7.2 million,
$1.8 million, and $0, respectively. CDNOW also includes the revenue associated
with barter advertising transactions in net sales. The total amount of barter
revenue included in net sales was approximately $1.9 million, $753,000, and $0
for the years ended December 31, 1999, 1998 and 1997, respectively.

Operating and Development. Operating and development expense consists primarily
of payroll and related expense for store management, design, development and
network operations personnel, systems and telecommunications infrastructure and
royalties paid by CDNOW on product sales in return for licensing of ratings,
reviews, sound samples and other information.

Sales and Marketing. Sales and marketing expense includes expenses related to
marketing agreements, advertising and promotions, as well as payroll and related
expenses for personnel engaged in marketing, selling and customer service
activities and credit card processing fees. The expenses associated with
redeemed coupons and barter advertising revenue are also included in sales and
marketing expense. Advertising costs are included in sales and marketing expense
and are charged as incurred. Advertising costs were $56,985,536, $33,703,301,
and $6,834,000, for the years ended December 31, 1999, 1998 and 1997,
respectively. CDNOW pays commissions in the form of merchandise credit or cash
to the members of its Cosmic Credit and C2 affiliate programs. Expenses related
to these programs are included in sales and marketing expenses. CDNOW estimates
the amount of unused credits and includes this amount in accrued expenses.

Gift Certificates. Unredeemed gift certificates are recorded as deferred revenue
and included in accrued expenses in the accompanying balance sheets. Gift
certificates are recognized in net sales when they are redeemed.

Supplemental Cash Flow Information. CDNOW paid interest of $391,075, $636,458
and $284,565 for the years ended December 31, 1999, 1998, and 1997,
respectively. CDNOW acquired fixed assets under capital lease arrangements in
the amount of $2,763,916, $1,742,266, and $1,070,290 for the years ended
December 31, 1999, 1998 and 1997, respectively.

The following table displays the net non-cash assets that were consolidated as a
result of CDNOW's acquisition of N2K (see Note 4):

<TABLE>
<CAPTION>
Non-cash assets (liabilities):
<S> <C>
Accounts receivable $ 1,502,102
Prepaid expenses and other 6,441,601
Property and equipment 9,766,458
Goodwill and other intangibles 91,768,692
Term loans and capital lease obligations (308,223)
Accounts payable (5,041,679)
Accrued expenses (17,797,947)
Common stock subject to put rights (2,999,995)
Fair market value of options and warrants assumed (9,281,189)
----------------
Net non-cash assets acquired 74,049,820
Cash acquired 27,783,893
----------------
Common stock issued $ 101,833,713
================
</TABLE>
F-8
<PAGE> 37

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

Segment and Geographic Information. 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. CDNOW operates in one principal business segment across
domestic and international markets. CDNOW derived 19%, 21%, and 29% of revenues
for the years ended December 31, 1999, 1998, and 1997, respectively, from
customers outside the United States. No foreign country or foreign geographic
area accounted for more than 10% of net sales in any of the periods presented.
Substantially all of the domestic operating results and identifiable assets are
in the United States.

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

On July 28, 1998 CDNOW consummated a secondary public offering of its Common
Stock (the "Secondary Offering") by selling 1,250,000 shares of its common
stock, no par value, at a price of $18.50 per share. After deducting the
underwriters' discount and other offering expenses, the net proceeds to CDNOW
were $21,473,044.

New Accounting Pronouncements. In June 1998, the FASB issued SFAS No. 133,"
Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). This
Statement 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 years beginning after
June 15, 2000. Management believes that the adoption of SFAS 133 will have no
impact on its operating results or financial position.

In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB
101"). SAB 101 summarizes certain of the Staff's views in applying generally
accepted accounting principles to recognition, presentation and disclosure of
revenue in financial statements. Compliance with SAB 101 is required no later
than the first quarter of the fiscal years beginning after December 15, 1999.
Management believes that SAB 101 will not have a material impact on the
company's operating results or financial position.

3. RISKS AND UNCERTAINTIES

CDNOW's future results of operations involve a number of risks and
uncertainties. Factors that may affect CDNOW's future operating results include:
(i) its ability to retain existing customers, attract new customers and maintain
customer satisfaction, (ii) the introduction of new or enhanced Web pages,
services, products and marketing agreements by CDNOW and its competitors, (iii)
price competition or higher wholesale prices, (iv) the level of use of the
Internet and consumer acceptance of the Internet for the purchase of CDNOW's
products, (v) seasonal fluctuations in sales of CDNOW's products, (vi) its
ability to upgrade and develop its systems and infrastructure and attract
qualified personnel, (vii) technical difficulties, system downtime or Internet
performance problems not attributable to CDNOW, (viii) the amount and timing of
operating costs and capital expenditures relating to expansion of CDNOW's
business, operations and infrastructure, (ix) the timing of promotions and sales
programs, (x) the level of merchandise returns experienced, (xi) government
regulation and (xii) general economic conditions and economic conditions
specific to the Internet, the online sale of products and the entertainment
industry.

Sufficient Cash to Fund Its Business. CDNOW believes that its current cash and
cash equivalents are sufficient to meet its payment obligations until
approximately September 30, 2000. CDNOW is actively seeking third party
financing or another merger transaction. However, CDNOW cannot assure that it
will be able to obtain the financing necessary to continue supporting its
business.
F-9
<PAGE> 38
Dependence on Suppliers

CDNOW's primary provider of order fulfillment for recorded music titles is
Valley Media, Inc. ("Valley"). CDNOW 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. During the fourth quarter of 1999, CDNOW signed a
two year contract extension with Valley. However, there can be no assurance that
the relationship with Valley will be maintained beyond the term of this contract
extension, which expires in October 2001, or that CDNOW will be able to find an
alternative, comparable vendor capable of providing fulfillment services on
terms satisfactory to CDNOW should its relationship with Valley terminate.
Valley accounted for 85%, 85%, and 81% of the cost of sales for the years ended
December 31, 1999, 1998 and 1997, respectively. No other vendor accounted for
more than 10% of the total cost of sales during 1999, 1998 or 1997.

4. ACQUISITIONS

On March 17, 1999, CDNOW completed its merger with N2K by acquiring 100% of
N2K's capital stock for 12,159,249 shares of CDNOW common stock valued at
approximately $101,834,000. CDNOW was the acquiring entity for accounting
purposes. The acquisition has been accounted for under the purchase method of
accounting, whereby the purchase price has been allocated to the assets
purchased and the liabilities assumed based on their fair market values at the
date of acquisition. The excess of the purchase price over the net assets
acquired was recorded as goodwill and other intangibles. The following table
indicates the current allocation of excess purchase price and amortization
periods of goodwill and other intangibles related to the acquisition of N2K:
<TABLE>
<CAPTION>
Intangible Assets Assigned Value Amortization Period
- ------------------------------------- ------------------- ----------------------
<S> <C> <C>
Web site technology $ 4,000,000 2 years
Strategic alliances/customers 19,000,000 3 years
Assembled workforce 2,200,000 3 years
Goodwill 66,568,692 3 years
-------------------
Total goodwill and other intangibles $91,768,692
===================
</TABLE>
CDNOW also recorded $3.3 million in deferred acquisition costs related to
the acquisition of N2K, which is being amortized over 3 years. The balance of
accrued merger costs relating to the acquisition of N2K was approximately $1.4
million as of December 31, 1999 and primarily includes severance-related costs
and professional fees. Amortization of goodwill and other intangibles related to
the acquisition of N2K and superSonic Boom, Inc. was approximately $25.8 million
for the year ended December 31, 1999. Amortization of goodwill and other
intangibles was $202,801 for the year ended December 31, 1998 and only related
to the acquisition of superSonic Boom, Inc. CDNOW recorded $1.0 million of
goodwill related to the May 1998 acquisition of superSonic Boom, Inc., which is
being amortized over 3 years.

N2K's results of operations have been included in the company's
consolidated financial statements since the effective date of the acquisition on
March 17, 1999. The following table summarizes the unaudited pro forma results
of operations of CDNOW as if the N2K acquisition had occurred on January 1,
1998. The pro forma information does not purport to be indicative of the results
that would have been attained had the operations actually been combined during
the period presented.
<TABLE>
<CAPTION>
Year Ended December 31,
--------------------------------
1999 1998
--------------- ---------------
<S> <C> <C>
Net revenue $ 160,673,784 $ 98,474,743
Net loss $ (138,366,738) $ (120,765,396)
Loss per common share $ (4.59) $ (4.33)
</TABLE>

5. PROPERTY AND EQUIPMENT
<TABLE>
<CAPTION>
December 31,
Useful Life/ ---------------------------------
Lease Term 1999 1998
--------------- --------------- ---------------
<S> <C> <C> <C>
Computers, software and equipment 3 years $ 19,075,430 $ 6,910,547
Office furniture and equipment and leasehold improvements 5 years 6,064,382 1,782,185
--------------- ---------------
25,139,812 8,692,732
Less - accumulated depreciation and amortization (7,922,832) (2,048,737)
--------------- ---------------
$ 17,216,980 $ 6,643,995
=============== ===============
</TABLE>
F-10
<PAGE> 39
Depreciation and amortization expense for the years ended December 31,
1999, 1998 and 1997 was $5,874,095, $1,506,828 and $460,589, respectively. Total
property and equipment under capital leases at December 31, 1999 and 1998 was
$5,850,621 and $2,959,396, less accumulated amortization of $2,506,510 and
$949,076, respectively.

6. 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, CDNOW operated as
an unincorporated entity. From April 25, 1995 until December 5, 1996, CDNOW was
incorporated and elected to be taxed under Subchapter S of the Internal Revenue
Code. As a result, CDNOW 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, CDNOW terminated its status as an S corporation
and is now subject to federal and state income taxes.

Due to CDNOW's acquisition of 100% of the capital stock of N2K (see Note
4), there was a change in ownership as defined by Section 382 of the Internal
Revenue Code (the "Section 382 Limitation"). The Section 382 Limitation limits
CDNOW's ability to utilize N2K's net operating loss carryforwards created prior
to the ownership change. CDNOW is currently analyzing the amount of the
limitation. CDNOW estimates that the maximum net operating loss carryforwards
available to offset future taxable income, including those generated by N2K, is
approximately $258 million at December 31, 1999.

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

<TABLE>
<CAPTION>
December 31,
----------------------------
1999 1998
------------- -------------
<S> <C> <C>
Accruals and reserves not currently deductible $ 3,703,465 $ 409,407
Benefit of net operating loss carryforward 87,590,511 18,126,168
Development expenses not currently deductible 2,933,895 124,493
Deferred revenues 594,331 420,144
Other (2,030,355) (315,425)
------------- -------------
92,791,847 18,764,787
(92,791,847) (18,764,787)
------------- -------------
Valuation allowance $ -- $ --
============= =============
</TABLE>
Due to CDNOW's history of operating losses the realization of the deferred
tax asset is uncertain. CDNOW has, therefore, provided a full valuation
allowance against the deferred tax asset.

7. DEBT

In 1997, CDNOW obtained three term loans from a bank for an aggregate of
$218,563. The proceeds from the loans were used to purchase equipment. The
equipment purchased collateralizes the loans. CDNOW's two founders personally
guaranteed the loans. In 1999, CDNOW elected to prepay the balance on one of the
loans. The remaining two loans bear interest at rates of 8.0% and 8.5% and are
repayable in installments over 36 and 48 months, respectively. On the remaining
two loans, annual principal repayments are $41,855 in 2000, and $26,866 in 2001.

In November 1997, CDNOW 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, CDNOW issued warrants to these investors. The warrants allowed
the investors to purchase 48,550 shares of common stock at an exercise price of
$11.90 to $16.00 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. Amortization of deferred financing
costs, related to the Series A Notes, was $87,397 in 1998 and 1997 and is
included in interest expense.

F-11
<PAGE> 40
From November 16, 1996 through January 31, 1997, CDNOW 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, CDNOW repaid $110,000 of the
loans and, on July 16, 1997, the remaining unpaid balance plus accrued interest
was paid.

In connection with CDNOW's Merger and Contribution Agreement with Sony and
Time Warner on July 12, 1999, to combine its business with that of Columbia
House, CDNOW received a short-term loan commitment from Sony and Time Warner to
provide it with $30 million in working capital financing, based on certain
working capital minimums, drawable on or after December 16, 1999. On March 13,
2000, Sony, Time Warner and CDNOW mutually consented to terminate the Merger
Contribution Agreement and entered into a Termination Agreement. Under the
Termination Agreement, Sony and Time Warner purchased $21 million of CDNOW
common stock, no par value, and converted the $30 million short-term loan
commitment from the Merger and Contribution Agreement, into long-term
convertible debt. Borrowings under the convertible loan bear interest at the six
month London interbank offered rate in effect two days prior to the borrowing
plus 3%. Principal and interest on the borrowings are due no later than January
15, 2003. Sony and Time Warner may at any time convert any portion of the
borrowings and accrued interest under the convertible loan into CDNOW common
stock at a $10 conversion price. As of December 31, 1999, no borrowings were
made under the convertible loan. As of March 16, 2000, CDNOW has made borrowings
of $20 million.

8. REDEEMABLE CONVERTIBLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY

Preferred Stock.

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

Each share of Series A and B Preferred was converted into shares of CDNOW
common stock, no par value, upon the consummation of CDNOW's Initial Public
Offering in February 1998, on a 1.5-for-1 basis.

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 CDNOW.

Common Stock Options.

On June 1, 1996, CDNOW adopted the CDNOW 1996 Equity Compensation Plan (the
"1996 Plan"). Under the 1996 Plan, incentive and nonqualified stock options,
restricted 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 1996
Plan. All grants made prior to the CDNOW/N2K merger were made under the 1996
Plan. As of December 31, 1999, 1,256,805 options were granted under the 1996
Plan of which 334,035 were exercised, 174,706 were cancelled and 748,064 remain
outstanding. As of December 31, 1999, there were options of 517,901 shares of
common stock available for grant under the 1996 Plan.

The CDNOW 1999 Equity Compensation Plan (the "1999 Plan") became effective
upon the CDNOW/N2K merger on March 17, 1999. Under the 1999 Plan, incentive and
nonqualified stock options and restricted stock may be granted to employees,
including employees who are officers or members of the Board of Directors,
members of the Board of Directors who are not employees and independent
contractors and consultants. An aggregate of 2,500,000 shares of common stock
have been reserved for issuance under the 1999 Plan. All grants made subsequent
to the CDNOW/N2K merger were made under the 1999 Plan. As of December 31, 1999,
2,339,075 options were granted under the 1999 Plan of which 385,564 were
cancelled and 1,953,511 remain outstanding. As of December 31, 1999, there were
options of 546,489 shares of common stock available for grant under the 1999
Plan.

Effective upon the CDNOW/N2K merger on March 17, 1999, CDNOW assumed the
equity compensation plans formerly administered by N2K (the "N2K Plans").
Consistent with outstanding N2K shares, all option shares were adjusted by a
factor of .83 and all exercise prices were adjusted by an inverse factor of .83.
CDNOW assumed 1,040,250 of options under the N2K Plans and 302,414 of options
outside of the N2K Plans. As of March 17, 1999, CDNOW had made no grants under
the N2K Plans and will not make future grants under the N2K Plans. CDNOW
recorded $7.1 million in additional paid in capital for the estimated fair value
of the options assumed in connection with the N2K acquisition (see Note 2). As
of December 31, 1999, 648,875 options under the N2K Plans remain outstanding and
121,544 options outside the N2K Plans remain outstanding.

F-12
<PAGE> 41
Information relative to all stock options is as follows:
<TABLE>
<CAPTION>

Range of Aggregate Weighted Average
Shares Exercise Prices Exercise Price Exercise 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
Granted 2,419,075 $ 14.50 - $24.00 42,377,830 $ 17.52
N2K options assumed 1,342,664 $ 3.13 - $39.16 19,971,574 $ 14.87
Exercised (344,806) $ 1.33 - $14.46 (788,925) $ 2.29
Cancelled (988,669) $ 1.33 - $39.16 (17,014,022) $ 17.21
------------ ------------------ ---------------- ----------------
Outstanding December 31, 1999 3,471,994 $ 1.33 - $35.50 $ 55,781,567 $ 16.07
============ ================== ================ ================
</TABLE>
Information relative to CDNOW's outstanding options as of December 31, 1999 is
as follows:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
------------------------------------------------------ -------------------------------------
Range of Exercise Shares Average Life Average Shares Average Exercise
Prices Outstanding (Years) Exercise Price Exercisable Price
- --------------------- ----------------- ------------------ ----------------- ------------------ ------------------
<S> <C> <C> <C> <C> <C>
$ 1.33 - $10.00 603,620 6.4 $ 4.39 427,216 $ 4.23
$ 10.01 - $20.00 2,331,166 8.4 $ 16.83 348,279 $ 15.79
$ 20.01 - $30.00 411,138 7.6 $ 23.27 228,122 $ 23.79
$ 30.01 - $39.16 126,070 7.8 $ 34.34 56,281 $ 33.71
----------------- ------------------ ----------------- ------------------ ------------------
3,471,994 7.9 $ 16.07 1,059,898 $ 13.81
================= ================== ================= ================== ==================
</TABLE>
CDNOW accounts for its options using the disclosure-only option under SFAS
No. 123, "Accounting for Stock-Based Compensation." CDNOW continues to apply APB
Opinion No. 25 and related interpretations to account for its option grants.
Accordingly, compensation has been recorded for the plans 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 CDNOW's common stock on the date of grant).
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 $155,008, $217,863, and $316,616 was
charged to compensation expense for the years ended December 31, 1999, 1998 and
1997, respectively. During 1999, CDNOW incurred a severance charge of $903,000
as a result of the acceleration of the vesting period of common stock options.
Also during 1999, CDNOW incurred a charge of $102,335 related to common stock
given as compensation to certain employees and a charge of $79,808 for common
stock options given to consultants in return for professional services.

Pro forma information regarding net income and earnings per share is
required by SFAS No. 123, and has been determined as if CDNOW had accounted for
its stock option plans under the fair value method of SFAS No. 123. Under the
provisions of SFAS No. 123, CDNOW's pro forma net loss and net loss per common
share for the years ended December 31, 1999, 1998 and 1997 were as follows:
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------------------------------------------
1999 1998 1997
------------------- -------------------- ------------------
<S> <C> <C> <C>
Net loss applicable to common shareholders:
As reported $ (119,229,025) $ (43,884,463) $ (11,157,508)
=================== ==================== ==================
Pro forma $ (125,239,113) $ (45,080,868) $ (11,265,003)
=================== ==================== ==================
Net Loss per common share:
As reported $ (4.32) $ (2.79) $ (1.42)
=================== ==================== ==================
Pro forma $ (4.53) $ (2.88) $ (1.45)
=================== ==================== ==================
</TABLE>
F-13

<PAGE> 42
The weighted average fair value of the stock options granted during the years
ended December 31, 1999, 1998 and 1997 was $12.13, $14.53, and $2.63,
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:
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------------------------------------------
1999 1998 1997
------------------- -------------------- ------------------
<S> <C> <C> <C>
Risk-free interest rate based on the rates in
effect on the date of grant 4.7% - 6.5% 5.9% 6.4% - 6.8%
Expected dividend yield 0.0% 0.0% 0.0%
Expected life 8 years 8 years 8 years
Expected volatility 60% 60% 60%
</TABLE>

Warrants.

In August 1997, CDNOW issued warrants to purchase 121,560 shares of Series
B Preferred at an exercise price of $5.45 per share, in connection with its
Series B Preferred financing. The warrants were issued to one of the investors
in the Series B Preferred and to the agent who represented CDNOW in that
financing. These warrants expire in August 2002. Upon 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 from November 16, 1996 through January
31, 1997 (see Note 7), 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. Based on the warrants' 18 month term and
exercise price, the Black-Scholes model calculated a minimal value for the
warrants.

In connection with the sale of the Series A Notes in November 1997 (see
Note 7), CDNOW issued warrants to the investors. The warrants allow the
investors to purchase 48,550 shares of common stock at an exercise price of
$11.90 to $16.00 per share. As of December 31, 1999, 27,523 of the shares under
warrant remain to be purchased. The warrants were valued using the
Black-Scholes, and the Series A Notes were recorded net of the value of $404,425
assigned to the warrants.

Pursuant to the May 18, 1998 binding memorandum of terms with MTV Networks
(see Note 10), CDNOW granted MTV Networks a warrant to purchase 226,892 shares
of CDNOW's common stock, no par value, at an exercise price of $23.28 per share.
On May 18, 1999, 75,630 shares vested and the remaining shares under the warrant
will vest annually over the remainder of the contract.

Effective upon the CDNOW/N2K merger on March 17, 1999, CDNOW assumed all
warrants issued by N2K. Consistent with outstanding N2K shares and options all
warranted shares were adjusted by a factor of .83 and all exercise prices were
adjusted by an inverse factor of .83. Outstanding warrants assumed from N2K by
CDNOW include 344,298 shares at a price of $14.46 with expirations ranging from
May 2003 through August 2004 and 153,331 shares related to the AOL agreement at
a price of $22.89 expiring October 2004. CDNOW recorded $2.2 million in
additional paid in capital for the estimated fair value of the warrants assumed
in connection with the N2K acquisition.

Information relative to the warrants follows:
<TABLE>
<CAPTION>
Grant Date
Shares Exercise Price Fair Value
------------- ----------------- -------------
<S> <C> <C> <C>
Outstanding warrants, January 1, 1997 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 7) 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 of 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
N2K warrants assumed 497,629 $ 14.46-$22.89 $ 2,181,189
Warrants exercised (2,521) $ 11.90
------------- -----------------
Outstanding warrants, December 31, 1999 789,671 $ 3.63-$23.28
============= =================
</TABLE>
F-14
<PAGE> 43
9. RELATED-PARTY TRANSACTIONS

A portion of additional paid-in capital represents the deemed fair value of
services contributed to CDNOW 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 CDNOW'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. CDNOW's Board of Directors
determined the fair value of services contributed by the founders. In
determining the value, the Board considered the founders' level of experience,
position in the company, the compensation level of other employees, CDNOW's
financial resources and the status of the company's development. In addition,
CDNOW received a $3,261 advance from a founder at December 31, 1996 and 1997.
This advance was repaid in 1998.

10. COMMITMENTS AND CONTINGENCIES

Marketing Agreements.

Yahoo! Agreement. On September 2, 1998, 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 was (i) granted music-retail exclusivity on music-related
search-results pages on Yahoo!'s main directory, www.yahoo.com (ii) integrated
into other areas of the Yahoo! service, including Yahoo! Mail and (iii) the
premier music retailer on many of Yahoo!'s international sites. In September of
1999, CDNOW elected to exercise the early termination clause in the Yahoo
Agreement, to terminate its relationship with Yahoo! effective December 31,
1999, and pay an early termination fee of $500,000. This termination did not
effect CDNOW's presence on Yahoo!'s international sites, which ends in March
2000. Coincident with the Yahoo! Agreement, Yahoo! agreed to purchase up to $2
million in newly-issued common shares of CDNOW common stock, no par value, at
market price, of which $1 million was invested in September 1998. The commitment
to purchase the remaining $1 million on December 31, 1999 was terminated in
conjunction with the termination of the Yahoo! Agreement.

Webcrawler Agreement. On September 30, 1997, CDNOW entered into an
agreement with Excite, Inc., the owner of the webcrawler.com service, pursuant
to which CDNOW became the exclusive retail music store sponsor of the
Webcrawler.com Internet site. The Webcrawler Agreement required CDNOW 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
Webcrawler Agreement was terminated effective August 16, 1999.

Lycos Agreement. On March 26, 1998, CDNOW entered into an agreement with
Lycos, Inc., pursuant to which it became the exclusive retail music store
sponsor of the www.lycos.com and www.tripod.com Web sites. The Lycos Agreement
was terminated by CDNOW effective August 13, 1999 in conjunction with the
initiation of litigation by the company against Lycos for breach of Lycos'
contractual obligations under the agreement.

Lycos Bertelsmann Agreement. On April 2, 1998, CDNOW entered into an
agreement with Lycos Bertelsmann GMBH & Co. KG, pursuant to which CDNOW 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 was amended on August 18, 1999 and expired on December 31, 1999.

MTV Agreement. On May 18, 1998, CDNOW 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 it committed to
purchase advertising on the MTV and VH1 cable television channels and obtained
the right to use certain MTV and VH1 content. CDNOW has granted MTV Networks a
warrant to purchase 226,892 shares of its common stock at an exercise price of
$23.28 per share (see Note 8).

America Online Agreement. Effective upon the CDNOW/N2K merger on March 17,
1999, CDNOW assumed the Interactive Marketing Agreement between N2K and America
Online, Inc. dated September 1, 1997. Pursuant to the AOL Agreement, CDNOW is
receiving an integrated package of placements, promotions and links through the
AOL Service. Additionally, N2K granted AOL a warrant for the future purchase of
up to 184,736 shares of N2K common stock at an exercise price equal to the
initial public offering price per share, which was $19.00 per share. Upon the
completion of the merger between CDNOW and N2K on March 17, 1999, CDNOW assumed
the warrant at the merger adjusted figures of 153,331 shares for future purchase
at a price of $22.89 (see Note 8). The AOL Agreement will continue until August
31, 2000.

Excite Agreement. Upon the completion of the merger between CDNOW and N2K
on March 17, 1999, CDNOW assumed the Sponsorship Agreement dated September 23,
1997 between N2K and Excite, Inc., pursuant to which it became the exclusive
retail music store sponsor of the Excite Web site and the Excite Broadcast
Pages. The Excite Agreement will continue until April 30, 2000.

Netscape Agreement. Upon the completion of the merger between CDNOW and N2K
on March 17, 1999, CDNOW assumed the Web Site Services Agreement dated September
27, 1997 between N2K and Netscape Communications Corporation. The Netscape
Agreement will continue until May 30, 2000.

F-15
<PAGE> 44
CDNOW is required to pay aggregate minimum fixed fees of $10.9 million and
$2.8 million during the years ended December 31, 2000 and 2001, respectively,
under its existing marketing agreements. Depending on the type of marketing
agreement, CDNOW will expense advertising purchased under marketing agreements
when the advertising is run or amortize the costs associated with its marketing
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.

Several of CDNOW's 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. CDNOW
will continue to evaluate the realizability of assets recorded under the
agreements above and other agreements, and, if necessary, write down the assets
to realizable value.

Leases. CDNOW 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, 1999 are as
follows:
<TABLE>
<CAPTION>
Operating Capital
------------------- -----------------
<S> <C> <C>
2000 $ 3,325,491 $2,169,550
2001 3,309,403 1,683,170
2002 2,722,771 1,033,627
2003 1,878,451 147,157
2004 1,897,551 147,157
2005 and thereafter 1,975,618 159,420
------------------- -----------------
Total minimum lease payments $ 15,109,285 5,340,081
=================== -----------------
Less - amount representing interest (1,108,605)
-----------------
Present value of minimum capitalized lease payments $4,231,476
=================
</TABLE>
Rent expense under operating leases was $1,798,623, $676,153, and $207,724
for the years ended 1999, 1998 and 1997, respectively.

Legal Actions.

F-16
<PAGE> 45

Sight/Sound, Inc. v. N2K Inc. (Docket 98 CV 0118), which is pending in the U.S.
District Court for the Western District of Pennsylvania. The plaintiffs in each
of these actions allege infringement of intellectual property rights, and each
seeks treble damages and costs in an unspecified amount, as well as other
declaratory and injunctive relief. In the Interactive Gift action, the court has
issued a preliminary ruling favorable to defendants. The plaintiffs consented to
entry of judgment against them in order to speed their appeal of the court's
ruling. The parties have appealed the matter to the U.S. Court of Appeals for
the Second Circuit. In the Parsec action, CDNOW has answered the complaint and
discovery is ongoing.

CDNOW is a party to other lawsuits and proceedings arising in the ordinary
course of its business, none of which, in CDNOW's opinion, is likely to have a
material adverse effect on operations.

F-17
<PAGE> 46

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 20, 2000

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

Signature Title Date
- --------------------------------- ------------------------------------- -------------------
<S> <C> <C>
/s/Jonathan V. Diamond Chairman of the Board March 20, 2000
- ---------------------------------
Jonathan V. Diamond

/s/Jason Olim President, Chief Executive Officer March 20, 2000
- --------------------------------- and Director (principal executive officer)
Jason Olim

/s/Joel Sussman Vice President and Chief Financial Officer March 20, 2000
- --------------------------------- (principal financial and accounting officer)
Joel Sussman

/s/Matthew Olim Technical Lead, Secretary, Treasurer and March 20, 2000
- --------------------------------- Director
Matthew Olim

/s/Patrick Kerins Director March 20, 2000
- ---------------------------------
Patrick Kerins

/s/John Regan Director March 20, 2000
- ---------------------------------
John Regan

/s/James Coane Director March 20, 2000
- ---------------------------------
James Coane

</TABLE>

<PAGE> 47

EXHIBIT INDEX

Exhibit No. Description
- ----------- -----------------------------------------

21 List of Subsidiaries
23 Consent of Independent Public Accountants
27 Financial Data Schedule

<PAGE> 48

EXHIBIT 21
LIST OF SUBSIDIARIES
<TABLE>
<CAPTION>
Percent
Name fo Subsidiary Owned State/Country of Incorporation/Organization
- ----------------------- ------- -------------------------------------------
<S> <C> <C>
CDNOW Investments, Inc. 100% Delaware

CDNOW Trademarks, Inc. 100% Delaware

CDNOW Online, Inc. 100% Pennsylvania

superSonic Boom, Inc. 100% Delaware

N2K Inc. 100% Delaware

CDNOW Japan Inc. 100% Japan

TSI Licensing, Inc. 100% Delaware

</TABLE>

<PAGE> 49

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 Statements on Form S-8 (File Nos. 333-51191 and 333-79715).

/S/ ARTHUR ANDERSEN LLP

Philadelphia, Pa.
March 28, 2000

<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
FINANCIAL STATEMENTS AS OF AND FOR THE YEAR ENDED DECEMBER 31, 1999 AND IS
QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>

<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> DEC-31-1999
<CASH> 20,612,706
<SECURITIES> 0
<RECEIVABLES> 5,560,830
<ALLOWANCES> (1,492,130)
<INVENTORY> 517,280
<CURRENT-ASSETS> 30,261,647
<PP&E> 25,139,812
<DEPRECIATION> (7,922,832)
<TOTAL-ASSETS> 118,801,757
<CURRENT-LIABILITIES> 67,414,418
<BONDS> 0
0
0
<COMMON> 204,573,908
<OTHER-SE> (159,808,619)
<TOTAL-LIABILITY-AND-EQUITY> 118,801,757
<SALES> 147,189,405
<TOTAL-REVENUES> 147,189,405
<CGS> 118,037,621
<TOTAL-COSTS> 118,037,621
<OTHER-EXPENSES> 150,678,616
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (391,075)
<INCOME-PRETAX> (119,229,025)
<INCOME-TAX> 0
<INCOME-CONTINUING> (119,229,025)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (119,229,025)
<EPS-BASIC> (4.32)
<EPS-DILUTED> (4.32)

</TABLE>