-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, KSFhcxt5DoTdZS2H6D8iqzJC0oRfd+TM+N0rdMzO36BUhtWCb7Y/aCshkAEyC3cP zZBp89DYevJt/R3m/CTUVw== 0001036050-97-001094.txt : 19971201 0001036050-97-001094.hdr.sgml : 19971201 ACCESSION NUMBER: 0001036050-97-001094 CONFORMED SUBMISSION TYPE: S-1 PUBLIC DOCUMENT COUNT: 13 FILED AS OF DATE: 19971128 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: CDNOW INC CENTRAL INDEX KEY: 0001050372 STANDARD INDUSTRIAL CLASSIFICATION: [] IRS NUMBER: 232813867 STATE OF INCORPORATION: PA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: S-1 SEC ACT: SEC FILE NUMBER: 333-41241 FILM NUMBER: 97730003 BUSINESS ADDRESS: STREET 1: 610 OLD YORK ROAD STREET 2: SUITE 300 CITY: JENKINTOWN STATE: PA ZIP: 19046 BUSINESS PHONE: 2155177325 MAIL ADDRESS: STREET 1: 610 OLD YORK ROAD STREET 2: SUITE 300 CITY: JENKINTOWN STATE: PA ZIP: 19046 S-1 1 FORM S-1 - CDNOW, INC. AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON NOVEMBER 26, 1997 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 -------------- FORM S-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 -------------- CDNOW, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN CHARTER) -------------- PENNSYLVANIA 5735 23-2813867 (STATE OR OTHER (PRIMARY STANDARD INDUSTRIAL (I.R.S. EMPLOYER JURISDICTION OF CLASSIFICATION CODE NUMBER) IDENTIFICATION NO.) INCORPORATION OR ORGANIZATION) 610 OLD YORK ROAD SUITE 300 JENKINTOWN, PA 19046 (215) 517-7325 (ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING AREA CODE, OF REGISTRANT'S PRINCIPAL EXECUTIVE OFFICES) -------------- JASON OLIM PRESIDENT AND CHAIRMAN OF THE BOARD 610 OLD YORK ROAD SUITE 300 JENKINTOWN, PA 19046 (215) 517-7325 (NAME, ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING AREA CODE, OF AGENT FOR SERVICE) COPIES TO: ALAN SINGER, ESQ. ALAN H. LIEBLICH, ESQ. MORGAN, LEWIS & BOCKIUS LLP SCHNADER HARRISON SEGAL & LEWIS LLP 2000 ONE LOGAN SQUARE 1600 MARKET STREET PHILADELPHIA, PA 19103 SUITE 3600 (215) 963-5000 PHILADELPHIA, PA 19103 (215) 751-2000 APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC: As soon as practicable after the effective date of this Registration Statement. -------------- If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box. [_] If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [_] If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [_] If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [_] If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box. [_] CALCULATION OF REGISTRATION FEE - ------------------------------------------------------------------------------- - -------------------------------------------------------------------------------
TITLE OF EACH CLASS OF PROPOSED MAXIMUM AMOUNT OF SECURITIES TO BE REGISTERED AGGREGATE OFFERING PRICE(1) REGISTRATION FEE - ----------------------------------------------------------------------------------- Common Stock, no par value........... $60,000,000 $17,700
- ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- (1) Estimated solely for the purpose of calculating the registration fee in accordance with Rule 457(o) under the Securities Act of 1933. -------------- THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(a) OF THE SECURITIES ACT OF 1933, AS AMENDED, OR UNTIL THIS REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SUCH SECTION 8(a), MAY DETERMINE. - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- ++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ +INFORMATION CONTAINED HEREIN IS SUBJECT TO COMPLETION OR AMENDMENT. A + +REGISTRATION STATEMENT RELATING TO THESE SECURITIES HAS BEEN FILED WITH THE + +SECURITIES AND EXCHANGE COMMISSION. THESE SECURITIES MAY NOT BE SOLD NOR MAY + +OFFERS TO BUY BE ACCEPTED PRIOR TO THE TIME THE REGISTRATION STATEMENT + +BECOMES EFFECTIVE. THIS PROSPECTUS SHALL NOT CONSTITUTE AN OFFER TO SELL OR + +THE SOLICITATION OF AN OFFER TO BUY NOR SHALL THERE BE ANY SALE OF THESE + +SECURITIES IN ANY STATE IN WHICH SUCH OFFER, SOLICITATION OR SALE WOULD BE + +UNLAWFUL PRIOR TO REGISTRATION OR QUALIFICATION UNDER THE SECURITIES LAWS OF + +ANY SUCH STATE. + ++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ SUBJECT TO COMPLETION, NOVEMBER , 1997 PROSPECTUS [SHARES] CDNOW, INC. [COMMON STOCK] ----------- All of the shares of Common Stock offered hereby will be sold by CDnow, Inc. (the "Company"). Prior to the Offering, there has been no public market for the Common Stock. For factors considered in determining the initial public offering price, see "Underwriting." Application has been made for quotation of the Common Stock on the Nasdaq National Market under the symbol "CDNW." ----------- THE COMMON STOCK OFFERED HEREBY INVOLVES A HIGH DEGREE OF RISK. SEE "RISK FACTORS" BEGINNING ON PAGE 7. ----------- THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
PRICE UNDERWRITING PROCEEDS TO DISCOUNTS AND TO PUBLIC COMMISSIONS(1) COMPANY(2) - -------------------------------------------------------------------------------- Per Share................................ $ $ $ - -------------------------------------------------------------------------------- Total(3)................................. $ $ $
- -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- (1) See "Underwriting" for information relating to indemnification of the Underwriters. (2) Before deducting expenses for this Offering, payable by the Company, estimated at $ . (3) The Company has granted the Underwriters a 30-day option to purchase up to additional shares of Common Stock solely to cover over-allotments, if any. To the extent that the option is exercised, the Underwriters will offer the additional shares at the Price to Public shown above. If the option is exercised in full, the total Price to Public, Underwriting Discounts and Commissions and Proceeds to Company will be $ , $ and $ , respectively. See "Underwriting." ----------- The shares of Common Stock offered by this Prospectus are offered by the several Underwriters, subject to prior sale, when, as and if issued to and accepted by them, and subject to approval of certain legal matters by counsel for the Underwriters and certain other conditions. The Underwriters reserve the right to withdraw, cancel or modify such offer and to reject orders in whole or in part. It is anticipated that delivery of the shares of Common Stock subject to the Offering will be made at the offices of BT Alex. Brown Incorporated, Baltimore, Maryland, on or about , 1998. BT ALEX.BROWN NATIONSBANC MONTGOMERY SECURITIES, INC. THE DATE OF THIS PROSPECTUS IS , 1998 [DESCRIPTIONS TO BE ADDED FOR EDGAR FILING] CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS THAT STABILIZE, MAINTAIN OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK, INCLUDING BY ENTERING STABILIZING BIDS, EFFECTING SYNDICATE COVERING TRANSACTIONS OR IMPOSING PENALTY BIDS. FOR A DESCRIPTION OF THESE ACTIVITIES, SEE "UNDERWRITING". 2 PROSPECTUS SUMMARY The following summary is qualified in its entirety by, and should be read in conjunction with, the more detailed information and the financial statements of the Company and the notes thereto included elsewhere in this Prospectus. Unless otherwise indicated, all information presented in this Prospectus assumes (i) no exercise of the over-allotment option granted by the Company to the Underwriters, (ii) a -for-1 stock split to be effected prior to the consummation of this Offering, (iii) the automatic conversion of all outstanding shares of the Company's Series A Convertible Preferred Stock, no par value (the "Series A Preferred Stock"), and Series B Convertible Preferred Stock, no par value (the "Series B Preferred Stock"), into an aggregate of shares of Common Stock upon the consummation of this Offering, and (iv) the exercise of a warrant held by a Director of the Company for shares of Common Stock upon the consummation of this Offering. Unless the context otherwise requires, each reference to the "Company" or "CDnow" refers to CDnow, Inc., and each reference to "CDs" refers collectively to compact disks, cassettes and vinyl records. THE COMPANY CDnow is the leading online retailer of CDs and other music-related products. Its early entry into the online music retailing industry has helped the Company gain a well-recognized brand and the largest customer base of any online music retailer. The Company strives to combine the advantages of online commerce with superior customer focus in order to be the authoritative source for CDs and other music-related products. The Company's online store, cdnow.com, offers broad selection, informative content, easy-to-use navigation and search capabilities, a high level of customer service, competitive pricing and personalized merchandising and recommendations. With approximately 250,000 items, the Company believes that it provides a selection of readily-available products that is five to ten times that of a typical music retailer. To assist customers in making music selections, the CDnow store contains approximately 70,000 reviews and related articles and 275,000 sound samples. The CDnow store is open 24 hours a day, seven days a week and offers its customers convenient and timely product fulfillment, including an overnight delivery option. CDnow has grown rapidly since its inception in 1994. Of the 195,000 customers who have made purchases since inception, 104,000 made their initial purchases in 1997. Average daily visits to the CDnow store have grown from approximately 12,000 in January 1996 to approximately 90,000 in September 1997. The Company's net sales grew to $9.5 million for the nine months ended September 30, 1997 compared to $4.1 million for the nine months ended September 30, 1996. Net sales for the first, second and third quarters of 1997 were $2.6 million, $3.0 million and $3.9 million, respectively. The Company has also generated significant customer loyalty. For the nine months ended September 30, 1997, repeat customers accounted for over 55% of net sales. The Company believes that a significant opportunity exists for the retailing of music on the Internet. According to the International Federation of the Phonographic Industry, worldwide sales of pre-recorded music in 1996 were approximately $39.8 billion, of which one-third was in North America. Online music retailers currently account for a small but growing portion of total sales. According to Jupiter Communications, Inc. ("Jupiter"), worldwide sales of pre-recorded music, music-related merchandise, advertising and concert tickets over the Internet are projected to grow from approximately $23 million in 1996 to over $2.8 billion in 2002. A number of characteristics of online music retailing make the sale of pre- recorded music via the Internet particularly attractive relative to traditional retail stores. The Internet offers many data management and multimedia features which enable consumers to listen to sound samples, search for 3 music by genre, title or artist and access a wealth of information and events, including reviews, related articles, music history, news and recommendations. Internet-based retailers can also offer consumers significantly broader product selection, the convenience of home shopping and 24-hour-a-day, seven-day-a-week operations. In addition, Internet-based retailers can also serve international consumers without significant incremental cost and more effectively target their direct marketing activities as a result of the extensive customer demographic and behavioral data that they are able to obtain. The Company's business strategy is designed to promote the CDnow brand and expand its leadership position by (i) focusing on recorded music retailing, (ii) providing an innovative and easy-to-use retail concept, (iii) acquiring customers on an efficient basis, (iv) maximizing customer retention, and (v) expanding its customer base through multiple marketing channels. The Company believes that the use of multiple marketing channels allows it to reduce its reliance on any one source of customers, maximize brand awareness and lower average customer acquisition costs. These marketing channels include: . Online and Traditional Advertising. The Company promotes its brand through an aggressive marketing campaign using a combination of online and traditional advertising. The Company advertises on the sites of major Internet content and service providers, including Infoseek, Lycos and CNN Interactive, and targeted music-related sites, such as Billboard. CDnow's traditional advertising efforts include radio advertising, such as advertising on the Howard Stern program, and print advertising in music-related publications, including Rolling Stone, Spin and Variety. . Strategic Alliances with Major Content and Service Providers. The Company seeks to enter into strategic alliances with major Internet content and service providers in order to enhance its new customer acquisition efforts, increase purchases by current customers and expand brand recognition. The Company has recently entered into alliances with Yahoo! and Excite's Webcrawler service that provide for the Company to be the premier online recorded music retailer on certain of their sites with the exclusive right to place music banner advertisements and integrated links to the CDnow store on certain music-related pages. . Cosmic Credit Program. Through its Cosmic Credit Program, CDnow has arrangements with over 9,000 small Web sites, typically fan sites devoted to particular musical artists. The Company provides these sites with embedded hyperlinks through which potential customers can immediately be connected to the CDnow store. . Direct Marketing Techniques. The Company uses direct marketing techniques to target new and existing customers with communications and promotions. The Company sends a personalized e-mail newsletter to its customers that includes purchase recommendations based on demonstrated customer preferences and prior purchases. The business of the Company was commenced as a sole proprietorship in February 1994. The Company was incorporated in Pennsylvania in April 1995. Its principal offices are located at 610 Old York Road, Suite 300, Jenkintown, Pennsylvania, 19046 and its telephone number is (215) 517-7325. 4 THE OFFERING Common Stock offered hereby... shares Common Stock to be outstanding after the Offering..................... shares(1) Use of proceeds............... For the repayment of short-term indebtedness; sales and marketing expenses, including payments due under strategic alliances; improvements to the Company's Web site and other capital expenditures; working capital; and other general corporate purposes. Proposed Nasdaq National Market symbol................ CDNW - -------------------- (1) Excludes (i) shares of Common Stock issuable upon the exercise of options outstanding as of December 31, 1997 under the Company's 1996 Equity Compensation Plan (the "Equity Compensation Plan") at a weighted average exercise price of $ per share, (ii) shares reserved for future grants under the Equity Compensation Plan and (iii) shares of Common Stock issuable upon the exercise of warrants outstanding as of December 31, 1997 at a weighted average exercise price of $ per share. See "Management-- Equity Compensation Plan" and "Description of Capital Stock." 5 SUMMARY FINANCIAL AND OPERATING DATA
PERIOD FROM INCEPTION (FEBRUARY 12, NINE MONTHS ENDED 1994) TO YEAR ENDED DECEMBER 31, SEPTEMBER 30, DECEMBER 31, ------------------------- ---------------------------- 1994(1) 1995(1) 1996 1996 1997 ------------- ------------ ------------ ------------ -------------- STATEMENT OF OPERATIONS DATA: Net sales.............. $103,116 $ 2,176,474 $ 6,300,294 $ 4,107,545 $ 9,452,864 Cost of sales.......... 92,962 1,844,612 5,363,989 3,543,960 7,730,975 -------- ----------- ------------ ----------- ----------- Gross profit.......... 10,154 331,862 936,305 563,585 1,721,889 Operating expenses: Operating and development.......... 26,946 149,982 523,080 329,467 1,228,040 Sales and marketing... 12,945 200,972 621,454 393,630 3,405,908 General and administrative....... 28,712 180,573 563,593 354,268 1,281,691 Dispute settlement(2)........ -- -- 1,024,030 -- -- -------- ----------- ------------ ----------- ----------- Total operating expenses............. 68,603 531,527 2,732,157 1,077,365 5,915,639 -------- ----------- ------------ ----------- ----------- Operating loss......... (58,449) (199,665) (1,795,852) (513,780) (4,193,750) Interest income (expense), net........ -- (1,248) (14,556) (11,296) 64,084 -------- ----------- ------------ ----------- ----------- Net loss............... $(58,449) $ (200,913) $ (1,810,408) $ (525,076) $(4,129,666) ======== =========== ============ =========== =========== Pro forma net loss per share(3).............. $ =========== Pro forma weighted average number of common and common equivalent shares..... =========== OPERATING DATA: Customers(4)........... 1,802 27,822 91,301 69,024 194,757 SEPTEMBER 30, 1997 ------------------------------------------ PRO FORMA ACTUAL PRO FORMA(5) AS ADJUSTED(6) BALANCE SHEET DATA: ------------ ------------ -------------- Cash and cash equivalents........................ $ 7,238,246 $13,815,307 Working capital.................................. 4,623,893 6,027,879 Total assets..................................... 10,394,950 17,172,011 Total long-term debt............................. 218,617 218,617 Redeemable convertible preferred stock........... 9,516,239 -- Total shareholders' equity (deficit)............. (3,660,243) 7,259,982
- -------------------- (1) The business of the Company was established as a sole proprietorship in February 1994 and commercial operations in August 1994. The Company was incorporated in April 1995. (2) In December 1996, in settlement of a dispute, the Company issued shares of Common Stock to certain persons. See Note 7 to Notes to Financial Statements. (3) See Note 1 to Notes to the Financial Statements for an explanation of the determination of the number of shares and share equivalents used in computing the pro forma net loss per share. (4) Cumulative number of customers who have purchased products from the Company from inception of its business in August 1994 through the end of period. (5) Represents actual data as adjusted to give effect to (i) the sale on November 26, 1997 of $5.8 million of Series A Convertible Notes (the "Series A Notes") and associated warrants, (ii) the conversion of the outstanding shares of Series A Preferred Stock and Series B Preferred Stock into shares of Common Stock upon the consummation of this Offering, and (iii) the exercise of a warrant exercisable for shares of Common Stock for an aggregate price of $1.0 million by a Director of the Company which is expected to occur upon the consummation of this Offering. See "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Certain Transactions" and "Principal Stockholders." (6) Represents pro forma data as adjusted to give effect to the sale of shares of Common Stock offered by the Company at an assumed initial public offering price of $ per share (after deducting underwriting discounts and commissions and estimated offering expenses) and the application of the estimated net proceeds therefrom. See "Capitalization" and "Use of Proceeds." 6 RISK FACTORS The following risk factors, as well as the other information contained in this Prospectus, should be considered carefully before purchasing the Common Stock offered hereby. This Prospectus contains forward-looking statements that address, among other things, the Company's business strategy, use of proceeds, projected capital expenditures, liquidity, possible business relationships, and possible effects of changes in government regulation. These statements may be found under "Prospectus Summary," "Risk Factors," "Use of Proceeds," "Management's Discussion and Analysis of Financial Condition and Results of Operations," and "Business" as well as in the Prospectus generally. Actual events or results may differ materially from those discussed in forward- looking statements as a result of various factors, including those factors discussed below and set forth in this Prospectus generally. Limited Operating History; History of Losses and Expectation of Future Losses. The Company was founded in February 1994 and began selling music- related products in August 1994. Accordingly, the Company has only a limited operating history on which to base an evaluation of its business and prospects. The Company's prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in their early stage of development, particularly companies in new and rapidly evolving markets such as online commerce. Such risks include, but are not limited to, possible inability to respond promptly to changes in a rapidly evolving and unpredictable business environment and the risk of inability to manage growth. To address these risks, the Company must, among other things, expand its customer base, successfully implement its business and marketing strategies, continue to develop and upgrade its Web site and transaction-processing systems, provide superior customer service, respond to competitive developments, and attract and retain qualified personnel. If the Company is not successful in addressing such risks, it will be materially adversely affected. Since inception, the Company has incurred significant losses, and as of September 30, 1997 had accumulated losses of $6.5 million. For the nine months ended September 30, 1997, the Company's net loss was $4.1 million. The Company intends to invest heavily in marketing and promotion, Web site development and technology, and development of its administrative organization. As a result, the Company believes that it will incur substantial operating losses for the foreseeable future, and that the rate at which such losses will be incurred will increase significantly from current levels. Because the Company has relatively low product gross margins, achieving profitability given planned investment levels depends upon the Company's ability to generate and sustain substantially increased revenue levels. There can be no assurance that the Company will be able to generate sufficient revenues to achieve or sustain profitability in the future. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." Dependence on Continued Growth of Online Commerce. The Company's long-term viability is substantially dependent upon the widespread consumer acceptance and use of the Internet as a medium of commerce. Use of the Internet as a means of effecting retail transactions is at an early stage of development, and demand and market acceptance for recently introduced services and products over the Internet is very uncertain. The Company cannot predict the extent to which consumers will be willing to shift their purchasing habits from traditional retailers to online retailers. The Internet may not become a viable commercial marketplace for a number of reasons, including potentially inadequate development of the necessary network infrastructure, delayed development of enabling technologies and inadequate performance improvements. In addition, the Internet's viability as a commercial marketplace could be adversely affected by delays in the development of services or due to increased government regulation. Changes in or insufficient availability of telecommunications services to support the Internet also could result in slower response times and adversely affect usage of the Internet generally and CDnow in particular. Moreover, adverse publicity and consumer concern about the security of transactions conducted on the Internet and the privacy of users may also inhibit the growth of commerce on the Internet. If the use of the Internet does not continue to grow or grows more slowly 7 than expected, or if the infrastructure for the Internet does not effectively support growth that may occur, the Company would be materially adversely affected. Competition. The online commerce market is new, rapidly evolving and intensely competitive, and the Company expects that competition will further intensify in the future. Barriers to entry are minimal, and current and new competitors can launch new sites at a relatively low cost. According to Jupiter, there were approximately 100 online music retailers, as of June 1997. In addition, the broader retail music industry is intensely competitive. The Company currently competes with a variety of companies, including (i) online vendors of music, music videos and other related products, (ii) online vendors of movies, books and other related products, (iii) online service providers which offer music products directly or cooperation with other retailers, (iv) traditional retailers of music products, including specialty music retailers, (v) other retailers that offer music products, including mass merchandisers, superstores and consumer electronic stores; and (vi) non-store retailers such as music clubs. Many of these traditional retailers also support dedicated Web sites which compete directly with the Company. The Company believes that the principal competitive factors in its online market are brand recognition, selection, variety of value-added services, ease of use, site content, quality of service, technical expertise and price. Many of the Company's current and potential competitors have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing and other resources than the Company. The Company is aware that certain of its competitors have and may continue to adopt aggressive pricing or inventory availability policies and devote substantially more resources to Web site and systems development than the Company. Increased competition may result in reduced operating margins, loss of market share and a diminished brand franchise. There can be no assurance that the Company will be able to compete successfully against current and future competitors. New technologies and the expansion of existing technologies may increase the competitive pressures of the Company. For example, client-agent applications that select specific titles from a variety of Web sites based on factors such as price may channel customers to online retailers that compete with the Company. In addition, many companies that allow access to transactions through network access or Web browsers promote the Company's competitors and could charge the Company a substantial fee for inclusion. Risk of Inability to Manage Potential Growth. The Company has rapidly expanded its operations. This expansion has placed, and is expected to continue to place, a significant strain on the Company's management, operations, systems, and financial resources. From December 31, 1994 to September 30, 1997, the Company has grown from three to approximately 90 employees, and several members of the Company's senior management have only recently joined the Company. CDnow's recently hired employees also include a number of key managerial, technical and operations personnel, and the Company expects to add additional key personnel in the near future. To manage its recent growth and any further growth of its operations and personnel, the Company must improve existing operations and systems and expand and integrate its employee base. If the Company is unable to manage its growth effectively, it will be materially adversely affected. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business-- Employees." Need for Additional Funds. The Company anticipates that the net proceeds from this Offering, together with other available resources, will be sufficient to fund the Company's operations for at least the next 12 months. However, the Company's capital requirements depend on several factors, including the rate of market acceptance, the ability to expand the Company's customer base, the level of expenditures for sales and marketing, the cost of Web site upgrades and other factors. If capital requirements vary materially from those currently planned, the Company may require additional financing sooner than anticipated. Regardless of when needed, there can be no assurance that financing will be available in amounts or on terms acceptable to the Company, if at all. If equity securities are issued in 8 connection with a financing, dilution to the Company's shareholders may result, and if additional funds are raised through the incurrence of debt, the Company may become subject to restrictions on its operations and finances. See "Management's Discussion and Analysis of Financial Condition and Results of Operation." Reliance on Certain Vendors. The Company's primary provider of order fulfillment for recorded music titles is Valley Record Distributors, Inc. ("Valley"). The Company has no fulfillment operation or facility of its own and, accordingly, is dependent upon maintaining its existing relationship with Valley or establishing a new fulfillment relationship with one of the few other fulfillment operations. There can be no assurance that the Company will maintain its relationship with Valley beyond the term of its existing two year agreement with Valley, which expires in June 1999, or that it will be able to find an alternative, comparable vendor capable of providing fulfillment services on terms satisfactory to the Company should its relationship with Valley terminate. An unanticipated termination of the Company's relationship with Valley, particularly during the fourth quarter of the calendar year in which a high percentage of recorded music sales are made, could materially adversely affect the Company's results of operations for the quarter in which such termination occurred even if the Company was able to establish a relationship with an alternative vendor. Valley may terminate its existing agreement with the Company upon 30 days' written notice, in the event that Valley decides to discontinue providing fulfillment services to all of Valley's online service customers. To date, Valley has satisfied the Company's requirements on a timely basis. However, to the extent that Valley does not have sufficient capacity and is unable to satisfy on a timely basis increasing requirements of the Company, the Company would be materially adversely affected. As is the case with Valley, the Company generally relies on a single vendor for order fulfillment with respect to each product line carried by the Company. Therefore, the loss of any one vendor could materially and adversely affect the Company's sales of that product line. While the Company seeks to negotiate multi-year contracts with its vendors to ensure the availability of merchandise, there can be no assurance that the Company's current vendors will continue to sell merchandise to the Company on current terms or that the Company will be able to establish new vendor relationships to ensure acquisition of merchandise in a timely and efficient manner and on acceptable commercial terms. If the Company were unable to develop and maintain relationships with vendors that would allow it to obtain sufficient quantities of merchandise on acceptable commercial terms, it would be materially adversely affected. See "Business--Fulfillment." Risk of System Failure; Absence of Redundant Facilities; Capacity Constraints. The Company's business is dependent on the efficient and uninterrupted operation of its computer and communications hardware systems. Substantially all of the Company's computer and communications hardware is located at a single leased facility in Jenkintown, Pennsylvania. The Company's systems and operations are vulnerable to damage or interruption from fire, flood, power loss, telecommunications failure, break-ins, earthquake and similar events. Any system interruptions that result in the unavailability of the Company's Web site or reduced transaction processing performance would reduce the volume of products sold and the attractiveness of the Company's product and service offerings and could, therefore, materially adversely affect the Company. The Company has, from time to time, experienced periodic systems interruptions, and anticipates that such interruptions will occur in the future. The Company does not presently have redundant systems or a formal disaster recovery plan and does not carry sufficient business interruption insurance to compensate it for losses that may occur. Any substantial increase in the volume of traffic on the Company's Web site or the number of orders placed by customers will require the Company to expand and upgrade further its technology, transaction-processing systems and network infrastructure. There can be no assurance that the Company will be able to accurately project the rate or timing of increases, if any, in the use of its Web site or expand and upgrade its systems and infrastructure to accommodate such increases. The failure to appropriately upgrade its systems and infrastructure would have a material adverse effect on the Company. 9 Security Risks. A significant barrier to online commerce is concern regarding the security of transmission of confidential information. The Company relies on encryption and authentication technology licensed from third parties that is designed to facilitate the secure transmission of confidential information, such as customer credit card numbers. Nevertheless, the Company's infrastructure is potentially vulnerable to physical or electronic computer break-ins, viruses and similar disruptive problems. A party who is able to circumvent the Company's security measures could misappropriate proprietary information or cause interruptions in the Company's operations. To the extent that activities of the Company or third-party contractors involve the storage and transmission of proprietary information, such as credit card numbers, security breaches could damage the Company's reputation and expose the Company to a risk of loss or litigation and possible liability. Therefore, the Company may be required to expend significant capital and other resources to protect against such security breaches or to alleviate problems caused by such breaches. There can be no assurance that the Company's security measures will prevent security breaches or that failure to prevent such security breaches will not have a material adverse effect on the Company. See "Business-- Technology." Risk of Reliance on Internally Developed Systems. The Company uses an internally developed system for its Web site, search engine and substantially all aspects of its transaction processing and order management. The Company's inability to modify this system as necessary to accommodate increased traffic on its Web site or increased volume through its transaction processing and order management systems may cause unanticipated system disruptions, slower response times, impaired quality and speed of order fulfillment, degradation in customer service, and delays in reporting accurate financial information. Any of these events could have a material adverse effect on the Company. Dependence Upon Strategic Alliances. The Company is increasingly relying on certain strategic alliances to attract users to its Web site. The Company has entered in such alliances with Yahoo! Inc. ("Yahoo!") with respect to certain areas on the Yahoo! service and Excite, Inc. ("Excite") with respect to its WebCrawler service. Although the Company has only recently entered into such strategic alliances, the Company's ability to generate revenues from online commerce may depend on increased traffic and purchases that the Company expects to generate through such strategic alliances. There can be no assurance that the Company's infrastructure will be sufficient to handle the expected increased traffic from such alliances. Moreover, there can also be no assurance that these relationships will be maintained beyond their initial terms or that additional third-party alliances will be available to the Company on acceptable commercial terms or at all. The inability to maintain and further develop strategic alliances could have a material adverse effect on the Company. Potential Fluctuation in Quarterly Operating Results. The Company expects to experience significant fluctuations in its future quarterly operating results due to a variety of factors, many of which are outside the Company's control. Factors that may affect the Company's quarterly operating results include (i) its ability to retain existing customers, attract new customers and maintain customer satisfaction, (ii) the introduction of new or enhanced Web pages, services, products and strategic alliances by the Company and its competitors, (iii) price competition or higher wholesale prices, (iv) the level of use of the Internet and consumer acceptance of the Internet for the purchase of recorded music, (v) seasonality of recorded music sales, (vi) its ability to upgrade and develop its systems and infrastructure and attract qualified personnel, (vii) technical difficulties, system downtime or Internet brownouts, (viii) the amount and timing of operating costs and capital expenditures relating to expansion of the Company's business, operations and infrastructure, (ix) the timing of Company promotions and sales programs, (xii) the level of merchandise returns experienced by the Company, (xi) government regulation and (xii) general economic conditions and economic conditions specific to the Internet and the music industry. The Company expects that it will experience seasonality in its business, reflecting a combination of seasonal fluctuations in Internet usage and traditional retail seasonality patterns affecting sales of recorded music. Sales in the traditional retail music industry are significantly higher in the fourth calendar quarter of each year than in the preceding three quarters. However, to date, the Company's limited operating 10 history and rapid growth make it difficult to ascertain the effects of seasonality on its business. Therefore, the Company believes that period-to- period comparisons of the Company's historical results are not necessarily meaningful and should not be relied upon as an indication of future results. The Company's results of operations in future periods may not meet the expectations of securities analysts and investors, in which case the price of the Common Stock would likely be materially adversely affected. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Quarterly Results and Seasonality". Rapid Technological Change. To remain competitive, the Company must continue to enhance and improve the responsiveness, functionality and features of its site and develop new features to meet customer needs. The Internet is characterized by rapid technological change, changes in user and customer requirements and preferences, frequent new product and service introductions and the emergence of new industry standards and practices that could render the Company's existing Web site, technology and systems obsolete. The Company's success will depend, in part, on its ability to license leading technologies useful in its business, enhance its existing services, develop new services and technology that address the needs of its customers, and respond to technological advances and emerging industry standards and practices on a cost-effective and timely basis. If the Company is unable to use new technologies effectively or adapt its Web site, proprietary technology and transaction-processing systems to customer requirements or emerging industry standards, it would be materially adversely affected. See "Business-- Technology." No Designated Use for Substantial Portion of Net Proceeds. The Company has not designated any specific use for a significant portion of the net proceeds from the sale by the Company of the Common Stock offered hereby. The net proceeds of this offering will be used by the Company to repay certain short- term indebtedness, to fund its obligations under its strategic alliances, to finance its sales and marketing campaign, to make improvements to and expand the capacity of its Web site, to make certain other capital expenditures and for working capital and other general corporate purposes. However, the Company cannot, with precision, estimate the portion of the net proceeds to be devoted to certain of these uses. From time to time, the Company may evaluate potential acquisitions involving complementary businesses, content, products or technologies. However, the Company has no present agreements with respect to any material acquisition or investment. Accordingly, management will have significant flexibility in applying the net proceeds of this Offering. See "Use of Proceeds." Trademarks and Proprietary Rights; Unlicensed Arrangements. The Company regards its trademarks, trade secrets and similar intellectual property as valuable to its business, and relies on trademark and copyright law, trade secret protection and confidentiality and/or license agreements with its employees, partners and others to protect its proprietary rights. There can be no assurance that the steps taken by the Company will be adequate to prevent misappropriation or infringement of its proprietary property. The Company has licensed in the past, and expects that it may license in the future, certain of its proprietary rights, such as trademarks or copyrighted material, to third parties. While the Company attempts to ensure that the quality of its brand is maintained by such licensees, there can be no assurance that such licensees will not take actions that might materially adversely affect the value of the Company's proprietary rights or reputation, which could have a material adverse effect on the Company. Through its Cosmic Credit Program, the Company is establishing a network of links with numerous small Web sites, typically fan sites devoted to particular musical artists, that permit customers to connect to the Company's site through an embedded hyperlink. See "Business--Marketing and Promotion. " Many of the sites are not officially sanctioned by the artists to which they relate, nor do they have licenses from the artists for use of any intellectual property of the artists and their licensees which the sites may display. There can be no assurance that the artists or their licensees will not assert infringement claims against the Cosmic Credit sites and the Company because of its relationships with these sites. In addition, the 11 Company's primary provider of artist and music-related information, such as reviews, articles, photographs and images, which the Company displays in its online retail store, has represented to the Company that it may not have a license to distribute a portion of such information. There can be no assurance that the owners (or their licensees) of intellectual property rights in such information will not assert infringement claims against the provider and the Company. Moreover, the Company has been subject to claims and expects to be subject to legal proceedings and claims from time to time in the ordinary course of its business, including claims of alleged infringement of the trademarks and other intellectual property rights of third parties by the Company and its licensees. Such claims could result in substantial costs and diversion of resources, even if ultimately decided in favor of the Company, and could have a material adverse effect on the Company, particularly if judgments on such claims are adverse to the Company. If a claim is asserted alleging that the Company has infringed the proprietary rights of a third party, the Company may be required to seek licenses to continue to use such intellectual property. The failure to obtain the necessary licenses or other rights at a reasonable cost could have a material adverse effect on the Company. Government Regulation and Legal Uncertainties. The Company is subject, both directly and indirectly, to various laws and regulations relating to its business, although there are few laws or regulations directly applicable to access to the Internet. However, due to the increasing popularity and use of the Internet, it is possible that a number of laws and regulations may be adopted with respect to the Internet. Such laws and regulations may cover issues such as user privacy, pricing, content, copyrights, distribution and characteristics and quality of products and services. Furthermore, the growth and development of the market for online commerce may prompt calls for more stringent consumer protection laws that may impose additional burdens on those companies conducting business online. The enactment of any additional laws or regulations may impede the growth of the Internet which could, in turn, decrease the demand for the Company's products and services and increase the Company's cost of doing business, or otherwise have an adverse effect on the Company. The applicability to the Internet of existing laws in various jurisdictions governing issues such as property ownership, sales and other taxes, libel and personal privacy is uncertain and could expose the Company to substantial liability. The laws of certain foreign countries provide the owner of copyrighted products with the exclusive right to expose, through sound and video samples, copyrighted items for sale to the public and the right to distribute such products. Any new legislation or regulation, or the application of existing laws and regulations to the Internet could have a material adverse effect on the Company. The Company is aware that one foreign distribution affiliate of a major record label has sought to enjoin the sale of music-related products by an Internet retailer in a particular foreign country. If successful, this and other distributors located in certain foreign countries could similarly seek to enjoin Internet retailers such as the Company, which could materially adversely affect the Company. The Company believes that its use of material on its Web sites is protected under current provisions of copyright law. However, legal rights to certain aspects of Internet content and commerce are not clearly settled. There can be no assurance that the Company will be able to continue to maintain rights to information, including downloadable music samples and artist, record and other information. The failure to be able to offer such information could have a material adverse effect on the Company. In addition, several telecommunications carriers are seeking to have telecommunications over the Internet regulated by the Federal Communications Commission (the "FCC") in the same manner as other telecommunications services. For example, America's Carriers Telecommunications Association has filed a petition with the FCC for this purpose. In addition, because the growing popularity and use of the Internet has burdened the existing telecommunications infrastructure and many areas with high Internet use have begun to experience interruptions in phone service, local telephone carriers, such as Pacific Bell, have petitioned the FCC to regulate Internet service providers and online service providers in a manner similar to long distance telephone carriers and to impose access fees on such providers. If either of these petitions 12 are granted, or the relief sought therein is otherwise granted, the costs of communicating on the Internet could increase substantially, potentially slowing the growth in use of the Internet. Any such new legislation or regulation or application or interpretation of existing laws could have a material adverse effect on the Company's business, results of operations and financial condition. Possible Liability for Information Retrieved from the Internet. Due to the fact that material may be downloaded from Web sites and may be subsequently distributed to others, there is a potential that claims will be made against the Company for defamation, negligence, copyright or trademark infringement or other theories based on the nature and content of such material. Such claims have been brought, and sometimes successfully pressed, against online services in the past. In addition, the Company could be exposed to liability with respect to the material that may be accessible through the Company's Web sites. For example, claims could be made against the Company if material deemed inappropriate for viewing by young children could be accessed though the Company Web sites. Although the Company carries general liability insurance, the Company's insurance may not cover potential claims of this type or may not be adequate to cover all costs incurred in defense of potential claims or to indemnify the Company for all liability that may be imposed. Any costs or imposition of liability that is not covered by insurance or is in excess of insurance coverage could have a material adverse effect on the Company. Potential Liability for Sales and Other Taxes. The Company does not currently collect sales or other similar taxes in respect of shipments of goods into states other than Pennsylvania, California and Florida. New state tax regulations may subject the Company to the assessment of sales and income taxes in additional states. Tax authorities in a number of states are currently reviewing the appropriate tax treatment of companies engaged in Internet and catalogue retailing and are currently considering an agreement with certain of these companies regarding the assessment and collection of sales taxes. The Company is not a party to any such discussions. As the Company's service is available over the Internet in multiple states and foreign countries, such jurisdictions may claim that the Company is required to qualify to do business as a foreign corporation in each such state and foreign country. The failure by the Company to qualify as a foreign corporation in a jurisdiction where it is required to do so could subject the Company to taxes and penalties for the failure to qualify. Dependence on Key Personnel; Need for Additional Personnel. The Company's success is substantially dependent on the ability and experience of its senior management and other key personnel, particularly Jason Olim, its President and Chairman of the Board. Moreover, to accommodate its current size and manage its anticipated growth, the Company must maintain and expand its employee base. Competition for personnel, particularly persons having software development and other technical expertise, is intense, and there can be no assurance that the Company will retain existing personnel or hire additional, qualified personnel. The inability of the Company to retain and attract the necessary personnel or the loss of services of any of its key personnel could have a material adverse effect on the Company. See "Business--Employees" and "Management." Control of the Company. Immediately upon completion of this offering, approximately %, %, % and % of the outstanding Common Stock will be beneficially owned by Jason Olim, the Company's President and Chairman of the Board; Matthew Olim, the Company's Technical Lead and Jason Olim's brother; Alan Meltzer, a director of the Company; and Grotech Partners, IV, one of the managing directors of which is Patrick Kerins, a director of the Company. As a result, such persons, acting together, will have the ability to control all matters submitted to shareholders of the Company for approval (including the election and removal of directors and any merger, consolidation or sale of all or substantially all of the Company's assets) and to control the management and affairs of the Company. Such concentration of ownership may have the effect of delaying, deferring or preventing a change in control of the Company, impede a merger, consolidation, takeover or other business combination involving the Company or discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of the Company, which in turn could have an adverse effect on the market price of the Company's Common Stock. See "Principal Shareholders" and "Certain Transactions." 13 No Prior Market; Possible Volatility of Stock Price. Prior to this offering, there has been no public market for the Company's Common Stock, and there can be no assurance that an active public market for the Common Stock will develop or continue after this offering. The initial public offering price has been determined by negotiations among the Company and BT Alex. Brown Incorporated and NationsBanc Montgomery Securities, Inc., as representatives of the Underwriters, and may not be indicative of the market price for the Common Stock after this offering. See "Underwriting" for factors to be considered in determining the initial public offering price. From time to time after this offering, there may be significant volatility in the market price of the Common Stock. Quarterly operating results of the Company, deviations in results of operations from estimates of securities analysts, changes in general conditions in the economy or the Internet services industry or other developments affecting the Company or its competitors could cause the market price of the Common Stock to fluctuate substantially. The equity markets have, on occasion, experienced significant price and volume fluctuations that have affected the market prices for many companies' securities and that have often been unrelated to the operating performance of these companies. Any such fluctuations that occur following completion of this offering may adversely affect the market price of the Common Stock. Potential Adverse Market Impact of Shares Eligible for Future Sale. The shares of Common Stock offered hereby (other than shares purchased by "affiliates" of the Company) will be freely tradeable immediately following this offering. All of the remaining outstanding shares (the "Restricted Shares"), have or will become available for sale in the public market during 1998 subject, in certain instances, to the applicable resale limitations of Rule 144 promulgated under the Securities Act of 1933, as amended (the "Securities Act"). In addition, the Company intends to file a Registration Statement on Form S-8 covering up to shares issuable upon exercise of stock options under the Equity Compensation Plan. Such shares, upon issuance, will be immediately available for resale (in the case of holders that are affiliates of the Company, subject to certain limitations under Rule 144). The Company's officers, directors and certain shareholders, who hold, in the aggregate, approximately shares of Common Stock, have agreed not to sell any shares of Common Stock (excluding shares of Common Stock offered by this Prospectus or shares purchased in the open market) for a period of 180 days following the consummation of this offering without the prior written consent of BT Alex. Brown Incorporated. Thereafter, these shares may become either freely resalable or eligible for sale pursuant to the applicable resale limitations of Rule 144. In addition, holders of approximately shares of Restricted Stock have demand and piggyback registration rights with respect to those shares. Sales of substantial amounts of Common Stock in the public market or the availability of substantial amounts of such stock for sale subsequent to this Offering could adversely affect the prevailing market price of the Common Stock and could impair the Company's ability to raise capital through the sale of its equity securities. Anti-Takeover Provisions; Possible Issuances of Preferred Stock and Classified Board. Certain provisions of Pennsylvania law could make it more difficult for a third party to acquire, or could discourage a third party from attempting to acquire control of the Company. Such provisions could limit the price that certain investors might be willing to pay in the future for shares of the Common Stock. In addition, shares of the Company's Preferred Stock, no par value (the "Preferred Stock"), may be issued by the Board of Directors without shareholder approval on such terms and conditions, and having such rights, privileges and preferences, as the Board of Directors may determine. The rights of the holders of the Common Stock will be subject to, and may be adversely affected by, the rights of the holders of any Preferred Stock that may be issued in the future. In addition, the Company's Amended and Restated Bylaws divide the Board of Directors into three classes, each serving a staggered three-year term. The issuance of Preferred Stock and the existence of a classified board could have the effect of delaying, deterring or preventing a change in control of the Company. The Company has no current plans to issue any shares of Preferred Stock. See "Management" and "Description of Capital Stock--Preferred Stock." Immediate and Substantial Dilution. The purchasers of the shares of Common Stock offered hereby will experience immediate and substantial dilution in the net tangible book value of their shares of 14 Common Stock in the amount of $ per share (based on an assumed offering price of $ per share and after giving effect to underwriting discounts and commissions and estimated offering expenses). See "Dilution." In the event the Company offers additional Common Stock in the future, including shares that may be issued upon exercise of stock options, purchasers of Common Stock in this offering may experience further dilution in the net tangible book value per share of the Common Stock of the Company. USE OF PROCEEDS The net proceeds to the Company from the sale of shares of Common Stock offered hereby at an assumed public offering price of $ per share are estimated to be $ million (approximately $ million if the Underwriters' overallotment option is exercised in full) after deducting underwriting discounts and commissions and estimated offering expenses. The net proceeds from this offering will be used by the Company as follows: approximately $5.8 million to retire the Series A Notes; approximately $12.0 million on advertising and promotion; payments due under the Company's strategic alliance agreements (including an aggregate minimum of $5.5 million expected to be paid to Yahoo! and Excite during the next 12 months); approximately $3.0 million to make enhancements to, and expand the capacity of, the Company's Web site, and for other capital expenditures; and the balance for working capital and other general corporate purposes. The Series A Notes were issued on November 26, 1997 to certain investors, bear interest at the rate of 12% per annum and are repayable in full upon the consummation of this offering. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Certain Transactions." The amounts actually expended for each purpose, other than the repayment of the indebtedness and the payments due under strategic alliance agreements described above, will be determined at the discretion of the Company. The Company's future capital requirements and the allocation of the net proceeds of this offering, will depend on many factors, including the entrance into new strategic alliances, increases in advertising and promotions, growth of the Company's customer base and other factors. Accordingly, the actual amount of proceeds devoted to each purpose other than the repayment of indebtedness may vary substantially from the amount set forth above. From time to time the Company may evaluate potential acquisitions involving complementary businesses, content, products or technologies. The Company has no present agreements or understanding with respect to any such acquisition. Pending utilization of the net proceeds of this offering, the Company intends to invest the funds in short-term, interest-bearing, investment-grade obligations. The Company believes that the net proceeds from this offering, together with its current cash and cash equivalents, will be sufficient to meet its anticipated cash needs for working capital and capital expenditures for at least the next 12 months. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." DIVIDEND POLICY The Company has not paid any cash dividends on its Common Stock and does not anticipate paying any cash dividends in the foreseeable future. The Company currently intends to retain future earnings, if any, to fund the development and growth of its business. Any future determination to pay cash dividends will be at the discretion of the Board of Directors and will be dependent upon the Company's financial condition, operating results, capital requirements, applicable contractual restrictions and such other factors as the Board of Directors deems relevant. 15 CAPITALIZATION The following table sets forth, as of September 30, 1997, (i) the actual capitalization of the Company, (ii) the pro forma capitalization of the Company after giving effect to the sale of the Series A Notes and associated warrants, the conversion of the outstanding Series A Preferred Stock and Series B Preferred Stock into an aggregate of shares of Common Stock upon the consummation of this offering and the exercise of a warrant exercisable for shares of Common Stock which is expected to occur upon the consummation of this offering and (iii) the pro forma capitalization, as adjusted to reflect the issuance and sale of the shares of Common Stock offered by the Company hereby at an assumed initial public offering price of $ per share and the application of the estimated net proceeds therefrom. See "Use of Proceeds." This table should be read in conjunction with the Financial Statements and the notes thereto and the other financial information included elsewhere in this Prospectus.
SEPTEMBER 30 , 1997 ------------------------------------- PRO FORMA ACTUAL PRO FORMA AS ADJUSTED ----------- ----------- ----------- Cash..................................... $ 7,238,246 $13,815,307 $ =========== =========== ======== Series A Notes........................... $ -- $ 5,373,075 $ =========== =========== ======== Long-term debt........................... $ 218,617 $ 218,617 $ ----------- ----------- -------- Redeemable Series A and Series B Convertible Preferred Stock............. 9,516,239 -- ----------- ----------- -------- Shareholders' equity (deficit): Preferred Stock, no par value; 20,000,000 shares authorized; 254,582 shares Series A Convertible Preferred Stock and 1,605,505 shares of Series B Convertible Preferred Stock issued and outstanding actual; no shares issued and outstanding pro forma; no shares issued and outstanding pro forma as adjusted.............................. -- -- Common Stock, no par value; 50,000,000 shares authorized; shares issued and outstanding actual; shares issued and outstanding pro forma; shares issued and outstanding pro forma as adjusted(1)........................... 1,330,941 11,846,741 Warrants outstanding(2).................. -- 404,425 Deferred compensation.................... (532,238) (532,238) Accumulated deficit...................... (4,458,946) (4,458,946) ----------- ----------- -------- Total shareholders' equity (deficit)... (3,660,243) 7,259,982 ----------- ----------- -------- Total capitalization................. $ 6,074,613 $ 7,478,599 $ =========== =========== ========
- --------------------- (1) Excludes (i) shares of Common Stock issuable upon the exercise of options outstanding as of December 31, 1997 under the Company's 1996 Equity Compensation Plan (the "Equity Compensation Plan") at a weighted average exercise price of $ per share, (ii) shares of Common Stock reserved for future grants under the Equity Compensation Plan and (iii) shares of Common Stock issuable upon the exercise of warrants outstanding as of December 31, 1997 at a weighted average exercise price of $ per share. See "Management--Equity Compensation Plan" and "Description of Capital Stock." (2) Represents the value of warrants to purchase shares of Common Stock at an exercise price of $ per share issued in tandem with the Series A Notes. See "Management's Discussion and Analysis of Financial Condition and Operating Results." 16 DILUTION At September 30, 1997, the pro forma net tangible book value of the Company was approximately $ million or $ per share of Common Stock after giving effect to the warrants associated with the sale of the Series A Notes, the conversion of the outstanding Series A Preferred Stock and Series B Preferred Stock into an aggregate of shares of Common Stock upon the consummation of this Offering and the exercise of a warrant exercisable for shares of Common Stock which is expected to occur upon the consummation of this offering. Pro forma net tangible book value per share is equal to the Company's total tangible assets less its total liabilities, divided by the total number of shares of Common Stock outstanding on a pro forma basis for the period immediately prior to this offering. After giving effect to the sale by the Company of the shares of Common Stock offered hereby at an assumed initial public offering price of $ per share and after deducting underwriting discounts and commissions and estimated offering expenses, the pro forma net tangible book value of the Company at September 30, 1997 would have been $ or approximately $ per share. This represents an immediate increase in the pro forma net tangible book value of $ per share to existing shareholders and immediate dilution of $ per share to new investors purchasing shares of Common Stock in this offering. The following table illustrates this per share dilution: Assumed initial public offering price per share.................. $ Pro forma net tangible book value per share as of September 30, 1997.......................................................... $ Increase in pro forma combined net tangible book value per share attributable to new investors........................... ---- Pro forma net tangible book value per share after this offering.. ---- Dilution per share to new investors.............................. $ ====
The following table sets forth, on an adjusted basis as of September 30, 1997, the number of shares of Common Stock purchased from the Company (assuming the conversion of the Series A Preferred Stock and Series B Preferred Stock into an aggregate of shares of Common Stock and the exercise of a warrant exercisable for shares of Common Stock which is expected to occur upon the consummation of this offering), the total cash consideration paid and the average price per share paid by the existing holders of Common Stock and by new investors, before deducting estimated underwriting discounts and commissions and expenses payable by the Company, at an assumed initial public offering price of $ share:
SHARES PURCHASED TOTAL CONSIDERATION ------------------- --------------------- AVERAGE PRICE NUMBER PERCENT AMOUNT PERCENT PER SHARE ------- --------- --------- ---------- ------------- Existing shareholders... % $ % $ New investors........... % % ------- --------- --------- ---------- Total................. 100.0% $ 100.0% ======= ========= ========= ==========
The foregoing tables exclude (i) shares of Common Stock issuable upon the exercise of options outstanding as of December 31, 1997 under the Equity Compensation Plan at a weighted average exercise price of $ per share, (ii) shares of Common Stock reserved for future grants under the Equity Compensation Plan and (iii) shares of Common Stock issuable upon the exercise of warrants outstanding as of December 31, 1997 at a weighted average exercise price of $ per share. See "Management--Equity Compensation Plan" and "Discretion of Common Stock." See "Management--Equity Compensation Plan" and Note 8 to Notes to Financial Statements. The exercise of outstanding options and warrants having an exercise price less than the initial public offering price would increase the dilution to new investors illustrated by the foregoing tables. 17 SELECTED FINANCIAL AND OPERATING DATA The selected financial data set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Financial Statements and notes thereto appearing elsewhere in this Prospectus. The selected statement of operations data for the period from inception, February 12, 1994, to December 31, 1994 and the years ended December 31, 1995 and 1996 and the selected balance sheet data as of December 31, 1995 and 1996 have been derived from the Financial Statements, which have been audited by Arthur Andersen LLP, independent public accountants, and are included elsewhere in this Prospectus. The selected statement of operations data for the nine months ended September 30, 1996 and 1997 and the selected balance sheet data as of September 30, 1997 have been derived from the unaudited financial statements of the Company which, in the opinion of management, include all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the financial condition and results of operation for these interim periods. The results for the nine months ended September 30, 1997 are not necessarily indicative of results that may be expected for any other interim period or for the entire year.
PERIOD FROM INCEPTION (FEBRUARY 12, NINE MONTHS ENDED 1994) TO YEAR ENDED DECEMBER 31, SEPTEMBER 30, DECEMBER 31, ------------------------- ----------------------- 1994(1) 1995(1) 1996 1996 1997 ------------- ------------------------- ---------- ----------- STATEMENT OF OPERATIONS DATA: Net sales.............. $103,116 $ 2,176,474 $ 6,300,294 $4,107,545 $ 9,452,864 Cost of sales.......... 92,962 1,844,612 5,363,989 3,543,960 7,730,975 -------- ----------- ------------ ---------- ----------- Gross profit.......... 10,154 331,862 936,305 563,585 1,721,889 Operating expenses: Operating and develop- ment................. 26,946 149,982 523,080 329,467 1,228,040 Sales and marketing... 12,945 200,972 621,454 393,630 3,405,908 General and adminis- trative.............. 28,712 180,573 563,593 354,268 1,281,691 Dispute settle- ment(2).............. -- -- 1,024,030 -- -- -------- ----------- ------------ ---------- ----------- Total operating ex- penses............... 68,603 531,527 2,732,157 1,077,365 5,915,639 -------- ----------- ------------ ---------- ----------- Operating loss......... (58,449) (199,665) (1,795,852) (513,780) (4,193,750) Interest income (ex- pense), net........... -- (1,248) (14,556) (11,296) 64,084 -------- ----------- ------------ ---------- ----------- Net loss............... $(58,449) $ (200,913) $ (1,810,408) $ (525,076) $(4,129,666) ======== =========== ============ ========== =========== Pro forma net loss per share(3).............. $ $ ============ =========== Pro forma weighted average number of common and common equivalent shares(3).. ============ =========== OPERATING DATA: Customers(4)........... 1,802 27,822 91,301 69,024 194,757
DECEMBER 31, ------------------------------- SEPTEMBER 30, 1994 1995 1996 1997 -------- --------- ---------- ------------- BALANCE SHEET DATA: Cash and cash equivalents....... $ 2,008 $ 43,812 $ 775,865 $ 7,238,246 Working capital................. (42,206) (235,478) 231,455 4,623,893 Total assets.................... 25,765 268,468 1,575,459 10,394,950 Total long-term debt............ -- 9,519 91,133 218,617 Redeemable convertible preferred stock.......................... -- -- -- 9,516,239 Total shareholders' equity (deficit)...................... (18,449) (99,362) 514,017 (3,660,243)
- --------------------- (1) The business of the Company was established as a sole proprietorship in February 1994 and commenced commercial operations in August 1994. The Company was incorporated in April 1995. (2) In December 1996, in settlement of a dispute, the Company issued shares of Common Stock to certain persons. See Note 7 to Notes to Financial Statements. (3) See Note 1 to Notes to Financial Statements for an explanation of the determination of the number of shares and share equivalents used in computing pro forma per share amount. (4) Cumulative number of customers who have purchased products from the Company from inception of its business in August 1994 through the end of period. 18 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Prospectus contains certain statements of a forward-looking nature relative to future events or the financial performance of the Company. Actual events or results may differ materially from those indicated by such forward- looking statements for a variety of reason, including the matters set forth under the caption "Risk Factors." CDnow is the leading online retailer of CDs and other music-related products. Its early entrance into the online music retailing industry has helped the Company gain a well-recognized brand and the largest customer base of any online music retailer. The Company strives to combine the advantages of online commerce with superior customer focus in order to be the authoritative source for CDs and other music-related products. CDnow offers broad selection, informative content, easy-to-use navigation and search capabilities, a high level of customer service, competitive pricing and personalized communication. Due to the Company's dedicated retail focus, revenues are almost entirely derived from the sale of pre-recorded music and related products, drawing from its comprehensive selection of approximately 250,000 items. The Company does not seek to generate advertising or other ancillary revenues. CDnow has grown rapidly since its inception in 1994. Of the 195,000 customers who have made purchases since inception, 104,000 made their initial purchases in 1997. Average daily visits to the CDnow store have grown from approximately 12,000 in January 1996 to approximately 90,000 in September 1997. The Company's net sales grew to $9.5 million for the nine months ended September 30, 1997 compared to $4.1 million for the nine months ended September 30, 1996. Net sales for the first, second and third quarters of 1997 were $2.6 million, $3.0 million and $3.9 million, respectively. The Company has also generated significant customer loyalty. For the nine months ended September 30, 1997, repeat customers accounted for over 55% of net sales. The Company believes that the key factors affecting its long-term financial success include its ability to obtain new customers at reasonable costs, retain customers and encourage repeat purchases. The Company seeks to expand its customer base through multiple marketing channels which include (i) pursuing an aggressive marketing campaign using a combination of online and traditional marketing, (ii) establishing strategic alliances with major Internet content and service providers, (iii) entering into linking arrangements with other Web sites as part of its Cosmic Credit Program, and (iv) using direct marketing techniques to target new and existing customers with personalized communications. The Company recently accelerated its marketing campaign and entered into strategic alliances with Yahoo! and Excite in August and September of 1997, respectively. Since its inception, the Company has incurred significant net losses and, as of September 30, 1997, had accumulated losses of $6.5 million. As it seeks to expand aggressively, the Company believes that its operating expenses will significantly increase as a result of the financial commitments related to the development of marketing channels, future strategic relationships, and improvements to its Web site and other capital expenditures. The Company expects that it will continue to incur losses and generate negative cash flow from operations for the foreseeable future as it continues to develop its business. Since the Company has relatively low product gross margins, the ability of the Company to generate and enhance profitability depends upon its ability to substantially increase its net sales. To the extent that significantly higher net sales do not result from the Company's marketing efforts, the Company will be materially adversely affected. There can be no assurance that the Company will be able to generate sufficient revenues from the sale of CDs and other music-related products to achieve or maintain profitability on a quarterly or annual basis. For the nine months ended September 30, 1997, international sales accounted for over 33% of net sales. While the Company expects that net sales from international markets will continue to represent a significant portion of net sales, the Company believes that the percentage of its net sales from international 19 markets may decrease in future periods due to the significant growth in the Company's net sales overall, and in the U.S. in particular. The Company's business started as a sole proprietorship in February 1994. The Company, which was incorporated in April 1995, was taxed as an S- corporation until December 6, 1996 and has been taxed as a C-corporation since such date. RESULTS OF OPERATIONS The following table sets forth statement of operations data as a percentage of net sales for the periods indicated:
YEAR ENDED NINE MONTHS ENDED DECEMBER 31, SEPTEMBER 30, --------------- ------------------- 1995 1996 1996 1997 ------ ------ -------- -------- Net sales........................... 100.0% 100.0% 100.0% 100.0% Cost of sales....................... 84.8 85.1 86.3 81.8 ------ ------ -------- -------- Gross profit...................... 15.2 14.9 13.7 18.2 Operating Expenses: Operating and development......... 6.9 8.3 8.0 13.0 Sales and marketing............... 9.2 9.9 9.6 36.0 General and administrative........ 8.3 8.9 8.6 13.6 Dispute settlement................ -- 16.3 -- -- ------ ------ -------- -------- Total operating expenses.......... 24.4 43.4 26.2 62.6 ------ ------ -------- -------- Operating loss...................... (9.2) (28.5) (12.5) (44.4) Interest (expense) income, net...... -- (0.2) (0.3) 0.7 ------ ------ -------- -------- Net loss............................ (9.2)% (28.7)% (12.8)% (43.7)% ====== ====== ======== ========
NINE MONTHS ENDED SEPTEMBER 30, 1997 COMPARED TO THE NINE MONTHS ENDED SEPTEMBER 30, 1996 Net Sales. Net sales primarily reflect the sales of CDs and related merchandise, net of estimated returns, and include outbound shipping and handling charges. Net sales increased by $5.4 million, or 130%, to $9.5 million for the nine months ended September 30, 1997 compared to $4.1 million for the nine months ended September 30, 1996. This increase is primarily attributable to the significant growth of the Company's customer base and repeat purchases from the Company's existing customers, who have typically purchased more units per order than new customers. International sales represented approximately 33% and 39% of net sales for the nine months ended September 30, 1997 and September 30, 1996, respectively. This decrease in international sales as a percentage of net sales is due to a higher rate of growth of domestic sales compared to the growth experienced in international markets. At September 30, 1997, the Company had approximately 195,000 customer accounts compared to approximately 69,000 customer accounts at September 30, 1996. Cost of Sales. Cost of sales consists primarily of the cost of merchandise sold to customers, including product fulfillment and outbound shipping and handling. Cost of sales also includes fees charged by credit card processors and royalties paid by the Company on CD sales in return for licensing of ratings, reviews and other information. Cost of sales increased by $4.2 million, or 118%, to $7.7 million for the nine months ended September 30, 1997 compared to $3.5 million for the nine months ended September 30, 1996. This increase is primarily attributable to the Company's increased sales volume. The Company's gross profit margin was 18.2% for the nine months ended September 30, 1997 compared to 13.7% for the nine months ended September 30, 1996. The increase in gross margin as a percentage of net sales was primarily due to price reductions from the Company's suppliers and a change to a lower- price supplier 20 for imported music and music-related products. The Company anticipates that its gross profit margin will decline in the fourth quarter of 1997 due to increased sales promotions during the holiday season. Operating and Development Expense. Operating and development expense consists primarily of payroll and related expenses for design, development and network operations personnel and systems and telecommunications infrastructure. Operating and development expense increased by $899,000 to $1.2 million for the nine months ended September 30, 1997 compared to $329,000 for the nine months ended September 30, 1996. As a percentage of net sales, these expenses were 13.0% for the nine months ended September 30, 1997 and 8.0% for the nine months ended September 30, 1996. This increase was due to increased staffing and associated costs related to enhancing the features, content and functionality of the Company's Web site and transaction-processing systems, as well as increased investment in systems and telecommunications infrastructure. Store development costs are charged to expense as incurred. Sales and Marketing Expense. Sales and marketing expense consists primarily of payments related to advertising and promotion, strategic alliances and public relations as well as payroll and related expenses for personnel engaged in marketing, selling and customer service activities. Sales and marketing expense increased by $3.0 million to $3.4 million for the nine months ended September 30, 1997 compared to $394,000 for the nine months ended September 30, 1996. As a percentage of net sales, these expenses increased to 36.0% for the nine months ended September 30, 1997 from 9.6% for the nine months ended September 30, 1996. This increase was due to the significant expansion of the Company's online advertising, promotional and public relations expenditures and to the increased staffing and associated costs related to implementing the Company's marketing strategy and supporting the Company's increased customer base. The Company increased its advertising expense to $2.2 million for the nine months ended September 30, 1997 compared to $24,000 for the nine months ended September 30, 1996. The Company intends to aggressively expand its sales and marketing campaign and expects the dollar amount of sales and marketing expense generally, and advertising expense in particular, to increase significantly. General and Administrative Expense. General and administrative expense consists of payroll and related expenses for executive, accounting and administrative personnel, recruiting, professional fees and other general corporate expenses. General and administrative expense increased by $927,000 to $1.3 million for the nine months ended September 30, 1997 compared to $354,000 for the nine months ended September 30, 1996. As a percentage of net sales, these expenses increased to 13.6% for the nine months ended September 30, 1997 compared to 8.6% for the nine months ended September 30, 1996. This increase was primarily due to the recruitment and hiring of additional personnel and increases in professional fees and travel expenses. Net Loss. The Company incurred a net loss of $4.1 million for the nine months ended September 30, 1997 compared to a net loss of $525,000 for the nine months ended September 30, 1996. YEAR ENDED DECEMBER 31, 1996 COMPARED TO THE YEAR ENDED DECEMBER 31, 1995 Net Sales. Net sales increased 189% to $6.3 million for the year ended December 31, 1996 from $2.2 million for the year ended December 31, 1995 as a result of the significant growth of the Company's customer base and repeat purchases from existing customers. International sales represented approximately 40% and 22% of net sales for the year ended December 31, 1996 and the year ended December 31, 1995, respectively. At December 31, 1996, the Company had approximately 91,000 customer accounts compared to approximately 28,000 customer accounts at December 31, 1995. Cost of Sales. Cost of sales increased 191% to $5.4 million for the year ended December 31, 1996 from $1.8 million for the year ended December 31, 1995, reflecting the Company's increased sales volume. The Company's gross profit margin decreased to 14.9% for the year ended December 31, 1996 from 15.2% for the year ended December 31, 1995. 21 Operating and Development Expense. Operating and development expense increased to $523,000 for the year ended December 31, 1996 from $150,000 for the year ended December 31, 1995. As a percentage of net sales, operating and development expense grew to 8.3% for the year ended December 31, 1996 from 6.9% for the year ended December 31, 1995. This increase in both absolute dollars and as a percentage of net sales was primarily attributable to increased staffing and associated costs related to enhancing the features, content and functionality of the Company's Web site and transaction-processing systems, as well as increased investment in systems and telecommunications infrastructure. Sales and Marketing Expense. Sales and marketing expense increased to $621,000 for the year ended December 31, 1996 from $201,000 for the year ended December 31, 1995. As a percentage of net sales, sales and marketing expense grew to 9.9% for the year ended December 31, 1996 from 9.2% for the year ended December 31, 1995. This increase in both absolute dollars and as a percentage of net sales was primarily attributable to increased staffing and associated costs related to implementing the Company's marketing strategy and supporting the Company's increased customer base, as well as to expansion of the Company's online advertising, promotional and public relations expenditures. General and Administrative Expense. General and administrative expense increased to $564,000 for the year ended December 31, 1996 from $181,000 for the year ended December 31, 1995. As a percentage of net sales, general and administrative expense grew to 8.9% for the year ended December 31, 1996 from 8.3% for the year ended December 31, 1995. This increase in both absolute dollars and as a percentage of net sales was primarily due to the hiring of additional personnel and increases in professional fees and travel expenses. Dispute Settlement. In December 1996, in settlement of a dispute, the Company issued Common Stock valued at $1.0 million to the three shareholders of MBL Entertainment Inc. See "Certain Transactions" and Note 7 to Notes to Financial Statements. Net Loss. The Company's net loss increased by $1.6 million to a loss of $1.8 million for the year ended December 31, 1996 compared to a loss of $201,000 for the year ended December 31, 1995. 22 QUARTERLY RESULTS OF OPERATIONS AND SEASONALITY The following table sets forth certain unaudited quarterly statement of operations data for the seven quarters ended September 30, 1997. This unaudited quarterly information has been derived from unaudited financial statements of the Company and, in the opinion of management, include all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the information for the periods covered. The quarterly data should be read in conjunction with the Financial Statements and the notes thereto. The operating results for any quarter are not necessarily indicative of the operating results for any future period.
THREE MONTHS ENDED ------------------------------------------------------------------------ MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, 1996 1996 1996 1996 1997 1997 1997 -------- -------- --------- -------- -------- -------- --------- (IN THOUSANDS) Net sales............... $1,128 $1,352 $1,629 $ 2,191 $2,582 $ 2,964 $ 3,907 Cost of sales........... 965 1,169 1,412 1,818 2,102 2,408 3,221 ------ ------ ------ ------- ------ ------- ------- Gross profit............ 163 183 217 373 480 556 686 Operating Expenses: Operating and development........... 77 106 146 194 254 423 551 Sales and marketing.... 92 127 174 228 430 722 2,254 General and administrative........ 83 115 157 209 342 410 530 Dispute settlement..... -- -- -- 1,024 -- -- -- ------ ------ ------ ------- ------ ------- ------- Total operating expenses............. 252 348 477 1,655 1,026 1,555 3,335 ------ ------ ------ ------- ------ ------- ------- Operating loss.......... (89) (165) (260) (1,282) (546) (999) (2,649) Interest income (expense), net......... (2) (3) (6) (3) 2 (6) 69 ------ ------ ------ ------- ------ ------- ------- Net loss................ $ (91) $ (168) $ (266) $(1,285) $ (544) $(1,005) $(2,580) ====== ====== ====== ======= ====== ======= ======= AS A PERCENTAGE OF NET SALES ------------------------------------------------------------------------ MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, 1996 1996 1996 1996 1997 1997 1997 -------- -------- --------- -------- -------- -------- --------- Net sales............... 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% Cost of sales........... 85.5 86.5 86.7 83.0 81.4 81.2 82.4 ------ ------ ------ ------- ------ ------- ------- Gross profit............ 14.5 13.5 13.3 17.0 18.6 18.8 17.6 Operating expenses: Operating and development........... 6.8 7.8 9.0 8.9 9.8 14.3 14.1 Sales and marketing.... 8.2 9.4 10.7 10.4 16.7 24.4 57.7 General and administrative........ 7.4 8.5 9.6 9.5 13.2 13.8 13.6 Dispute settlement..... -- -- -- 46.7 -- -- -- ------ ------ ------ ------- ------ ------- ------- Total operating expenses............. 22.4 25.7 29.3 75.5 39.7 52.5 85.4 ------ ------ ------ ------- ------ ------- ------- Operating loss.......... (7.9) (12.2) (16.0) (58.5) (21.1) (33.7) (67.8) Interest income (expense), net......... (0.2) (0.2) (0.3) (0.1) -- (0.2) 1.8 ------ ------ ------ ------- ------ ------- ------- Net loss................ (8.1)% (12.4)% (16.3)% (58.6)% (21.1)% (33.9)% (66.0)% ====== ====== ====== ======= ====== ======= =======
The Company expects to experience significant fluctuations in its future quarterly operating results due to a variety of factors, many of which are outside the Company's control. Factors that may affect the Company's quarterly operating results include (i) its ability to retain existing customers, attract new customers and maintain customer satisfaction, (ii) the introduction of new or enhanced Web pages, services, products and strategic alliances by the Company and its competitors, (iii) price competition or higher wholesale prices, (iv) the level of use of the Internet and consumer acceptance of the Internet for the purchase of recorded music, (v) seasonality of recorded music sales, (vi) its ability to upgrade and 23 develop its systems and infrastructure and attract qualified personnel, (vii) technical difficulties, system downtime or Internet brownouts, (viii) the amount and timing of operating costs and capital expenditures relating to expansion of the Company's business, operations and infrastructure, (ix) the timing of Company promotions and sales programs, (xii) the level of merchandise returns experienced by the Company, (xi) government regulation and (xii) general economic conditions and economic conditions specific to the Internet and the music industry. The Company expects that it will experience seasonality in its business, reflecting a combination of seasonal fluctuations in Internet usage and traditional retail seasonality patterns affecting sales of recorded music. Sales in the traditional retail music industry are significantly higher in the fourth calendar quarter of each year than in the preceding three quarters. However, to date, the Company's limited operating history and rapid growth make it difficult to ascertain the effects of seasonality on its business. The Company believes that period-to-period comparisons of the Company's historical results are not necessarily meaningful and should not be relied upon as an indication of future results. LIQUIDITY AND CAPITAL RESOURCES Since inception, the Company has primarily financed its operations through private sales of capital stock (which, through September 30, 1997, totaled $10.5 million, including $9.3 million raised in July and August of 1997), internally-generated cash flow, advances from related parties and certain other short-term loans. Net cash used in operating activities totaled $116,000 for the year ended December 31, 1996 compared to cash provided by operating activities of $41,000 for the year ended December 31, 1995. Net cash used in operating activities for the year ended December 31, 1996 was attributable to a net loss of $1.8 million (however, $1.0 million of the net loss was attributable to the issuance of common stock in settlement of a dispute, which had no cash effect on the Company) and increases in accounts receivable and prepaid expenses, partially offset by increases of $394,000 in accounts payable and accrued expenses, $161,000 in deferred revenues, $118,000 of services contributed by the Company's founders, and $105,000 in depreciation and amortization. Net cash used in operating activities was $738,000 for the nine months ended September 30, 1997 compared to cash provided by operating activities of $100,000 for the nine months ended September 30, 1996. For the nine months ended September 30, 1997, cash used in operating activities was attributable to a $4.1 million net loss, and a $491,000 increase in prepaid expenses, partially offset by a $3.2 million increase in accounts payable, $254,000 increase in accrued expenses and $439,000 in depreciation and amortization. Net cash provided by operating activities for the nine months ended September 30, 1996 was primarily due to a $269,000 increase in accounts payable and a $243,000 increase in accrued expenses, which collectively more than offset a net loss of $525,000 and an increase in accounts receivable of $46,000. Net cash used in investing activities totaled $445,000 for the year ended December 31, 1996 compared to $136,000 for the year ended December 31, 1995. The increase was attributable to purchases of short-term marketable securities and increased purchases of property and equipment. Cash used in investing activities was $2.0 million for the nine months ended September 30, 1997 compared to $97,000 for the nine months ended September 30, 1996. The increase was attributable to purchases of property and equipment and investments in short-term marketable securities. Net cash from financing activities totaled $1.3 million for the year ended December 31, 1996 compared to $136,000 for the year ended December 31, 1995. The increase was principally attributable to $1.2 million in proceeds from the sale of Common Stock in December 1996 to Alan Meltzer, a board member. The Company repaid in December 1996 a $100,000 loan made in 1995 by Mr. Meltzer. In addition, in 1996 the Company borrowed $200,000 from private investors. Cash flows from financing activities were $9.2 million for the nine months ended September 30, 1997 compared to $7,000 used in financing activities for the nine months ended September 30, 1996. This increase was primarily the result 24 of $10.0 million in proceeds received from the sale of Series A and Series B Preferred Stock, net of issuance costs of approximately $700,000 and the proceeds from notes payable of $219,000. The Company also repaid $200,000 of short-term loans from private investors that had been incurred in 1996. On July 15, 1997, the Company sold 254,582 shares of Series A Preferred Stock to Keystone Ventures IV, L.P. ("Keystone Ventures") for an aggregate price of $1.3 million. The outstanding shares of Series A Preferred Stock will automatically convert upon the consummation of this offering into an aggregate of shares of Common Stock. On August 5, 1997, the Company sold 1,543,505 shares of Series B Preferred Stock to Grotech Partners IV, LP ("Grotech") and 62,000 shares of Series B Preferred Stock to ABS Employees' Venture Fund Limited Partnership ("ABS") for an aggregate price of $8.7 million. Each outstanding shares of Series B Preferred Stock will automatically convert upon the consummation of this offering into an aggregate of shares of Common Stock. In November 1997, the Company issued $5.8 million aggregate principal amount of Series A Notes to a group of investors, including Grotech. The Series A Notes bear interest at 12% per annum, are due upon the consummation of this offering and will be repaid from a portion of the net proceeds of this offering. The Company issued warrants to these investors to purchase shares of Common Stock at an exercise price of $ per share. The Series A Notes have been recorded net of the estimated value ($404,000) associated with these warrants. This discount is being amortized over the anticipated term of the Series A Notes. On August 21, 1997, the Company entered into a one-year Advertising and Promotion Agreement with Yahoo! (the "Yahoo! Agreement") which automatically extends for an additional one year period unless CDnow provides Yahoo! with a notice of termination prior to July 1998. Under the Yahoo! Agreement, (i) CDnow has exclusivity on music-related pages on the main Yahoo! site, including the Yahoo! Metro Sites and My Yahoo!, with respect to music banner advertising opportunities, integrated links and specific keywords, (ii) CDnow has exclusive advertising rights with respect to any additional music-related pages created by Yahoo! under such sites and (iii) Yahoo! is required to deliver a minimum number of page views during the term of the Agreement. The Company is required to pay Yahoo! minimum fees of $3.9 million during the first year of the Agreement, of which an aggregate of $300,000 was paid in September 1997, $600,000 is required to be paid in December 1997 and $3.0 million is due in periodic installments between January and October of 1998. If the Yahoo! Agreement is extended for an additional one year period, the Company will be required to pay Yahoo! certain additional fees during such period based on the number of users that access the CDnow Web site through the links with Yahoo! during the last two months of the initial term, provided that such fees may not be less than $4.5 million in the aggregate. In addition, during the term of the Yahoo! Agreement, the Company is required to pay Yahoo! an additional variable fee based on the number of users that access the CDnow Web site through the links with Yahoo! in excess of certain stated minimums. See "Business--Marketing and Promotion." On September 30, 1997, the Company and Excite entered into a two-year Linking Agreement (the "Excite Agreement"). Under the Excite Agreement, (i) the Company has been designated as the exclusive online music retailer within Excite's WebCrawler service and has obtained the exclusive right to sponsor targeted links, advertising banners and specific keywords for online retail music purchases within WebCrawler and (ii) Excite is required to provide the Company with a minimum number of banners and links on the WebCrawler service during each year of the Agreement and is limited in its right to advertise other music retailers on the remainder of the WebCrawler service. The Company is required to pay Excite $2.0 million and $2.5 million in fees during the first and second years, respectively, of the Excite Agreement. The Company is required to pay Excite additional variable fees based on the number of users which access the CDnow site through links with the WebCrawler service in excess of certain minimums. The Company has the right to terminate the Excite Agreement and eliminate any obligation to pay Excite any of the fees scheduled to be paid during the second year of the term if a certain minimum level of links and advertising banners have not been delivered by the WebCrawler service within 30 days after the first anniversary of such Agreement. See "Business--Marketing and Promotion." 25 As of September 30, 1997, the Company had $7.2 million of cash and cash equivalents and short-term marketable securities of $1.0 million. As of that date, the Company's principal commitments consisted of obligations to Yahoo! and Excite as well as its obligations outstanding under operating and capital leases. Although the Company has no material commitments for capital expenditures, it anticipates a substantial increase in its capital expenditures and lease commitments consistent with anticipated growth in operations, infrastructure and personnel. The Company believes that the net proceeds from this Offering, together with its current cash and cash equivalents, will be sufficient to meet its anticipated cash needs for working capital and capital expenditures for at least the next 12 months. However, the Company's capital requirements depend on several factors, including the rate of market acceptance, the ability to expand the Company's customer base, the cost of Web site upgrades, the level of expenditures for sales and marketing, and other factors. The timing and amount of such capital requirements cannot accurately be predicted. If capital requirements vary materially from those currently planned, the Company may require additional financing sooner than anticipated. The Company has no commitments for any additional financing, and there can be no assurance that any such commitments can be obtained on favorable terms, if at all. Any additional equity financing may be dilutive to the Company's shareholders, and debt financing, if available, may involve restrictive covenants with respect to dividends, raising future capital and other financial and operational matters which could restrict its operations or finances. If the Company is unable to obtain additional financing as needed, the Company may be required to reduce the scope of its operations or its anticipated expansion, which could have a material adverse effect on the Company. At September 30, 1997, the Company had a net operating loss ("NOL") carryforward of approximately $3.9 million, which begin to expire in 2005. The utilization of the NOL carryforward will be limited pursuant to the Tax Reform Act of 1986, due to cumulative changes in ownership in excess of 50%. See Note 5 to Notes to Financial Statements. See Note 2 to Notes to Financial Statements for information regarding recently adopted accounting standards and recently issued accounting standards. 26 BUSINESS INTRODUCTION CDnow is the leading online retailer of CDs and other music-related products. Its early entry into the online music retailing industry has helped the Company gain a well-recognized brand and the largest customer base of any online music retailer. The Company strives to combine the advantages of online commerce with superior customer focus in order to be the authoritative source for CDs and other music-related products. The Company's online store, cdnow.com, offers broad selection, informative content, easy-to-use navigation and search capabilities, a high level of customer service, competitive pricing and personalized merchandising and communication. With approximately 250,000 items, the Company believes that it provides a selection of readily-available products that is five to ten times that of a typical music retailer. To assist customers in making music selections, the CDnow store contains approximately 70,000 reviews and related articles and 275,000 sound samples. The CDnow store is open 24 hours a day, seven days a week and offers its customers convenient and timely product fulfillment, including an overnight delivery option. CDnow has grown rapidly since its inception in 1994. Of the 195,000 customers who have made purchases since inception, 104,000 made their initial purchases in 1997. Average daily visits to the CDnow store have grown from approximately 12,000 in January 1996 to approximately 90,000 in September 1997. The Company's net sales grew to $9.5 million for the nine months ended September 30, 1997 compared to $4.1 million for the nine months ended September 30, 1996. Net sales for the first, second and third quarters of 1997 were $2.6 million, $3.0 million and $3.9 million, respectively. The Company has also generated significant customer loyalty. For the nine months ended September 30, 1997, repeat customers accounted for over 55% of net sales. INDUSTRY OVERVIEW The Internet is an increasingly significant global medium for communications, information and commerce. International Data Corporation ("IDC") estimates that the number of Web users grew to approximately 28 million by the end of 1996 and will grow to approximately 175 million by 2001. The Company believes that the growth in Internet usage has resulted from a number of factors, including the large and growing installed base of PCs in the workplace and home, advances in the performance and speed of PCs and modems, improvements in network infrastructure, easier and cheaper access to the Internet and increased awareness of the Internet among businesses and consumers. Jupiter Communications ("Jupiter") estimates that the number of online households (households using e-mail, the Internet or a consumer online service) making purchases will grow from an estimated 15.2 million households in 1996 to 57.0 million households, representing over 50% of U.S. households, by the year 2002. IDC estimates that the total value of services and products purchased over the Web grew from $296 million in 1995 to approximately $2.6 billion in 1996, and will increase to approximately $123 billion by 2000. The Company believes that a significant opportunity exists for the retailing of music on the Internet. According to the International Federation of the Phonographic Industry, worldwide sales of pre-recorded music and music videos in 1996 were approximately $39.8 billion, of which one-third was in North America. Online music retailers currently account for a small but growing portion of total sales. According to Jupiter, sales of pre-recorded music, music-related merchandise, advertising and concert tickets over the Internet are projected to grow on a worldwide basis from approximately $23 million in 1996 to over $2.8 billion in 2002. A number of characteristics of online music retailing make the sale of pre- recorded music via the Internet particularly attractive relative to traditional retail stores. The Internet offers many data management and multimedia features which enable consumers to listen to sound samples, search for music by genre, title or artist and access a wealth of information and events, including reviews, related 27 articles, music history, news and recommendations. Internet retailers can more easily obtain extensive demographic and behavioral data about their customers, providing them with greater direct marketing opportunities and the ability to offer a more personalized shopping experience. In addition, Internet retailers can also offer consumers significantly broader product selection, the convenience of home shopping and 24-hour-a-day, seven-day-a-week operations, available to any location, foreign or domestic, that has access to the Internet. While physical store-based music retailers must make significant investments in inventory, real estate and personnel for each store location, online retailers incur a fraction of these costs, generally use centralized distribution, and have virtually unlimited merchandising space. Traditional retailers are compelled to limit the amount of inventory they carry at each store and focus on a smaller selection of faster-selling hit releases. As a result, the Company believes that a typical music store may carry up to 12,000 SKUs and a megastore may carry up to 50,000 SKUs, compared to the 250,000 SKU's carried by the CDnow store. According to Jupiter, approximately 80% of unit sales at traditional retail stores come from approximately 20% of the available titles. Online retailers can offer consumers a broader range of titles and information and can also offer products from a wider range of music labels, including smaller independent labels which account for an increasing percentage of new titles. According to Soundscan, independent labels accounted for 21% of the total music market in 1996 versus 12% in 1992. While independent labels released 66% of new titles in 1996, traditional music stores often lack the capacity to stock or promote the vast majority of these titles. The Company also believes that online retailers will benefit from the changing demographic profile of music consumers. According to the Recording Industry Association of America, domestic purchases of recorded music by persons age 30 and over have increased from approximately 34% of total U.S. sales in 1986 to approximately 47% of sales, or approximately $5.9 billion, in 1996. The Company believes that the Internet represents a particularly attractive medium for retailing to customers in this age group as they are typically less "hits-driven" than younger age groups and are more likely to purchase a wide variety of titles. These customers generally can afford to buy more titles at one time, have access to computers and use the Internet, and have credit cards with which to make electronic payments. STRATEGY The Company focuses on promoting its brand and extending its leadership position through the following key strategies: Focus on Recorded Music Retailing. CDnow is dedicated to online music retailing. By focusing on its core competency, the Company is able to offer a high quality, customer-oriented online music store and build a clearly delineated brand, which the Company believes will make CDnow the site of choice for recorded music customers. The Company believes that this focus enables it to better direct its sales and marketing campaigns, form effective relationships with Internet content and service providers, and minimize potential conflicts of interest with alternate distribution channels or recorded music labels. Provide Innovative and Easy-to-Use Retail Concept. The Company strives to make its customer experience informative, efficient and intuitive by constantly updating and improving its store format and features. The CDnow store incorporates "point and click" options, supported by technical enhancements including easy-to-use search capabilities (by artist, album title, song title or record label), personalized music suggestions, order tracking and confirmation. The CDnow store promotes music learning and discovery by enabling visitors to access information on titles, music reviews, ratings, articles on music topics and approximately 275,000 sound samples. These features are designed to make shopping at the store entertaining and informative and encourage purchases and repeat visits. The Company is dedicated to providing its customers with a comprehensive selection of both popular and hard-to-find CDs and offers over 250,000 items. The account registration and ordering instructions contained in the CDnow store are available in several foreign language versions to facilitate international sales. 28 Expand Customer Base Through Multiple Marketing Channels. The Company seeks to expand its customer base through multiple marketing channels. The Company believes that this strategy enables it to reduce reliance on any one source of customers, maximize brand awareness and lower average customer acquisition cost. . Online and Traditional Advertising. The Company promotes its brand through an aggressive marketing campaign using a combination of online and traditional marketing. The Company advertises on the sites of major Internet content and service providers, including Infoseek, Lycos and CNN Interactive, and targeted music-related sites, such as Billboard. As part of these arrangements, the Company typically purchases the right to display its banners and hyperlinks, often in conjunction with specified search keywords such as "music store." The Company's traditional advertising effort includes radio advertising, including advertising on the Howard Stern program. The Company has also begun to employ print advertising in music-related publications such as Rolling Stone, Spin and Variety. . Strategic Alliances with Major Content and Service Providers. The Company believes it can enhance its new customer acquisition efforts, increase purchases by current customers and expand brand recognition through strategic alliances with major Internet content and service providers. The Company has recently entered into alliances with Yahoo! and Excite's WebCrawler service to be the premier online recorded music retailer on certain of their sites with exclusivity with respect to certain music-related pages. These pages will prominently feature the CDnow branded link that allows users to click through to the CDnow site. The Company has also entered into marketing arrangements with, among others, ABC News Starwave Partners and USA TODAY Information Network and will seek to develop relationships with other major content and service providers. . Cosmic Credit Program. Through its Cosmic Credit program, CDnow has arrangements with over 9,000 small Web sites, typically fan sites devoted to particular musical artists. The Company provides these sites with embedded hyperlinks through which potential customers can immediately be connected to the CDnow site. The Company believes that highly-focused, music-oriented sites, while having less traffic than major content providers, are likely to have a high percentage of users that will be attracted to the CDnow store. . Direct Marketing Techniques. The Company uses direct marketing techniques to target new and existing customers with communications and promotions. The Company sends a personalized e-mail newsletter to its customers that includes purchase recommendations based on demonstrated customer preferences and prior purchases, as well as more general information concerning new releases and Company promotions. The Internet allows rapid and effective experimentation and analysis, instant user feedback and efficient personalization of the store for each customer, all of which CDnow seeks to incorporate in its merchandising. Acquire Customers Efficiently. The Company seeks to target its marketing expenditures towards sources that most efficiently attract new customers. The Company utilizes its three years of online retailing experience and its database of approximately 200,000 customers to better evaluate and predict the effectiveness of potential advertising opportunities and strategic relationships. To enhance the possibility that its banners and other links will be effective, the Company works closely with Internet content and service providers with respect to the placement of banners and other links as well as the surrounding content. As a result, the Company believes that it can acquire new customers and retain existing customers on a more cost-effective basis. Maximize Customer Retention. The Company seeks to maximize customer retention through its emphasis on customer service and personalized communications. The success of this strategy is evidenced by CDnow's high level of repeat customers, which accounted for over 55% of net sales during the nine months ended September 30, 1997. The Company strives to accommodate its customers by providing 24-hour-a-day, seven-day-a-week operations and rapid order fullfillment. Products are typically shipped 29 within a day after an order is placed and confirmation is provided within minutes via e-mail. Customers can make separate inquiries through e-mail or telephone access during extended business hours. The Company strives to ensure prompt response to customer inquiries, which are generally answered within 24 hours of receipt. The Company also maintains ongoing customer contact through its customized e-mail newsletter, The CDnow Update. THE CDNOW ONLINE RETAIL STORE The Company strives to make the CDnow store informative and authoritative, allowing customers to easily learn about, discover and purchase CDs and other music-related products. The store is designed to be intuitive and easy to use and to enable the ordering process to be completed with a minimum of customer effort. Customers enter the CDnow store through its Web site, cdnow.com, and in addition to ordering music products, can conduct targeted searches, browse among top sellers and other featured titles, read reviews, listen to music samples, register for personalized communications, participate in promotions and check order status. New users may access a page specifically designed to provide a quick understanding of the site and its many features. Merchandising. CDnow believes that its ability to offer a substantially larger selection than traditional retail stores is a significant competitive advantage. The Company currently offers approximately 200,000 CDs, 40,000 movies and 10,000 music videos as well as t-shirts, music books and CD-ROMs. To encourage purchases, the Company features various promotions on a rotating basis throughout the store. The Company also launched its Gift Center in November 1997 which features an online recommendation service. The Company adjusts pricing strategies and tactics as necessary to maintain competitiveness and generally prices all recent releases and popular titles aggressively. The Company seeks to encourage the purchase of multiple titles by providing more favorable shipping terms for larger orders. Searching. Through the Company's "FastFind" search engine, customers can quickly and easily navigate the store to find CDs or other products of interest. Customers can search for products based on artist, album title, song title, record label, musical genre or release date for new releases. By clicking on the "Info" buttons, a visitor can browse among CDnow's database of reviews, cover art, sound samples and album notes. Content and Music Discovery. The Company believes that effective use of content encourages purchases by customers who may be browsing the site without a specific title in mind. The Company's Web site contains approximately 275,000 sound samples, extensive information with regard to titles, reviews, ratings, articles on music topics and other information. To help customers browse and discover CDs, CDnow recently launched six music spaces organized by genre: Rock/Pop, Jazz/Blues, Urban/Electronic, Country/Folk, World/New Age and Classical. The main page of each space features links to genre-specific lists, articles, reviews and contests. Within each space, customers can browse sale items, new releases, advance orders and charts, read exclusive CDnow reviews, listen to sound samples and purchase CDs recommended by the Company. Purchasing. Once a CD has been selected, customers simply click on the price to add products (including, advance orders of yet-to-be released products) to their virtual shopping carts. Customers can add and remove products from their shopping carts as they browse, prior to making a final purchase. The shopping cart page displays each item that has been placed in the cart, including title, price and any applicable discount. To execute orders, customers click on the "Buy" button and are prompted to select shipping and payment methods online or by e-mail, facsimile or telephone. Customers can also add products which they may wish to purchase on future visits to their "lunch box," a special section of the shopping cart where items may be stored over multiple visits. Payment. In paying for orders, customers may use credit cards, personal checks or money orders. For convenience, the Company enables customers to store credit card information on the Company's 30 secure server, thereby avoiding the need to re-enter this information when making future purchases. Customers are offered a variety of shipping options, including overnight delivery. The Company automatically confirms each order by e-mail within minutes after the order is placed and subsequently confirms shipment of each order by e-mail. The Company offers a money back returns policy. Distribution and Fulfillment. All of the Company's inventory is owned and held by outside vendors and shipped directly from these vendors to customers. The breadth of the inventory maintained by these vendors provides CDnow with the ability to maintain high order fill rates. CDnow updates its site daily with inventory information received from its vendors, which enables customers to check the availability of products before ordering. The Company electronically transmits orders to its outside vendors at least once daily. Orders are shipped by these vendors using a CDnow label and invoice, in most cases within a day after an order is placed with the Company. A customer's credit card is charged once an order is shipped. Multilingual Capabilities. The Company believes that international markets will continue to represent a significant portion of the Company's sales since many products offered by CDnow are not otherwise available in these markets. International music sales in 1996 were estimated to be approximately twice that of the U.S. Approximately 33% of the Company's sales for the nine months ended September 30, 1997 were generated from international markets. The Company has introduced Spanish, French, German, Portuguese and Japanese language versions of its Web site that contain translation of account registration and ordering instructions, and supports its international sales efforts with customer service representatives fluent in these languages. The Company intends to introduce additional foreign language versions in the near future. MARKETING AND PROMOTION CDnow's marketing and promotion strategy is designed to broaden awareness of the CDnow brand, increase customer traffic to the Company's Web site and encourage new and repeat purchases. The Company utilizes multiple channels to market and promote its brand, including online and traditional advertising, strategic alliances, the Company's Cosmic Credit Program, and direct marketing. The Company believes that the use of multiple marketing channels reduces reliance on any one source of customers, maximizes brand awareness and lowers average customer acquisition cost. Online and Traditional Advertising The Company promotes its brand through an aggressive marketing campaign using a combination of online and traditional advertising. The Company advertises on the sites of major Internet content and service providers, including Infoseek, Lycos and CNN Interactive, and targeted music-related sites, such as Billboard. As part of these arrangements, the Company typically purchases banner advertisements, often in conjunction with specified search keywords or on contextually appropriate pages, that allow consumers to immediately click through to the CDnow site. The significant flexibility of online advertising allows the Company to quickly adjust its advertising plans in response to seasonal and promotional activities. CDnow believes that traditional advertising is a key ingredient in building brand recognition and promoting the benefits of online retail shopping. Traditional advertising can be an effective means of promoting widespread brand awareness and attracting traditional retail consumers to the Company's Website, including consumers with little or no history of online purchases. The Company's traditional advertising effort includes radio advertising, such as advertising on the Howard Stern program. The Company has also begun to employ print advertising in music-related publications such as Rolling Stone, Spin and Variety. The Company conducts an active public relations campaign and regularly participates in trade shows and conferences relating to online commerce. 31 Strategic Alliances The Company believes that the Web sites of major Internet service and content providers can be a source of a significant number of new customers. These sites have a high volume of user traffic, and the Company believes that the utilization of carefully targeted links and other advertising on the sites can be very effective in attracting potential customers. The Company has recently entered into agreements with Yahoo! and Excite's WebCrawler, two widely used Internet search engines, and also has arrangements with several other content and service providers. Yahoo! The Company and Yahoo! have entered into the Yahoo! Agreement, under which CDnow has been granted exclusivity on selected pages within music- related pages on the main Yahoo! site, including the Yahoo! Metro Sites and My Yahoo (collectively, the "Yahoo! Service"). In particular, Yahoo! has agreed to place integrated links to the CDnow store and banner advertisements on certain pages generated from the Yahoo! Service. The Yahoo! Agreement requires Yahoo! to deliver a minimum number of page views during each quarter of the term of the Agreement and limits the ability of other music retailers to place links or advertise on these pages. In addition, CDnow was granted a right-of-first-refusal regarding any promotional opportunity developed by Yahoo! that is similar in scope and nature to that provided by the Yahoo! Agreement. The initial term of the Yahoo! Agreement expires in October 1998, subject to an automatic one year renewal unless otherwise terminated by the Company. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-- Liquidity and Capital Resources." WebCrawler. The Company and Excite have entered into the Excite Agreement, under which the Company has been designated as the exclusive online music retailer within Excite's WebCrawler service and has been granted the exclusive right to sponsor targeted links, advertising banners and specific keywords for online retail music purchases within WebCrawler. The Excite Agreement also requires Excite to deliver a minimum number of links and banners on the WebCrawler service during each year of the Agreement and limits the ability of Excite to include advertising for other music retailers on the WebCrawler service. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources." Other Alliances. CDnow has established relationships with other major Internet content and service providers, including ABC News Starwave Partners and USA TODAY Information Network ("USA TODAY"), to attract additional users to, and increase brand awareness of, the Company's Web site. CDnow and ABC News Starware Partners are parties to an agreement dated September 22, 1997 under which ABC News Starware Partners has created links to the CDnow Web site from certain music-related pages of its Mr. Showbiz, CelebSite and Wall of Sound Web sites and is required to provide CDnow with a minimum number of banner advertisements per month on these Web sites. CDnow and USA TODAY are parties to an agreement dated April 8, 1997, under which USA TODAY places links to the CDnow Web site from the Market Place segment of its Web site and shares in a portion of the revenues realized by CDnow as a result of these links. Cosmic Credit Program Through its Cosmic Credit Program, CDnow has entered into arrangements with over 9,000 small Web sites, typically fan sites devoted to particular music artists. The Company provides these sites with embedded hyperlinks through which potential customers can immediately be connected to the CDnow site. The Company pays Cosmic Credit participants commissions in store credit or cash based upon the dollar amount of purchases made by persons using the link. The Company believes that highly focused, music-oriented sites, while having less traffic than major content providers, are likely to have a high percentage of users that will be attracted to the CDnow store. Cosmic Credit participants sign up online at a special Web page, cdnow.com/credit, and are listed inside the CDnow store to assist the Company's customers in finding these sites. The Company rewards the best Cosmic Credit sites with special incentives. 32 Direct Marketing The Company uses direct marketing techniques to target new and existing customers with communications and promotions. The Company sends a personalized e-mail newsletter to its customers, The CDnow Update, that includes purchase recommendations based on demonstrated customer preferences and prior purchases. The newsletter also includes more general information concerning new releases and Company promotions. The Internet allows rapid and effective experimentation and analysis, instant user feedback and efficient personalization of the store for each customer, all of which CDnow seeks to incorporate in its marketing and merchandising activities. CUSTOMER SERVICE The Company believes that a high level of customer service and support is critical to retaining and expanding its user base. CDnow customer service representatives are available from 7:30 AM to 10:00 PM Eastern Standard Time on weekdays and 10:00 AM to 6:00 PM Eastern Standard Time on weekends to provide assistance via e-mail, phone or fax. Inquiries are generally answered within 24 hours. The Company currently has 23 customer service representatives, including representatives fluent in several foreign languages. These customer service representatives handle questions about orders, assist customers in finding CDs and other music-related products, and register customer's credit card information over the telephone. The customer service representatives are a valuable source of feedback regarding user satisfaction. CDnow uses BizRate, an online market research company, to compile customer comments on their experiences. BizRate provides monthly reports that enable CDnow to make improvements in response to its customers' comments. The CDnow store also contains a customer service page that outlines store policies and provides answers to frequently asked questions. DISTRIBUTION AND FULFILLMENT The Company does not carry any inventory and relies exclusively on third party vendors for distribution and fulfillment. The Company believes that this distribution strategy allows it to offer extensive selection while avoiding the high fixed costs and capital requirements associated with owning and warehousing product inventory and the significant operational effort associated with same-day shipment. CDnow has experienced a return rate of approximately one percent of all merchandise sold. The Company primarily uses Valley Record Distributors to ship CDs, cassettes and vinyl records. CDnow transmits data to Valley through a secure network to ensure customer security and data integrity. Valley picks, packs and ships customer orders and charges CDnow for merchandise, shipping and handling. In most cases, products are shipped within a day after an order is placed with the Company. Customer billing is performed by CDnow through a third-party credit card processor. To date, Valley has satisfied the Company's requirements on a timely basis. The Company's agreement with Valley expires in June 1999, although Valley may terminate its existing agreement with the Company upon 30 days' written notice, if Valley discontinues providing fulfillment services to all of its online service customers. TECHNOLOGY CDnow has developed technologies and implemented systems to support distributed, reliable and scalable online retailing in a secure and easy-to- use format. Using a combination of proprietary solutions and commercially available, licensed technologies, the Company has deployed systems for online content dissemination, online transaction processing, customer service, market analysis and electronic data interchange. Multimedia and User Database. CDnow has developed a database management system to index, retrieve and manipulate product information, content, product catalog, orders and transactions, and customer information. This system allows for rapid searching, sorting, viewing and distribution of a large 33 volume of content including audio samples, music reviews, track lists, cover art and photos. The Company uses Oracle 7.3 as the technology for database management. In December 1997, the Company expects to deploy a data warehouse that will enable it to access detailed transaction and customer interaction data and perform sophisticated market analysis and predictive modeling. Store Architecture. The Company's hardware and software systems are based upon a distributed transaction processing model that allows applications to be distributed among multiple parallel servers. Many of the software components, and the pages of the Website, are developed using a proprietary technology that extends HTML with product, transaction, retail, and advanced programming constructs. This technology results in the separation of the page look and feel from the individual data elements and their associated database lookups thus reducing software updates for Website changes and minimizing the engineering required to maintain a growing amount of items and content. CDnow's technology also enables Web sites with different formats to integrate CDnow store elements such as search, discography (artist) and product (album) pages. Interfaces. CDnow has developed technologies and tools for managing interfaces with Internet service and content providers. A switchboard system and linking interface are made available to businesses with which the Company has developed strategic alliances and to Cosmic Credit sites. These allow the linking of external Web sites, banners, and promotions to items and functions contained in the CDnow store. Proprietary tools are used by the Company's Client Relations department to manage the strategic alliances and Cosmic Credit relationships in an efficient and scalable manner. Similar systems and tools have been developed by CDnow for its Customer Service department. The ability to manage customer accounts and orders enables CDnow's Customer Service department to scale effectively and communicate efficiently, thereby responding to most inquiries within 24 hours. These systems automate many routine communications and allow customers to better manage their accounts and orders. Fault Tolerance and Scalability. CDnow's hardware redundant servers, storage systems, Internet connections and networks allow its online systems to operate continuously and enable it to maintain a 24-hour-a-day, seven-day-a-week retail store. The Company runs its Oracle databases and Web Servers on a series of Sun Enterprise 3000 and 4000 servers with fault tolerant characteristics including redundant, "hot-swappable" components. The Company maintains redundant dedicated DS-3 connections to the Internet lines provided by multiple Internet service providers. This technology, combined with the architecture of the systems, allows the Company to scale by adding new components or servers while maintaining performance and cost effectiveness. Both proprietary and commercially available tools are used to monitor and manage these systems with minimal operator participation. Security. The Company employs a proprietary firewall integrated into the architecture of its system to keep its Internet connections secure. The Company uses the Netscape SSL Commerce Server for secure electronic transactions over the Internet and uses proprietary EDI interfaces and private networks to ensure the security of customer order information and credit card transactions shared with its vendors and credit card processor. Advanced Technologies. The Company continually evaluates emerging technologies and new developments in many areas including electronic commerce, database management, and networking. The Company is currently evaluating technologies that allow for the digital distribution of music recordings. Since April 1997, the Company has been using collaborative filtering to make personal music recommendations in its customer newsletter, The CDnow Update. In November 1997, as part of the Company's Gift Center, online recommendation technology was made available to all CDnow shoppers. COMPETITION The online commerce market is new, rapidly evolving and intensely competitive, and the Company expects that competition will further intensify in the future. Barriers to entry are minimal, and current 34 and new competitors can launch new sites at a relatively low cost. According to Jupiter, there were approximately 100 online music retailers as of June 1997. In addition, the broader retail music industry is intensely competitive. The Company currently competes with a variety of companies, including (i) online vendors of music, music videos and other related products, (ii) online vendors of movies, books and other related products, (iii) online service providers which offer music products directly or cooperation with other retailers, (iv) traditional retailers of music products, including specialty music retailers, (v) other retailers that offer music products, including mass merchandisers, superstores and consumer electronic stores; and (vi) non-store retailers such as music clubs. Many of these traditional retailers also support dedicated Web sites which compete directly with the Company. The Company believes that the principal competitive factors in its online market are brand recognition, selection, variety of value-added services, ease of use, site content, quality of service, technical expertise and price. Many of the Company's current and potential competitors have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing and other resources than the Company. The Company is aware that certain of its competitors have and may continue to adopt aggressive pricing or inventory availability policies and devote substantially more resources to Web site and systems development than the Company. Increased competition may result in reduced operating margins, loss of market share and a diminished brand franchise. There can be no assurance that the Company will be able to compete successfully against current and future competitors. New technologies and the expansion of existing technologies may increase the competitive pressures of the Company. For example, client-agent applications that select specific titles from a variety of Web sites based on factors such as price may channel customers to online retailers that compete with the Company. In addition, many companies that allow access to transactions through network access or Web browsers promote the Company's competitors and could charge the Company a substantial fee for inclusion. INTELLECTUAL PROPERTY The Company regards its trademarks, trade secrets and similar intellectual property as valuable to its business, and relies on trademark and copyright law, trade secret protection and confidentiality and/or license agreements with its employees, partners and others to protect its proprietary rights. There can be no assurance that the steps taken by the Company will be adequate to prevent misappropriation or infringement of its intellectual property. The Company has licensed in the past, and expects that it may license in the future, certain of its proprietary rights, such as trademarks or copyrighted material, to third parties. While the Company attempts to ensure that the quality of its brand is maintained by such licensees, there can be no assurance that such licensees will not take actions that might materially adversely affect the value of the Company's proprietary rights or reputation, which could have a material adverse effect on the Company. See "Risk Factors-- Trademarks and Proprietary Rights; Unlicensed Arrangements." EMPLOYEES As of September 30, 1997, the Company had 80 full-time and 10 part-time employees. The Company also employs independent contractors and other temporary employees in its editorial, operations and administrative functions. None of the Company's employees is represented by a labor union, and the Company considers its employee relations to be good. Competition for qualified personnel in the Company's industry is intense, particularly among software development and other technical staff. The Company believes that its future success will depend in part on its continued ability to attract, hire and retain qualified personnel. See "Risk Factors--Risk of Inability to Manage Potential Growth" and "--Dependence on Key Personnel; Need for Additional Personnel." 35 FACILITIES All of the Company's principal activities are conducted from its facility located in Jenkintown, Pennsylvania. The Company has leased this facility, which contains approximately 17,000 square feet, under a lease that expires in September 2002. The Company believes that additional space may be required as its business expands and believes that it will be able to obtain suitable space as needed. The Company does not own any real estate. LEGAL PROCEEDINGS From time-to-time, the Company may be involved in litigation relating to claims arising out of its ordinary course of business. The Company believes that there are no claims or actions pending or threatened against the Company, the ultimate disposition of which, would have a materially adverse effect on the Company. 36 MANAGEMENT OFFICERS AND DIRECTORS The executive officers and directors of the Company are as follows:
NAME AGE POSITION ---- --- -------- Jason Olim.............. 28 President and Chairman of the Board of Directors Matthew Olim............ 28 Technical Lead, Secretary, Treasurer and Director Rod Parker.............. 54 Senior Vice President of Product Management and Marketing Joel Sussman............ 49 Vice President and Chief Financial Officer Michael Krupit.......... 34 Vice President of Technology Alan Meltzer(2)......... 53 Director Patrick Kerins(1)(2).... 42 Director John Regan(1)(2)........ 38 Director
- --------------------- (1) Member of the Audit Committee of the Company's Board of Directors. (2) Member of the Compensation Committee of the Company's Board of Directors. Jason Olim co-founded the Company in February 1994 and has been its President since the Company's inception. Previously, Mr. Olim was employed in the Professional Services group of Soft-Switch, Inc. where he designed and built software systems for routing mail and documents for domestic and international clients. Mr. Olim has a Bachelor of Arts degree in Computer Science from Brown University. Matthew Olim co-founded the Company in February 1994 and has been responsible for the development of the Company's system architecture and transactions systems. Mr. Olim has a Bachelor of Arts degree in Astrophysics from Columbia University. Rod Parker has been the Senior Vice President of Product Management and Marketing since June 1997. Mr. Parker served as the Vice President of Interactive Merchandising at Time Warner Cable Programming from September 1995 to June 1997; General Manager of Catalog I, a joint venture between Time Warner and Spiegel, Inc., from October 1993 to September 1995; and in various other positions with Spiegel, Inc. (including Vice President, New Media and Vice President, Creative Division) from April 1987 to September 1995. Mr. Parker spent more than twenty years in the advertising industry, including service as a Senior Vice President in account management with Ogilvy and Mather. Joel Sussman has been the Vice President and Chief Financial Officer since September 1997. From June 1995 to September 1997, Mr. Sussman was an independent financial management consultant and served as Interim Chief Financial Officer of a number of companies, including CDnow. From July 1994 to June 1995, Mr. Sussman was Vice President, Finance and Administration, and Chief Financial Officer of Personnel Data Systems, Inc. From January 1991 to December 1994, Mr. Sussman was Vice President of Finance and Chief Financial Officer of The Devereux Foundation. Prior to January 1991, Mr. Sussman served for 10 years as Treasurer of Decision Data, Inc. and six years in commercial banking and leasing. Mr. Sussman is a Certified Public Accountant and Certified Management Accountant and holds a Masters degree in Business Administration from the Wharton School of the University of Pennsylvania. Michael Krupit has been the Vice President of Technology since October 1997 and was the Director of Technology from April 1997 to October 1997. Mr. Krupit was the Director of Technology and Product Development at Infonautics, Inc., a provider of searching, viewing, and retrieval applications for the 37 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. Alan Meltzer has been a director since December 1996. Mr. Meltzer has been the Chairman and Chief Executive Officer of Wind-up Entertainment, Inc., a New York based record label distributed through Bertelsman Music Group. Mr. Meltzer was the founder of CD One Stop, Inc., a distributor of CDs, and was its Chief Executive Officer from April 1986 to August 1993 and was the President of Alliance Entertainment, a distributor and the successor to CD One Stop, Inc., from September 1993 to September 1994. Mr. Meltzer was elected to the Board of Directors in December 1996 pursuant to an agreement among certain shareholders of the Company that terminates upon the consummation of this Offering. Patrick Kerins has been a director since August 1997. Mr. Kerins is a Managing Director of Grotech Capital Group IV, LLC ("Grotech Capital"). From 1987 to March 1997, he served in the Investment Banking Division of Alex. Brown & Sons Incorporated, most recently as a Managing Director beginning in January 1994. John Regan has been a director since July 1997. Since February 1995, Mr. Regan has been a Vice President of Keystone Venture IV Management Company, L.P. which is the general partner of Keystone Venture IV, L.P. From 1989 to February 1995, he was an associate and then general partner of Apex Management Partnership, a venture capital partnership. The Company's Amended and Restated Bylaws divide the Board of Directors into three classes, and each director will serve for a staggered three year term. Messrs. Kerins and Regan will initially serve as the Class I directors until the annual meeting of shareholders held in 1998, or until their respective successors have been elected and qualified. Matthew Olim will initially serve as the Class II director until the annual meeting of shareholders held in 1999, or until his successor has been elected and qualified. Alan Meltzer and Jason Olim will initially serve as the Class III directors until the annual meeting of shareholders held in 2000, or until their respective successors have been elected and qualified. At each meeting of shareholders, a class of directors will be elected for a three-year term to succeed the directors of the same class whose terms are then expiring. To the extent there is an increase in the number of directors, additional directorships resulting therefrom will be distributed among the three classes so that, as nearly as possible, each class will consist of an equal number of directors. Executive officers of the Company are elected by, and serve at the pleasure of, the Board of Directors. Jason Olim and Matthew Olim are brothers. DIRECTOR COMPENSATION The Company will reimburse its directors for out-of-pocket expenses incurred in connection with their rendering of services as directors. The Company currently does not intend to pay cash fees to directors for attendance at meetings. Directors who are not currently receiving compensation as officers or employees of the Company will be eligible to receive options under the 1996 Equity Compensation Plan. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION Since August 1997, recommendations concerning the aggregate compensation of the Company's employees were made to the Compensation Committee by the Company's President. The Compensation Committee was formed in August 1997. The members of the Compensation Committee are Alan Meltzer, Patrick Kerins and John Regan. Mr. Kerins is a Managing Director of Grotech Capital, the general partner of Grotech Capital Partners IV, L.P., a significant shareholder of the Company. See "Certain Transactions." Prior to August 1997, decisions concerning the compensation of the Company's employees, including its executive officers, were made by the Company's Board of Directors, which included Jason Olim and Matthew Olim. 38 EXECUTIVE COMPENSATION The following table provides information concerning compensation paid or accrued in the year ended December 31, 1997 with respect to the Company's President and the two other executive officers of the Company who earned total salary and bonus in excess of $100,000 in such year. SUMMARY COMPENSATION TABLE
LONG-TERM COMPENSATION ---------------- ANNUAL COMPENSATION ------------------------- SHARES OF COMMON NAME AND OTHER ANNUAL STOCK UNDERLYING PRNCIPAL POSITION YEAR SALARY BONUS COMPENSATION OPTIONS - --------------- ---- ------ ----- ------------ ---------------- Jason Olim..................... 1997 President and Chairman of the Board of Directors Matthew Olim................... 1997 Technical Lead, Secretary and Treasurer Rod Parker..................... 1997 Senior Vice President of Product Management and Marketing
The following table sets forth certain information regarding stock options granted by the Company during 1997 to Rod Parker. Neither Jason Olim nor Matthew Olim have been granted any options by the Company. OPTION GRANTS IN LAST FISCAL YEAR
INDIVIDUAL GRANTS -------------------------------------------- POTENTIAL REALIZABLE VALUE AT ASSUMED PERCENT OF ANNUAL RATES OF NUMBER OF TOTAL STOCK PRICE SHARES OPTIONS APPRECIATION FOR UNDERLYING GRANTED TO EXERCISE OPTION TERM(1) OPTIONS EMPLOYEES IN PRICE PER EXPIRATION ------------------ NAME GRANTED FISCAL YEAR SHARE DATE 5% 10% - ---- ---------- ------------ --------- ---------- -------- --------- Rod Parker......
- --------------------- (1) Based on the initial public offering price per share. The following table sets forth information regarding stock options held as of December 31, 1997 by Rod Parker. Mr. Parker did not exercise any stock options in 1997. FISCAL YEAR END OPTION VALUES
VALUE OF UNEXERCISED IN- NUMBER OF SECURITIES UNDERLYING THE- UNEXERCISED OPTIONS AT MONEY OPTIONS AT DECEMBER 31, 1997 DECEMBER 31, 1997(1) ------------------------------------ ------------------------- NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE - ---- --------------- ---------------- ----------- ------------- Rod Parker..
- --------------------- (1) There was no public trading market for the Common Stock as of December 31, 1997. These values have been calculated based on the difference between the initial public offering price and the applicable exercise price. 39 EQUITY COMPENSATION PLAN The Company has adopted the Equity Compensation Plan pursuant to which it has awarded and expects to award in the future stock options to its employees, officers, non-employee directors and certain independent contractors and consultants. The Equity Compensation Plan provides for the issuance to employees, non- employee directors and eligible independent contractors and consultants of up to shares of Common Stock pursuant to the grant of incentive stock options ("ISOs"), non-qualified stock options ("NQSOs"), Stock Appreciation Rights ("SARs") and restricted stock. The Equity Compensation Plan is administered by a Committee of directors appointed by the Board of Directors (the "Committee") that currently consists of Messrs. Olim, Kerias and . Upon the completion of this Offering, the Committee will consist of two directors that are not employees of the Company. Subject to the provisions of the Equity Compensation Plan, the Committee has the authority to determine to whom stock options will be granted and the terms of any such grant, including the number of shares subject to, the exercise price and the vesting provisions of, the award. Subject to the terms of the Equity Compensation Plan, the Committee may also amend the terms of any outstanding award. As of December 31, 1997, options to purchase a total of shares of Common Stock at a weighted average exercise price per share of $ were outstanding. Of these options, options to purchase shares of Common Stock were fully vested and exercisable as of December 31, 1997. As of December 31, 1997, the Company had an additional shares of Common Stock available for future grants under the Equity Compensation Plan. The option price per share of Common Stock under the Equity Compensation Plan is determined by the Committee at the time of each grant, provided, however, that the option price per share for any ISO may not be less than the fair market value of the Common Stock at the time of the grant. In addition, if a person who owns 10 percent or more of the Company's Common Stock (a "10% Shareholder") is granted an ISO, the exercise price for such ISO may not be less than 110% of the fair market value on the date of grant. The term of each stock option may not exceed ten years; in the case of a 10% shareholder, the term may not exceed five years. Payment for the exercise of an option may be made by cash, check or other instrument as the Committee may accept, including, in the discretion of the Committee, unrestricted Common Stock of the Company. The Committee may also allow an option holder to surrender all or a portion of a stock option and receive a number of shares of Common Stock with a value equal to the excess of the fair market value over the option price of the surrendered stock option or portion of the stock option. 40 CERTAIN TRANSACTIONS SERIES A CONVERTIBLE NOTES In November 1997, the Company issued $5.8 million aggregate principal amount of Series A Notes to a group of investors, including $1.0 million to Grotech. The Series A Notes, which will be repaid upon the consummation of this offering, bear interest at the rate of 12% per annum. In addition, the Company issued warrants to these investors to purchase an aggregate of shares of Common Stock at an exercise price of $ per share, including a warrant issued to Grotech exercisable for shares of Common Stock. SERIES A PREFERRED STOCK Pursuant to the terms of the Stock Purchase Agreement dated July 15, 1997 by and among the Company, Keystone Ventures IV, L.P. ("Keystone Ventures"), Jason Olim and Matthew Olim (the "Stock Purchase Agreement"), Keystone Ventures purchased 254,582 shares of Series A Convertible Preferred Stock, no par value (the "Series A Preferred Stock"), of the Company at a purchase price of $4.91 per share. The outstanding shares of Series A Preferred Stock will automatically convert upon the consummation of this Offering into an aggregate of shares of Common Stock. John Regan is a Vice President of the general partner of Keystone Ventures and was elected to the Company's Board of Directors pursuant to an agreement among certain shareholders of the Company that terminates upon the consummation of this Offering. Keystone Ventures received certain registration rights in connection with this transaction. See "Shares Eligible for Future Sale--Registration Rights." SERIES B PREFERRED STOCK Pursuant to the terms of the Stock Purchase Agreement, as amended by the Amendment No. 1 to the Stock Purchase Agreement dated as of August 5, 1997 by and among the Company, Keystone Ventures, Jason Olim, Matthew Olim, Grotech Partners IV, LP ("Grotech IV") and ABS Employees' Venture Fund Limited Partnership ("ABS"), (i) Grotech purchased 1,543,505 shares of Series B Convertible Preferred Stock, no par value (the "Series B Preferred Stock"), of the Company at a purchase price of $5.45 per share, (ii) ABS purchased 62,000 shares of Series B Preferred Stock at a purchase price of $5.45 per share, (iii) the Company issued to Grotech Capital a warrant to purchase up to 18,349 shares of Series B Preferred Stock at an exercise price of $5.45 per share, and (iv) the Company issued to Alex. Brown & Sons Incorporated, a predecessor- in-interest to BT Alex. Brown Incorporated ("BT Alex. Brown"), a warrant to purchase up to 103,211 shares of Series B Preferred Stock at an exercise price of $5.45 per share in partial consideration of its services as the placement agent for the offering of the Series A and Series B Preferred Stock. The outstanding shares of Series B Preferred Stock will automatically convert upon the consummation of this Offering into an aggregate of shares of Common Stock and these warrants will automatically become exercisable for an aggregate of shares Common Stock upon the consummation of this Offering. Patrick Kerins is a Managing Director of Grotech Capital, the general partner of Grotech IV, and was elected to the Company's Board of Directors pursuant to an agreement among certain shareholders of the Company that terminates upon the consummation of this Offering. Grotech IV, Grotech Capital, ABS and BT Alex. Brown received certain registration rights in connection with this transaction. See "Shares Eligible for Future Sale." STOCK PURCHASE AND SHAREHOLDERS' AGREEMENT In May 1995, Milo Productions, Inc. ("Milo"), a corporation owned by Jason and Matthew Olim, entered into a general partnership with MBL Entertainment, Inc. ("MBL") to form a partnership company known as "Music Now." In December 1995, MBL, Alan Meltzer and Jason and Matthew Olim entered into non-binding discussions for the purpose of creating a new company ("NewCo") which would merge with Music Now. These discussions contemplated, among other things, that Alan Meltzer would make a significant cash investment in, and Jason and Matthew Olim would contribute all of the outstanding capital stock of both Milo and CDnow to, NewCo. The parties abandoned these discussions and, in August 1996, 41 MBL and Alan Meltzer instituted a legal action against CDnow, Milo and Jason and Matthew Olim (the "Legal Action"). On December 6, 1996, the Company entered into a Stock Purchase and Shareholders' Agreement (the "Stock Purchase and Shareholders Agreement") with Milo, Jason Olim, Matthew Olim, Alan Meltzer, Jeffrey McClusky, Anthony Lucenti, William Brennan and MBL pursuant to which (i) Mr. Meltzer purchased, for an aggregate purchase price of $1,200,000, shares of Common Stock and a warrant presently exercisable for shares of Common Stock, and (ii) an aggregate of shares of Common Stock were issued to Messrs. McClusky, Lucenti and Brennan, the sole shareholders of MBL, in exchange for substantially all of the assets and business of MBL. A primary inducement for these transactions was the mutual release by all parties to the Stock Purchase Agreement relating to (i) the Legal Action and (ii) all other prior agreements and relationships among such parties. In addition, pursuant to the terms of the Stock Purchase and Shareholders Agreement, each of Jason and Matthew Olim is generally restricted from competing with the Company's business for a three-year period ending on the termination of his relationship (either as an employee, director or consultant) with the Company. Mr. Meltzer has delivered written notice to the Company that he intends to exercise his warrant upon the consummation of this offering and will receive shares of Common Stock for an aggregate exercise price of $1.0 million. SHAREHOLDER ADVANCES The Company had indebtedness due to Dave Olim, the father of Jason and Matthew Olim, in the amount of $81,923, at December 31, 1995. On August 16, 1996, in consideration of the cancellation of this debt, the Company issued shares of the Company's Common Stock to Dave Olim. NOTES PAYABLE On December 31, 1995, the Company issued a note for $100,000 to Alan Meltzer, a director of the Company. All remaining amounts due under the note were repaid on December 31, 1996. From November 16, 1996 through January 31, 1997, the Company received short- term loans aggregating $250,000 from Saltzman Music Partners and Nathan Schwartz. On May 15, 1997, the Company repaid $110,000 of the principal amount due under these loans. The remaining principal balance was repaid on July 16, 1997. As additional consideration for these loans, these private investors received warrants to purchase an aggregate of shares of Common Stock at a price of $ per share. The warrants expire on May 16, 1998 with respect to shares of Common Stock and July 16, 1998 with respect to shares of Common Stock. 42 PRINCIPAL SHAREHOLDERS The following table sets forth certain information regarding beneficial ownership of the Common Stock as of the date of this Prospectus and as adjusted to reflect the sale of the shares offered hereby by (i) each person known by the Company to own beneficially more than 5% of the outstanding shares of Common Stock, (ii) each director of the Company, (iii) each executive officer of the Company and (iv) all directors and executive officers of the Company as a group. Unless otherwise indicated below, to the knowledge of the Company, all persons listed below have sole voting and investment power with respect to their shares of Common Stock, except to the extent authority is shared by spouses under applicable law.
BENEFICIAL OWNERSHIP BENEFICIAL OWNERSHIP PRIOR TO OFFERING AFTER OFFERING ---------------------- ---------------------- NAME OF BENEFICIAL OWNER SHARES PERCENT SHARES PERCENT - ------------------------ ---------- ---------- ---------- ---------- EXECUTIVE OFFICERS AND DIRECTORS Jason Olim(1).................. Matthew Olim(1)................ Alan Meltzer(2)................ Rod Parker(3).................. Michael Krupit(4).............. Joel Sussman(5)................ John Regan(6).................. Patrick Kerins(7).............. All executive officers and directors as a group ( persons)(8)................ FIVE PERCENT HOLDERS Grotech Partners IV, L.P.(7)...
- --------------------- (1) Excludes shares owned by Dave Olim, the father of Jason and Matthew Olim. Jason and Matthew Olim each disclaim beneficial ownership of these shares. The address of Jason and Matthew Olim is 610 Old York Road, Suite 300, Jenkintown, Pennsylvania 19046. (2) Includes shares of Common Stock issuable upon the exercise of a presently exercisable warrant Mr. Meltzer has notified the Company that he intends to exercise this warrant upon the consummation of this Offering. The address of Mr. Meltzer is 944 Park Avenue, New York, New York 10028. (3) Does not include shares of Common Stock that are not exercisable within the next 60 days under a stock option granted under the Equity Compensation Plan. (4) Does not include shares of Common Stock that are not exercisable within the next 60 days under a stock option granted under the Equity Compensation Plan. (5) Includes shares of Common Stock obtainable upon the exercise of a stock option granted under the Equity Compensation Plan. Does not include shares which are not exercisable within the next 60 days under such option. (6) Includes shares of Common Stock held by Keystone Ventures IV, L.P. ("Keystone"). John Regan is a Vice President of the general partner of Keystone and disclaims beneficial ownership of any shares owned by Keystone. (7) Includes shares of Common Stock obtainable upon the conversion of a presently exercisable warrant held by Patrick Kerins and shares of Common Stock obtainable upon the exercise of a warrant held by Grotech Partners IV, L.P. Patrick Kerins is a managing director of Grotech Partners IV, L.P. Mr. Kerins disclaims beneficial ownership of any shares owned by Grotech Partners IV L.P. The address of Grotech Partners IV L.P. is 9600 Deereco Road, Timonium, Maryland 21093. (8) Includes shares of Common Stock obtainable upon the exercise of options and warrants. 43 DESCRIPTION OF CAPITAL STOCK The authorized capital stock of the Company consists of 50,000,000 shares of Common Stock, no par value (the "Common Stock"), and 20,000,000 shares of Preferred Stock, no par value (the "Preferred Stock"). Immediately after the sale of the shares of Common Stock offered hereby, there will be shares of Common Stock outstanding and no shares of Preferred Stock outstanding. The following summary is qualified in its entirety by reference to the Company's Amended and Restated Articles of Incorporation (the "Articles of Incorporation"), which is included as an exhibit to the Registration Statement of which this Prospectus is a part. COMMON STOCK Holders of Common Stock are entitled to one vote for each share held of record on all matters submitted to a vote of shareholders and do not have cumulative voting rights. The election of directors is determined by a plurality of the votes cast and, except as otherwise required by law, all other matters are determined by a majority of the votes cast. The holders of Common Stock are entitled to receive ratably such dividends, if any, as may be declared by the Board of Directors out of funds legally available therefor, subject to any preferential dividend rights of outstanding Preferred Stock. Upon the liquidation, dissolution or winding up of the Company, subject to any preferential liquidation rights of any outstanding shares of Preferred Stock, the holders of Common Stock are entitled to receive ratably the net assets of the Company available after the payment of all debts and other liabilities. The holders of Common Stock have no preemptive, subscription, redemption, sinking fund or conversion rights. The rights and preferences of holders of Common Stock will be subject to the rights of any series of Preferred Stock which the Company may issue in the future. PREFERRED STOCK The Company, by resolution of the Board of Directors and without any further vote or action by the shareholders, has the authority, subject to certain limitations prescribed by law, to issue from time to time up to an aggregate of 20,000,000 shares of Preferred Stock in one or more classes or series and to determine the designation and the number of shares of any class or series as well as the voting rights, preferences, limitations and special rights, if any, of the shares of any such class or series, including the dividend rights, conversion rights, voting rights, redemption rights, and liquidation preferences. The issuance of Preferred Stock may have the effect of delaying, deferring or preventing a change of control of the Company. Prior to the Offering, 254,582 shares of Series A Preferred Stock and 1,605,505 shares of Series B Preferred Stock were outstanding. Upon the consummation of this Offering, all outstanding shares of Series A Preferred Stock and Series B Preferred Stock will be converted into and shares of Common Stock, respectively. No such shares of Series A Preferred Stock or shares of Series B Preferred Stock will be available for reissuance. PENNSYLVANIA ANTI-TAKEOVER LAWS The Pennsylvania Business Corporation Law of 1988, as amended (the "BCL"), contains provisions applicable to publicly held Pennsylvania corporations that may be deemed to have an anti-takeover effect. The Company has specifically opted out of all but one of these provisions. The following is a description of the provision of the BCL that remains applicable to the Company. Under Section 1715 of the BCL, directors of the corporation are not required to regard the interests of the shareholders as being dominant or controlling in considering the best interests of the corporation. The directors may consider, to the extent they deem appropriate, such factors as the effects of any action upon any group affected by such action (including shareholders, employees, suppliers, customers and 44 creditors of the corporation and upon communities in which offices or other establishments of the corporation are located); the short term and long term interests of the corporation (including benefits that may accrue to the corporation from its long term plans and the possibility that these interests may be best served by the continued independence of the corporation); the resources, intent and conduct of any person seeking to acquire control of the corporation; and all other pertinent factors. The BCL provisions also provide directors with broad discretion with respect to actions that may be taken in response to acquisitions or proposed acquisitions of corporate control. Section 1715 of the BCL may discourage open market purchases of Common Stock or a non-negotiated tender or exchange offer for the Common Stock and, accordingly, may be considered disadvantageous by a shareholder who would desire to participate in any such transaction. In addition, Section 1715 of the BCL may have a depressive effect on the price of the Common Stock. SHARES ELIGIBLE FOR FUTURE SALE The market price of the Common Stock will be adversely affected by the sale of substantial amounts of the Common Stock in the public market following this Offering. Upon completion of this Offering, the Company will have shares of Common Stock outstanding. Of these shares, the Common Stock sold in this Offering to persons other than affiliates of the Company, will be freely tradeable without restriction or further registration under the Act. The remaining shares of Common Stock (the "Restricted Shares") were sold by the Company in reliance on exemptions from the registration requirements of the Securities Act and are "restricted securities" as defined in Rule 144 and may not be sold in the absence of registration under the Securities Act unless an exemption is available, including an exemption afforded by Rule 144 or Rule 701 under the Securities Act. Subject to the contractual restrictions described below, approximately (i) Restricted Shares will be eligible for sale ninety days after the date of this Prospectus, subject to certain restrictions imposed by Rule 144, and (ii) Restricted Shares will be eligible for future sale without restriction. Certain restrictions apply to any shares of Common Stock purchased in this Offering by affiliates of the Company, which may be sold subject to volume limitations and certain other conditions of Rule 144. In addition, shares subject to options issued under the Equity Compensation Plan will be eligible for sale pursuant to Rule 701 under the Securities Act. It is anticipated that a Registration Statement on Form S-8 covering the Common Stock that may be issued pursuant to the options granted under the Equity Compensation Plan will be filed shortly after the consummation of this Offering. The shares of Common Stock issued pursuant to the Form S-8 Registration Statement generally may be resold in the public market without restriction or limitation, except in the case of affiliates of the Company, who generally may only resell such shares in accordance with the provisions of Rule 144, other than the holding period requirement. The Company and its officers, directors and certain shareholders who collectively beneficially own shares of Common Stock, have agreed with the underwriters that they will not sell or otherwise dispose of any shares of Common Stock (excluding shares offered by this Prospectus or shares purchased in the open market) for a period of 180 days from the date of this Prospectus without the prior written consent of BT Alex. Brown Incorporated. Keystone Ventures, Grotech IV, Grotech Capital, ABS, BT Alex. Brown, Alan Meltzer, Jeffrey McClusky, Anthony Lucenti and William Brennan (collectively, the "Registration Rights Holders"), who collectively beneficially own shares of Common Stock, have been granted by the Company certain demand and incidental registration rights. Under these registration rights, the Registration Rights Holders may require, on not more than two occasions at any time after six months following the date of this Offering, that the Company use its best efforts to file a registration statement covering the public sale of Common Stock having an aggregate public offering price of at least $10,000,000; provided, however, that the Company will have the right to delay such a demand registration under certain circumstances for a 45 period not in excess of 120 days each in any 12-month period. The Registration Rights Holders will also have piggyback registration rights, subject to underwriter cut back, and the Registration Rights Holders, as separate classes, will have the right to one demand registration every 12 months on Form S-3, provided at least 30% of the securities within such class join in the demand, at least $500,000 worth of securities are to be sold in the registration and the Company will have the right to delay the registration for up to 120 days if, in the good faith judgment of the Company, the registration would be seriously detrimental to the Company and its shareholders. The registration rights expire six years after the date of this Offering, and no Registration Rights Holder can exercise any registration rights for an intended sale that can be effectuated in compliance with Rule 144 under the Securities Act. UNDERWRITING Subject to the terms and conditions set forth in the underwriting agreement (the "Underwriting Agreement"), the Company has agreed to sell to the underwriters named below (the "Underwriters"), and each of the Underwriters, for whom BT Alex. Brown Incorporated and NationsBanc Montgomery Securities, Inc. are acting as representatives (the "Representatives"), has severally agreed to purchase from the Company, the aggregate number of shares of Common Stock set forth opposite its name below.
UNDERWRITERS NUMBER OF SHARES ------------ ---------------- BT Alex. Brown Incorporated.............................. NationsBanc Montgomery Securities, Inc................... --- Total.................................................. ===
In the Underwriting Agreement, the Underwriters have agreed, subject to the terms and conditions set forth therein, to purchase all of the shares of Common Stock offered by this Prospectus (other than those subject to the Over- allotment Option described below) if any such shares are purchased. In the event of a default by the Underwriters, the Underwriting Agreement provides that, in certain circumstances, the purchase commitments of non-defaulting Underwriters may be increased or the Underwriting Agreement may be terminated. The Company has granted to the Underwriters an option, exercisable by the Representatives during the 30-day period after the date of this Prospectus, to purchase up to an aggregate of shares of Common Stock at the same price per share as the initial shares of Common Stock to be purchased by the Underwriters. The Representative may exercise such option only to cover over- allotments in the sale of shares of Common Stock. To the extent that the Representatives exercise such option, the Underwriters will have a firm commitment, subject to certain conditions, to purchase the same proportion of such additional shares of Common Stock as the number of shares of Common Stock to be purchased and offered by such Underwriters in the above table bears to the total number of shares in the above table. The Company has been advised by the Representatives that the Underwriters propose initially to offer the shares of Common Stock to the public at the offering price set forth on the cover page of this Prospectus, and through the Representatives to certain dealers at such price less a concession not in excess of per share. The Underwriters may allow, and such dealers may reallow, a concession not in excess of per share to certain other dealers. After the Offering, the public offering price and other selling terms may be changed. The Company and its officers, directors and certain shareholders have agreed that, except for shares offered by this Prospectus, the underlying shares sold by the Company upon the exercise of options or warrants or shares purchased in the open market, they will not offer, sell, contract, to sell, or otherwise dispose of, directly or indirectly, any shares of Common Stock, or any interests therein, or any securities convertible into, or exchangeable for, shares of Common Stock, or rights to acquire the same, for a period of 180 days from the date of this Prospectus without the prior written consent of the 46 Representatives, except pursuant to the Underwriting Agreement. Such consent may be given without any public notice. The Company has agreed to indemnify the Underwriters against certain liabilities, including liabilities under the Securities Act, or to contribute to payments that the Underwriters may be required to make in respect thereof. Prior to the Offering, there has been no public market for the Common Stock. Consequently, the initial public offering price of the Common Stock was determined after negotiation among the Company and the Representatives. Among the factors considered in such negotiations were prevailing market conditions, the results of the operations of the Company in recent periods, the market capitalization and stages of development of other companies which the Company and the Representatives believed to be comparable to the Company, estimates of the business potential of the Company, the present state of the Company's development and other factors deemed relevant. In connection with the Offering, certain persons participating in the Offering may engage in transactions that stabilize, maintain or otherwise affect the price of the Common Stock. Specifically, the Representatives may bid for and purchase Common Stock in the open market to stabilize the price of the Common Stock. The Underwriters may also over-allot the Offering, creating a syndicate short position, and may bid for and purchase Common Stock in the open market to cover the syndicate short position. The Representatives may also impose a penalty bid pursuant to which the Representatives may reclaim from any Underwriter or dealer participating in the Offering the selling concession on shares sold by them and purchased by the Representatives in stabilizing or short covering transactions. In addition, the Underwriters may bid for and purchase the Common Stock above market levels that may otherwise prevail. The Underwriters are not required to engage in these activities, and may end these activities at any time. The Underwriters have reserved for sale, at the initial public offering price, up to of the Common Stock offered hereby for employees and directors of the Company and certain other individuals who have expressed an interest in purchasing such shares of Common Stock in the Offering. The number of shares available for sale to the general public will be reduced to the extent such persons purchase such reserved shares. Any reserved shares not so purchased will be offered by the Underwriters to the general public on the same basis as other shares offered hereby. The Underwriters have informed the Company that they do not intend to confirm sales of Common Stock offered hereby for accounts over which they exercise discretionary authority. LEGAL MATTERS The validity of the Common Stock offered hereby will be passed upon for the Company by Morgan, Lewis & Bockius LLP, Philadelphia, Pennsylvania. Certain legal matters in connection with the Offering are being passed upon for the Underwriters by Schnader Harrison Segal & Lewis LLP, Philadelphia, Pennsylvania. EXPERTS The financial statements of the Company, as of December 31, 1995 and 1996 and for the period from Inception (February 12, 1994) to December 31, 1994 and the years ended December 31, 1995 and 1996, included in this Prospectus have been audited by Arthur Andersen LLP, independent public accountants, as indicated in their report with respect thereto, and are included herein in reliance upon the authority of such firm as experts in giving said report. 47 ADDITIONAL INFORMATION The Company has filed with the Commission a Registration Statement on Form S-1 under the Securities Act (the "Registration Statement") with respect to the Common Stock offered hereby. This Prospectus does not contain all of the information set forth in the Registration Statement and the exhibits and schedules thereto. For further information with respect to the Company and the Common Stock offered hereby, reference is hereby made to the Registration Statement and to the exhibits and schedules filed therewith. Statements contained in this Prospectus as to the contents of any agreement or other document are not necessarily complete, and in each instance, reference is made to the copy of such agreement or document filed as an exhibit to the Registration Statement, each such statement being qualified in all respects by such reference. A copy of the Registration Statement may be inspected without charge at the Commission's principal office in Washington, D.C. at 450 Fifth Street, N.W., Washington, D.C. 20549, and at the Commissions's Regional Offices at Seven World Trade Center, Suite 1300, New York, New York 10048, and Northwest Atrium Center, 500 West Madison Street, Suite 1400, Chicago, Illinois 60661, and copies may be obtained at prescribed rates from the Public Reference Section of the Commission at 450 Fifth Street, N.W., Washington, D.C. 20549. In addition, the Registration Statement and certain other filings made with the Commission through its Electronic Data Gathering Analysis and Retrieval ("EDGAR") system are publicly available through the Company's Web site located at http://www.sec.gov. The Registration Statement has been filed with the Commission through EDGAR. Information concerning the Company is also available for inspection at the offices of the Nasdaq National Market, Reports Section, 1735 K Street, N.W., Washington, D.C. 20006. 48 CDNOW, INC. INDEX TO FINANCIAL STATEMENTS Report of Independent Public Accountants.................................. F-2 Balance Sheets............................................................ F-3 Statements of Operations.................................................. F-4 Statements of Redeemable Convertible Preferred Stock and Shareholders' Equity (Deficit)......................................................... F-5 Statements of Cash Flows.................................................. F-6 Notes to Financial Statements............................................. F-7
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To CDnow, Inc.: We have audited the accompanying balance sheets of CDnow, Inc. (a Pennsylvania Corporation) as of December 31, 1995 and 1996, and the related statements of operations, redeemable convertible preferred stock and shareholders' equity (deficit) and cash flows for the period from inception (February 12, 1994) to December 31, 1994 and the years ended December 31, 1995 and 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of CDnow, Inc. as of December 31, 1995 and 1996, and the results of its operations and its cash flows for the period from inception (February 12, 1994) to December 31, 1994 and the years ended December 31, 1995 and 1996, in conformity with generally accepted accounting principles. /S/ ARTHUR ANDERSEN LLP Philadelphia, Pa., May 15, 1997 (except with respect to the matter discussed in Note 2, as to which the date is July 15, 1997) F-2 CDNOW, INC. BALANCE SHEETS
DECEMBER 31, --------------------- 1995 1996 SEPTEMBER 30, 1997 --------- ---------- ------------------ (UNAUDITED) ASSETS CURRENT ASSETS: Cash and cash equivalents......... $ 43,812 $ 775,865 $ 7,238,246 Short-term investments............ -- 245,641 983,600 Accounts receivable, net of reserve for doubtful accounts of $12,000 in 1996 and $17,000 in 1997............................. 56,127 130,437 180,312 Prepaid expenses and other........ 22,894 49,821 542,072 --------- ---------- ----------- Total current assets............. 122,833 1,201,764 8,944,230 PROPERTY AND EQUIPMENT, net........ 141,535 362,035 1,440,487 OTHER ASSETS....................... 4,100 11,660 10,233 --------- ---------- ----------- $ 268,468 $1,575,459 $10,394,950 ========= ========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT) CURRENT LIABILITIES: Notes payable..................... $ 100,000 $ 200,000 $ -- Current portion of term loans payable.......................... -- -- 56,176 Current portion of capitalized lease obligations................ 3,952 35,942 36,400 Accounts payable.................. 109,386 435,682 3,630,357 Accrued expenses.................. 61,178 129,317 383,434 Deferred revenues................. 4,952 166,107 213,970 Advances due to related parties... 78,843 3,261 -- --------- ---------- ----------- Total current liabilities........ 358,311 970,309 4,320,337 --------- ---------- ----------- TERM LOANS PAYABLE................. -- -- 147,823 --------- ---------- ----------- CAPITALIZED LEASE OBLIGATIONS...... 9,519 91,133 70,794 --------- ---------- ----------- REDEEMABLE SERIES A AND B CONVERTIBLE PREFERRED STOCK (liquidation value of $10,125,575)...................... -- -- 9,516,239 --------- ---------- ----------- COMMITMENTS AND CONTINGENCIES (Note 10) SHAREHOLDERS' EQUITY (DEFICIT): Preferred stock, no par value, 20,000,000 shares authorized, 254,582 Redeemable Series A Convertible shares and 1,605,505 Redeemable Series B Convertible shares issued and outstanding at September 30, 1997............... -- -- -- Common stock, no par value, 50,000,000 shares authorized, 4,000,000, 5,230,456 and 5,230,456 shares issued and outstanding in 1995, 1996 and 1997............................. -- 579,549 1,330,941 Additional paid-in capital........ 160,000 -- -- Deferred compensation............. -- -- (532,238) Accumulated deficit............... (259,362) (65,532) (4,458,946) --------- ---------- ----------- Total shareholders' equity (deficit)....................... (99,362) 514,017 (3,660,243) --------- ---------- ----------- $ 268,468 $1,575,459 $10,394,950 ========= ========== ===========
The accompanying notes are an integral part of these statements. F-3 CDNOW, INC. STATEMENTS OF OPERATIONS
PERIOD FROM INCEPTION (FEBRUARY 12, YEAR ENDED NINE MONTHS ENDED 1994) TO DECEMBER 31, SEPTEMBER 30, DECEMBER 31, ----------------------- ----------------------- 1994 1995 1996 1996 1997 ------------- ---------- ----------- ---------- ----------- (UNAUDITED) NET SALES............... $103,116 $2,176,474 $ 6,300,294 $4,107,545 $ 9,452,864 COST OF SALES........... 92,962 1,844,612 5,363,989 3,543,960 7,730,975 -------- ---------- ----------- ---------- ----------- Gross profit.......... 10,154 331,862 936,305 563,585 1,721,889 -------- ---------- ----------- ---------- ----------- OPERATING EXPENSES: Operating and development........... 26,946 149,982 523,080 329,467 1,228,040 Sales and marketing.... 12,945 200,972 621,454 393,630 3,405,908 General and administrative........ 28,712 180,573 563,593 354,268 1,281,691 Dispute settlement (Note 7).............. -- -- 1,024,030 -- -- -------- ---------- ----------- ---------- ----------- 68,603 531,527 2,732,157 1,077,365 5,915,639 -------- ---------- ----------- ---------- ----------- Operating loss........ (58,449) (199,665) (1,795,852) (513,780) (4,193,750) INTEREST INCOME......... -- -- -- -- 94,045 INTEREST EXPENSE........ -- (1,248) (14,556) (11,296) (29,961) -------- ---------- ----------- ---------- ----------- NET LOSS................ $(58,449) $ (200,913) $(1,810,408) $ (525,076) $(4,129,666) ======== ========== =========== ========== =========== PRO FORMA NET LOSS PER SHARE (unaudited)...... $ =========== PRO FORMA WEIGHTED AVERAGE NUMBER OF COMMON AND COMMON EQUIVALENT SHARES (unaudited)............ ===========
The accompanying notes are an integral part of these statements. F-4 CDNOW, INC. STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY (DEFICIT)
SHAREHOLDERS' EQUITY (DEFICIT) ------------------------------------------------------------------------ REDEEMABLE CONVERTIBLE COMMON STOCK ADDITIONAL PREFERRED --------------------- PAID-IN DEFERRED ACCUMULATED STOCK SHARES AMOUNT CAPITAL COMPENSATION DEFICIT TOTAL ----------- --------- ----------- ---------- ------------ ----------- ----------- BALANCE, FEBRUARY 12, 1994 (inception)....... $ -- -- $ -- $ -- $ -- $ -- $ -- Services contributed by the founders (Note 9).................... -- -- -- 40,000 -- -- 40,000 Net loss............... -- -- -- -- -- (58,449) (58,449) ---------- --------- ----------- --------- --------- ----------- ----------- BALANCE, DECEMBER 31, 1994................... -- -- -- 40,000 -- (58,449) (18,449) Issuance of common stock to founders..... -- 4,000,000 -- -- -- -- -- Services contributed by the founders (Note 9).................... -- -- -- 120,000 -- -- 120,000 Net loss............... -- -- -- -- -- (200,913) (200,913) ---------- --------- ----------- --------- --------- ----------- ----------- BALANCE, DECEMBER 31, 1995................... -- 4,000,000 -- 160,000 -- (259,362) (99,362) Sale of common stock... -- 614,556 1,200,000 -- -- -- 1,200,000 Issuance of common stock in settlement of a dispute (Note 7).... -- 588,404 1,024,030 -- -- -- 1,024,030 Issuance of common stock to repay advances due to a related party......... -- 27,496 81,923 -- -- -- 81,923 Services contributed by the founders (Note 9).................... -- -- -- 117,834 -- -- 117,834 Termination of S Corporation status.... -- -- (1,726,404) (277,834) -- 2,004,238 -- Net loss............... -- -- -- -- -- (1,810,408) (1,810,408) ---------- --------- ----------- --------- --------- ----------- ----------- BALANCE, DECEMBER 31, 1996................... -- 5,230,456 579,549 -- -- (65,532) 514,017 Sale of Redeemable Series A and B Convertible Preferred Stock, net of expenses (unaudited)........... 9,252,491 -- -- -- -- -- -- Grant of common stock options below deemed fair value for accounting purposes (unaudited)........... -- -- 751,392 -- (751,392) -- -- Amortization of deferred compensation (unaudited)........... -- -- -- -- 219,154 -- 219,154 Accretion of preferred stock to redemption value (unaudited)..... 263,748 -- -- -- -- (263,748) (263,748) Net loss (unaudited)... -- -- -- -- -- (4,129,666) (4,129,666) ---------- --------- ----------- --------- --------- ----------- ----------- BALANCE, SEPTEMBER 30, 1997 (unaudited)....... $9,516,239 5,230,456 $ 1,330,941 $ -- $(532,238) $(4,458,946) $(3,660,243) ========== ========= =========== ========= ========= =========== ===========
The accompanying notes are an integral part of these statements. F-5 CDNOW, INC. STATEMENTS OF CASH FLOWS
PERIOD FROM INCEPTION YEAR ENDED NINE MONTHS ENDED (FEBRUARY 12, 1994) DECEMBER 31, SEPTEMBER 30, TO DECEMBER 31, ---------------------- ---------------------- 1994 1995 1996 1996 1997 --------------------- --------- ----------- --------- ----------- (UNAUDITED) OPERATING ACTIVITIES: Net loss................ $(58,449) $(200,913) $(1,810,408) $(525,076) $(4,129,666) Adjustments to reconcile net loss to net cash provided by (used in) operating activities-- Depreciation and amortization........... 4,751 32,999 105,439 87,136 438,503 Provision for doubtful accounts............... -- -- 12,000 -- 5,000 Common stock issued in settlement of a dispute................ -- -- 1,024,030 -- -- Services contributed by the founders........... 40,000 120,000 117,834 96,408 -- Increase in operating assets and liabilities-- Accounts receivable.... -- (56,127) (86,310) (46,166) (54,875) Prepaid expenses and other................. -- (26,994) (34,487) (19,577) (490,824) Accounts payable....... -- 109,386 326,296 268,999 3,194,675 Accrued expenses....... 3,054 58,124 68,139 243,035 254,117 Deferred revenues...... -- 4,952 161,155 (4,952) 44,602 -------- --------- ----------- --------- ----------- Net cash provided by (used in) operating activities.. (10,644) 41,427 (116,312) 99,807 (738,468) -------- --------- ----------- --------- ----------- INVESTING ACTIVITIES: Purchases of short-term investments............ -- -- (245,641) -- (737,959) Purchases of property and equipment.......... (28,508) (135,777) (198,985) (97,130) (1,297,801) -------- --------- ----------- --------- ----------- Net cash used in investing activities........... (28,508) (135,777) (444,626) (97,130) (2,035,760) -------- --------- ----------- --------- ----------- FINANCING ACTIVITIES: Borrowings on term loans payable................ -- -- -- -- 218,563 Payments on term loans payable................ -- -- -- -- (14,546) Borrowings on notes payable................ -- 100,000 200,000 -- -- Payments on notes payable................ -- -- (100,000) -- (200,000) Proceeds from sale of common stock and warrants............... -- -- 1,200,000 -- -- Proceeds from sale of preferred stock........ -- -- -- -- 9,252,491 Proceeds from advances due to related parties................ 41,160 37,683 6,341 3,080 -- Payments on capitalized lease obligations...... -- (1,529) (13,350) (10,054) (19,881) -------- --------- ----------- --------- ----------- Net cash provided by financing activities........... 41,160 136,154 1,292,991 (6,974) 9,236,609 -------- --------- ----------- --------- ----------- INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS........ 2,008 41,804 732,053 (4,297) 6,462,381 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD............... -- 2,008 43,812 43,812 775,865 -------- --------- ----------- --------- ----------- CASH AND CASH EQUIVALENTS, END OF PERIOD............... $ 2,008 $ 43,812 $ 775,865 $ 39,515 $ 7,238,246 ======== ========= =========== ========= ===========
The accompanying notes are an integral part of these statements. F-6 CDNOW, INC. NOTES TO FINANCIAL STATEMENTS (INFORMATION AS OF SEPTEMBER 30, 1997 AND FOR THE NINE MONTHS ENDEDSEPTEMBER 30, 1996 AND 1997 IS UNAUDITED) 1. THE COMPANY: CDnow, Inc. (the "Company") is an online retailer of compact discs ("CDs") and other music-related products. The Company strives to combine the advantage of online commerce with superior customer focus in order to be the authoritative source of CDs and other music-related products. The Company contracts with outside warehouses for fulfillment services to deliver products to customers and, therefore, the Company maintains no inventories. Since inception, the Company has incurred significant losses, and as of September 30, 1997 had accumulated losses of $6,463,184. For the nine months ended September 30, 1997, the Company's net loss was $4,129,666. The Company intends to invest heavily in marketing and promotion, Web site development and technology, and development of its administration organization. As a result, the Company believes that it will incur substantial operating losses for the foreseeable future, and that the rate at which such losses will be incurred will increase significantly from current levels. Because the Company has relatively low product gross margins, achieving profitability given planned investment levels depends upon the Company's ability to generate and sustain substantially increased revenue levels. There can be no assurance that the Company will be able to generate sufficient revenues to achieve or sustain profitability in the future. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Prospectus. In order to make the investments necessary to expand its business and to meet its cash flow requirements, the Company plans to raise capital through an initial public offering of its common stock (the Offering). If successfully completed, the net proceeds from the Offering, together with other available resources, will be sufficient to fund the Company's operations for at least the next twelve months after the Offering. If capital requirements vary materially from those currently planned, the Company may require additional financing sooner than anticipated. Based on the variable nature of a significant portion of the Company's expenditures, the cash balance at September 30, 1997, the sale of the Series A Convertible Notes in November 1997(see Note 12), additional credit that may be secured from key vendors and management's belief that additional debt and equity financing can be raised, the Company believes that it has the ability to continue its business through December 31, 1997. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Interim Financial Statements The financial statements as of September 30, 1997 and for the nine months ended September 30, 1996 and 1997 are unaudited and, in the opinion of management, include all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of results for those interim periods. The results of operations for the nine months ended September 30, 1997 are not necessarily indicative of the results to be expected for the entire year. Management's Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and F-7 CDNOW, INC. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) (INFORMATION AS OF SEPTEMBER 30, 1997 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1997 IS UNAUDITED) 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED) liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Pro Forma Net Loss Per Common Share (unaudited) Pro forma net loss per share was calculated by dividing the net loss by the weighted average number of common shares outstanding for the respective periods adjusted for the dilutive effect of common stock equivalents, which consist of stock options, using the treasury stock method. Pursuant to the requirements of the Securities and Exchange Commission, common stock issued by the Company during the twelve months immediately preceding the Offering, plus the number of common equivalent shares which became issuable during the same period pursuant to the grant of common stock options, have been included in the calculation of the shares used in computing pro forma net loss per share as if they were outstanding for all periods presented (using the treasury stock method and the estimated initial public offering price of $ per share). Pursuant to the policy of the Securities and Exchange Commission, the calculation of shares used in computing pro forma net loss per share also includes the Redeemable Series A and B Convertible Preferred Stock, which will convert into 1,860,087 shares of common stock effective upon the closing of the Offering. Historical net loss per share amounts are not presented, since such amounts are not considered meaningful as a result of the significant change in the Company's capital structure that will occur in connection with the Offering (see Note 8). Cash and Cash Equivalents Cash equivalents are carried at cost plus accrued interest, which approximates fair value. The Company considers all highly liquid investments with an original maturity date of three months or less to be cash equivalents. Cash equivalents of $742,784 and $6,021,895 at December 31, 1996 and September 30, 1997, respectively, included government mortgage-backed bonds and highly rated corporate bonds. At December 31, 1995, the Company had no cash equivalents. Short-Term Investments At December 31, 1996 and September 30, 1997, short-term investments were comprised of government mortgage-backed bonds maturing in less than a year, which have been classified as available-for-sale. Pursuant to Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities," available-for-sale securities are carried at fair value, based on quoted market prices, with unrealized gains and losses, net of tax, reported as a separate component of shareholders' equity. At December 31, 1996 and September 30, 1997, unrealized gains and losses were immaterial. Property and Equipment Property and equipment are stated at cost. Depreciation and amortization are provided using the straight-line basis over the estimated useful lives of the assets or the lease term, whichever is shorter. Revenue Recognition Net sales, which consist primarily of recorded music sold via the Internet, include outbound shipping and handling charges and are recognized when the products are shipped. The Company records a reserve for estimated returns. F-8 CDNOW, INC. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) (INFORMATION AS OF SEPTEMBER 30, 1997 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1997 IS UNAUDITED) 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED) Operating and Development Operating and development expenses consist principally of payroll and related expenses for development, editorial, and network operations personnel and consultants and expenses for systems and telecommunications infrastructure. Sales and Marketing Advertising costs are included in sales and marketing expenses and are charged to expense as incurred. Such costs were $7,406, $40,523, $61,432, $23,870 and $2,221,913, for the period from inception (February 12, 1994) to December 31, 1994, the years ended December 31, 1995 and 1996, and the nine months ended September 30, 1996 and 1997, respectively. The Company gives merchandise credit to the providers of various small Web sites through its Cosmic Credit Program. Expenses related to this program are included in sales and marketing expenses and, to date, have been immaterial. The Company estimates the amount of unused credits and includes this amount in accrued expenses. Gift Certificates and Coupons Gift certificates are included in deferred revenues in the accompanying balance sheets and are recognized as net sales when they are redeemed. The Company estimates the amount of outstanding coupons which will be redeemed and includes that amount in accrued expenses. This accrual is immaterial for all periods presented. Coupon expense is included in sales and marketing expenses. Supplemental Cash Flow Information For the years ended December 31, 1995 and 1996 and the nine months ended September 30, 1996 and 1997, the Company paid interest of $2,329, $19,467, $11,296 and $29,960, respectively. In addition, the Company incurred $115,000 and $126,954 in capitalized lease obligations for the years ended December 31, 1995 and 1996, respectively. No capitalized lease obligations were incurred in the nine months ended September 30, 1997. Prior to 1995, the Company incurred no capitalized lease obligations and paid no interest. Recapitalization In April 1996, the Company amended its Articles of Incorporation to effect a 10,000-for-1 split of its common shares and to change the number of authorized common shares to 5,000,000. In July 1997, the Company amended its Articles of Incorporation to effect a 4-for-1 split of its common shares, to change the number of authorized common shares to 50,000,000, and to authorize 20,000,000 shares of preferred stock. Recently Adopted Accounting Pronouncements In March 1995, the Financial Accounting Standards Board ("FASB") issued Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of" ("SFAS 121"). SFAS 121 requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Adoption of SFAS 121 had no effect on the financial statements of the Company. F-9 CDNOW, INC. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) (INFORMATION AS OF SEPTEMBER 30, 1997 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1997 IS UNAUDITED) 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED) In October 1995, the FASB issued Statement No. 123, "Accounting for Stock- Based Compensation" ("SFAS 123"), which establishes financial accounting and reporting standards for stock-based employee compensation plans and for transactions in which an entity issues its equity instruments to acquire goods or services from nonemployees. The Company continues to account for stock- based compensation arrangements in accordance with Accounting Principles Board No. 25, "Accounting for Stock Issued to Employees," and, therefore, the adoption of SFAS 123 had no effect on the financial position or results of operations of the Company. The Company has included additional disclosures on stock-based employee compensation plans, as required by SFAS 123, in its financial statements. Recently Issued Accounting Pronouncements In February 1997, the FASB issued Statement No. 128, "Earnings per Share." This statement establishes standards for computing and presenting earnings per share and is effective for financial statements issued for periods ending after December 15, 1997. Earlier application of this statement is not permitted and, upon adoption, requires restatement (as applicable) of all prior-period earnings per share data presented. Management believes that the implementation of this standard will have no effect on the Company's calculation of earnings per share. In February 1997, the FASB issued Statement No. 129, "Disclosure of Information about Capital Structure." This statement establishes standards for disclosing information about an entity's capital structure. Management intends to comply with the disclosure requirements of this statement, which are effective for periods ending after December 15, 1997. In June 1997, the FASB issued Statement No. 130, "Reporting Comprehensive Income" ("SFAS 130"). This statement requires companies to classify items of other comprehensive income by their nature in a financial statement and display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position. SFAS 130 is effective for financial statements issued for fiscal years beginning after December 15, 1997. Management believes that SFAS 130 will not have a material effect on the Company's financial statements. In June 1997, the FASB issued Statement No. 131, "Disclosure About Segments of an Enterprise and Related Information" ("SFAS 131"). This statement establishes additional standards for segment reporting in the financial statements and is effective for fiscal years beginning after December 15, 1997. Management believes that SFAS 131 will not have an effect on the Company's financial statements. 3. RISKS AND UNCERTAINTIES: The Company's future results of operations involve a number of risks and uncertainties. Factors that could affect the Company's future operating results and cause actual results to vary materially from expectations include, but are not limited to, dependence on key personnel, uncertain growth of online commerce, reliance on suppliers of entertainment products, government regulation, online commerce security risks, substantial competition, reliance on certain vendors, risk of system failure, absence of redundant facilities, and capacity constraints. See "Risk Factors" in the Prospectus. F-10 CDNOW, INC. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) (INFORMATION AS OF SEPTEMBER 30, 1997 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1997 IS UNAUDITED) 3. RISKS AND UNCERTAINTIES: (CONTINUED) Dependence on Suppliers The Company's primary provider of order fulfillment for recorded music titles is Valley Record Distributors ("Valley"). The Company has no fulfillment operation or facility of its own and, accordingly, is dependent upon maintaining its existing relationship with Valley or establishing a new fulfillment relationship with one of the few other fulfillment operations. There can be no assurance that the Company will maintain its relationship with Valley beyond the term of its existing two year agreement with Valley, which expires in August, 1999, or that it will be able to find an alternative, comparable vendor capable of providing fulfillment services on terms satisfactory to the Company should its relationship with Valley terminate. Valley accounted for 69%, 70%, 72% and 74% of the cost of sales for the period from inception (February 12, 1994) to December 31, 1994, in 1995 and 1996 and for the nine months ended September 30, 1997, respectively. Additionally, the Company purchased all of its import music titles from another vendor. This vendor accounted for 27%, 21%, and 14% of the cost of sales for the period from inception (February 12, 1994) to December 31, 1994, in 1995 and 1996. The Company replaced this vendor during the nine months ended September 30, 1997 and neither the current nor the former vendor accounted for more than 10% of sales in the nine months ended September 30, 1997. International Sales The Company derived 14%, 22%, 40% and 33% of revenues for the period from inception (February 12, 1994) to December 31, 1994, in 1995 and 1996 and for the nine months ended September 30, 1997, respectively, from customers outside the United States. 4. PROPERTY AND EQUIPMENT:
DECEMBER 31, USEFUL LIFE/ ------------------- SEPTEMBER 30, LEASE TERM 1995 1996 1997 ------------ -------- --------- ------------- Computers and equipment.... 3 years $164,530 $ 387,348 $1,449,350 Office furniture and equipment................. 5 years 14,755 117,876 353,675 -------- --------- ---------- 179,285 505,224 1,803,025 Less--Accumulated depreciation and amortization.............. (37,750) (143,189) (362,538) -------- --------- ---------- $141,535 $ 362,035 $1,440,487 ======== ========= ==========
Depreciation and amortization expense for the period from inception (February 12, 1994) through December 31, 1994, in 1995 and 1996 and for the nine months ended September 30, 1996 and 1997 was $4,751, $32,999, $105,439, $87,136 and $219,349 respectively. Total property and equipment under capital leases was $15,000, $141,954 and, $146,840, less accumulated amortization of $2,500, $25,659 and $62,369, at December 31, 1995 and 1996 and September 30, 1997, respectively. 5. INCOME TAXES: The Company records income taxes using the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. F-11 CDNOW, INC. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) (INFORMATION AS OF SEPTEMBER 30, 1997 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1997 IS UNAUDITED) 5. INCOME TAXES: (CONTINUED) From inception (February 12, 1994) until April 25, 1995, the Company operated as an unincorporated entity. From April 25, 1995 until December 5, 1996, the Company was incorporated and elected to be taxed under Subchapter S of the Internal Revenue Code. As a result, the Company was not subject to federal or state income taxes, and the taxable loss of the Company was included in the shareholders' individual tax returns. On December 6, 1996, the Company terminated its status as an S corporation and is now subject to federal and state income taxes. At December 31, 1996, the Company had a net operating loss carryforward for federal income tax purposes of approximately $4,700. The net operating loss carryforward will expire in 2005. The Company's utilization of its loss carryforward will be limited pursuant to the Tax Reform Act of 1986, due to cumulative changes in ownership in excess of 50%. The approximate income tax effect at December 31, 1996 of each type of temporary difference and the loss carryforward is as follows: Accruals and reserves not currently deductible for tax............ $ 6,275 Benefit of net operating loss carryforward........................ 1,592 Research and development expenses not currently deductible........ 160,062 Depreciation methods.............................................. 12,134 Deferred revenues................................................. 42,500 --------- 222,563 Valuation allowance............................................... (222,563) --------- $ -- =========
Due to the uncertain realization of the deferred tax asset, the Company has provided a full valuation allowance. 6. DEBT: On December 31, 1995, the Company issued a note for $100,000 to a private investor who is also a member of the Company's Board of Directors. The note plus accrued interest of 10% was repaid on December 31, 1996. From November 16, 1996 through January 31, 1997, the Company received short- term loans of $250,000 from certain unrelated investors. The investors received warrants as part of the consideration for the loans (see Note 8). These loans bore interest at 6% per year. On May 15, 1997, the Company repaid $110,000 of the loans and, on July 16, 1997, the remaining unpaid balance plus accrued interest was paid. The Company believes the warrants had minimal value on the dates of grant. Given the size of the loans and the short period for which they were outstanding, any imputed interest expense would be immaterial to the statements of operations for 1996 and 1997. In 1997, the Company obtained three term loans from a bank for an aggregate of $218,563. The proceeds from the loans were used to purchase equipment, which equipment collateralizes the loans. The two founders of the Company have personally guaranteed the loans. The loans bear interest at rates ranging from 8.0% to 9.0% and are repayable in installments over 36 to 48 months. Annual principal repayments are $28,175 in 1997, $57,351 in 1998, $62,300 in 1999, $45,676 in 2000 and $25,061 in 2001. F-12 CDNOW, INC. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) (INFORMATION AS OF SEPTEMBER 30, 1997 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1997 IS UNAUDITED) 7. DISPUTE SETTLEMENT: In May 1995, MILO Productions, Inc. ("MILO"), which was owned by the Company's then shareholders, entered into a partnership with MBL Entertainment, Inc. ("MBL") called Music Now. In December 1995, MBL, an investor and the Company's then shareholders entered into nonbinding discussions for the purpose of creating a new company ("NewCo") which would merge with Music Now. These discussions contemplated, among other things, that the private investor would make a significant cash investment in, and the Company's then shareholders would contribute all of the outstanding capital stock of both Milo and the Company, to NewCo. The parties abandoned these discussions in August 1996, and MBL and the private investor subsequently instituted a legal action against the Company, Milo and the Company's then shareholders. On December 6, 1996, the Company and all parties involved in this dispute negotiated a settlement pursuant to which (i) the private investor made an investment in the Company (see Note 8) and (ii) the shareholders of MBL were issued an aggregate of 588,404 shares of common stock. The shares issued to MBL were valued at $1,024,030 based on the sale of common stock to the investor, with the related charge recorded as an expense in the accompanying statement of operations for the year ended December 31, 1996. The Company had advances due from Music Now of $7,185 at December 31, 1995, which were forgiven as part of the settlement. 8. REDEEMABLE CONVERTIBLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY: Common Stock In December 1996, the Company sold to an investor 614,556 shares of common stock and a warrant to purchase an additional 581,140 common shares at $1.72 per share, for aggregate consideration of $1,200,000. The warrant expires on June 16, 1998. The investor received the right to appoint two members of the Company's Board of Directors, each having one-half vote. Preferred Stock As of September 30, 1997, the Company had 20,000,000 shares of preferred stock authorized, of which 254,582 were designated, issued and outstanding as no par value Redeemable Series A Convertible Preferred Stock ("Series A Preferred") and 1,606,505 were designated, issued and outstanding as no par value Redeemable Series B Convertible Preferred Stock ("Series B Preferred"). The Series A Preferred was sold to an investor in July 1997 for $4.91 per share, resulting in proceeds to the Company of $1,152,186, net of expenses. The Series B Preferred was sold to investors in August 1997 for $5.45 per share, resulting in proceeds to the Company of $8,100,305, net of expenses. Each share of Series A and B Preferred is convertible into one share of the Company's common stock. In addition, effective upon the closing of the Offering, all shares of Series A and Series B Preferred will automatically convert into common stock on a one-for-one basis, subject to certain adjustments. Each preferred stockholder is entitled to one vote per share and registration rights, as defined. The Series A and B Preferred shareholders each have the right to appoint one Board member. This right terminates upon the closing of the Offering. Beginning January 1, 2003, the Series A and B Preferred are redeemable at the option of a majority of the holders at $4.91 per share and $5.45 per share, respectively, plus accrued but unpaid dividends, if any. The Series A and B Preferred are being accreted to their redemption values for accounting purposes. The holders of Series A and B Preferred are entitled to receive cumulative dividends of 8% per share per F-13 CDNOW, INC. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) (INFORMATION AS OF SEPTEMBER 30, 1997 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1997 IS UNAUDITED) 8. REDEEMABLE CONVERTIBLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY: (CONTINUED) year, when and if declared by the Company; provided, however, that no dividends may be declared or paid on common stock unless all cumulative dividends have been declared and paid on the preferred stock. The Series A and Series B Preferred have liquidation preferences equal to $4.91 per share and $5.45 per share, respectively, plus any accrued and unpaid dividends. Equity Compensation Plan On June 1, 1996, the Company adopted the Equity Compensation Plan (the "Plan"). Under the Plan, incentive and nonqualified stock options, restricted stock and stock appreciation rights may be granted to employees, officers, employee directors and independent contractors and consultants. An aggregate of 800,000 shares of common stock have been reserved for issuance under the Plan. No stock options, restricted stock or stock appreciation rights were granted in 1996. Information relative to the Plan is as follows:
RANGE OF AGGREGATE SHARES EXERCISE PRICES EXERCISE PRICE ------- --------------- -------------- Outstanding January 1, 1997.......... -- -- -- Granted.............................. 395,437 $2.00-$4.50 $1,117,857 ------- ----------- ---------- Outstanding September 30, 1997....... 395,437 $2.00-$4.50 $1,117,857 ======= =========== ==========
As of September 30, 1997, there were 28,000 options exercisable at an aggregate exercise price of $91,000. In addition, as of September 30, 1997, there were 404,563 additional options to purchase common stock available for grant under the Plan. The Company accounts for its option grants under APB Opinion No. 25 and related interpretations. Accordingly, compensation has been recorded for the Plan based on the intrinsic value of the stock option at the date of grant (i.e., the difference between the exercise price and the fair value of the Company's stock). Compensation, if any, is deferred and recorded as expense over the vesting period. For the nine months ended September 30, 1997, deferred compensation of $751,392 was recorded for options granted, of which $219,154 was charged to compensation expense. In 1995, the Financial Accounting Standards Board issued SFAS No. 123 "Accounting for Stock Based Compensation" (SFAS 123). SFAS 123 establishes a fair value based method of accounting for stock-based compensation plans. This statement also applies to transactions in which an entity issues its equity instruments to acquire goods or services from non-employees. SFAS 123 requires that an employer's financial statements include certain disclosures about stock-based employee compensation arrangements regardless of the method used to account for the plan. Had the Company recognized compensation cost for its stock option plans consistent with the provisions of SFAS 123, the Company's pro forma net loss and net loss per common share for the nine months ended September 30, 1997 would have been as follows: F-14 CDNOW, INC. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) (INFORMATION AS OF SEPTEMBER 30, 1997 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1997 IS UNAUDITED) 8. REDEEMABLE CONVERTIBLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY: (CONTINUED)
NINE MONTHS ENDED SEPTEMBER 30, 1997 ------------- Net loss: As reported................................................. $(4,129,666) =========== Pro forma................................................... $(4,195,895) =========== Net loss per common share: As reported................................................. $ =========== Pro forma................................................... $ ===========
The weighted average fair value of the stock options granted during the nine months ended September 30, 1997 was $3.05. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model, with the following weighted average assumptions: risk free interest rates ranging from 6.4% to 6.8% based on the rates in effect on the date of grant, no expected dividend yield, and an expected life of eight years for the options. Warrants In August 1997, the Company issued warrants to purchase 121,560 shares of Series B Preferred at an exercise price of $5.45 per share in connection with the Series B Preferred financing. The warrants were issued to one of the investors in the Series B Preferred and to the agent who represented the Company in that financing. These warrants expire in August 2002. Upon the closing of the Offering, the warrants will convert to warrants to purchase 121,560 shares of common stock at $5.45 per share. As consideration for certain loans, the lenders received warrants to purchase 39,998 and 50,910 shares of common stock at a price of $2.75 per share until May 16, 1998 and July 16, 1998, respectively (see Note 6). 9. RELATED-PARTY TRANSACTIONS: Additional paid-in capital represents the deemed fair value of services contributed to the Company by the founders in 1994, 1995 and 1996. In 1994 and 1995, the founders were paid no compensation and in 1996 the founders' compensation was below market. The Company had advances due to a founder and his father of $4,105 and $81,923, respectively, at December 31, 1995. On August 16, 1996, in consideration of the cancellation of the debt due to the father, the Company issued 27,496 shares of the Company's common stock. 10. COMMITMENTS AND CONTINGENCIES: Yahoo Agreement In August 1997, the Company entered into an agreement with Yahoo! Inc. (the "Yahoo Agreement"), pursuant to which the Company will become the exclusive retail music store sponsor of the F-15 CDNOW, INC. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) (INFORMATION AS OF SEPTEMBER 30, 1997 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1997 IS UNAUDITED) 10. COMMITMENTS AND CONTINGENCIES: (CONTINUED) www.yahoo.com website. The Yahoo Agreement consists of two one-year terms. The initial term began in October 1997 and will expire on October 5, 1998. The Company can terminate the contract after the first year by providing Yahoo with notice, as defined, and paying a termination fee. During the first one- year term, the Company is required to pay Yahoo $3,900,000 (of which $300,000 was paid in September, 1997 and $600,000 is due by December 31, 1997) in exchange for a specified number of page views. The Company expects to amortize the costs associated with the Yahoo Agreement over the contract term, with the amortization method primarily based on the number of impressions received during the contract term. The Company will continue to evaluate the realizability of this asset and, if necessary, write down the asset to realizable value. In connection with the Yahoo Agreement, the Company paid Yahoo an additional $600,000 for advertising in August and September 1997, which amount was charged to expense for the nine months ended September 30, 1997. Excite Agreement On September 30, 1997, the Company entered into a two-year agreement with Excite, Inc. (the "Excite Agreement"), pursuant to which the Company will become the exclusive retail music store sponsor of the WebCrawler.com website. The Excite Agreement requires the Company to pay Excite a set-up fee, an annual exclusivity fee and an annual sponsorship fee for ongoing programming, links, placements, advertisements and promotions. The Company has agreed to pay Excite a minimum of $4,500,000 over the contract term, of which $2,000,000 will be paid by December 31, 1997, $625,000 will be paid in 1998 and $1,875,000 will be paid in 1999. The Company expects to amortize the costs associated with the Excite agreement over the contract term, with the amortization method primarily based on the number of impressions received during the contract term. The Company will continue to evaluate the realizability of this asset and, if necessary, write down the asset to realizable value. Leases The Company has entered into various noncancelable operating and capital leases for office space, telephones and other equipment. Future minimum lease payments under operating and capital leases as of December 31, 1996 are as follows:
OPERATING CAPITAL --------- -------- 1997.................................................... $63,937 $ 56,570 1998.................................................... 21,637 46,956 1999.................................................... 4,106 36,199 2000.................................................... -- 20,037 2001.................................................... -- 14,763 ------- -------- Total minimum lease payments............................ $89,680 174,525 ======= Less--Amount representing interest...................... (47,450) -------- Present value of minimum capitalized lease payments..... $127,075 ========
Rent expense under operating leases was $51,836 in 1995, $16,905 in 1996, and $119,176 for the nine months ended September 30, 1997. There was no rent expense prior to 1995. F-16 CDNOW, INC. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) (INFORMATION AS OF SEPTEMBER 30, 1997 AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1997 IS UNAUDITED) 10. COMMITMENTS AND CONTINGENCIES: (CONTINUED) Legal Actions From time-to-time, the Company may be involved in litigation relating to claims arising out of its ordinary course of business. The Company believes that there are no claims or actions pending or threatened against the Company, the ultimate disposition of which, would have a materially adverse effect on the Company. 11. BRIDGE FINANCING (UNAUDITED): In November 1997, the Company issued $5,777,500 of Series A Convertible Notes (Series A Notes) to certain investors. The notes bear interest at an annual rate of 12% and are due upon consummation of the Offering. A portion of the proceeds of the Offering will be used to repay the Series A Notes. In addition to the Series A Notes, the Company issued warrants to these investors. The warrants allow the investors to purchase $ of common stock at an exercise price of $ . If the Offering is not consummated, the loan will convert into a class of Preferred Stock at a price per share, as defined, and the warrants will be equal to 20% of the security received upon conversion and be exercisable at an exercise price, as defined. F-17 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- NO DEALER, SALESPERSON OR ANY OTHER PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY REPRESENTATIONS NOT CONTAINED IN THIS PROSPECTUS, AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED BY THE COMPANY OR ANY OF THE UNDERWRITERS. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER OF ANY SECURITIES OTHER THAN THOSE TO WHICH IT RELATES OR AN OFFER TO SELL, OR A SOLICITATION OF AN OFFER TO BUY, TO ANY PERSON IN ANY JURISDICTION WHERE SUCH AN OFFER OR SOLICITATION WOULD BE UNLAWFUL. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE ANY IMPLICATION THAT THE INFORMATION CONTAINED HEREIN IS CORRECT AS OF ANY TIME SUBSEQUENT TO THE DATE HEREOF. ---------------- TABLE OF CONTENTS
PAGE ---- Prospectus Summary....................................................... 3 Risk Factors............................................................. 7 Use of Proceeds.......................................................... 15 Dividend Policy.......................................................... 15 Capitalization........................................................... 16 Dilution................................................................. 17 Selected Financial and Operating Data.................................... 18 Management's Discussion and Analysis of Financial Condition and Results of Operations........................................................... 19 Business................................................................. 27 Management............................................................... 37 Certain Transactions..................................................... 41 Principal Shareholders................................................... 43 Description of Capital Stock............................................. 44 Shares Eligible for Future Sale.......................................... 45 Underwriting............................................................. 46 Legal Matters............................................................ 47 Experts.................................................................. 47 Additional Information................................................... 48 Index to Financial Statements............................................ F-1
---------------- UNTIL , 1998 (25 DAYS AFTER THE DATE OF THIS PROSPECTUS), ALL DEALERS EFFECTING TRANSACTIONS IN THE COMMON STOCK, WHETHER OR NOT PARTICIPATING IN THIS DISTRIBUTION, MAY BE REQUIRED TO DELIVER A PROSPECTUS. THIS IS IN ADDITION TO THE OBLIGATIONS OF DEALERS TO DELIVER A PROSPECTUS WHEN ACTING AS UNDERWRITERS AND WITH RESPECT TO THEIR UNSOLD ALLOTMENTS OR SUBSCRIPTIONS. - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- Shares [LOGO] CDNOW, INC. Common Stock ---------------- PROSPECTUS ---------------- BT ALEX. BROWN NATIONSBANC MONTGOMERY SECURITIES, INC. , 1998 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- PART II INFORMATION NOT REQUIRED IN PROSPECTUS ITEM 13. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION. The following table sets forth the estimated expenses, other than underwriting discounts and commissions, in connection with the issuance and distribution of the shares of Common Stock being registered, all of which are being borne by the Company: Registration fee.................................................... $17,700 NASD filing fee..................................................... 6,500 Transfer agent and registrar fees................................... Printing and engraving.............................................. Legal fees.......................................................... Blue Sky fees and expenses.......................................... Nasdaq National Market listing fee.................................. 50,000 Accounting fees..................................................... Miscellaneous....................................................... Total......................................................... $ =======
- --------------------- * To be filed by amendment ITEM 14. INDEMNIFICATION OF DIRECTORS AND OFFICERS. The Registrant's Amended and Restated Articles of Incorporation and By-laws require the Registrant to indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed proceeding by reason of the fact that he is or was a director or officer of the Registrant or any other person designated by the Board of Directors (which may include any person serving at the request of the Registrant as a director, officer, employee, agent, fiduciary or trustee of another corporation, partnership, joint venture, trust, employee benefit plan or other entity or enterprise), in each case, against certain liabilities (including damages, judgments, amounts paid in settlement, fines, penalties and expenses (including attorneys' fees and disbursements)), except where such indemnification is expressly prohibited by applicable law, where such person has engaged in willful misconduct or recklessness or where such indemnification has been determined to be unlawful. Such indemnification as to expenses is mandatory to the extent the individual is successful on the merits of the matter. Pennsylvania law permits the Registrant to provide similar indemnification to employees and agents who are not directors or officers. The determination of whether an individual meets the applicable standard of conduct may be made by the disinterested directors, independent legal counsel or the stockholders. Pennsylvania law also permits indemnification in connection with a proceeding brought by or in the right of the Registrant to procure a judgment in its favor. Insofar as indemnification for liabilities arising under the Securities Act of 1933, as amended (the "Act") may be permitted to directors, officers, or persons controlling the Registrant pursuant to the foregoing provisions, the Registrant has been informed that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in that Act and is therefore unenforceable. The Registrant has a directors and officers liability insurance policy. ITEM 15. RECENT SALES OF UNREGISTERED SECURITIES Since the Company's incorporation in April 1995, the Company has issued and sold the following unregistered securities: 1. On August 16, 1996, the Company issued shares to an accredited investor in exchange for the cancellation of $81,923 of debt owed by the Company to this investor. II-1 2. On December 6, 1996, the Company issued shares of Common Stock to an accredited investor for $1,200,000 and an aggregate of shares of Common Stock to three investors in exchange for substantially all of the business and assets of an organization owned by these investors. 3. On July 15, 1997, the Company issued 254,582 shares of Series A Preferred Stock to an accredited investor for $1,250,000. 4. On August 5, 1997, the Company issued 1,605,605 shares of Common Stock to two accredited investors for an aggregate of $8,750,000. 5. On November 26, 1997, the Company issued $5,812,500 in aggregate principal amount of its Series A Convertible Notes and associated warrants exercisable for capital stock of the Company. The Company believes that the transactions described above were exempt from registration under Section 4(2) of the Act because the subject securities were sold to a limited group of persons, each of whom was believed to have been either an accredited investor or a sophisticated investor or had a pre- existing business or personal relationship with the Company or its management and was purchasing for investment without a view to further distribution. Restrictive legends were placed on stock certificates evidencing the shares and/or agreements relating to the right to purchase such shares described above. ITEM 16. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES. (a) Exhibits: The following is a list of exhibits filed as part of this Registration Statement.
EXHIBIT NUMBER DESCRIPTION ------- ----------- 1.1 Form of Underwriting Agreement. # 3.1 Amended and Restated Articles of Incorporation of the Company.# 3.2 Amended and Restated Bylaws of the Registrant.# 5.1 Opinion of Morgan, Lewis & Bockius LLP regarding legality of the shares of Common Stock being registered.# 10.1 Stock Purchase Agreement dated as of July 15, 1997 by the Registrant and certain shareholders of the Registrant. 10.2 Amendment No. 1 to Stock Purchase Agreement dated as of August 5, 1997 by the Registrant and certain shareholders of the Registrant. 10.3 Investors' Rights Agreement dated as of July 15, 1997 by the Registrant and certain shareholders of the Registrant. 10.4 CDnow, Inc. 1996 Equity Compensation Plan. 10.5 Amendment 1997-1 to the CDnow, Inc. 1996 Equity Compensation Plan. 10.6 Warrant dated August 5, 1997 issued by the Registrant to Alex. Brown & Sons Incorporated 10.7 Warrant dated August 5, 1997 issued by the Registrant to Grotech Capital Group IV, L.L.P. 10.8 Linking Agreement dated September 30, 1997 by and between the Registrant and Excite, Inc. 10.9 Advertising and Promotion Agreement dated as of August 21, 1997 by and between the Registrant and Yahoo! Inc. 11.1 Statement re: Computation of Per Share Earnings.* 23.1 Consent of Arthur Andersen LLP. * 23.2 Consent of Morgan, Lewis & Bockius LLP (included in its opinion filed as Exhibit 5 hereto). 24.1 Power of Attorney (included on signature page to this Registration Statement).* 27.1 Financial Data Schedule. *
- --------------------- * Filed herewith. # To be filed by amendment. II-2 ITEM 17. UNDERTAKINGS. (i) The undersigned Registrant hereby undertakes to provide to the Underwriters at the closing specified in the Underwriting Agreement certificates in such denominations and registered in such names as required by the Underwriters to permit prompt delivery to each purchaser. (ii) Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers and controlling persons of the Registrant pursuant to the foregoing provisions, or otherwise, the Registrant has been advised that in the opinion of the Commission such indemnification is against public policy as expressed in the Securities Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer or controlling person of the Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act and will be governed by the final adjudication of such issue. (iii) The undersigned Registrant hereby undertakes that: (1) For purposes of determining any liability under the Securities Act, the information omitted from the form of prospectus filed as part of this Registration Statement in reliance upon Rule 430A and contained in a form of prospectus filed by the Registrant pursuant to Rule 424(b)(1) or (4) or 497(h) under the Securities Act shall be deemed to be part of this Registration Statement as of the time it was declared effective. (2) For the purpose of determining any liability under the Securities Act, each post-effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. II-3 SIGNATURES PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1933, AS AMENDED, THE REGISTRANT HAS DULY CAUSED THIS REGISTRATION STATEMENT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, IN JENKINTOWN, PENNSYLVANIA ON NOVEMBER 26, 1997. CDnow, Inc. /s/ Jason Olim By: _________________________________ JASON OLIM, PRESIDENT AND CHAIRMAN OF THE BOARD PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1933, AS AMENDED, THIS REGISTRATION STATEMENT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS IN THE CAPACITIES AND ON THE DATES INDICATED. Each person in so signing also makes, constitutes and appoints Jason Olim and Joel Sussman and each of them acting alone, his true and lawful attorney- in-fact, with full power of substitution, to execute and cause to be filed with the Securities and Exchange Commission pursuant to the requirements of the Securities Act of 1933, as amended, any and all amendments and post- effective amendments to this Registration Statement, and including any Registration Statement for the same offering that its to be effective upon filing pursuant to Rule 462(b) under the Securities Act, with exhibits thereto and other documents in connection therewith, and hereby ratifies and confirms all that said attorney-in-fact or his substitute or substitutes may do or cause to be done by virtue hereof. NAME CAPACITY DATE /s/ Jason Olim President and November 26, - ------------------------------------- Chairman of the 1997 JASON OLIM Board (principal executive officer) /s/ Joel Sussman Vice President and November 26, - ------------------------------------- Chief Financial 1997 JOEL SUSSMAN Officer (principal financial and accounting officer) /s/ Matthew Olim Director November 26, - ------------------------------------- 1997 MATTHEW OLIM /s/ Alan Meltzer Director November 26, - ------------------------------------- 1997 ALAN MELTZER /s/ Patrick Kerins Director November 26, - ------------------------------------- 1997 PATRICK KERINS /s/ John Regan Director November 26, - ------------------------------------- 1997 JOHN REGAN II-4 EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION PAGE ------- ----------- ---- 1.1 Form of Underwriting Agreement. # 3.1 Amended and Restated Articles of Incorporation of the Company.# 3.2 Amended and Restated Bylaws of the Registrant.# 5.1 Opinion of Morgan, Lewis & Bockius LLP regarding legality of the shares of Common Stock being registered.# 10.1 Stock Purchase Agreement dated as of July 15, 1997 by the Registrant and certain shareholders of the Registrant. 10.2 Amendment No. 1 to Stock Purchase Agreement dated as of August 5, 1997 by the Registrant and certain shareholders of the Registrant. 10.3 Investors' Rights Agreement dated as of July 15, 1997 by the Registrant and certain shareholders of the Registrant. 10.4 CDnow, Inc. 1996 Equity Compensation Plan. 10.5 Amendment 1997-1 to the CDnow, Inc. 1996 Equity Compensation Plan. 10.6 Warrant dated August 5, 1997 issued by the Registrant to Alex. Brown & Sons Incorporated 10.7 Warrant dated August 5, 1997 issued by the Registrant to Grotech Capital Group IV, L.L.P. 10.8 Linking Agreement dated September 30, 1997 by and between the Registrant and Excite, Inc. 10.9 Advertising and Promotion Agreement dated as of August 21, 1997 by and between the Registrant and Yahoo! Inc. 11.1 Statement re: Computation of Per Share Earnings.* 23.1 Consent of Arthur Andersen LLP. * 23.2 Consent of Morgan, Lewis & Bockius LLP (included in its opinion filed as Exhibit 5 hereto). 24.1 Power of Attorney (included on signature page to this Registration Statement).* 27.1 Financial Data Schedule. *
- --------------------- * Filed herewith. # To be filed by amendment. EX-10.1 2 STOCK PURCHASE AGREEMENT - DATED 07/15/97 STOCK PURCHASE AGREEMENT AMONG CDNOW, INC., KEYSTONE VENTURE IV, L.P. and THE ADDITIONAL PURCHASERS PARTIES HERETO TABLE OF CONTENTS -----------------
Page ARTICLE 1. ISSUANCE AND SALE OF PREFERRED STOCK..................................................................2 SECTION 1.1. Authorization of Series A Preferred Stock..................................................2 SECTION 1.2. Purchase and Sale of the Series A Shares and Series B Shares...............................2 SECTION 1.3. Representations by the Purchasers..........................................................3 SECTION 1.4. Definitions, etc...........................................................................5 ARTICLE 2. REPRESENTATIONS AND WARRANTIES OF THE COMPANY.........................................................5 SECTION 2.1. Subsidiaries and Investments..............................................................5 SECTION 2.2. Organization and Authority................................................................5 SECTION 2.3. Capital Stock.............................................................................6 SECTION 2.4. Contravention; Validity...................................................................7 SECTION 2.5. Proprietary Information and Invention Agreements..........................................7 SECTION 2.6. Consents..................................................................................7 SECTION 2.7. Financial Statements and Other Information; Financial Condition...........................8 SECTION 2.8. No Material Adverse Change................................................................8 SECTION 2.9. Licenses, Registrations etc...............................................................9 SECTION 2.10. Title to Properties; Leases...............................................................9 SECTION 2.11. Compliance with Other Instruments, etc....................................................9 SECTION 2.12. Contracts and Binding Commitments........................................................10 SECTION 2.13. Compliance with Law, etc.; Non-Discrimination............................................11 SECTION 2.14. Compliance with ERISA; Multiemployer Plans...............................................12 SECTION 2.15. Pending Litigation, etc..................................................................13 SECTION 2.16. Taxes....................................................................................13 SECTION 2.17. Holding Company Act; Investment Company Act..............................................15 SECTION 2.18. No Margin Regulation Violation...........................................................15 SECTION 2.19. Outstanding Securities...................................................................15 SECTION 2.20. Events Since December 31, 1996...........................................................16 SECTION 2.21. Compliance with Environmental Laws.......................................................17 SECTION 2.22. Labor Relations..........................................................................18 SECTION 2.23. Broker's or Finder's Commissions.........................................................19 SECTION 2.24. Insurance................................................................................19 SECTION 2.25. Private Offering.........................................................................19 SECTION 2.26. Other Names..............................................................................19 SECTION 2.27. Intellectual Property Rights.............................................................19 SECTION 2.28. Full Disclosure..........................................................................20 SECTION 2.29. Use of Proceeds..........................................................................20
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Page ---- ARTICLE 3. REPRESENTATIONS AND WARRANTIES OF THE CONTROLLING PERSONS........................................................................................20 SECTION 3.1. Validity. ..............................................................................20 SECTION 3.2. Transactions with Affiliates. ..........................................................20 SECTION 3.3. Taxes....................................................................................21 SECTION 3.4. Stock Ownership..........................................................................21 ARTICLE 4. CONDITIONS OF OBLIGATION TO PURCHASE SECURITIES AT FIRST CLOSING...............................................................................21 SECTION 4.1. Opinions of Counsel for the Company......................................................21 SECTION 4.2. Performance of Obligations...............................................................22 SECTION 4.3. Representations True; No Event of Default................................................22 SECTION 4.4. Tender of Shares; Consummation of Related Transactions...................................22 SECTION 4.5. Fees and Disbursements of Special Counsel for Purchaser..................................22 SECTION 4.6. Legality.................................................................................22 SECTION 4.7. Certificate as to "S" Corporation Status.................................................22 SECTION 4.8. Consents and Approvals...................................................................22 SECTION 4.9. Certificate of Incorporation.............................................................23 SECTION 4.10. Proceedings, Instruments, etc............................................................23 SECTION 4.11. Corporate Proceedings....................................................................23 SECTION 4.12. Legislation..............................................................................23 SECTION 4.13. No Adverse Change........................................................................23 SECTION 4.14. No Proceedings...........................................................................24 SECTION 4.15. Payment of Fees..........................................................................24 SECTION 4.16. Investors' Rights Agreement..............................................................24 SECTION 4.17. Comfort Letter...........................................................................24 ARTICLE 5. CONDITIONS OF OBLIGATION TO PURCHASE SECURITIES AT EACH SUBSEQUENT CLOSING ....................................................................24 SECTION 5.1. Opinion of Counsel for the Company.......................................................24 SECTION 5.2. Performance of Obligations...............................................................25 SECTION 5.3. Representations True; No Event of Default................................................25 SECTION 5.4. Tender of Shares; Consummation of Related Transactions...................................25 SECTION 5.5. Fees and Disbursements of Special Counsel for Purchasers.................................25 SECTION 5.6. Legality.................................................................................25 SECTION 5.7. Consents and Approvals...................................................................25 SECTION 5.8. Statement With Respect To Shares.........................................................26 SECTION 5.9. Proceedings, Instruments, etc............................................................26 SECTION 5.10. Corporate Proceedings....................................................................26
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Page ---- SECTION 5.11. Legislation..............................................................................26 SECTION 5.12. No Adverse Change........................................................................26 SECTION 5.13. No Proceedings...........................................................................27 SECTION 5.14. Payment of Fees..........................................................................27 SECTION 5.15. Investors' Rights Agreement..............................................................27 SECTION 5.16 Comfort Letter...........................................................................27 SECTION 5.17. Agent Warrant............................................................................27 ARTICLE 6. COVENANTS OF THE COMPANY.............................................................................27 SECTION 6.1. Financial Statements.....................................................................27 SECTION 6.2. Other Information. .....................................................................28 SECTION 6.3. Rule 144A................................................................................28 SECTION 6.4. Shares...................................................................................29 SECTION 6.5. Inspection. ............................................................................29 SECTION 6.6. Prohibited Offers........................................................................29 SECTION 6.7. Termination..............................................................................29 SECTION 6.8. Prohibited Sales.........................................................................30 SECTION 6.9. Tax Returns..............................................................................30 ARTICLE 7. REGISTRATION RIGHTS..................................................................................30 ARTICLE 8. INTERPRETATION OF AGREEMENT..........................................................................30 SECTION 8.1. Definitions..............................................................................30 SECTION 8.2. Directly or Indirectly...................................................................36 SECTION 8.3. Governing Law............................................................................36 SECTION 8.4. Independence of Covenants................................................................37 SECTION 8.5. Construction.............................................................................37 ARTICLE 9. MISCELLANEOUS........................................................................................37 SECTION 9.1. Notices..................................................................................37 SECTION 9.2. Survival.................................................................................37 SECTION 9.3. Successors and Assigns...................................................................38 SECTION 9.4. Amendment and Waiver.....................................................................38 SECTION 9.5. Severability.............................................................................39 SECTION 9.6. Counterparts.............................................................................39 SECTION 9.7. Reproduction of Documents................................................................39 SECTION 9.8. Captions.................................................................................39 SECTION 9.9. No Agency................................................................................39 SECTION 9.10. Entire Agreement.........................................................................39 SECTION 9.11. No Waiver................................................................................39
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Page ---- SECTION 9.12. Third Party Beneficiary...................................................................40 SECTION 9.13. Obligations..............................................................................40 Statement With Respect to Shares..........................................................................Exhibit A Restated and Amended Articles of Incorporation of the Company.............................................Exhibit B Investors' Rights Agreement...............................................................................Exhibit C Agent Warrant.............................................................................................Exhibit D
-iv- THIS STOCK PURCHASE AGREEMENT (this "Agreement"), dated as of July 15, 1997, by and among CDNOW, INC., a Pennsylvania corporation (including its successors and assigns, the "Company"), Keystone Venture IV, L.P., a Pennsylvania limited partnership (including its successors and assigns, "Purchaser"), Jason and Matthew Olim (the "Controlling Persons") and the Additional Purchasers (as hereinafter defined) parties hereto. WHEREAS, at the First Closing (as hereinafter defined) the Company desires to sell to Purchaser, and Purchaser desires to purchase from the Company for the Initial Purchase Price (as hereinafter defined) and upon the terms and subject to the conditions as hereinafter set forth, 254,582 shares of the Company's Series A Convertible Preferred Stock, no par value (the "Series A Shares"), the terms of which are set forth in the Statement With Respect to Shares in the form attached as Exhibit "A" hereto (the "Statement With Respect to Shares") which Series A Shares may be converted into shares of common stock, no par value (the "Common Stock") of the Company in accordance with the terms of the Statement With Respect to Shares, and providing for certain rights with respect to the Common Stock issued or issuable upon conversion of the Series A Shares (the "Series A Conversion Shares") and the Common Stock issued or issuable upon conversion of the Series B Shares (as hereinafter defined) (the "Series B Conversion Shares") as hereinafter set forth; and WHEREAS, at one or more Subsequent Closings (as hereinafter defined), the Company intends to sell certain shares of the Company's Series B Convertible Preferred Stock (the "Series B Shares"; the Series A Shares and the Series B Shares collectively referred to as the "Shares"), the terms of which are set forth in the Statement With Respect to Shares, for the Additional Purchase Prices (as hereinafter defined) and upon the terms and subject to the conditions hereinafter set forth, to certain additional investors (the "Additional Purchasers") who shall be acceptable to the Company and Alex. Brown & Sons Incorporated, the Company's exclusive agent in connection with the private placement of the Series A Shares and the Series B Shares (the "Agent"), such Additional Purchasers to be set forth on Schedule A to this Agreement and became signatories to this Agreement on or before each Subsequent Closing; NOW, THEREFORE, in consideration of the premises and of the respective representations, warranties, covenants, agreements and conditions contained herein, each of the parties hereto intending to be legally bound hereby agrees as follows: ARTICLE 1. ISSUANCE AND SALE OF PREFERRED STOCK SECTION 1.1. Authorization of Series A Preferred Stock. ------------------------------------------ The Company has duly authorized the issuance and sale of (a) 254,582 shares of its Series A Shares having the rights, preferences and privileges set forth in the Restated Articles and (b) up to 1,605,505 shares of its Series B Shares having the rights, preferences and privileges set forth in the Statement With Respect to Shares. The Statement With Respect to Shares and the Amended and Restated Articles of Incorporation of the Company in the form attached as Exhibit B hereto (the "Restated Articles") have each been duly filed with the Secretary of State of the Commonwealth of Pennsylvania. SECTION 1.2. Purchase and Sale of the Series A Shares and Series B Shares. ----------------------------------------------- (a) Series A Shares Purchase and Sale. The Company agrees to --------------------------------- sell to the Purchaser and, subject to the terms and conditions hereof and in reliance upon the representations and warranties of the Company and the Controlling Persons contained herein, the Purchaser agrees to purchase from the Company shares of Series A Shares, in consideration for the payment of $4.91 per Series A Share or in the aggregate $1,249,997.60 (the "Initial Purchase Price"). (b) The First Closing. The Series A Shares are to be sold and ----------------- delivered at a closing (the "First Closing") to be held on July 15, 1997 at Noon, Philadelphia, Pennsylvania time, or such other date and time as shall be agreed upon by Purchaser and the Company, and in any event not later than July 18, 1997 (such date and time being hereinafter called the "First Closing Date"), at the offices of Morgan, Lewis & Bockius LLP, 2000 One Logan Square, Philadelphia, Pennsylvania 19103. (c) First Closing Deliveries. At the First Closing, the Company ------------------------ shall deliver to Purchaser one or more stock certificates representing the Series A Shares duly executed by the Company, dated the First Closing Date, registered in Purchaser's name or the name of Purchaser's nominee (and for purposes of this Agreement ownership by such nominee shall be deemed to be ownership by Purchaser). The delivery of all the Series A Shares to Purchaser shall be made against payment to the Company by wire transfer of immediately available funds to the account of the Company at PNC Bank, Philadelphia, PA, account number 8611588233, in the amount of the Initial Purchase Price. If at the First Closing the Company shall fail to tender the Series A Shares to Purchaser as provided above in this Section 1.2 or any of the conditions specified in Article 4 hereof shall not have been fulfilled to Purchaser's satisfaction, at Purchaser's election Purchaser shall be relieved of all obligations under this Agreement, without thereby waiving any other rights Purchaser may have by reason of such failure or such nonfulfillment. (d) Series B Shares Purchase and Sale. The Company agrees to --------------------------------- sell to each Additional Purchaser and, subject to the terms and conditions hereof and in reliance upon -2- the representations and warranties of the Company and the Controlling Persons contained herein, each Additional Purchaser, severally and not jointly, agrees to purchase from the Company that number of Series B Preferred Shares set forth opposite the Additional Purchaser's name on Schedule A hereto at a purchase price per share of $5.45 per share. The aggregate purchase price at each Subsequent Closing (as hereinafter defined) shall hereinafter be defined as an Additional Purchase Price. The aggregate of all Additional Purchase Prices shall be a minimum of $7,000,000 and shall not exceed $8,750,000, unless the Company and the Purchaser shall have consented in writing to such other amount. (e) Subsequent Closings. The Series B Shares are to be sold and ------------------- delivered at one or more closings (each a "Subsequent Closing") to be held on one or more dates (each a "Subsequent Closing Date"), the last one to be held no later than January 31, 1998 at 10:00 A.M., Philadelphia, Pennsylvania time, or such other date and time as shall be agreed upon by Purchaser, Agent (on behalf of the Additional Purchasers) and the Company. All Subsequent Closing Dates are to be held at the offices of Morgan, Lewis & Bockius LLP, 2000 One Logan Square, Philadelphia, Pennsylvania 19103. (f) Subsequent Closing Deliveries. At each Subsequent Closing, ----------------------------- the Company shall deliver to each Additional Purchaser one or more stock certificates representing the Series B Shares that such Additional Purchaser is purchasing, duly executed by the Company, dated such Subsequent Closing Date, registered in his (its) name or the name of his (its) nominee (and for purposes of this Agreement ownership by such nominee shall be deemed to be ownership by such Additional Purchaser). The delivery of the Series B Shares to each Additional Purchaser shall be made against payment to the Company by wire transfer of immediately available funds to the account of the Company at PNC Bank, Philadelphia, PA, account number 8611588233, or, at least 5 Business Days prior to the Subsequent Closing Date at which such Additional Purchaser is purchasing Series B Shares, by check payable to the Company's escrow account established for sale of the Series B Shares in the amount of the purchase price therefor. If at any Subsequent Closing the Company shall fail to tender the Series B Shares to an Additional Purchaser as provided above in this Section 1.2 or any of the conditions specified in Article 5 hereof shall not have been fulfilled such Additional Purchaser shall be relieved of all obligations under this Agreement, without thereby waiving any other rights he (it) may have by reason of such failure or such nonfulfillment. SECTION 1.3. Representations by the Purchasers. --------------------------------- Purchaser and each Additional Purchaser severally represents to the Company that he (it) is purchasing his (its) Shares for his (its) own account for investment and with no present intention of distributing or reselling his (its) Shares or any part thereof in violation of any applicable law, subject, nevertheless, to any requirement of law that the disposition of his (its) property shall at all times be and remain within his (its) control. Purchaser and each Additional Purchaser is an "accredited investor" within the meaning of Rule 501(a) promulgated under the Securities Act. -3- Purchaser and each Additional Purchaser has been provided with a complete copy of the PPM and has reviewed the PPM and has had the opportunity to consult with his or its financial advisor to the extent necessary to make an informed investment decision. Purchaser and each Additional Purchaser has been provided with or been given complete access to all of the financial and other information requested by such Purchaser or Additional Purchaser or deemed by such Purchaser or such Additional Purchaser to be necessary or material for such person to make an analysis and decision concerning the investment contemplated by this Agreement. Purchaser and each Additional Purchaser has substantial experience in investing and acknowledges that he (it) is able to bear the economic risk of an investment in the Securities and has such knowledge and experience in financial or business matters that he (it) is capable of evaluating the merits and risks of the investment in the Securities (hereinafter defined). Purchaser and each Additional Purchaser hereby acknowledges (i) that neither his (its) Shares nor the Series A Conversion Shares nor Series B Conversion Shares issuable upon conversion of his (its) Shares (Series A Conversion Shares and Series B Conversion Shares together with the Shares are collectively referred to herein as the "Securities") have been registered under the provisions of the Securities Act, and must be held indefinitely unless they are subsequently registered thereunder or an exemption from such registration is available; (ii) that any sale of the Securities made in reliance upon Rule 144 or Rule 144A can be made only in accordance with the terms and conditions of such Rules and, further, that if such Rules are not applicable, any resale of the Securities under circumstances in which the seller, or the Person through whom the sale is made, may be deemed to be an underwriter, as that term is used in the Securities Act, may require compliance with some other exemption under the Securities Act or the rules and regulations of the Securities and Exchange Commission, or other governmental authority substituted therefor; and (iii) that the Company is under no obligation to register the Securities under the Securities Act or to comply with the terms and conditions of any exemption thereunder, except as provided in this Section 1.3 and the Investors' Rights Agreement. The certificates representing the Securities may bear restrictive legends in the following form (and a stop-transfer order may be placed against transfer of the Securities): "1. The securities represented by this Certificate have not been registered under the Securities Act of 1933, as amended (the "Act") or any applicable state securities laws, and may not be sold, transferred or assigned, and the Company is not required to give effect to any attempted sale, transfer or assignment, except (i) pursuant to an effective registration statement covering such securities under the Act and any applicable state securities laws, (ii) in a transaction permitted by Rule 144 promulgated under the Act and as to which the Company has received reasonably satisfactory evidence of compliance with the provisions of Rule 144, (iii) to a person who the seller reasonably believes is a Qualified Institutional Buyer -4- within the meaning of Rule 144A promulgated under the Act purchasing for its own account or for the account of a Qualified Institutional Buyer that is aware that the resale, pledge or other transfer is being made in reliance upon Rule 144A promulgated under the Act, or (iv) upon receipt of a legal opinion rendered by counsel (who may be an employee of the party for whom or on whose behalf the opinion is being rendered) reasonably satisfactory to the Company to the effect that the transaction does not require registration under the Act and any applicable state securities laws. 2. The presentation of this Certificate to the transfer agent more than two years after the date of issuance shall be deemed a representation by the holder that the holder is not an affiliate of the Company and the holder has been the beneficial owner of the securities represented by this Certificate for at least two years and is free to sell the securities under Rule 144(k) and any applicable state securities laws. 3. The sale, transfer, assignment, pledge or encumbrance of the securities represented by this Certificate are also subject to the terms and conditions of a Stock Purchase Agreement among the Company and certain holders of outstanding capital stock of the Company. Copies of such agreement may be obtained at no cost by written request made by the holder of record of this Certificate to the Secretary of the Company." SECTION 1.4. Definitions, etc. Certain terms used in this Agreement ----------------- are defined in Article 8 hereof; references to a "Schedule" or "Exhibit" are, unless otherwise specified, to the Schedules and Exhibits attached to this Agreement. All of the Schedules and Exhibits attached to this Agreement are hereby incorporated by reference herein in their entirety. ARTICLE 2. REPRESENTATIONS AND WARRANTIES OF THE COMPANY. --------------------------------------------- The Company hereby represents and warrants to you as follows: SECTION 2.1. Subsidiaries and Investments. ---------------------------- (a) The Company has no Subsidiaries. Except as set forth in Schedule 2.1 hereto, the Company does not own, directly or indirectly, more than 1% of the total outstanding capital stock of any class of any corporation and does not, directly or indirectly, exercise Control or have the ability, directly or indirectly to exercise Control, over any Person. (b) The Company does not have any Investment in any Person (and is not engaged in any joint venture or partnership with any other Person). -5- SECTION 2.2. Organization and Authority. -------------------------- (a) The Company: (i) is a corporation duly organized, validly existing and in good standing under the laws of the Commonwealth of Pennsylvania; (ii) has all requisite power and authority (corporate and other) to own and operate its properties, to conduct its business as currently conducted and as currently proposed to be conducted; and (iii) is duly qualified to do business as a foreign corporation and is in good standing in each jurisdiction in which the failure to so qualify could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect. SECTION 2.3. Capital Stock. On the date hereof and on the First ------------- Closing Date, the authorized capital stock of the Company consists of: (i) 50,000,000 shares of common stock, no par value (the "Common Stock"), and (ii) 20,000,000 shares of preferred stock, no par value, of which 300,000 shares have been designated Series A Shares and 1,800,000 shares have been approved for designation as the Series B Shares. On the date hereon and on the First Closing Date there are 5,230,456 shares of Common Stock issued and outstanding, 2,000,000 of which are owned of record and beneficially by Jason Olim, 2,000,000 of which are owned of record and beneficially by Matthew Olim, 614,556 of which are owned of record and beneficially by Allen Meltzer, 27,496 of which are owned of record and beneficially by David Olim, and 215,748 of which are owned of record and beneficially by Jeffrey McClusky, 186,328 of which are owned of record and beneficially by William Brennan and 186,328 of which are owned of record and beneficially by Anthony Lucenti. On the First Closing Date, after giving effect to the transactions contemplated in this Agreement, there will be 254,582 Series A Shares issued and outstanding. There are no other shares of preferred stock issued and outstanding. All such outstanding shares of capital stock have been duly authorized, validly issued and are fully paid, nonassessable and free of preemptive rights. On each Subsequent Closing Date there shall be no other shares of preferred stock of the Company other than the Series A Shares and Series B Shares issued and outstanding and all shares of Series B Shares issued and outstanding shall have been duly authorized, validly issued, fully paid, non-assessable and free of statutory preemptive rights. Except as set forth in Schedule 2.3 hereto, no shares of Common Stock or Preferred Stock are held in the treasury of the Company. Except as listed in Schedule 2.3, there are no Liens, encumbrances, subscriptions, options, warrants, calls or other rights, agreements or commitments relating to the purchase from or issuance by the Company of any shares of its capital stock, including any right of conversion (except for rights of conversion relating to the Shares) or exchange, actually or contingently, under any outstanding security or other instrument. All Conversion Shares have been duly authorized and reserved for issuance and upon issuance such shares will be duly and validly issued by the Company, fully paid, nonassessable and free and clear of all Liens, taxes, charges, rights of third parties, preemptive rights and rights of first refusal. No further approval or authority of the stockholders or Board of Directors of the Company will be required for the issuance and sale of the Conversion Shares. Except as set forth -6- in Schedule 2.3 hereto, there are no voting trusts or other agreements or understandings with respect to the voting of any capital stock of the Company. Except as set forth in Schedule 2.3 hereto, the Company is not subject to any obligation (contingent or otherwise) to repurchase or otherwise acquire or retire any shares of its capital stock or any security convertible into or exchangeable for any of its capital stock. SECTION 2.4. Contravention; Validity. ----------------------- The execution, delivery and performance by the Company of this Agreement and each of the other documents and agreements related to any of the foregoing, the consummation by the Company of the transactions contemplated hereby and thereby, the authorization, issuance and sale of the Shares and the Conversion Shares as contemplated hereby and compliance by the Company with all of the provisions of this Agreement, and with the terms of the Series A Shares and the Series B Shares, will not, with or without the giving of notice, the passage of time or both, (i) result in any breach or violation of, or conflict with, any statute, law (including any judicial decision), or any judgment, writ, injunction, order, rule, award, decree or regulation of any court, governmental authority or arbitration board or other tribunal; (ii) violate or result in any breach of any of the provisions of, or constitute a default under, give rise to a right of termination or cancellation of, or accelerate the performance required by any terms of, as the case may be, any indenture, mortgage, agreement, lease, license, note, permit, franchise, contract, deed of trust or other instrument to which the Company or any Controlling Person or any of their properties is a party or by which it or any Controlling Person or any of their properties may be bound, or result in the creation of any Lien upon any of the properties or assets owned by the Company, or any Controlling Person or any of their properties; or (iii) violate or conflict with any provision of the Restated Articles, as amended by the Statement With Respect to Shares or the Bylaws attached as Schedule 2.4 hereto, of the Company. (a) Each of the Transaction Documents have been and, upon consummation of each of the First Closing and each Subsequent Closing, the stock certificates representing the Shares will have been, duly and validly executed and delivered by the Company and constitutes the valid and binding obligation of the Company, enforceable against the Company in accordance with its terms. SECTION 2.5. INTENTIONALLY LEFT BLANK. SECTION 2.6. Consents. (a) The execution, delivery and performance -------- of this Agreement and all other documents and agreements related thereto and the offer, issuance and sale by the Company of the Shares and the Conversion Shares are within the Company's corporate powers, have been duly authorized by all necessary corporate action on the part of the Company and do not and will not (i) require any consent or approval of any Person (other than consents or approvals which have been obtained) or any authorization, consent or approval by, or registration, qualification, declaration or filing with, or notice to any federal, state, municipal or other governmental body, official, department, commission, board, bureau, agency or instrumentality, domestic or foreign (other than actions and filings that have been taken or made or the filing of the Statement With Respect to Shares before the First Closing Date), or (ii) result -7- in, or require, the creation or imposition of any mortgage, deed of trust, pledge, Lien, security interest or other charge or encumbrance of any nature upon or with respect to any of the properties now owned or hereafter acquired by the Company. The Company has obtained all consents, approvals or authorizations of, made all declarations or filings with, and given all notices to, all federal, state or local governmental or public authorities or agencies which are necessary for the continued conduct by the Company of its respective business as now conducted or as proposed to be conducted and which the failure to so obtain, make or give could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect. SECTION 2.7. Financial Statements and Other Information; Financial Condition. ------------------------------------------------------------------- (a) Financial Statements. Attached hereto as Schedule 2.7A are -------------------- complete and accurate copies of audited combined financial statements of the Company for Fiscal Years ended December 31, 1996, and December 31, 1995, including audited balance sheets of the Company as of the end of Fiscal Years 1996 and 1995 and audited statements of income, changes in Shareholders' Equity and cash flows of the Company for each such Fiscal Year, together with the report thereon of Arthur Andersen LLP, independent accountants and its unaudited balance sheet, statement of income, and cash flows for the five-month period ended May 31, 1997 (together with the related notes, the "Financial Statements"). The Financial Statements have been prepared in accordance with generally accepted accounting principles applied on a consistent basis during the respective periods. The Financial Statements are complete and present fairly in all material respects the combined financial position of the Company as of such dates and the results of its operations and changes in its cash flows, as the case may be, for such periods subject to normal recurring year-end adjustments and the absence of notes in the case of the May 31, 1997 Financial Statements. The Company does not have any material obligation or liability, individually or in the aggregate, of the nature required to be disclosed on a balance sheet prepared in accordance with generally accepted accounting principles that is not disclosed by the Financial Statements referred to above. Except as set forth in the Financial Statements, the Company is not a guarantor or indemnitor of any Person. (b) Forecasts. Attached hereto as Schedule 2.7B is a copy of a --------- five-year financial forecast of the Company, including forecasted income statements and balance sheets for Fiscal Years 1997 through 2001 (the "Forecasts"). The Forecasts have been prepared on the basis of reasonable assumptions made in good faith by the Company, and at the date on which such assumptions were made, and no events have occurred subsequent thereto that are known to the Company and that reasonably could be expected to have a material adverse effect on the reasonableness of such assumptions. The Company does not know of any reasonable basis for the assertion against the Company of any liability or obligation of any nature whatsoever that is not fully reflected in the Forecasts which, either individually or in the aggregate, could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect. SECTION 2.8. No Material Adverse Change. Except as disclosed in the -------------------------- PPM or Schedule 2.8, since December 31, 1996 there has not been, occurred or arisen any material -8- adverse change in, or any event, condition or state of facts which materially and adversely affects, or threatens to affect in a material and adverse manner, the business, earnings, prospects, properties or condition (financial or otherwise) of the Company. SECTION 2.9. Licenses, Registrations etc. Except as set forth in ---------------------------- Schedule 2.9, the Company owns or possesses, and holds free from burdensome restrictions or known material conflicts with the rights of others, all licenses, authorizations, certificates, consents, approvals, registrations, franchises, permits and waivers, and all rights with respect to the foregoing, necessary for the conduct of its business as now conducted and as proposed to be conducted, except where the failure to hold any such approval could not reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect. The Company and its respective properties are in compliance with the requirements of all regulatory agencies and authorities, except for such non-compliance as could not reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect, and no regulatory agency or authority has taken any action, or threatened to take any action, to revoke or suspend any material license, authorization, permit, certificate, consent, approval or franchise necessary for the conduct of such business as now conducted and as proposed to be conducted. SECTION 2.10. Title to Properties; Leases. The Company is the sole --------------------------- owner of, and has good title to all assets and properties reflected as being owned by it in the balance sheet for the Fiscal Year ended December 31, 1996, as well as to all assets and properties, acquired since said date (except property disposed of since said date in the ordinary course of business). Except for Permitted Liens and except as set forth on Schedule 2.10, there are no Liens on any of such assets or properties. The Company does not have any notice of the assertion of or intent to assert any mechanics' or materialmen's lien with respect to any such assets or properties that could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect. The Company has the right to, and does, enjoy peaceful and undisturbed possession under all leases under which it is leasing property. All such leases are valid, subsisting and in full force and effect, and none of such leases is in default on the part of the Company and to the knowledge of the Company, on the part of any other Person. The Company owns all right, title and interest in and to the tradenames, domain names, servicemarks, logos, and abbreviations and words and combinations thereof associated with the Company's business (collectively, "Names"), whether or not registered, other than Names owned by third parties. The Company owns all right, title and interest in and to, and has the exclusive right to use, the name "CDnow" in the music retailing industry. SECTION 2.11. Compliance with Other Instruments, etc. Except as set --------------------------------------- forth on Schedule 2.11, the Company is not: (a) in violation of any term of its Restated Articles, By-laws or other governing agreement; or (b) in default in the performance, observance or fulfillment of any of the material obligations, covenants or conditions contained in, and is not otherwise in default under, (i) any evidence of Indebtedness for Money Borrowed or any other evidence of Indebtedness or any instrument or agreement under or pursuant to which any evidence of Indebtedness for Money Borrowed or other evidence of Indebtedness has been issued; -9- or (ii) any other material instrument or agreement not listed on Schedule 2.12 to which it is a party or by which it is bound or any of its properties is affected. SECTION 2.12. Contracts and Binding Commitments. --------------------------------- (a) Set forth on Schedule 2.12 hereto is a list of, and the Company has previously furnished to the Purchaser and special counsel to the Purchasers, correct and complete copies, or if none exists, written descriptions of all of the following contracts, agreements or arrangements to which the Company is a party or by which any of its assets or properties are or may be bound (such contracts described in the following paragraphs (i) through (ix) being referred to as the "Contracts"), as such Contracts may have been amended, modified or supplemented: (i) All contracts out of the ordinary course of business and not cancelable upon 30 days notice or calling for the payment of more than $100,000; (ii) All contracts or similarly binding arrangements with any Person containing any provision or covenant limiting the ability of the Company to engage in any line of business or compete with any Person or limiting the ability of any Person to compete with the Company; (iii) All Contracts requiring the Company to keep information secret or confidential; (iv) All contracts relating to the borrowing of money, or the direct or indirect Guaranty of any obligation for, or contract to service the repayment of, money borrowed or any other liability in respect of Indebtedness for Money Borrowed of any other Person; (v) All contracts relating to the future disposition or acquisition of (A) any Investment in any Person, (B) any interest in any business enterprise or joint venture or (C) any interest in any property, and all contracts requiring the Company to purchase any security, business enterprise or any property; (vi) Each employment or consulting contract or any other arrangement or agreement with or for the direct or indirect benefit of any Controlling Person or any member of the Immediate Family of such Controlling Person; (vii) Each contract (other than contracts cancelable upon 90 days notice) involving payments of more than $100,000 during its term for the purchase of materials, supplies, property or services; (viii) All Contracts with Affiliates or between the Company and any relative (whether by blood or marriage) of any director, stockholder, officer, partner or employee of the Company; and -10- (ix) All other Contracts material to the operations of the business of the Company. (b) All of the Contracts are valid and binding in all respects, in full force and effect and enforceable in accordance with their terms except as enforceability by third parties may be limited by applicable bankruptcy, insolvency, reorganization, moratorium or similar laws affecting creditors' rights generally and except as such third party enforceability may be subject to general principles of equity (regardless of whether such enforceability is considered in a proceeding in equity or at law). None of the Contracts contain terms which in the ordinary course of business could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect. The Company and, to the knowledge of the Company, each other party to the Contracts, has performed in all material respects all obligations required to be performed by them to date. Neither the Company and, to the knowledge of the Company, no other party to any of the Contracts, is in or claimed to be in material breach or default in any respect under the Contracts. The issuance and sale of the Shares pursuant to this Agreement or the Conversion Shares will not result in the termination of any of the Contracts will not require the consent of any party thereto (other than the consents set forth on Schedule 2.12A and which have been obtained) and will not bring into operation any other provision thereof nor result in a breach or default thereunder. There exists no condition or event which, after notice or lapse of time or both, would constitute a default by the Company. To the knowledge of the Company, there exists no condition or event which, after notice or lapse of time or both, would constitute a default by any other party to any of the Contracts. (c) The Company is not a party to or bound by (nor is any of its respective properties affected by) any contract or agreement, or subject to any order, writ, injunction or decree or other action of any court or any governmental department, commission, bureau, board or other administrative agency or official, or any charter or other corporate or contractual restriction, which could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect. (d) Except as disclosed in Schedule 2.12, the Company is not a party to any contract or agreement with any Affiliate of any director, officer, stockholder, partner or employee of the Company the terms of which are not commercially reasonable or are less favorable to it than it would obtain in a comparable arm's length transaction with a Person other than an Affiliate. SECTION 2.13. Compliance with Law, etc.; Non-Discrimination. --------------------------------------------- The Company is in full compliance with all laws and ordinances and all governmental rules and regulations to which it is subject, except where the failure so to comply could not be reasonably expected in the judgment of a prudent business person to have a Material Adverse Effect. The Company is not in material default with respect to any order, writ, injunction, judgment or decree of any court or other governmental or public body, department, official, authority or agency or arbitrator or arbitration panel except where such default could not -11- be reasonably expected to have in the judgment of a prudent business person a Material Adverse Effect. The Company does not discriminate against any Person on the basis of race, religion, nationality or sex in the conduct of its business or otherwise. SECTION 2.14. Compliance with ERISA; Multiemployer Plans. ------------------------------------------ Except as set forth in Schedule 2.14 hereto: (a) There are no Plans, and there are no other deferred compensation, bonus, incentive, stock option, stock purchase, child or dependent care, educational assistance, vacation or leave, sick pay, cafeteria or other employee benefit or fringe benefit plans or arrangements sponsored, maintained or contributed to by the Company. Copies of all Plans and other such plans or arrangements (including any amendments and any related trust or other funding agreements) and the most recent annual reports, summary annual reports and summary plan descriptions (or if none is required, other descriptive material) of all Plans and other such plans or arrangements have been delivered to the Purchaser and special counsel to the Purchasers. (b) There is no failure of the Plans, individually or in the aggregate, to be in compliance with the applicable provisions of ERISA, the Code and applicable foreign law that could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect. There is no failure of the Company to make all contributions, and pay all expenses, with respect to the Plans required to be made or paid by it, or to pay or accrue any obligations to contribute, or pay any expenses, with respect to any Plan for the portion of the plan year or other fiscal period ending on the Closing Date that could be reasonably expected in the judgment of a prudent business person to have a Material Adverse Effect. (c) Each Plan that is intended to be qualified under Section 401(a) or 403(a) of the Code, and each Plan trust that is intended to be exempt under Section 501(c)(9) or (17) of the Code, has received a favorable determination letter from the Internal Revenue Service, a copy of the most recent such letter for such plan has been delivered to the Purchaser and special counsel to the Purchaser, and nothing has occurred since the date of such letter with respect to such Plan that could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect. (d) Except for liabilities to make contributions and to pay PBGC premiums and administrative costs, neither the Company nor any ERISA Affiliate has incurred any liability to or on account of any Pension Plan or other Plan under applicable provisions of ERISA, the Code or applicable foreign law, and no condition exists which could reasonably be expected in the judgment of a prudent business person to cause the Company or an ERISA Affiliate to have incurred any such liability that would have a Material Adverse Effect. (e) None of the Plans is a Multiemployer Plan, and neither the Company nor any ERISA Affiliate has contributed or been obligated to contribute to any Multiemployer Plan at any time within the preceding six years. -12- (f) None of the Plans that is not a Pension Plan provides benefits for retired employees except as required by law. (g) There are no actions, suits or claims which have been instituted or asserted, or which could reasonably be expected to be asserted, against or with respect to any Plan, other than claims for benefits under and services rendered to each such plan in the ordinary course. SECTION 2.15. Pending Litigation, etc. Except as set forth in the ------------------------ PPM, there is no action at law, suit in equity or other proceeding or investigation (whether or not purportedly on behalf of the Company) in any court or by or before any other governmental or public body, department, official, authority or agency, or any arbitrator or arbitration panel pending or, to the knowledge of the Company, threatened against or affecting the Company or any of its respective properties that, either individually or in the aggregate, (a) that could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect, or (b) that could question the validity or enforceability of this Agreement, the Shares or the Conversion Shares. SECTION 2.16. Taxes. ----- (a) Except as set forth on Schedule 2.16, as of the First Closing, the Company has filed, in accordance with all applicable laws, all federal, state, local and other returns, reports or declarations with respect to Taxes ("Tax Returns") required to be filed prior to the First Closing Date. All such Tax Returns will have set forth all items required to be set forth therein. In addition, as of the First Closing, the Company will have paid, or will have established adequate reserves for the payment of, all Taxes, whether or not yet due or payable, and whether or not disputed, in respect to the period covered by such Tax Returns and the periods ending December 31, 1996 and May 31, 1997 for which Tax Returns have not yet been filed. The Company will not have a material liability for any Taxes in excess of the amounts so paid or the reserve so established. (b) There are no Taxes due or claimed to be due or threatened by any governmental authority or otherwise for which the Company may be liable in its own right or as a transferee of the assets or successor to any corporation, Person, association, partnership, joint venture or other entity. (c) All amounts required to be withheld or collected under applicable federal, state, local or other tax laws and regulations by the Company for income taxes, social security taxes, unemployment insurance and other employee withholding taxes, or other Taxes, have been so withheld or collected, and such withholding or collection has either been paid to the respective governmental agencies or set aside in accounts for such purpose or accrued and reserved against and entered on the Financial Statements. (d) No deficiencies, adjustments, changes in assessments or increase in tax rate for any Taxes (other than real estate taxes) have been proposed, asserted or assessed (tentatively or definitely) against the Company and no request for waivers of the time to assess -13- any such Taxes are pending. No federal, state, local or other taxing authorities are presently auditing the tax returns of the Company and the Company know of any proposed audit of any such Tax Returns. There is no action, suit, proceeding, audit, investigation, or claim pending or to the knowledge of the Company threatened, in respect of any Taxes for which the Company may become liable in its own right or as a transferee. (e) The Company is not a party to or bound by or obligated under any tax sharing or similar agreement. (f) There are no Liens on any properties or assets of the Company imposed or arising as a result of the delinquent payment or the non- payment of any Taxes. (g) The Company neither (i) has assumed or is liable for any Taxes of any other Person, including any predecessor corporation or partnership, as a result of any purchase of assets or other business acquisition transaction (other than a merger in which the Company or such Person was the surviving corporation or a consolidation) nor (ii) has indemnified any other Person or otherwise agreed to pay on behalf of any other Person any Taxes growing out of or which may be asserted on the basis of any tax treatment adopted with respect to all or any aspect of such a business acquisition transaction. (h) There are no applicable taxes, fees or other governmental charges payable by the Company in connection with the execution and delivery of this Agreement, or the offer, issuance, sale and delivery of the Shares or the Conversion Shares. (i) The termination of the Company's "S" Corporation status as of December 6, 1996 shall not result in the payment of any Taxes by the Company. (j) Neither the shareholders of the Company nor the Company have, as of the date hereof, (A) entered into an agreement or waiver or been requested to enter into an agreement or waiver extending any statute of limitations or having the effect of an extension of time relating to the filing of any Tax Return or the payment, collection or assessment of Taxes of the Company, (B) applied for and not yet received a ruling or determination from a taxing authority regarding a past or prospective transaction of the Company, or (C) is or are presently contesting the Tax liability of the Company before any court, tribunal or agency. (k) The Company has not been included in or joined in the filing of any "consolidated" or "combined" Tax Return for any Tax purpose under the law of the United States, any state or locality with respect to Taxes for any taxable period. The Company is not responsible for any Taxes as a transferee of the assets of, or successor to, any entity or person or on account of its ever having been a member of a consolidated or affiliated group. (l) Since the last filing date of each applicable Tax Return, there has not been any change in any method of reporting income or expenses for federal, state or local Tax purposes followed by the Company. No adjustment to taxable income by reason of a change -14- of accounting method is required in respect of any taxable year of the Company as to which the applicable statutes of limitations have not expired. (m) The Company has not filed a consent with the Internal Revenue Service pursuant to Section 341(f) of the Internal Revenue Code of 1986, as amended (the "Code"), and has not agreed to have Section 341(f)(2) of the ---- Code apply to any disposition of a subsection (f) asset (as defined in Section 341(f) of the Code) owned by the Company. (n) At all times from its inception to December 6, 1996, the Company was an "S corporation" for Federal and Pennsylvania purposes at all times, pursuant to elections to be treated as an S corporation properly made by the Company. The Company has continually qualified to be taxed and has continuously been taxed as an S corporation since the date of its inception until December 6, 1996. (o) Except as set forth in the PPM, the Company is not now and has never been a partner in any partnership and has not participated in any joint venture. SECTION 2.17. Holding Company Act; Investment Company Act. ------------------------------------------- (a) The Company is not a "public utility Company" or a "holding Company", or a "subsidiary Company" of a "holding Company", or an "affiliate" of a "holding Company" or of a "subsidiary Company" of a "holding Company", as such terms are defined in the Public Utility Holding Company Act of 1935, as amended; or a "public utility" within the meaning of the Federal Power Act, as amended. (b) The Company is not an "investment Company" or an "affiliated Person" of an "investment company" or a company "controlled" by an "investment company" as such terms are defined in the Investment Company Act of 1940, as amended. The Company is not an "investment adviser" or an "affiliated Person" of an "investment adviser" as such terms are defined in the Investment Advisers Act of 1940, as amended. SECTION 2.18. No Margin Regulation Violation. None of the ------------------------------ transactions contemplated by this Agreement (including, without limitation, the direct or indirect use of the proceeds from the sale of the Securities), will violate or result in a violation of Section 7 of the Exchange Act or any regulations issued pursuant thereto as now in effect, including, without limitation, Regulation G (12 C.F.R., Part 207), as amended, Regulation T (12 C.F.R., Part 220), as amended, Regulation U (12 C.F.R., Part 221), as amended and Regulation X (12 C.F.R., Part 224), as amended, of the Board of Governors of the Federal Reserve System. The Company does not own any Margin Stock and the proceeds received by the Company from the sale of the Securities will not be used for the purpose of purchasing or carrying a Margin Stock or for the purpose of reducing or retiring any indebtedness which was originally incurred to purchase a Margin Stock or for any other purpose not permitted by Regulation G (12 CFR Part 207) of the Board of Governors of the Federal Reserve System, as amended from time to time. -15- SECTION 2.19. Outstanding Securities. Assuming the accuracy of the ---------------------- representations set forth in Section 1.3 hereof, all securities (as defined in the Securities Act) of the Company have been offered, issued, sold and delivered in compliance with all applicable federal and state laws, and the rules and regulations of federal and state regulatory bodies governing the offering, issuance, sale and delivery of securities. Assuming the accuracy of the representations set forth in Section 1.3 hereof the Company is not required to file on the date hereof nor has it filed prior to the date hereof, nor will it be required to file on the First Closing Date and each Subsequent Closing Date, pursuant to Section 12 of the Exchange Act, a registration statement relating to any class of debt or equity securities. Except as set forth in Schedule 2.19 hereto or pursuant to Article 7 hereof or pursuant to this Agreement, the Company has not registered on or prior to the date hereof or agreed to register any securities under the Securities Act. SECTION 2.20. Events Since December 31, 1996. ------------------------------ Except as provided in Schedule 2.20, since December 31, 1996, there has not been: (i) Any material change in the business policies or practices of the Company which are not described in the PPM; (ii) Any damage, destruction or loss (whether or not covered by insurance) which has had or could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect; (iii) Any Indebtedness for Money Borrowed incurred by the Company or any commitment to borrow money entered into or any Guaranty given by the Company; (iv) Any amendments to the Articles of Incorporation of the Company or to the By-laws of the Company; (v) Any change in any method of accounting or accounting practice by the Company; (vi) Any amendment, modification, alteration or termination of any contract, agreement or license to which the Company is a party, which could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect; (vii) Any waiver of any rights of material value or any cancellation of any material claims, debts or accounts receivable owing to the Company; -16- (viii) Any employment, bonus, incentive or deferred compensation agreement or arrangement between the Company and an Affiliate, director, officer or other employee or consultant of the Company; or (ix) Any change in or agreement to change or modify the terms of any stock option, stock plan or any employee benefit plan of the Company. SECTION 2.21. Compliance with Environmental Laws. ---------------------------------- Except as set forth in Schedule 2.21 hereto: (a) The Company is in full compliance with all Environmental Laws governing its business, assets and all real estate it owns, leases or operates, for which failure to comply could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect. The Company is not liable for any penalties, fines or forfeitures which could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect for failure to comply with any Environmental Laws. All licenses, permits, registrations, certificates and other approvals required by the Environmental Laws for the business of the Company or required in connection with its ownership, leasing or operation of all real estate have been secured where the failure to do so could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect, and the Company is in compliance therewith where the failure to comply could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect. (b) As used herein, the term "Hazardous Material" shall mean any hazardous or toxic chemical, solid, liquid, gas or other substance, material, pollutant or waste which is regulated by any federal, state or local governmental authority, including, but not limited to, the following: hazardous substances as defined under the Comprehensive Environmental Response, Compensation and Liability Act, as amended ("CERCLA"), 42 U.S.C. Sections 9601 et seq., hazardous waste as defined under the Solid Waste Disposal Act, as - ------- amended, 42 U.S. C. Section 6901 et seq.; air pollutants regulated under the ------- Clean Air Act, as amended, 42 U.S.C. Section 7401 et seq. pollutants as defined ------- under the Clean Water Act, as amended, 33 U.S.C. Sections 1251 et seq.; any ------- pesticide as defined by the Federal Insecticide, Fungicide, and Rodenticide Act, as amended, 7 U.S.C. Sections 136 et seq.; any hazardous chemical substance or mixture or imminently hazardous substance or mixture regulated by the Toxic Substances Control Act, as amended, 15 U.S.C. Sections 2601 et seq.; any ------- substance listed in the United States Department of Transportation Table at 49 CFR 172.101; any petroleum, crude oil, gasoline, natural gas, liquefied natural gas, synthetic fuel or other petroleum, oil or gas based products, any explosives, any radioactive, nuclear or atomic material and any asbestos or asbestos containing material. (c) To the knowledge of the Company no Hazardous Material is present or is suspected to be present in the air, soil, groundwater, surface water, or waterways or in any structure at or under any property currently or formerly owned, leased or operated by the Company, in quantities or concentrations sufficient to require investigation, removal or -17- remediation under the Environmental Laws for which the Company could have financial responsibility, which presence could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect. (d) Neither the Company, nor, to the knowledge of the Company any other Person, has ever caused or permitted any Hazardous Material to be Released, generated, stored, transported or disposed of on any properties formerly or currently owned, leased or operated by the Company, in violation of the Environmental Laws, where such actions could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect. (e) The Company (i) has not ever been held legally responsible for any release or threatened release of any Hazardous Material; (ii) does not currently own, lease or operate, or to its knowledge, has ever in the past owned, leased or operated, any property listed or proposed for listing on the National Priority List under CERCLA, or on the Comprehensive Environmental Response, Compensation Liability Information System or any similar state list of sites requiring investigation or clean-up; or (iii) has not ever been required to pay the costs or expenses incurred for the release or threatened release of any Hazardous Material, where any of such actions could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect. The Company is not aware of any other condition or occurrence relating to any Hazardous Material that could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect. (f) There are no outstanding notices of violation, orders, claims, citations, complaints, penalty assessments, suits or other proceedings, administrative, civil or criminal, at law or in equity, pursuant to Environmental Laws pending against the Company, and to the knowledge of the Company, no investigation or review is pending or threatened, with respect to any release or threatened release of Hazardous Materials or with respect to any alleged violation of any Environmental Law, in connection with the business of or the ownership, leasing or operation of any real estate by the Company, any of which could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect. (g) The Company has delivered to the Purchaser and special counsel to the Purchasers true, complete and correct copies of all environmental reports, inspections, investigations, studies, audits, tests, reviews or other analyses in its possession with respect to the properties it owns, leases or operates. SECTION 2.22. Labor Relations. No employees of the Company are covered by --------------- a collective bargaining agreement to which the Company is subject. The Company is not or has not engaged in any unfair labor practice which could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect. There is (a) no unfair labor practice complaint pending or, to the best knowledge of the Company, threatened against the Company before the National Labor Relations Board which could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect and no grievance or arbitration proceeding arising out of or under a collective bargaining agreement is so pending or -18- threatened; (b) no strike, material labor dispute, slowdown or stoppage pending or, to the knowledge of the Company, threatened against the Company; (c) no union representation question existing with respect to the employees of the Company and no union organizing activities are taking place with respect to any thereof; and (d) no strike, material labor dispute, slowdown or stoppage pending or, to the knowledge of the Company, threatened against any Person that could materially adversely affect the ability of the Company conduct its business as currently contemplated. SECTION 2.23. Broker's or Finder's Commissions. Other than fees -------------------------------- payable to the Agent, no broker's or finder's fee or similar fee or commission will be payable by the Company, or any of the Controlling Persons with respect to the issuance, sale and delivery of the Securities or with respect to any of the transactions contemplated hereby. SECTION 2.24. Insurance. The Company has, with respect to its --------- respective properties and businesses, with financially sound insurers of nationally recognized stature and responsibility, insurance of such a nature, with such terms and in such amounts, as a prudent person would maintain with respect to similar properties, including without limitation fire and casualty insurance, sufficient in amount (subject to reasonable deductibles) to allow it to replace any of its properties that might be damaged or destroyed. SECTION 2.25. Private Offering. Neither the Company, any of the ---------------- Controlling Persons nor any agent on its or their behalf has directly or indirectly offered any of the Securities or any similar security of the Company for sale to, or solicited any offer to buy any thereof with, any prospective purchaser, under circumstances which would require that any of the Securities be registered under the Securities Act or any applicable state securities law. Based on the representations in Section 1.3 hereof, the offer and sale of the Securities to the Purchasers is, and the issuance by the Company of the Conversion Shares upon conversion of the Shares will be, exempt from registration under the Securities Act and all applicable state securities laws. SECTION 2.26. Other Names. The businesses conducted by the Company ----------- prior to the date hereof have not been conducted, during the past three (3) years, under any corporate, trade or fictitious name other than those names listed in Schedule 2.26 hereto. SECTION 2.27. Intellectual Property Rights. Except as set forth on ---------------------------- Schedule 2.27: (a) The Company owns or has the right to use those trademarks and other Intellectual Property Rights (as defined below) identified in Schedule 2.27 or used in the ordinary course of its business (collectively the "Requisite Rights"), as well as those works created by employees in the scope of their employment. Except as set forth in Schedule 2.27, none of the Requisite Rights or their past or current uses has infringed or infringes, in any material respect, upon any patent, copyright, trade secret or other proprietary right of any person or company; and to the Company's knowledge no person or company is infringing upon any of the Requisite Rights; -19- (b) no royalties, honoraria or fees are payable by the Company to other persons by reason of the ownership or use of the Requisite Rights; and (c) no product, service or process manufactured, marketed, sold or used, or proposed to be manufactured, marketed, sold or used, by the Company violates, or will violate, any license or infringes, or will infringe, any Intellectual Property Rights or assumed name of another and there is no pending or threatened claim or litigation against the Company (nor does there exist any basis therefore) contesting the validity of or right to use any of the foregoing, nor has the Company received any notice that any of the Requisite Rights or the operation or proposed operation of the Company's business conflicts, or will conflict, with the asserted rights of others, nor does there exist any basis for any such conflict. As used in this Agreement, the term "Intellectual Property Rights" means all industrial and intellectual property rights, including, without limitation, patents, patent applications, patent rights, trademarks, trademark applications, trade names, service marks, service mark applications, copyrights, know-how, certificates of public convenience and necessity, franchises, licenses, trade secrets, proprietary processes and technology and formulas. (d) The Company has delivered to Purchaser and its special counsel the form of agreement between the Company and its employees concerning the Company's Intellectual Property Rights, and has delivered to special counsel to the Purchasers all agreements substantially similar to such form executed by the Company's employees. SECTION 2.28. Full Disclosure. None of the Transaction Documents --------------- (including all Exhibits and Schedules hereto and any other agreements or documents delivered on the First Closing Date or delivered on each Subsequent Closing Date), the PPM or any written certificate, documents, or report (collectively, "Documents") delivered or furnished to the Purchasers or their special counsel by or on behalf of the Company pursuant to or in accordance with this Agreement, or the transactions contemplated hereby or the sale of the Securities, contains any untrue statement of a material fact or omits to state a material fact necessary to make the statements contained herein or therein not misleading and in light of the circumstances under which they were made. There is no fact known to the Company that has not been disclosed to the Purchasers or their special counsel in writing that (a) has or could reasonably be expected in the judgment of a prudent business person to have a Material Adverse Effect or (b) adversely and materially affects or could reasonably be expected in the judgment of a prudent business person to have a material and adverse effect on the ability of the Company to perform its obligations under this Agreement, the Series A Shares or the Series B Shares. SECTION 2.29. Use of Proceeds. The proceeds from the sale of the --------------- Securities will be solely used by the Company in the manner set forth in the PPM. -20- ARTICLE 3. REPRESENTATIONS AND WARRANTIES OF THE CONTROLLING PERSONS. ------------------- Each of the Controlling Persons severally but not jointly hereby represents and warrants to the Purchasers and the Company as follows: SECTION 3.1. Validity. The Transaction Documents have has been duly and -------- validly executed and delivered by such Controlling Person and, to the extent that any Transaction Document imposes obligations on such Controlling Person, constitutes the valid and binding obligation of such Controlling Person, enforceable against each of the Controlling Persons in accordance with its terms. SECTION 3.2. Transactions with Affiliates. Except as disclosed in ---------------------------- Schedule 2.12, the Company is not a party to any contract or agreement with any Controlling Person, Affiliate of such Controlling Person, or any director, officer, stockholder, partner or employee of the Company, or to the knowledge of such Controlling Person, any Affiliate of any director, officer, stockholder, partner or employee of the Company the terms of which are not commercially reasonable or are less favorable to it than it would obtain in a comparable arm's length transaction with a Person other than an Affiliate. SECTION 3.3. Taxes. ----- (a) As of the First Closing Date, each Controlling Person will have filed, in accordance with all applicable laws, all federal and state income Tax returns ("Controlling Person Returns") required to be filed prior to the First Closing Date and will have set forth therein with reasonable accuracy his respective share of all items of income, gain, loss, deduction and credit (hereinafter referred to as "Flow-Through Items") attributable to his direct or indirect ownership of the Company prior to the termination of "S" Corporation status. Such Controlling Person has paid all federal and state income Taxes required to be paid on or before the First Closing Date with respect to his allocable share of Flow-Through Items and will timely pay all federal and state income Taxes required to be paid following the First Closing Date with respect to those Flow-Through Items required to be reflected on such Controlling Person Returns due following the First Closing Date. (b) All amounts required to be withheld or collected under applicable federal, state, local or other tax laws and regulations by the Company for income taxes, social security taxes, unemployment insurance and other employee withholding taxes, or other Taxes, have been so withheld or collected, and such withholding or collection has either been paid to the respective governmental agencies or set aside in accounts for such purpose or accrued and reserved against and entered on the Financial Statements. SECTION 3.4. Stock Ownership. On the date hereof, and the First Closing --------------- Date, such Controlling Person is the owner of record and beneficial owner of 2,000,000 shares of Common Stock. -21- ARTICLE 4. CONDITIONS OF OBLIGATION TO PURCHASE SECURITIES AT FIRST CLOSING. - ---------------------------------------------------------------- The Purchaser's obligation to purchase and pay for the Securities to be purchased by it hereunder on the First Closing Date shall be subject to the satisfaction, prior to or concurrently with such purchase and payment, of the following conditions: SECTION 4.1. Opinions of Counsel for the Company. Purchaser shall have ----------------------------------- received from Morgan, Lewis & Bockius, LLP special counsel for the Company, an opinion, dated the First Closing Date, in substantially the form set forth in Schedule 4.1 hereto. The Company hereby covenants and agrees to instruct such counsel to prepare and deliver to Purchaser pursuant to this Section 4.1 its opinion referred to above. SECTION 4.2. Performance of Obligations. The Company shall have performed -------------------------- and complied in all material respects with all obligations, covenants and conditions contained herein which are required to be performed or complied with by the Company prior to or on the First Closing Date, and Purchaser shall have received a certificate from the President and the Chief Financial Officer or Controller of the Company, dated the First Closing Date, to such effect. SECTION 4.3. Representations True; No Event of Default. The ----------------------------------------- representations and warranties of the Company set forth in Article 2 of this Agreement and each Controlling Person contained in Article 3 of this Agreement shall be true and correct in all material respects on and as of the First Closing Date with the same effect as though such representations and warranties had been made on and as of the First Closing Date. Purchaser shall have received a certificate from the President and the Chief Financial Officer or Controller of the Company and a certificate from each Controlling Person, dated the First Closing Date, to the effect of each of the foregoing sentences as applicable. SECTION 4.4. Tender of Shares; Consummation of Related Transactions. ------------------------------------------------------ The Company shall tender to the Purchaser a certificate representing the Shares being purchased by it hereunder. SECTION 4.5. Fees and Disbursements of Special Counsel for Purchaser. ------------------------------------------------------- Eilenberg & Zivian, special counsel to Purchaser, shall have received payment by check of the invoice rendered for its fees and disbursements posted through the date of such invoice (with the understanding that a supplemental statement for fees and disbursements subsequently posted is to be rendered at a later date), such aggregate fees and disbursements not to exceed $7,500, in connection with Purchaser's purchase of Shares hereunder. SECTION 4.6. Legality. Each of the Securities shall qualify as a legal -------- investment for Purchaser under all applicable laws and Purchaser's purchase thereof shall not cause it to be subject to any onerous or burdensome legal requirement or penalty. -22- SECTION 4.7. Consents and Approvals. The Company shall have delivered to ---------------------- Purchaser a certificate of the President and the Chief Financial Officer, dated the First Closing Date, listing any necessary consents, waivers, approvals, authorizations, registrations, filings and notifications of the character referred to in Section 2.6 hereof, to which shall be attached evidence satisfactory to Purchaser that the same have been obtained or made and are in full force and effect, or stating that none is necessary. SECTION 4.8. Certificate of Incorporation. The Restated Articles, shall ---------------------------- be in full force and effect without further amendment or modification thereto, and Purchaser shall have received evidence of the filing thereof. The Restated Articles shall provide that the authorized number of the directors of the Company shall be eight (8),two (2) of whom shall only have the right to a one- half vote and six (6) of whom shall have the right to a whole vote for all matters to be voted upon by the directors. The Restated Articles shall further provide that all Subchapters of Article 25 of the Pennsylvania Business Corporation Law shall not be applicable to the Company. SECTION 4.9. Proceedings, Instruments, etc. All proceedings and actions ----------------------------- taken on or prior to the First Closing Date in connection with the transactions contemplated by this Agreement and all instruments incident thereto shall be in form and substance satisfactory to Purchaser and its special counsel, and Purchaser and its special counsel shall have received copies of all documents that they may request in connection with such proceedings, actions and transactions (including, without limitation, copies of court documents, certifications and evidence of the correctness of the representations and warranties contained herein and certifications and evidence of the compliance with the terms and the fulfillment of the conditions of this Agreement, in form and substance satisfactory to Purchaser and its special counsel). SECTION 4.10. Corporate Proceedings. Purchaser and its special counsel --------------------- shall have received: (i) the Restated Articles and all amendments thereto (including the Statement With Respect to Shares) certified by the Secretary of State of the Commonwealth of Pennsylvania; (ii) a Certificate from the Secretary of the State Commonwealth of Pennsylvania certifying the good standing of the Company; (iii) the By-laws of the Company, certified by the Secretary or Assistant Secretary of the Company; (iv) the resolutions of the Board of Directors and stockholders of the Company taking appropriate action to authorize and approve the execution, delivery and performance of this Agreement, the offer, sale, issuance and delivery of the Shares and the Conversion Shares and each other agreement and document required to be executed and delivered pursuant hereto and thereto, and approving and authorizing the other transactions contemplated hereby and thereby, (v) an incumbency certificate with the signatures of the officers of the Company executing the foregoing agreements, certificates, and the stock certificates representing the Shares; and (vi) copies of such other documents and papers as Purchaser or its special counsel may reasonably request in connection therewith, all in form and substance reasonably satisfactory to Purchaser and its special counsel. SECTION 4.11. Legislation. No federal, state, local or foreign law, rule ----------- or regulation shall have been enacted which prohibits the consummation of the transactions contemplated hereby. -23- SECTION 4.12. No Adverse Change. No Material Adverse Effect shall have ----------------- occurred since December 31, 1996, as determined by Purchaser. Purchaser shall have received a Certificate from the President and the Chief Financial Officer or Controller dated the First Closing Date, to the effect of the foregoing sentence. SECTION 4.13. No Proceedings. No order of any court or governmental -------------- authority shall be in effect which restrains or prohibits the transactions contemplated hereby and no suit, action, investigation, inquiry or proceeding by any governmental authority or any other Person or legal or administrative proceeding shall be pending or threatened which challenges the consummation of the transactions contemplated hereby or which may have a Material Adverse Effect. SECTION 4.14. Payment of Fees. All fees and taxes in connection with --------------- the offer, issuance, sale and delivery of the Shares or in connection with the execution, delivery and performance of this Agreement payable to any governmental authority shall have been paid by the Company. SECTION 4.15. Investors' Rights Agreement. The Company, the Purchaser and --------------------------- each Security holder (as defined in the Investors' Rights Agreement) shall have entered into the Investors' Rights Agreement in the form attached hereto as Exhibit C. SECTION 4.16. Comfort Letter. Purchaser and Agent shall have received a -------------- "comfort letter" dated the First Closing Date, signed by the independent public accountants who have certified the Company's financial statements included in the PPM, covering such matters with respect to the PPM as are reasonably requested by Purchaser and Agent. SECTION 4.17. Agent Warrant. The Company shall have issued an Agent ------------- Warrant in the form attached as Exhibit D hereto. ARTICLE 5. CONDITIONS OF OBLIGATION TO PURCHASE SECURITIES AT EACH SUBSEQUENT CLOSING -------------------------- Each Additional Purchaser's obligation to purchase and pay for the Securities to be purchased by him (it) hereunder on each Subsequent Closing Date shall be subject to the satisfaction, prior to or concurrently with such purchase and payment, of the following conditions, the waiver of which shall not be effective against any Additional Purchaser who does not consent in writing thereto: SECTION 5.1. Opinion of Counsel for the Company. Each Additional ---------------------------------- Purchaser shall have received from Morgan, Lewis & Bockius, special counsel for the Company, an opinion, dated the Subsequent Closing Date on which the Company is selling Series B Shares to such Additional Purchaser, in substantially the form set forth in Schedule 5.1 hereto. The -24- Company hereby covenants and agrees to instruct such counsel to prepare and deliver to each Additional Purchaser pursuant to this Section 5.1 its opinion referred to above. SECTION 5.2. Performance of Obligations. The Company shall have performed -------------------------- and complied in all material respects with all obligations, covenants and conditions contained herein which are required to be performed or complied with by the Company prior to or on each Subsequent Closing Date, and the Company shall have received a certificate from the President and Chief Financial Officer or Controller of the Company, dated such Subsequent Closing Date, to such effect. SECTION 5.3. Representations True; No Event of Default. The ----------------------------------------- representations and warranties of the Company set forth in Article 2 of this Agreement and each Controlling Person contained in Article 3 of this Agreement shall be true and correct in all material respects on and as of each Subsequent Closing Date with the same effect as though such representations and warranties had been made on and as of each Subsequent Closing Date (except to the extent such representations and warranties specifically refer to an earlier date). All references to the First Closing or the First Closing Date shall be deemed to refer to each Subsequent Closing or each Subsequent Closing Date respectively. Each of the Purchasers shall have received a certificate from the President and the Chief Financial Officer of the Company and a certificate from each Controlling Person, dated each Subsequent Closing Date, to the effect of each of the foregoing sentences as applicable. SECTION 5.4. Tender of Shares; Consummation of Related Transactions. The ------------------------------------------------------ Company shall tender to each Additional Purchaser a certificate representing the Shares being purchased by such Additional Purchaser hereunder. SECTION 5.5. Fees and Disbursements of Special Counsel for Purchasers. On -------------------------------------------------------- the first Subsequent Closing Date, Schnader Harrison Segal & Lewis LLP, special counsel to the Purchasers, shall have received payment by check of the invoice rendered for its fees and disbursements posted through the date of such invoice (with the understanding that a supplemental statement for fees and disbursements subsequently posted is to be rendered at a later date), such aggregate fees and disbursements not to exceed $35,000, in connection with the Purchasers' purchase of Shares hereunder. SECTION 5.6. Legality. Each of the Securities shall qualify as a legal -------- investment for each Additional Purchaser under all applicable laws and his (its) purchase thereof shall not cause him (it) to be subject to any onerous or burdensome legal requirement or penalty. SECTION 5.7. Consents and Approvals. The Company shall have delivered to ---------------------- all Additional Purchasers a certificate of the President and the Chief Financial Officer, or Controller dated the Second Closing Date, listing any necessary consents, waivers, approvals, authorizations, registrations, filings and notifications of the character referred to in Section 2.6 hereof, to which shall be attached evidence satisfactory to each Additional Purchaser that the same have been obtained or made and are in full force and effect, or stating that none is necessary. -25- SECTION 5.8. Statement With Respect To Shares. The Statement With Respect -------------------------------- To Shares shall be in full force and effect without further amendment or modification thereto from its original filing date, and each of the Purchasers shall have received evidence of the filing thereof. SECTION 5.9. Proceedings, Instruments, etc. All proceedings and actions ----------------------------- taken on or prior to each Subsequent Closing Date in connection with the transactions contemplated by this Agreement and all instruments incident thereto shall be in form and sub stance satisfactory to each of the Purchasers and their special counsel, and each of the Purchasers and their special counsel shall have received copies of all documents that they may request in connection with such proceedings, actions and transactions (including, without limitation, copies of court documents, certifications and evidence of the correctness of the representations and warranties contained herein and certifications and evidence of the compliance with the terms and the fulfillment of the conditions of this Agreement, in form and substance satisfactory to each of the Purchasers and their special counsel). SECTION 5.10. Corporate Proceedings. Each of the Purchasers and their --------------------- special counsel shall have received: (i) the Restated Articles and all amendments thereto (including the Statement With Respect to Shares), certified by the Secretary of State of the Commonwealth of Pennsylvania; (ii) a Certificate from the Secretary of State of the Commonwealth of Pennsylvania certifying the good standing of the Company; (iii) the By-laws of the Company, certified by the Secretary or Assistant Secretary of the Company; (iv) the resolutions of the Board of Directors and stockholders of the Company taking appropriate action to authorize and approve the execution, delivery and performance of this Agreement, the offer, sale, issuance and delivery of the Shares and the Conversion Shares and each other agreement and document required to be executed and delivered pursuant hereto and thereto, and approving and authorizing the other transactions contemplated hereby and thereby certified by the Secretary of the Company; (v) an incumbency certificate with the signatures of the officers of the Company executing the foregoing agreements, certificates, and the stock certificates representing the Shares; and (vi) copies of such other documents and papers as each Additional Purchaser or their special counsel may reasonably request in connection therewith, all in form and substance reasonably satisfactory to each Additional Purchaser and their special counsel. SECTION 5.11. Legislation. No federal, state, local or foreign law, rule ----------- or regulation shall have been enacted which prohibits the consummation of the transactions contemplated hereby. SECTION 5.12. No Adverse Change. No Material Adverse Effect shall have ----------------- occurred since the date of this Agreement, as determined by each Additional Purchaser. Each Additional Purchaser shall have received a Certificate from the President and the Chief Financial Officer or Controller dated the Subsequent Closing Date on which the Company is selling Series B Shares to such Additional Purchaser, to the effect of the foregoing sentence. -26- SECTION 5.13. No Proceedings. No order of any court or governmental -------------- authority shall be in effect which restrains or prohibits the transactions contemplated hereby and no suit, action, investigation, inquiry or proceeding by any governmental authority or any other Person or legal or administrative proceeding shall be pending or threatened which challenges the consummation of the transactions contemplated hereby or which may have a Material Adverse Effect. SECTION 5.14. Payment of Fees. All fees and taxes in connection with the --------------- offer, issuance, sale and delivery of the Shares or in connection with the execution, delivery and performance of this Agreement payable to any governmental authority shall have been paid by the Company. SECTION 5.15. Investors' Rights Agreement. Each Securityholder (as --------------------------- defined in the Investors' Rights Agreement) shall have entered into the Investors' Rights Agreement. SECTION 5.16. Comfort Letter. Agent shall have received a "comfort -------------- letter" dated each Subsequent Closing Date, signed by the independent public accountants who have certified the Company's financial statements included in the PPM, covering such matters with respect to the PPM as are reasonably requested by Agent. SECTION 5.17. Agent Warrant. The Company shall have issued to Agent an ------------- Agent Warrant in the form attached as Exhibit D hereto. ARTICLE 6. COVENANTS OF THE COMPANY. ------------------------ The Company covenants and agrees as follows: SECTION 6.1. Financial Statements. (a) The Company shall furnish to each -------------------- holder of any Shares, Conversion Shares or Agent Warrant as soon as available, but in any event within 45 days after the close of each of the first three quarterly accounting periods in each fiscal year of the Company, (i) an unaudited balance sheet of the Company prepared in accordance with generally accepted accounting principles as at the end of such quarter, (ii) an unaudited consolidated statement of revenues and expenses of the Company prepared in accordance with generally accepted accounting principles for that quarter and for the portion of the fiscal year ending with such quarter, (iii) an unaudited consolidated statement of stockholders' equity of the Company prepared in accordance with generally accepted accounting principles, for that quarter, and (iv) an unaudited consolidated statement of cash flows of the Company in accordance with generally accepted accounting principles; all such statements provided for by clauses (i), (ii), (iii) and (iv) shall be in reasonable detail, shall set forth comparable figures for the same accounting period in the preceding fiscal year and any and all variances from budgeted amounts, and shall contain management's written explanation for the Company's financial condition, changes to its financial condition and results of operations for the period. -27- (b) The Company will furnish to each holder of any Shares or Conversion Shares, as soon as available, but in any event within 90 days after the close of each fiscal year of the Company, duplicate signed copies of an audit report prepared and certified (without qualification as to the scope of the audit) by Arthur Andersen LLP or another firm of independent certified public accountants of national standing selected by the Company, which report shall include a balance sheet of the Company prepared in accordance with generally accepted accounting principles, as at the end of such year, and statements of income, retained earnings and cash flows of the Company prepared in accordance with generally accepted accounting principles, reflecting its operations during said year. All such financial statements shall be in reasonable detail and shall set forth comparable figures for the preceding fiscal year. Such statements shall contain management's written explanation for the Company's financial condition, changes to its financial condition and results of operations for the fiscal year. (c) The Company, at the time of the delivery of the reports and financial statements referred to in paragraphs (a) and (b) above, will deliver to each holder of any Shares or Conversion Shares a certificate signed by the Chief Executive or Chief Financial Officer of the Company, certifying that such financial statements have been prepared in accordance with generally accepted accounting principles consistently applied (except for changes in application in which the accountants concur), and present fairly the financial condition of the Company as of the end of such fiscal period and the results of its operations for the period then ended, subject, in the case of interim financial statements, to year-end adjustments. SECTION 6.2. Other Information. The Company shall deliver to each holder ----------------- of any Shares, Conversion Shares or Agent Warrant: (a) immediately upon their becoming available one copy of each financial statement, proxy statement, report or notice sent by the Company to stockholders of the Company generally, and of each regular or periodic report and any registration statement or prospectus, if any, filed by the Company, with any securities exchange or with the SEC or any successor agency or any similar or analogous governmental or quasi-governmental body outside of the United States of America; and (b) with reasonable promptness, such other data and information as from time to time is reasonably requested. SECTION 6.3. Rule 144A. As long as the Purchaser, any Additional --------- Purchaser or Agent holds any Shares, Conversion Shares or Agent Warrant, the Company shall take any and all actions necessary to enable such holder to sell such securities held or any part thereof in reliance upon Rule 144A, including but not limited to, furnishing such holder and prospective purchasers with the information and financial statements specified in subsection (d) of Rule 144A or any successor section or rule. -28- SECTION 6.4. Shares. The Company shall at all times keep validly ------ reserved a sufficient number of shares of its Common Stock to provide for the conversion of the Shares into shares of Common Stock. and a sufficient number of Series B Shares to provide for the exercise of the Agent Warrant for Series B Shares. SECTION 6.5. Inspection. The Company will permit any holder of Shares, ---------- Conversion Shares or Agent Warrant or such holder's potential transferee, by each of its representatives, agents or attorneys, to examine all books of account, records, reports and other papers of it, to make copies and take extracts from any thereof, to discuss the affairs, finances and accounts of it with its officers and independent accountants (and by this provision the Company hereby authorizes said accountants to discuss with any such holder the finances and accounts of the Company) and to visit and inspect, upon reasonable advance notice and at reason able times during normal business hours, the properties of the Company provided, however, that the Company shall not be obligated pursuant to this Section 6.5 to provide access to any information which it reasonably considers to be a trade secret the disclosure of which the Company reasonably believes may adversely affect its business unless the Person making the inspection signs a confidentiality agreement. Each such inspection shall be at the expense of the Person making the inspection, unless such inspection shall be made as a result of the occurrence and during the continuance of any default by Company of its obligations under this Agreement or the Restated Articles, as amended (in which event, the reasonable expense of such inspection shall be borne by the Company). Notwithstanding the foregoing sentence, it is understood and agreed by the Company that all expenses in connection with any such inspection incurred by the Company or any other Person, any officers and employees thereof and the attorneys and independent certified public accountants therefor shall be expenses payable by the Company and shall not be expenses of the Person making the inspection. Purchaser and each Additional Purchaser acknowledges that he (it) will hold, and will cause his (its) counsel and agents to hold, in confidence and not disclose any confidential data or information (other than information that is now or hereafter becomes in the public domain other than through the actions of any holder or their agents or that was previously in his (its) possession) made available to him (it) in connection with this Agreement (including without limitation pursuant to this Section 6.5) using the same standard of care to protect such confidential data or information as is used to protect his (its) confidential information. SECTION 6.6. Prohibited Offers. The Company and each of the Purchasers ----------------- agree that neither such person nor anyone on its or their behalf will offer any of the Securities, the Agent Warrant or any part thereof or any similar security for issue or sale to, or solicit any offer to acquire any of the same from, anyone so as to bring the issuance and sale of the Securities to the Purchasers or the Agent Warrant to the Agent within the provisions of Section 5 of the Securities Act or of any applicable state securities laws. SECTION 6.7. Termination. The Company's covenants in Sections 6.1, 6.2, ----------- 6.3 and 6.5 hereof shall terminate upon the consummation of a Qualified Public Offering (as defined in the Statement With Respect to Shares). -29- SECTION 6.8. Prohibited Sales. The Company covenants that except as ---------------- otherwise consented to in writing by the holder of the Series A Shares, which consent shall not be unreasonably withheld, (a) it shall only sell Series B Shares pursuant to the terms of this Agreement, the Investor Rights Agreement referred to above, and the other Transaction Documents, (b) it shall not extend to any purchaser of Series B Shares any rights or terms which are greater than or preferential to the rights and terms of the Series B Shares set forth in this Agreement, the Investor Rights Agreement, the Company's Certificate of Incorporation and the other Transaction Documents, and (c) shall not enter into any contract or agreement with any purchaser of Series B Shares other than the Transaction Documents. SECTION 6.9. Tax Returns. The Company shall have filed with all ----------- applicable taxing authorities its Tax Returns for the years ended December 6, 1996 and December 31, 1996 no later than August 31, 1997. ARTICLE 7. REGISTRATION RIGHTS ------------------- The parties agree that the Purchasers and Agent shall have the registration and other rights set forth in the Investors' Rights Agreement. ARTICLE 8. INTERPRETATION OF AGREEMENT. --------------------------- SECTION 8.1. Definitions. Except as the context shall otherwise ----------- require, the following terms shall have the following meanings for all purposes of this Agreement (the definitions to be applicable to both the singular and the plural form of the terms defined, where either such form is used in this Agreement): The term "Affiliate", with respect to any Person, shall mean (a) any --------- director, officer or employee or any member of the Immediate Family of such Person, (b) any Person directly or indirectly controlling or controlled by or under direct or indirect common control with such Person, and (c) any Person beneficially owning or holding 5% or more of any class of voting securities of such Person or any corporation of which such Person beneficially owns or holds, in the aggregate, 5% or more of any class of voting securities; provided, -------- however, that neither any of the Purchasers nor any Person directly or - ------- indirectly controlled by any of the Purchasers nor any other Person which is an institutional investor shall be deemed to be an Affiliate of the Company solely by reason of ownership of or the exercise of rights resulting from the ownership of any of the Securities or other securities issued in exchange therefor, or by reason of having the benefits of any agreements or covenants of the Company contained in this Agreement. The term "Control" means the possession, directly ------- or indirectly, of the power to direct or cause the direction of the management and policies of a Person, whether through the ownership of voting stock, by contract or otherwise. The term "Affiliate", when used herein without reference --------- to any Person, shall mean an Affiliate of the Company. The term "Agreement" shall have the meaning set forth in the recitals --------- to this Agreement. -30- The term "Board" shall mean the Board of Directors of the Company. ----- The term "Business Day" shall mean any day on which commercial banks ------------ are not authorized or required to close in Philadelphia, Pennsylvania. The term "Code" shall mean the Internal Revenue Code of 1986, as ---- amended from time to time. Reference to a specific section of the Code shall include such section, any regulations promulgated thereunder and any comparable provision of any future legislation amending, supplementing or superseding such section. The term "Common Stock" shall have the meaning set forth in the ------------ recitals to this Agreement. The term "Company" shall have the meaning set forth in the recitals to ------- this Agreement. The term "Controlling Persons" shall have the meaning set forth in the ------------------- recitals to this Agreement. The term "Environmental Laws" means all applicable federal, state and ------------------ local laws, statutes, ordinances, rules, regulations and valid final orders of any court or agency relating to the use, possession, handling, generation, transportation, treatment, storage, recycling, discharge, disposal, emission, presence or Release, or the threat of Release of, or any remedial, removal or response action in connection with, any Hazardous Material, as defined in Section 2.21(b) hereof. The term "ERISA" shall mean the Employee Retirement Income Security ----- Act of 1974, as amended from time to time. Reference to a specific section of ERISA shall include such section, any regulations promulgated thereunder and any comparable provision of any future legislation amending, supplementing or superseding such section. The term "ERISA Affiliate" shall mean any Person which is under --------------- "common control" with the Company (within the meaning of Section 4001(b) of ERISA). The term "Exchange Act" shall mean the Securities Exchange Act of ------------ 1934, as amended from time to time. The term "Financial Statements" shall have the meaning set forth in -------------------- Section 2.7(a) hereof. The terms "First Closing" and "First Closing Date" shall have the ------------- ------------------ meanings set forth in Section 1.2 hereof. The term "Fiscal Year" shall mean a fiscal year of the Company, ----------- commencing on January 1 and ending on December 31st. -31- The term "Forecasts" shall have the meaning set forth in Section --------- 2.7(b) hereof. The term "generally accepted accounting principles" shall mean, as of ----------------------------------------- the date of any determination with respect thereto, generally accepted accounting principles as used by the Financial Accounting Standards Board and/or the American Institute of Certified Public Accountants, consistently applied and maintained throughout the periods indicated. The term "Guaranty," with respect to any Person, shall mean all -------- obligations of such Person guaranteeing or in effect guaranteeing any Indebtedness, dividend or other obligation or investment of any other Person. The term "Hazardous Materials" shall have the meaning set forth in ------------------- Section 2.21(b) hereof. The terms "hereof", "herein", "hereunder" and other words of similar ------ ------ --------- import shall be construed to refer to this Agreement as a whole and not to any particular Section or other subdivision. The term "Indebtedness", with respect to any Person, shall mean all ------------ items (other than capital stock, capital surplus, retained earnings and deferred credits), which in accordance with generally accepted accounting principles would be included in determining total liabilities of such Person as shown on the liability side of a balance sheet of such Person as at the date on which Indebtedness is to be determined. The term "Indebtedness" shall also include, ------------ whether or not so reflected, (a) indebtedness, obligations and liabilities secured by any Lien on property of such Person whether or not the indebtedness secured thereby shall have been assumed by such Person, (b) all obligations in respect of capital leases and (c) all guaranties of any of the above. Notwithstanding the foregoing, in determining the indebtedness of the Company there shall be included all indebtedness of the Company of the character referred to in the foregoing clauses (a), (b) and (c) deemed to be extinguished under generally accepted accounting principles but for which such Person remains legally liable. The amount of "Indebtedness" shall not be reduced by any ------------ unamortized debt discount. The term "Indebtedness for Money Borrowed", with respect to any ------------------------------- Person, shall mean and include the aggregate amount of, without duplication: (a) all obligations of such Person for borrowed money; (b) all obligations of such Person evidenced by bonds, debentures, notes, or other similar instruments, and all reimbursement or other obligations of such Person in respect of letters of credit, banker's acceptances, interest rate swaps or other financial products; (c) all obligations of such Person to pay the deferred purchase price of assets or services, exclusive of trade payables which, by their terms, are due and payable within ninety (90) calendar days of the creation thereof; (d) all capitalized lease obligations of such Person; (e) all obligations or liabilities of others secured by a Lien on any asset owned by such Person, irrespective of whether such obligation or liability is assumed, to the extent of such obligation or liability; and (f) any guaranties of such Person of any Indebtedness for Money Borrowed of another Person. The amount of "Indebtedness ------------ for Money Borrowed" shall not be reduced by unamortized debt discount. - ------------------ -32- The term "Initial Purchase Price" shall mean $1,249,997.60. ---------------------- The term "Institutional Investor" shall mean any one or more of the ---------------------- following Persons: (a) any bank, savings institution, trust company or national banking association, acting for its own account or in a fiduciary capacity; (b) any charitable foundation; (c) any insurance company or Affiliate thereof or fraternal benefit association; (d) any pension, retirement or profit sharing trust or fund; or (e) any public employees' pension or retirement system or any other governmental agency supervising the investment of public funds. The term "Investment" shall mean as applied to any Person (a) any ---------- direct or indirect purchase or other acquisition by such Person of stock or other securities of or any partnership interest in any other Person, or (b) any direct or indirect loan, (including, without limitation, any guaranties), advance or capital contribution by such Person to any other Person, including all Indebtedness and accounts receivable from such other Person which are not current assets or did not arise from sales to such other Person in the ordinary course of business, and (c) any direct or indirect purchase or other acquisition by such Person of any assets other than assets used in the ordinary course of business. The term "Lien" shall mean any interest in property securing an ---- obligation owed to, or a claim by, any Person other than the owner of the property, whether such interest shall be based on the common law, statute or contract, whether or not such interest shall be recorded or perfected and whether or not such interest shall be contingent upon the occurrence of some future event or events or the existence of some future circumstance or circumstances, and including the lien or security interest arising from a mortgage, security agreement, encumbrance, pledge, adverse claim or charge, conditional sale or trust receipt, or from a lease, consignment or bailment for security purposes. The term "Lien" shall also include reservations, exceptions, ---- encroachments, easements, rights-of-way, covenants, conditions, restrictions, leases and other title exceptions and encumbrances affecting property. For the purposes of this Agreement, a Person shall be deemed to be the owner of any property that such Person shall have acquired or shall hold subject to a conditional sale agreement or other arrangement (including a leasing arrangement) pursuant to which title to the property shall have been retained by or vested in some other Person for security purposes. The term "Margin Stock" shall have the meaning ascribed to that term ------------ in Section 207.2(i) of Regulation G (12 CFR Part 207) of the Board of Governors of the Federal Reserve Board. The term "Material Adverse Effect" shall mean a material adverse ----------------------- effect on the business, earnings, properties, profits or condition (financial or other) of the Company. The term "Multiemployer Plan" shall mean any plan that is a ------------------ "multiemployer plan" (within the meaning of Section 4001(a)(3) of ERISA). The term "Partnerships" shall mean collectively those partnerships, ------------ joint ventures and limited partnerships in which the Company or the Subsidiaries or the Partnerships or any -33- combination thereof has, directly or indirectly, (i) limited partnership interests entitling them to 50% or more of the profits or losses of the partnership or (ii) a general partnership interest. The term "PBGC" shall mean the Pension Benefit Guaranty Corporation or ---- any successor thereto. The term "Pension Plan" shall mean any Plan that is an "employee ------------ pension benefit plan" (within the meaning of Section 3(2) of ERISA). The term "Permitted Liens" shall mean the following: --------------- (i) liens and the amount thereof in connection with workmen's compensation, unemployment insurance or other social security obligations; and (ii) statutory liens, including without limitation liens of mechanics, workmen and contractors, provided that the liens permitted by this clause (ii) do not exceed $100,000 in the aggregate and either such liens have not been filed or, if such liens have been filed, either (x) a stay of enforcement thereof has been obtained, or (y) such liens have been satisfied of record within 30 days after the date of filing thereof. The term "Person" shall mean any individual, corporation, partnership, ------ limited liability Company, limited liability Partnership, entity, joint venture, association, joint stock company, trust, estate, unincorporated organization or government (or any agency or political subdivision thereof). The term "Plan" shall mean any "employee benefit plan" (within the ---- meaning of Section 3(3) of ERISA) that the Company or any ERISA Affiliate maintains, contributes to or is obligated to contribute to for the benefit of employees or former employees of the Company or ERISA Affiliate. The term "PPM" shall mean prior to the First Closing Date the draft dated July 11, 1997 of the Company's Confidential Private Placement Memorandum relating to the private offer and sale of the Series B Shares and after the First Closing Date the final draft of such Memorandum distributed to Additional Purchasers. The term "Purchaser" shall have the meaning set forth in the recitals --------- to this Agreement. The term "Purchasers" shall mean collectively the Purchaser and the ---------- Additional Purchasers. The term "Qualified Institutional Buyer" shall have the meaning set ----------------------------- forth in Rule 144A. -34- The term "Regulated Waters" shall mean wetlands, rivers, streams, ---------------- flood plains or other similarly environmentally sensitive areas that may be regulated pursuant to any federal or state acts or regulations and any related transition or buffer areas. The term "Release" shall mean any spilling, leaking, pumping, pouring, ------- emitting, emptying, discharging, injecting, disposing, escaping, leaching and dumping of any Hazardous Materials. The term "Remedial Action" shall mean --------------- (a) clean-up or removal of Hazardous Materials; (b) such actions as may be necessary to monitor, assess, or evaluate the Release or threatened Release of Hazardous Materials or to otherwise comply with any environmental law; (c) proper disposal or removal of Hazardous Materials; (d) the taking of such other actions as may be necessary to prevent, minimize, or mitigate the damages caused by a Release or threatened Release of Hazardous Materials to the public health or welfare or to the environment; and (e) the providing of emergency assistance after a Release. Remedial Actions include, but are not limited to, such actions at the location of a Release as: storage; confinement; perimeter protection using dikes, trenches, or ditches; clay cover; neutralization; clean-up of Hazardous Materials or contaminated materials; recycling or reuse; diversion; destruction; segregation of reactive wastes; dredging or excavations; repair or replacement of leaking containers; collection of leachate and runoff; onsite treatment or incineration; providing alternative water supplies; and any monitoring reasonably required to assure that such actions protect the public health and welfare and the environment. The term "Reportable Event" shall mean an event that is required to be ---------------- reported under Department of Labor Regulations 29 CFR Part 2615, whether or not the 30-day notice requirement is waived, and any event or condition with respect to a foreign Pension Plan which might result in liability of the Company or any of its ERISA Affiliates. The term "Rule 144" shall mean Rule 144 under the Securities Act, as -------- presently in effect and as hereafter amended from time to time, or any superseding or substituted rule adopted by the SEC from time to time. The term "Rule 144A" shall mean Rule 144A under the Securities Act, as --------- presently in effect and as hereafter amended from time to time, or any superseding or substituted rule adopted by the SEC from time to time. -35- The term "Securities" shall have the meaning set forth in Section 1.3 ---------- hereof. The term "Securities Act" shall mean the Securities Act of 1933, as -------------- amended from time to time. The terms "Series A Shares" and "Series A Conversion Shares" shall --------------- -------------------------- have the meanings set forth in the recitals to this Agreement. The terms "Series B Shares" and "Series B Conversion Shares" shall --------------- -------------------------- have the meanings set forth in the recitals to this Agreement. The term "Shares" shall have the meaning set forth in the recitals to ------ this Agreement. The term "Statement With Respect to Shares" shall have the meaning set -------------------------------- forth in the recitals to this Agreement. The terms "Subsequent Closings" and "Subsequent Closing Dates" shall ------------------- ------------------------ have the meanings set forth in Section 1.2 hereof. The term "Subsidiary", with respect to any Person, shall mean any ---------- corporation 50% of the outstanding shares of voting stock or similar interest of which are owned, directly or indirectly, by such Person. The term "Subsidiary", ---------- when used herein without reference to any particular Person, shall mean a Subsidiary of the Company. The terms "Taxes" means any income taxes, franchise taxes, gross ----- receipts taxes, transfer taxes, value added taxes, sales taxes, use taxes, wage and/or employment taxes, excise taxes, real and personal property taxes, taxes measured on or imposed by capital, levies, imposts, duties licensing fee, registration fees, withholding taxes, estimate taxes, and charges of any nature whatsoever relating to any of the foregoing, including without limitation, interest, penalties, fines, additions to tax, assessments and deficiencies related thereto. The term "this Agreement" shall mean this Stock Purchase Agreement -------------- (including the annexed Exhibits and Schedules), as it may from time to time be amended, supplemented or modified in accordance with its terms. The term "to the Company's knowledge" and terms of like import shall -------------------------- mean that which is known at the time of determination by any of the Company's Chairman, President, Chief Executive Officer, Chief Financial Officer, Controller or Senior Vice President, after due inquiry. The term "Transaction Documents" shall mean this Agreement (including all Exhibits and Schedules hereto) and all agreements, instruments and other documents executed and delivered pursuant to or in connection with any of the transactions contemplated by this Agreement or any of the foregoing. -36- SECTION 8.2. Directly or Indirectly. Any provision in this Agreement ---------------------- referring to action to be taken by any Person, or that such Person is prohibited from taking, shall be applicable whether such action is taken directly or indirectly by such Person. SECTION 8.3. Governing Law. This Agreement shall be governed by and ------------- construed in accordance with Pennsylvania law, without regard to conflicts of laws. If any action or proceeding shall be brought by Purchaser or any Additional Purchaser in order to enforce any right or remedy under this Agreement or under any Securities, the Company hereby consents and will submit to the jurisdiction of any of the courts of the Commonwealth of Pennsylvania and of any federal court located therein and any of the Purchasers may bring suit against the Company in any of such courts. The Company waives any right to a jury trial in any action with respect to this Agreement, the Securities, and any other document, agreement or instrument delivered in connection herewith or therewith. SECTION 8.4. Independence of Covenants. Each covenant made by the ------------------------- Company herein is independent of each other covenant so made. The fact that the operation of any such covenant permits a particular action to be taken or condition to exist does not mean that such action or condition is not prohibited, restricted or conditioned by the operation of the provisions of any other covenant herein. SECTION 8.5. Construction. This Agreement is the result of arms- ------------ length negotiations between the parties hereto and has been prepared jointly by the parties. In applying and interpreting the provisions of this Agreement, there shall be no presumption that the Agreement was prepared by any one party or that the Agreement shall be construed in favor of or against any one party. ARTICLE 9. MISCELLANEOUS. ------------- SECTION 9.1. Notices. All notices, advices and communications to be ------- given or otherwise made to any party to this Agreement shall be deemed given upon receipt thereof if contained in a written instrument and delivered in person, sent by overnight courier, sent by first class registered or certified mail, postage prepaid and return receipt requested, or sent by facsimile telecopier, confirmed by mail, addressed to such party at the address or telecopier number set forth below or at such other address or telecopier number as may hereafter be designated in writing by the addressee to the addressor listing all parties: (a) if to Purchaser: c/o John Regan, Keystone Venture Capital Management, 1601 Market Street, Suite 2500, Philadelphia, Pennsylvania 19103, (b) if any other holder of a Security: to it at its address listed on the books for the registration and registration of transfer of the Securities maintained by the Company and (c) if to the Company: at the address specified on page 1 hereof, Attention: President, with required copies to Stephen M. Goodman, Esquire, Morgan, Lewis & Bockius LLP, 2000 One Logan Square, Philadelphia, Pennsylvania 19103. Whenever pursuant to this Agreement, notice is required to be given to any or all of the holders of the Securities, such requirement shall be satisfied if such notice is given in the manner prescribed to the Persons last known by the Company to be a Security holder, entitled to such notice, at the addresses of such Persons last known to the Company. -37- SECTION 9.2. Survival. All representations, warranties and covenants -------- made by the Company or any Controlling Person herein or by the Company or any Controlling Person in any certificate or other instrument delivered to the Purchasers or Agent pursuant to this Agreement shall survive the First Closing and all Subsequent Closings, the delivery to the Purchasers or Agent of the Securities and Agent Warrants, and any conversion or redemption of the Shares or exercise of the Agent Warrants regardless of any investigation made by any of the Purchasers or Agent. All statements in any such certificate or other instrument delivered by the Company shall constitute representations and warranties of the Company. All statements in any such certificate or other instrument delivered by the Controlling Persons shall constitute representations and warranties of the Controlling Persons. SECTION 9.3. Successors and Assigns. This Agreement shall be binding ---------------------- upon the parties hereto and their respective successors and assigns, and shall inure to the benefit of and be enforceable by the parties hereto, the Agent and their respective successors and assigns; provided, however, that Purchaser and -------- ------- Additional Purchasers shall not have any obligation to purchase Shares of any Person other than those of the Company. Whether or not expressly so stated and subject to the restrictions set forth therein, the provisions of Article 2 through Article 9 of this Agreement are intended to be for the benefit of all holders from time to time of any of the Securities or Agent Warrant and shall be enforceable by Purchaser, Additional Purchasers and the Agent and any other such holder whether or not an express assignment to such holder of rights under this Agreement shall have been made by the Purchasers or the Agent on, their assigns and provided, further, that the provisions of Section 9.4 hereof shall also be -------- ------- for the benefit of, and shall be enforceable by, any Person who shall no longer be a holder of any Securities or Agent Warrant but who shall have incurred any expense or been subjected to any liability referred to therein while, or on the basis of being, such a holder. SECTION 9.4. Amendment and Waiver. -------------------- (a) This Agreement may be amended or supplemented, and the observance of any term hereof or thereof may be waived, with the written consent of the Company and (i) on or prior to the first Subsequent Closing Date, the Purchaser, and (ii) after the first Subsequent Closing Date, as it applies to such holder, the holder of the Securities. (b) Except for communications with any designees of the holders of the Series A Shares or the Series B Shares serving on the Board, neither the Controlling Persons, nor the Company will solicit, request or negotiate for or with respect to any proposed waiver or amendment of any of the provisions of this Agreement unless each holder of the Securities shall be informed thereof by the Company and shall be afforded the opportunity of considering the same and shall be supplied by the Company with such information with respect thereto as such holder shall reasonably request. Executed or true and correct copies of any waiver effected pursuant to the provisions of this Section 9.4 shall be delivered by the Company to each holder of Securities forthwith following the date on which the same shall have been executed and delivered by the holder or holders of the Securities. After the First Subsequent Closing Date, neither the Controlling Persons nor the Company will, directly or indirectly, pay or cause to be -38- paid any remuneration, to any holder of the Securities as consideration for or as an inducement to the entering into by any holder of the Securities of any waiver or amendment of any of the terms and provisions of this Agreement unless such remuneration is concurrently paid, on the same terms, ratably to the holders of all of the Securities then outstanding. (c) After the First Closing Date, the Company shall be required to pay to any holder of any Securities any fee in connection with the waiver by such holder of any provisions of this Agreement or any amendments to Transaction Documents for the actual and reasonably incurred out-of-pocket expenses of such holder in connection with such waiver including without limitation reasonable attorneys fees. SECTION 9.5. Severability. If any term, provision, covenant or ------------ restriction of this Agreement is held by a court or a governmental agency of competent jurisdiction to be invalid, void or unenforceable, or to cause any party to be in violation of any applicable provision of law, the remainder of the terms, provisions, covenants and restrictions of this Agreement shall remain in full force and effect and in no way shall be affected, impaired or invalidated. SECTION 9.6. Counterparts. This Agreement may be executed and ------------ delivered to you simultaneously in one or more counterparts, each of which shall be deemed an original, but all such counterparts shall together constitute but one and the same instrument. SECTION 9.7. Reproduction of Documents. This Agreement, and all ------------------------- documents relating hereto (other than the certificates representing the Securities), including, without limitation, (a) consents, waivers and modifications that may hereafter be executed, (b) documents received by the Purchasers and their agents at the closings of the purchases of Shares, and (c) financial statements, certificates and other information heretofore or hereafter furnished to the Purchasers and their agents, may be reproduced by the Purchasers and their agents by any photographic or other similar process and the Purchasers and their agents may destroy any original document so reproduced. The Company agrees and stipulates that, to the extent permitted by applicable law and court or agency rules, any such reproduction shall be admissible in evidence as the original itself in any judicial or administrative proceeding (whether or not the original is in existence and whether or not such reproduction was made by the Purchasers and their agents in the regular course of business) and that any enlargement, facsimile or further reproduction of such reproduction shall be admissible in evidence to the same extent. SECTION 9.8. Captions. The descriptive headings of the various -------- paragraphs or parts of this Agreement are for convenience only and shall not affect the meaning or construction of any of the provisions hereof. SECTION 9.9. No Agency. Each of the Purchasers shall not be deemed --------- to be an agent, partner or joint venturer of the Company or of any other Person, and nothing herein contained shall be construed to impose any liability upon any of the Purchasers by reason of the execution or delivery of this Agreement or the consummation of the transactions contemplated hereby. -39- SECTION 9.10. Entire Agreement. This Agreement states the entire ---------------- agreement reached between the parties hereto with respect to the transactions contemplated hereby and supersedes all prior or contemporaneous agreements, negotiations, understandings, discussions, representations and warranties between the parties, whether oral or written. SECTION 9.11. No Waiver. No forbearance to enforce any provision or --------- right hereunder shall be deemed a waiver thereof, and no waiver of any breach of any term or covenant herein shall be construed as a waiver of any other breach of the same, or any other term or covenant herein. SECTION 9.12. Third Party Beneficiary. The parties hereto acknowledge ----------------------- and agree that the Agent is a third party beneficiary of all rights of the Purchasers or Agent set forth in this Agreement and the Agent shall have full power and authority to enforce such rights as if it had been a party executing this Agreement. SECTION 9.13. Obligations. The Company and the Controlling Persons ----------- covenant that none of them will enter into any agreement that would restrict any of the Company and the Controlling Persons' ability to perform any of their obligations under this Agreement. -40- IN WITNESS WHEREOF, the parties have executed this Stock Purchase Agreement effective as of the day and year first above written. ATTEST: [CORPORATE SEAL] CD NOW, INC. By: By: /s/ Jason Olim ----------------------- Title: Title: President WITNESS: /s/ Jason Olim - --------------------------- Jason Olim WITNESS: /s/ Matthew Olim - --------------------------- Matthew Olim KEYSTONE VENTURE IV, L.P. By: Keystone Venture IV Mgmt. Co., the G.P. of Keystone Venture IV, L.P. By: KVM IV MCGP, Inc., the G.P. of Keystone Venture IV Mgmt. Co. By: /s/ John R. Regan John R. Regan Vice President EX-10.2 3 AMENDMENT NO. 1 TO STOCK PURCHASE AGREEMENT 08/05/97 EXHIBIT 10.2 AMENDMENT NO. 1 TO STOCK PURCHASE AGREEMENT This Amendment No. 1 (the "Amendment") is entered into by and among each of CD NOW, INC., a Pennsylvania corporation (including its successors and assigns, the "Company"), KEYSTONE VENTURE IV, L.P., a Pennsylvania limited partnership (including its successors and assigns, "Purchaser"), JASON AND MATTHEW OLIM (the "Controlling Persons"), GROTECH PARTNERS IV, L.P., a Maryland limited partnership (including its successors and assigns, "Grotech"), ABS EMPLOYEES' VENTURE FUND LIMITED PARTNERSHIP, a Maryland limited partnership (including its successors and assigns, "ABS") (Purchaser, Grotech and ABS collectively referred to hereinafter as the "Purchasers") with respect to that certain Stock Purchase Agreement dated as of July 15, 1997, among the Company, the Purchaser and the Controlling Persons (the "Stock Purchase Agreement"). Capitalized terms not otherwise defined herein shall have the respective meanings specified for such terms in the Stock Purchase Agreement. RECITAL In conjunction with the sale of the Series B Shares to Grotech and ABS, each of the Company, the Purchaser and the Controlling Persons desire to amend the Stock Purchase Agreement as set forth below and to acknowledge that Grotech and ABS are parties to the Stock Purchase Agreement, as amended hereby. NOW THEREFORE, in consideration of the foregoing and good and valuable consideration, and intending to be legally bound, each of the Purchasers, the Company and the Controlling Persons agree as follow: 1. Section 4.15 of the Stock Purchase Agreement is hereby deleted and replaced in its entirety with the following new Section 4.15: SECTION 4.15 Investors' Rights Agreement. The Company, --------------------------- the Purchasers and each Securityholder (as defined in the Investors' Rights Agreement) shall have entered into the Investors' Rights Agreement in the form attached hereto as Exhibit C. 2. Article 5 of the Stock Purchase Agreement is hereby amended by adding, immediately following Section 5.17, the following new Sections 5.18 and 5.19: SECTION 5.18 Grotech Warrant. The Company shall have --------------- issued to Grotech the Warrant in the form attached as Exhibit E hereto. SECTION 5.19 Certificate of Incorporation. The Restated ---------------------------- Articles, as amended through August 4, 1997, pursuant to the Amendment in the form attached as Schedule 5.19 hereto, shall be in full force and effect without further amendment or modification thereto, and Purchasers shall have received evidence of the filing thereof. The Restated Articles shall provide that the authorized number of the directors of the Company shall be eight (8), two (2) of whom shall only have the right to a one-half vote and six (6) of whom shall have the right to a whole vote for all matters to be voted upon by the directors. The Restated Articles shall further provide that all Subchapters of Article 25 of the Pennsylvania Business Corporation Law shall not be applicable to the Company. 3. Section 5.12 and Section 6.8 of the Stock Purchase Agreement are hereby deleted and replaced in their entirety with the following new Sections 5.12 and 6.8 of the Stock Purchase Agreement. SECTION 5.12 No Adverse Change. No Material Adverse Effect shall ----------------- have occurred since December 31, 1996, as determined by each Additional Purchaser. Each Additional Purchaser shall have received a Certificate from the President and the Chief Financial Officer or Controller of the Company dated the Subsequent Closing Date on which the Company is selling Series B Shares to such Additional Purchasers, to the effect of the foregoing sentence. SECTION 6.8 Prohibited Sales. The Company covenants that except ---------------- as otherwise consented to in writing by the holder of the Series A Shares, which consent shall not be unreasonably withheld, (a) it shall only sell Series B Shares pursuant to the terms of this Agreement, as amended, the Investor Rights Agreement referred to above, and the other Transaction Documents, (b) it shall not extend to any purchaser of Series B Shares any rights or terms which are greater than or preferential to the rights and terms of the Series B Shares set forth in this Agreement, the Investor Rights Agreement, the Company's Restated Articles, as amended through August 4, 1997, and the other Transaction Documents, and (c) shall not enter into any contract or agreement with any purchaser of Series B Shares other than the Transaction Documents, which shall include the Warrant for Grotech. 4. Section 6.1 of the Stock Purchase Agreement is hereby amended by adding the following subparagraph (d): (d) The Company hereby covenants and agrees that it will deliver the reports described below to the current members of Board of Directors of the Company separately elected by the holders of a majority of the Series A Shares and a majority of the Series B Shares issued and outstanding at any time, or to such other person affiliated respectively with Purchaser and Grotech as each such member may designate by written notice to the Company: As soon as practical after the end of each month and in any event within thirty (30) days thereafter, a consolidated, unaudited balance sheet of the -2- Company and its subsidiaries, if any, as at the end of such month and consolidated statements of income, expenses and cash flows of the Company and its subsidiaries, if any, for each month and for the current fiscal year of the Company to date, all subject to normal year-end audit adjustments, prepared in reasonable detail in accordance with generally accepted accounting principles consistently applied and certified by the principal financial or accounting officer of the Company, together with a comparison of such statements to the corresponding periods of the prior fiscal year and to the Company's operating plan then in effect and approved by its Board of Directors. 5. The parties to this Amendment acknowledge and agree that by execution of this Amendment, Grotech and ABS shall be parties to the Stock Purchase Agreement as amended hereby. 6. All other provisions of the Stock Purchase Agreement shall not be affected by this Amendment and shall remain in full force and effect. -3- IN WITNESS WHEREOF, the parties hereto have duly executed this Amendment as of August __, 1997. ATTEST: [CORPORATE SEAL] CD NOW, INC. By: By: /s/ Jason Olim ------------------------ Title:President Title: WITNESS: /s/ Jason Olim - --------------------------- Jason Olim WITNESS: /s/ Matthew Olim - --------------------------- Matthew Olim KEYSTONE VENTURE IV, L.P. By: Keystone Venture IV Mgmt. Co., the G.P. of Keystone Venture IV, L.P. By: KVM IV MCGP, Inc., the G.P. of Keystone Venture IV Mgmt. Co. By: /s/ John R. Regan John R. Regan Vice President [Signatures continue on next page] [Signatures continued from previous page] GROTECH PARTNERS IV, L.P. By: Grotech Capital Group IV, LLC, its General Partner By: /s/ Patrick Kerins Patrick Kerins, Managing Director ABS EMPLOYEES' VENTURE FUND LIMITED PARTNERSHIP By: Alex. Brown Investments, Inc., its General Partner By: /s/ Mayo A. Shattuck, III Mayo A. Shattuck, III, President EX-10.3 4 INVESTORS RIGHTS AGREEMENT - DATED 07/15/97 EXHIBIT 10.3 CDNOW, INC. INVESTORS' RIGHTS AGREEMENT CDNOW, INC. INVESTORS' RIGHTS AGREEMENT TABLE OF CONTENTS
Page ---- 1. RESTRICTIONS ON TRANSFERABILITY OF SECURITIES; REGISTRATION RIGHTS..................................................... 2 1.1 Certain Definitions................................................ 2 1.2 Restrictions on Transfer........................................... 6 1.3 Requested Registration............................................. 7 1.4 Company Registration............................................... 9 1.5 Expenses of Registration........................................... 10 1.6 Registration on Form S-3........................................... 11 1.7 Registration Procedures............................................ 12 1.8 Indemnification.................................................... 14 1.9 Information by Holder.............................................. 16 1.10 Limitations on Subsequent Registration Rights...................... 16 1.11 Rule 144 Reporting................................................. 16 1.12 Transferor Assignment of Rights.................................... 17 1.13 Market-Stand-Off Agreement......................................... 17 1.14 Allocation of Registration Opportunities........................... 17 2. COVENANTS OF THE COMPANY................................................ 18 2.1 Right of First Refusal............................................. 18 3. COVENANTS OF CERTAIN PARTIES............................................ 20 3.1 Termination........................................................ 20 3.2 Co-Sale............................................................ 20 3.3 Key Person Life Insurance.......................................... 21 3.4 Obligations........................................................ 21 3.5 Election of Directors.............................................. 21 4. MISCELLANEOUS........................................................... 23 4.1 Governing Law...................................................... 23 4.2 Successors and Assigns............................................. 23 4.3 Entire Agreement; Amendment; Waiver................................ 23 4.4 Notices, etc....................................................... 23
-i- Page ---- 4.5 Delays or Omissions.................................................. 23 4.6 Rights; Separability................................................. 23 4.7 Information Confidential............................................. 24 4.8 Titles and Subtitles................................................. 24 4.9 Counterparts......................................................... 24
-ii- CDNOW, INC. INVESTORS' RIGHTS AGREEMENT This Investors' Rights Agreement (this "Agreement") is made and entered into as of the 15th day of July, 1997, by and among CDnow, Inc., a Pennsylvania corporation (the "Company"), Jeffrey McClusky, Anthony Lucenti and William Brennan (collectively, the "MBL Individuals"), MBL Entertainment, Inc., an Illinois corporation ("MBL" and together with the MBL Individuals, the "MBL Shareholders") and Alan Meltzer ("Meltzer" and together with the MBL Shareholders, the "Minority Shareholders"), Keystone Venture IV, L.P. ("Keystone"), and together with the Minority Shareholders, the "Initial Securityholders"), the persons who shall become additional securityholders in the Company and signatories to this Agreement on or before the Second Closing (as hereinafter defined) to be set forth on Exhibit A hereto (the "Additional Securityholders"), Jason and Matthew Olim (collectively, the "Olims") and Alex. Brown & Sons Incorporated (the "Agent") who shall become an additional signatory with the Additional Securityholders. The Initial Securityholders, the Additional Securityholders and Agent are collectively referred to hereinafter as the "Securityholders." Recitals WHEREAS, the Minority Shareholders own Common Stock of the Company and Meltzer owns a Warrant to subscribe for Common Stock of the Company dated December 6, 1996 (the "Meltzer Warrant") , the Minority Shareholders possess certain voting, preemptive, tag-along and other rights pursuant to a Stock Purchase and Shareholders' Agreement among the Minority Shareholders, the Company, the Olims and Milo Productions, Inc., a Pennsylvania corporation (the "Shareholders' Agreement") and possess certain registration and other rights pursuant to a Registration Rights Agreement for Common Stock dated December 6, 1996 among the Company, the Olims and the Minority Shareholders (the "1996 Agreement") and the Minority Shareholders desire to terminate the 1996 Agreement and certain provisions of the Shareholders' Agreement and to accept the rights created pursuant hereto in lieu of the rights granted to them under the Shareholders' Agreement and the 1996 Agreement; WHEREAS, Keystone is a party to the Stock Purchase Agreement dated the date hereof whereby Keystone's obligation to purchase (on the date hereof) the Company's Series A Convertible Preferred Stock is conditioned upon the execution and delivery by the Initial Securityholders of this Agreement; NOW, THEREFORE, in consideration of the mutual promises and covenants set forth herein, and, intending to be legally bound, the parties hereto agree as follows: 1. RESTRICTIONS ON TRANSFERABILITY OF SECURITIES; REGISTRATION RIGHTS. 1.1 Certain Definitions. As used in this Agreement, the following terms shall have the meanings set forth below: "Agent" shall mean Alex. Brown & Sons Incorporated, the Company's exclusive agent in connection with the sale of the Series A Convertible Preferred Stock and Series B Convertible Preferred Stock. "Agent Warrant" shall mean the five year noncancelable warrant to purchase Series B Convertible Preferred Stock issued to Agent by the Company on the date of the sale of the Series B Preferred Stock. "Articles" shall mean the Company's Amended and Restated Articles of Incorporation as amended on July 15, 1997. "Commission" shall mean the Securities and Exchange Commission or any other federal agency at the time administering the Securities Act. "Common Stock" means the Common Stock, no par value, of the Company. "Conversion Shares" means shares of Common Stock issued or issuable upon exercise of the Meltzer Warrant. "Co-Sale Securities" shall mean (i) shares of Common Stock issued pursuant to the conversion of the Shares including the conversion of the Series B Conversion Shares; (ii) any Common Stock issued as a dividend or other distribution with respect to or in exchange for or in replacement of the shares referenced in (i) above and (iii) and (iv) below; (iii) issued Conversion Shares; and (iv) shares of Common Stock owned by the Minority Shareholders on the First Closing Date. "Exchange Act" shall mean the Securities Exchange Act of 1934, as amended, or any similar successor federal statute and the rules and regulations thereunder, all as the same shall be in effect from time to time. "First Closing" shall mean the closing of the sale of shares of the Com pany's Series A Convertible Preferred Stock. "First Closing Date" shall mean the date of the closing of the sale of shares of the Company's Series A Convertible Preferred Stock. "Holder" shall mean any Investor and any Other Investor who holds Registrable Securities and any holder of Registrable Securities to whom the registration rights -2- conferred by this Agreement have been transferred in compliance with Section 1.2 and Section 1.12 hereof. "Initiating Holders" shall mean any Holder or Holders (excluding Other Investors and their permitted transferees other than Investors) who in the aggregate hold not less than fifty percent (50%) of the outstanding Registrable Securities. "Investors" shall mean the Agent and all persons who purchased Shares pursuant to the Stock Purchase Agreement. "Minority Rights Holders" shall mean the Holders excluding, Investors, and their permitted transferees (such permitted transferees to exclude Minority Rights Holders and their permitted transferees). "Minority Shareholder Registrable Securities" shall mean Conversion Shares and shares of Common Stock owned by Minority Shareholders on the First Closing Date; and any Common Stock issued as a dividend or other distribution with respect to or in exchange for or in replacement of such Conversion Shares and shares of Common Stock. "Other Investors" shall mean collectively, the Minority Shareholders. "Pro Rata Share" shall mean for each Holder the ratio of (A) the number of shares of Common Stock owned by such Holder immediately prior to the issuance of New Securities assuming full conversion of the Shares and exercise of any warrant to acquire Common Stock or Shares of the Company held by such Holder, to (B) the total number of shares of Common Stock outstanding immediately prior to the issuance of New Securities assuming full conversion of the Shares and the exercise of all outstanding rights, options and warrants to acquire Common Stock or Shares of the Company. "Pro Rata Co-Sale Share" shall mean for each Holder the ratio of (A) the number of shares of Common Stock owned by such Holder immediately prior to the sale of Co-Sale Securities, assuming full conversion of the Shares and exercise of any warrant to acquire Common Stock or Shares of the Company held by such Holder, to (B) the total number of shares of Common Stock owned by all Holders immediately prior to the sale of Co-Sale Securities, assuming full conversion of the Shares and the exercise of all outstanding rights, options and warrants to acquire Common Stock or Shares of the Company held by such Holders. "Qualified Public Offering" shall mean the initial public offering of the Company's Common Stock pursuant to a registration statement under the Securities Act of 1933, as amended, where (A) the offering is firmly underwritten at a price per share to the public which is equal to or greater than 200% of the "Series A Conversion Factor" prior to the issuance of Series B Preferred Stock and after such issuance, the "Series B Conversion Factor" (as such terms are defined in Article 4 of the Articles) in effect immediately prior to such offering, (B) the aggregate gross proceeds received by the Company exceeds $20 million, and (C) the Company's Common -3- Stock has been approved for listing or quotation on the New York Stock Exchange, the American Stock Exchange or the Nasdaq National Market. "Registrable Securities" shall mean (i) shares of Common Stock issued or issuable pursuant to the conversion of the Shares; (ii) shares of Common Stock issued or issuable pursuant to the conversion of the Series B Conversion Shares; (iii) Conversion Shares; (iv) shares of Common Stock owned by the Minority Shareholders on the First Closing Date; and (v) any Common Stock or other security exchangeable or convertible into Common Stock issued as a dividend or other distribution with respect to or in exchange for or in replacement of the shares referenced in (i) through (iv) above, provided, however, that Registrable Securities shall not include any shares of Common Stock (x) which are then already registered, (y) which have been sold to the public either pursuant to a registration under the Securities Act or Rule 144 or (z) so long as the Common Stock is listed on the New York Stock Exchange, the American Stock Exchange or the Nasdaq National Market, which can be sold pursuant to Rule 144 under the Securities Act without restrictions as a result of volume limitations. The terms "register," "registered" and "registration" shall refer to a reg istration effected by preparing and filing a registration statement in compliance with the Securities Act and applicable rules and regulations thereunder, and the declaration or ordering of the effectiveness of such registration statement. "Registration Expenses" shall mean all expenses incurred in effecting any registration pursuant to this Agreement, including, without limitation, all registration, qualification, and filing fees, printing expenses, escrow fees, fees and disbursements of counsel for the Company, blue sky fees and expenses, and expenses of any regular or special audits incident to or required by any such registration, but shall not include Selling Expenses, fees and disbursements of counsel for the Holders and the compensation of regular employees of the Company, which shall be paid in any event by the Company. "Restricted Securities" shall mean any Registrable Securities required to bear the legend set forth in Section 1.2(b) hereof. "Rule 144" shall mean Rule 144 as promulgated by the Commission under the Securities Act, as such Rule may be amended from time to time, or any similar successor rule that may be promulgated by the Commission. "Rule 145" shall mean Rule 145 as promulgated by the Commission under the Securities Act, as such Rule may be amended from time to time, or any similar successor rule that may be promulgated by the Commission. "Second Closing" shall mean the closing of the sale of shares of the Company's Series B Convertible Preferred Stock. -4- "Securities Act" shall mean the Securities Act of 1933, as amended, or any similar successor federal statute and the rules and regulations thereunder, all as the same shall be in effect from time to time. "Selling Expenses" shall mean all underwriting discounts, selling commissions and stock transfer taxes applicable to the sale of Registrable Securities and fees and disbursements of counsel for any Holder (other than the fees and disbursements of counsel included in Registration Expenses). "Series A Conversion Stock" shall mean the Common Stock issued or issuable upon conversion of the Series A Preferred Stock. "Series B Conversion Stock" shall mean the Common Stock issued or issuable upon conversion of the Series B Preferred Stock. "Series A Preferred Stock" shall mean the Series A Convertible Preferred Stock, no par value of the Company. "Series B Preferred Stock" shall mean the Series B Convertible Preferred Stock, no par value of the Company, including the Series B Conversion Shares. "Shares" shall mean the Company's Series A Preferred Stock and Series B Preferred Stock. "Series B Conversion Shares" shall mean shares of Series B Preferred Stock issued or issuable upon exercise of the Agent Warrant. "Series A Registrable Securities" shall mean the shares of Common Stock issued or issuable pursuant to the conversion of the Series A Preferred Stock and any Common Stock issued as a dividend or other distribution with respect thereto or in exchange for or replacement thereof. "Series B Registrable Securities" shall mean the shares of Common Stock issued or issuable pursuant to the conversion of the Series B Preferred Stock and any Common Stock issued as a dividend or distribution with respect thereto or in exchange for or replacement thereof. "Stock Purchase Agreement" shall mean the Stock Purchase Agreement among Keystone, the Additional Securityholders and the Olims dated as of the First Closing Date and each Subsequent Closing Date. -5- 1.2 Restrictions on Transfer. (a) Each Holder agrees not to make any disposition of all or any portion of the Registrable Securities unless and until the transferee has agreed in writing for the benefit of the Company to be bound by this Section 1.2, provided and to the extent such Section is then applicable, and: (i) There is then in effect a registration statement under the Securities Act covering such proposed disposition and such disposition is made in accordance with such registration statement; or (ii) Such Holder shall have notified the Company of the proposed disposition and shall have furnished the Company with a detailed statement of the circumstances surrounding the proposed disposition, and (B) if reasonably requested by the Company, such Holder shall have furnished the Company with an opinion of counsel, reasonably satisfactory to the Company, that such disposition will not require registration of such shares under the Securities Act. It is agreed that the Company will not require opinions of counsel or prior notice for transactions made pursuant to Rule 144. (iii) Notwithstanding the provisions of paragraphs (i) and (ii) above, no such registration statement or opinion of counsel shall be necessary for a transfer by a Holder which is (A) a partnership to its partners or retired partners in accordance with partnership interests, (B) a corporation to its shareholders in accordance with their interest in the corporation, (C) a limited liability company to its members or former members in accordance with their interest in the limited liability company, (D) in the case of Minority Shareholders, to another Minority Shareholder or (E) to a family member of a Holder (which shall include the spouse's parents of such Holder) or trust for the benefit of an individual Holder or any of such Holder's family members, provided the transferee will be subject to the terms of this Section 1.2 to the same extent as if such transferee were an original Holder hereunder. (b) Each certificate representing Registrable Securities shall (unless otherwise permitted by the provisions of this Agreement) be stamped or otherwise imprinted with a legend substantially similar to the following (in addition to any legend required under applicable state securities laws): THE SHARES REPRESENTED HEREBY HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED, AND MAY NOT BE SOLD OR TRANSFERRED, ASSIGNED, PLEDGED OR HYPOTHECATED UNLESS AND UNTIL REGISTERED UNDER SUCH ACT OR UNLESS THE COMPANY HAS RECEIVED AN OPINION OF COUNSEL OR OTHER EVIDENCE, SATISFACTORY TO THE COMPANY AND ITS COUNSEL, THAT SUCH REGISTRATION IS NOT REQUIRED. -6- (c) The Company shall be obligated to reissue promptly unlegended certificates at the request of any Holder thereof if the Holder shall have obtained an opinion of counsel at such Holder's expense (which counsel may be counsel to the Company) reasonably acceptable to the Company to the effect that the securities proposed to be disposed of may lawfully be so disposed of without registration, qualification or legend. (d) Any legend endorsed on an instrument pursuant to applicable state securities laws and the stop-transfer instructions with respect to such securities shall be removed upon receipt by the Company of an order of the appropriate blue sky authority authorizing such removal. 1.3 Requested Registration. (a) Request for Registration. If the Company shall receive from Initiating Holders at any time or times not earlier than the earlier of (i) two years after the date of this Agreement or (ii) one hundred and eighty (180) days after the effective date of the first registration statement filed by the Company covering an underwritten offering of any of its securities to the general public, a written request that the Company effect any registration with respect to all or a part of the Registrable Securities the aggregate proceeds of which (after deduction for underwriter's discounts and expenses related to the issuance) exceed $10,000,000 the Company shall: (i) promptly give written notice of the proposed registration to all other Holders; and (ii) as soon as practicable, use its best efforts to effect such registration (including, without limitation, filing post-effective amendments, appropriate qualifications under applicable blue sky or other state securities laws, and appropriate compliance with the Securities Act) and as would permit or facilitate the sale and distribution of all or such portion of such Registrable Securities as are specified in such request, together with all or such portion of the Registrable Securities of any Holder or Holders joining in such request as are specified in a written request received by the Company within twenty (20) days after such written notice from the Company is mailed or delivered. The Company shall not be obligated to effect, or to take any action to effect, any such registration pursuant to this Section 1.3: (A) In any particular jurisdiction in which the Company would be required to execute a general consent to service of process in effecting such registration, qualification, or compliance, unless the Company is already subject to service in such jurisdiction and except as may be required by the Securities Act; (B) After the Company has initiated two such registrations pursuant to this Section 1.3(a) (counting for these purposes only registrations which have been declared or ordered effective and pursuant to which securities have been sold and registrations -7- which have been withdrawn by the Holders as to which the Holders have not elected to bear the Registration Expenses pursuant to Section 1.5 hereof and would, absent such election, have been required to bear such expenses); (C) During the period starting with the date thirty (30) days prior to the Company's good faith estimate of the date of filing of, and ending on a date one hundred twenty (120) days after the effective date of, a Company-initiated registration; provided that the Company is actively employing in good faith all reasonable efforts to cause such registration statement to become effective; (D) If the Initiating Holders propose to dispose of shares of Registrable Securities which may be immediately registered on Form S-3 pursuant to a request made under Section 1.6 hereof, (E) If the Initiating Holders do not request that such offering be underwritten by underwriters selected by the majority in interest of the Initiating Holders (subject to the consent of the Company, which consent will not be unreasonably withheld); or (F) If the Company and the majority in interest of the Initiating Holders are unable to obtain the commitment of the underwriter described in clause (E) above to underwrite the offer. (b) Subject to the foregoing clauses (A) through (F), the Company shall file a registration statement covering the Registrable Securities so requested to be registered as soon as practicable after receipt of the request or requests of the Initiating Holders; provided, however, that if (i) in the good faith judgment of the Board of Directors of the Company, such registration would be seriously detrimental to the Company and the Board of Directors of the Company concludes, as a result, that it is essential to defer the filing of such registration statement at such time, and (ii) the Company shall furnish to such Holders a certificate signed by the President of the Company stating that in the good faith judgment of the Board of Directors of the Company, it would be seriously detrimental to the Company for such registration statement to be filed in the near future and that it is, therefore, essential to defer the filing of such registration statement, then the Company shall have the right to defer such filing (except as provided in clause (C) above) for a period of not more than one hundred twenty (120) days after receipt of the request of the Initiating Holders, and, provided further, that the Company shall not defer its obligation in this manner more than once in any twelve-month period. The registration statement filed pursuant to the request of the Initiating Holders may, subject to the provisions of Sections 1.3(b) and 1.14 hereof, include other securities of the Company, with respect to which registration rights have been granted, and may include securities of the Company being sold for the account of the Company. (c) Underwriting. The right of any Holder to registration pursuant to Section 1.3 shall be conditioned upon such Holder's participation in such underwriting and the -8- inclusion of such Holder's Registrable Securities in the underwriting (unless otherwise mutually agreed by a majority in interest of the Initiating Holders and such Holder with respect to such participation and inclusion) to the extent provided herein. A Holder may elect to include in such underwriting all or a part of the Registrable Securities he holds. (d) Procedures. If the Company shall request inclusion in any registration pursuant to Section 1.3 of securities being sold for its own account, or if other persons shall request inclusion in any registration pursuant to Section 1.3, such inclusion shall be conditioned upon the further applicable provisions of this Section 1 (including Sections 1.13 and 1.14). The Company shall (together with all Holders and other persons proposing to distribute their securities through such underwriting) enter into an underwriting agreement in customary form with the representative of the underwriter or underwriters selected for such underwriting by a majority in interest of the Initiating Holders, which underwriters are reasonably acceptable to the Company. Notwithstanding any other provision of this Section 1.3, if the representative of the underwriters advises the Initiating Holders in writing that marketing factors require a limitation on the number of shares to be underwritten, the number of shares to be included in the underwriting or registration shall be allocated as set forth in Section 1.14 hereof. If a person who has requested inclusion in such registration as provided above does not agree to the terms of any such underwriting, such person shall be excluded therefrom by written notice from the Company, the underwriter or the Initiating Holders. The securities so excluded shall also be withdrawn from registration. Any Registrable Securities or other securities excluded or withdrawn from such underwriting shall also be withdrawn from such registration. If shares are so withdrawn from the registration and if the number of shares to be included in such registration was previously reduced as a result of marketing factors pursuant to this Section 1.3(d), then the Company shall offer to all holders who have retained rights to include securities in the registration the right to include ad ditional securities in the registration in an aggregate amount equal to the number of shares so withdrawn, with such shares to be allocated among such Holders requesting additional inclusion in accordance with Section 1.14. 1.4 Company Registration. (a) If the Company shall determine to register any of its securities either for its own account or the account of a security holder or holders exercising their respective demand registration rights (other than pursuant to Section 1.3 hereof), other than a registration relating solely to employee benefit plans, or a registration relating to a corporate reorganization or other transaction under Rule 145, or a registration on any registration form that does not permit secondary sales, the Company will: (i) promptly give to each Holder written notice thereof; and (ii) use its best efforts to include in such registration (and any related qualification under blue sky laws or other compliance), except as set forth in Section 1.4(b) below, and in any underwriting involved therein, all the Registrable Securities specified in a written request or requests, made by any Holder and received by the Company within twenty (20) days after the written notice from the Company described in clause (i) above is mailed or -9- delivered by the Company. Such written request may specify all or a part of a Holder's Registrable Securities. (b) Underwriting. If the registration of which the Company gives notice is for a registered public offering involving an underwriting, the Company shall so advise the Holders as a part of the written notice given pursuant to Section 1.4(a)(i). In such event, the right of any Holder to registration pursuant to this Section 1.4 shall be conditioned upon such Holder's participation in such underwriting and the inclusion of such Holder's Registrable Securities in the underwriting to the extent provided herein. All Holders proposing to distribute their securities through such underwriting shall (together with the Company and the other holders of securities of the Company with registration rights to participate therein distributing their securities through such underwriting) enter into an underwriting agreement in customary form with the representative of the underwriter or underwriters selected by the Company. Notwithstanding any other provision of this Section 1.4, if the representative of the underwriters advises the Company in writing that a limitation on the number of shares to be underwritten is required because the total number of shares to be included in the registration exceeds the maximum number of shares specified by the representative that may be distributed without materially adversely affecting the price of such shares, the representative may (subject to the limitations set forth below) exclude all Registrable Securities from, or limit the number of Registrable Securities to be included in, the registration and underwriting. The Company shall so advise all holders of securities requesting registration, and the number of shares of securities that are entitled to be included in the registration and underwriting shall be allocated first to the Company for securities being sold for its own account and thereafter as set forth in Section 1.14. If any person does not agree to the terms of any such underwriting, he shall be excluded therefrom by written notice from the Company or the underwriter. Any Registrable Securities or other securities excluded or withdrawn from such underwriting shall be withdrawn from such registration. If shares are so withdrawn from the registration or if the number of shares of Registrable Securities to be included in such registration was previously reduced as a result of marketing factors, the Company shall then offer to all persons who have retained the right to include securities in the registration the right to include additional securities in the registration in an aggregate amount equal to the number of shares so withdrawn, with such shares to be allocated among the persons requesting additional inclusion in accordance with Section 1.14 hereof. 1.5 Expenses of Registration. All Registration Expenses incurred in connection with any registration, qualification or compliance pursuant to Sections 1.4 and 1.6 hereof, and the first two registrations pursuant to Section 1.3 hereof and reasonable fees of one counsel for the selling stockholders in the case of registrations pursuant to Section 1.3 shall be borne by the Company; provided, however, that if the Holders bear the Registration Expenses for any registration proceeding begun pursuant to Section 1.3 and such registration proceeding is subsequently withdrawn by the Holders registering shares therein, such registration proceeding shall not be counted as a requested registration pursuant to Section 1.3 hereof. Furthermore, in the event that a withdrawal by the Holders is based upon material adverse information relating to -10- the Company that is different from the information known or available (upon request from the Company or otherwise) to the Holders requesting registration at the time of their request for registration under Section 1.3, such registration shall not be treated as a counted registration for purposes of Section 1.3 hereof, even though the Holders do not bear the Registration Expenses for such registration. All Selling Expenses relating to securities so registered shall be borne by the holders of such securities pro rata on the basis of the number of shares of securities so registered on their behalf, as shall any other expenses in connection with the registration required to be borne by the Holders of such securities. 1.6 Registration on Form S-3. (a) After its initial public offering ("IPO"), the Company shall use its best efforts to qualify for registration on Form S-3 or any comparable or successor form or forms pursuant to Rule 415 promulgated under the Securities Act or any successor rule thereto. After the Company has qualified for the use of Form S-3, in addition to the rights contained in the foregoing provisions of this Section 1, any Holder of Registrable Securities shall have the right to request registrations on Form S-3 (such requests shall be in writing and shall state the number of shares of Registrable Securities to be disposed of and the intended methods of disposition of such shares by such Holder or Holders), provided, however, that the Company shall not be obligated to effect any such registration (i) for Holders of Minority Shareholder Registrable Securities (A) unless the IPO is an offering for equity securities in which gross proceeds to the Company therefrom are at least $20,000,000 or (B) more than once; (ii) for Holders of Series A Convertible Securities (A) unless such Holders, together with the holders of any other securities of the Company entitled to inclusion in such registration, propose to sell such securities at an aggregate price to the public of less than $500,000 or (B) in a given 12 month period the Company has previously effected one such registration for such Holders; (iii) for Holders of Series B Convertible Securities (A) unless such Holders, together with the holders of any other securities of the Company entitled to inclusion in such registration, propose to sell such securities at an aggregate price to the public of less than $500,000 or (B) in a given 12 month period the Company has previously effected one such registration for such Holders; or (iv) in the event that the Company shall furnish the certification described in Section 1.3(a)(ii) (but subject to the limitations set forth therein and excluding the Company's rights under Section 1.3(a)(ii)(B)). (b) If a request complying with the requirements of Section 1.6(a) hereof is delivered to the Company, the provisions of Sections 1.3(a)(i) and (ii) (but excluding the Company's rights under Section 1.3(a)(ii)(B)) and Section 1.3(b) hereof shall apply to such registration. If, pursuant to Section 1.3(b), the Company defers any registration pursuant to a request complying with the requirements of Section 1.6(a), such deferral shall not effect an elimination of the requesting Holder's rights under Section 1.6(a). If the registration is for an underwritten offering, the provisions of Sections 1.3(c) and 1.3(d) hereof shall apply to such registration. 1.7 Registration Procedures. In the case of each registration effected by the Company pursuant to Section 1, the Company will keep each Holder advised in writing as to the -11- initiation of each registration and as to the completion thereof. At its expense, the Company will use its best efforts to: (a) Keep such registration effective for a period of two hundred seventy (270) days or until the Holder or Holders have completed the distribution described in the registration statement relating thereto, whichever first occurs; provided, however, that (i) such 270-day period shall be extended for a period of time equal to the period the Holder refrains from selling any securities included in such registration at the request of an underwriter of Common Stock (or other securities) of the Company; and (ii) in the case of any registration of Registrable Securities on Form S-3 which are intended to be offered on a continuous or delayed basis, such 270-day period shall be extended, if necessary, to keep the registration statement effective until all such Registrable Securities are sold, provided that applicable rules under the Securities Act governing the obligation to file a post-effective amendment permit, in lieu of filing a post-effective amendment that (I) includes any prospectus required by Section 10(a)(3) of the Securities Act or (II) reflects facts or events representing a material or fundamental change in the information set forth in the registration statement, the incorporation by reference of information required to be included in (I) and (II) above to be contained in periodic reports filed pursuant to Section 13 or 15(d) of the Exchange Act in the registration statement; (b) Prepare and file with the Commission such amendments and supplements to such registration statement and the prospectus used in connection with such registration statement as may be necessary to comply with the provisions of the Securities Act with respect to the disposition of all securities covered by such registration statement; (c) Furnish such number of prospectuses and other documents incident thereto, including any amendment of or supplement to the prospectus, as a Holder from time to time may reasonably request; (d) Notify each seller of Registrable Securities covered by such registration statement at any time when a prospectus relating thereto is required to be delivered under the Securities Act of the happening of any event as a result of which the prospectus included in such registration statement, as then in effect, includes an untrue statement of a material fact or omits to state a material fact required to be stated therein or necessary to make the statements therein not misleading or incomplete in the light of the circumstances then existing, and at the request of any such seller, prepare and furnish to such seller a reasonable number of copies of a supplement to or an amendment of such prospectus as may be necessary so that, as thereafter delivered to the purchasers of such shares, such prospectus shall not include an untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary to make the statements therein not misleading or incomplete in the light of the circumstances then existing; (e) Cause all such Registrable Securities registered pursuant hereunder to be listed on each securities exchange on which similar securities issued by the Company are then listed; -12- (f) Provide a transfer agent and registrar for all Registrable Securities registered pursuant to such registration statement and a CUSIP number for all such Registrable Securities, in each case not later than the effective date of such registration; (g) Otherwise use its best efforts to comply with all applicable rules and regulations of the Commission, and make available to its security holders, as soon as reasonably practicable, an earnings statement covering the period of at least twelve months, but not more than eighteen months, beginning with the first month after the effective date of the Registration Statement, which earnings statement shall satisfy the provisions of Section 11(a) of the Securities Act; (h) In connection with any underwritten offering pursuant to a registration statement filed pursuant to Section 1.3 hereof, the Company will enter into an underwriting agreement in form reasonably necessary to effect the offer and sale of Common Stock, provided such underwriting agreement contains customary underwriting provisions and provided further that if the underwriter so requests the underwriting agreement will contain customary contribution provisions; and (i) furnish to each seller of Registrable Securities covered by such registration statement a signed counterpart, addressed to such seller (and the underwriters, if any) of: (i) an opinion of counsel for the Company, dated the effective date of such registration statement (or, if such registration involves an underwritten public offering, dated the date of the closing under the underwriting agreement), reasonably satisfactory in form and substance to the sellers of such Registrable Securities (and the managing underwriter, if any); and (ii) a "comfort" letter, dated the effective date of such registration statement (or, if such registration involves an underwritten public offering, dated the date of the closing under the underwriting agreement), signed by the independent public accountants who have certified the Company's financial statements included in such registration statement, covering such matters with respect to such registration statement as are customarily covered in accountants' letters delivered to the underwriters in underwritten offerings of securities as may reasonably be requested by the sellers of such Registrable Securities (and the managing underwriter, if any). 1.8 Indemnification. (a) The Company will indemnify each Holder, each of its officers, directors and partners, legal counsel, and accountants and each person controlling such Holder within the meaning of Section 15 of the Securities Act, with respect to which registration, qualification, or compliance has been effected pursuant to this Section 1, and each underwriter, if any, and each person who controls within the meaning of Section 15 of the Securities Act any underwriter, against all expenses, claims, losses, damages, and liabilities (or actions, proceedings, -13- or settlements in respect thereof) arising out of or based on any untrue statement (or alleged untrue statement) of a material fact contained in any prospectus, offering circular, or other document (including any related registration statement, notification, or the like) incident to any such registration, qualification, or compliance, or based on any omission (or alleged omission) to state therein a material fact required to be stated therein or necessary to make the statements therein not misleading, or any violation by the Company of the Securities Act or any rule or regulation thereunder applicable to the Company and relating to action or inaction required of the Company in connection with any such registration, qualification, or compliance, and will reimburse each such Holder, each of its officers, directors, partners, legal counsel, and accountants and each person controlling such Holder, each such underwriter, and each person who controls any such underwriter, for any legal and any other expenses reasonably incurred in connection with investigating and defending or settling any such claim, loss, damage, liability, or action, provided that the Company will not be liable in any such case to the extent that any such claim, loss, damage, liability, or expense arises out of or is based on any untrue statement or omission based upon written information furnished to the Company by such Holder or underwriter and stated to be specifically for use therein. It is agreed that the indemnity agreement contained in this Section 1.8(a) shall not apply to amounts paid in settlement of any such loss, claim, damage, liability, or action if such settlement is effected without the consent of the Company (which consent has not been unreasonably withheld). (b) Each Holder will, if Registrable Securities held by such Holder are included in the securities as to which such registration, qualification, or compliance is being effected, indemnify the Company, each of its directors, officers, partners, legal counsel, and accountants and each underwriter, if any, of the Company's securities covered by such a registration statement, each person who controls the Company or such underwriter within the meaning of Section 15 of the Securities Act, each other such Holder, and each of their officers, directors, and partners, and each person controlling such Holder, against all claims, losses, damages and liabilities (or actions in respect thereof) arising out of or based on any untrue statement (or alleged untrue statement) of a material fact contained in any such registration statement, prospectus, offering circular, or other document, or any omission (or alleged omission) to state therein a material fact required to be stated therein or necessary to make the statements therein not misleading, and will reimburse the Company and such Holders, directors, officers, partners, legal counsel, and accountants, persons, underwriters, or control persons for any legal or any other expenses reasonably incurred in connection with investigating or defending any such claim, loss, damage, liability, or action, in each case to the extent, but only to the extent, that such untrue statement (or alleged untrue statement) or omission (or alleged omission) is made in such registration statement, prospectus, offering circular, or other document in reliance upon and in conformity with written information furnished to the Company by such Holder and stated to be specifically for use therein provided, however, that the obligations of such Holder hereunder shall not apply to amounts paid in settlement of any such claims, losses, damages, or liabilities or actions in respect thereof if such settlement is effected without the consent of such Holder (which consent shall not be unreasonably withheld); and provided that in no event shall any indemnity under this Section 1.8 exceed the proceeds from the offering received by such Holder. -14- (c) Each party entitled to indemnification under this Section 1.8 (the "Indemnified Party") shall give notice to the party required to provide indemnification (the "Indemnifying Party") promptly after such Indemnified Party has actual knowledge of any claim as to which indemnity may be sought, and shall permit the Indemnifying Party to assume the defense of such claim or any litigation resulting therefrom, provided that counsel for the Indemnifying Party, who shall conduct the defense of such claim or any litigation resulting therefrom, shall be approved by the Indemnified Party (whose approval shall not unreasonably be withheld), and the Indemnified Party may participate in such defense at such party's expense, and provided further that the failure of any Indemnified Party to give notice as provided herein shall not relieve the Indemnifying Party of its obligations under this Section 1, to the extent such failure is not prejudicial. No Indemnifying Party, in the defense of any such claim or litigation, shall, except with the consent of each Indemnified Party, consent to entry of any judgment or enter into any settlement that does not include as an unconditional term thereof the giving by the claimant or plaintiff to such Indemnified Party of a release from all liability in respect to such claim or litigation. Each Indemnified Party shall furnish such information regarding itself or the claim in question as an Indemnifying Party may reasonably request in writing and as shall be reasonably required in connection with defense of such claim and litigation resulting therefrom. (d) If the indemnification provided for in this Section 1.8 is held by a court of competent jurisdiction to be unavailable to an Indemnified Party with respect to any loss, liability, claim, damage, or expense referred to therein, then the Indemnified Party, in lieu of indemnifying such Indemnified Party hereunder, shall contribute to the amount paid or payable by such Indemnified Party as a result of such loss, liability, claim, damage, or expense in such proportion as is appropriate to reflect the relative fault of the Indemnifying Party on the one hand and of the Indemnified Party on the other in connection with the statements or omissions that resulted in such loss, liability, claim, damage, or expense as well as any other relevant equitable considerations. The relative fault of the Indemnifying Party and of the Indemnified Party shall be determined by reference to, among other things, whether the untrue or alleged untrue statement of a material fact or the omission to state a material fact relates to information supplied by the Indemnifying Party or by the Indemnified Party and the parties' relative intent, knowledge, access to information, and opportunity to correct or prevent such statement or omission. In no event shall any contribution by a Holder under this Section 1.8 exceed the proceeds from the offering received by such Holder. No person guilty of fraudulent misrepresentation (within the meaning of Section 11(f) of the Securities Act) shall be entitled to contribution from any person who was not guilty of fraudulent misrepresentation. (e) Notwithstanding the foregoing, to the extent that the provisions on indemnification and contribution contained in the underwriting agreement entered into in connection with the underwritten public offering are in conflict with the foregoing provisions, the provisions in the underwriting agreement shall control. (f) The provisions of this Section 1.8 shall survive termination of this Agreement. -15- 1.9 Information by Holder. Each Holder of Registrable Securities shall furnish to the Company such information regarding such Holder and the distribution proposed by such Holder as the Company may reasonably request in writing and as shall be reasonably required in connection with any registration, qualification, or compliance referred to in this Section 1. 1.10 Limitations on Subsequent Registration Rights. From and after the date of this Agreement, the Company shall not, without the prior written consent of a majority in interest of the Holders of the Series A Convertible Securities and the Series B Convertible Securities acting as a class, enter into any agreement with any holder or prospective holder of any securities of the Company giving such holder or prospective holder any registration rights the terms of which are more favorable than the registration rights granted to such Holders hereunder. 1.11 Rule 144 Reporting. With a view to making available the benefits of certain rules and regulations of the Commission that may permit the sale of the Restricted Securities to the public without registration, the Company agrees to use its best efforts to: (a) Make and keep public information regarding the Company available as those terms are understood and defined in Rule 144 under the Securities Act, at all times from and after ninety (90) days following the effective date of the first registration under the Securities Act filed by the Company for an offering of its securities to the general public; (b) File with the Commission in a timely manner all reports and other documents required of the Company under the Securities Act and the Exchange Act at any time after it has become subject to such reporting requirements; (c) So long as a Holder owns any Restricted Securities, furnish to the Holder forthwith upon written request a written statement by the Company as to its compliance with the reporting requirements of Rule 144 (at any time from and after ninety (90) days following the effective date of the first registration statement filed by the Company for an offering of its securities to the general public), and of the Securities Act and the Exchange Act (at any time after it has become subject to such reporting requirements), a copy of the most recent annual or quarterly report of the Company, and such other reports and documents so filed as a Holder may reasonably request in availing itself of any rule or regulation of the Commission allowing a Holder to sell any such securities without registration. 1.12 Transferor Assignment of Rights. The rights to cause the Company to register securities, the rights of first refusal and the rights of co-sale granted to a Holder by the Company under this Agreement may be transferred or assigned by a Holder to any transferee or assignee provided that the Company is given written notice at the time of or within a reasonable time after said transfer or assignment, stating the name and address of the transferee or assignee and identifying the securities with respect to which such rights are being transferred or assigned, and, provided further, that, with respect to rights to register securities, the transferee or assignee of such rights assumes in writing the obligations of such Holder under this Section 1. -16- 1.13 Market-Stand-Off Agreement. If requested by the Company and an underwriter of Common Stock (or other securities) of the Company, a Holder shall not sell or otherwise transfer or dispose of any Common Stock (or other securities) of the Company held by such Holder (other than those included in the registration) during the one hundred eighty (180) day period following the effective date of a registration statement of the Company filed under the Securities Act, provided that: (a) such agreement shall only apply to the first such registration statement of the Company, including securities to be sold on its behalf to the public in an underwritten offering; and (b) all officers and directors of the Company and holders of at least one percent (1%) of the Company's voting securities (including in any event, each of the Olims) are bound by and have entered into similar agreements. The obligations described in this Section 1.13 shall not apply to a registration relating solely to employee benefit plans on Form S-8 or similar forms that may be promulgated in the future, or a registration relating solely to a Commission Rule 145 transaction on Form S-4 or similar forms that may be promulgated in the future. The Company may impose stop-transfer instructions with respect to the shares of Common Stock (or other securities) subject to the foregoing restriction until the end of said one hundred eighty (180) day period. 1.14 Allocation of Registration Opportunities. In any circumstance in which all of the Registrable Securities and other shares of Common Stock of the Company (including without limitation shares of Common Stock issued or issuable upon conversion of shares of any currently unissued series of Preferred Stock of the Company) with registration rights (the "Other Shares") requested to be included in a registration on behalf of the Holders or other selling stockholders cannot be so included as a result of limitations of the aggregate number of shares of Registrable Securities and Other Shares that may be so included, the number of shares of Registrable Securities and Other Shares that may be so included shall be allocated among the Holders and other selling stockholders requesting inclusion of shares in the following orders of priority: (a) if the registration is pursuant to a request under Section 1.3 then first, pro rata among the Holders (excluding Other Investors and their permitted transferees other than Investors) on the basis of the number of shares of Registrable Securities held by such Holders; second, all securities that the Company proposes to sell for its own account; and third, pro rata on the basis of the number of shares of Registrable Securities and Other Shares that would be held by the remaining Holders and other selling stockholders; (b) if the registration is a registration described in Section 1.4, then first, all securities that the Company proposes to sell for its own account; second, pro rata among the Holders on the basis of the number of shares of Registrable Securities held by such Holders; and third, pro rata on the basis of the number of Other Shares held by other selling stockholders; and -17- (c) for all other registrations, then first, pro rata among the Holders on the basis of the number of shares of Registrable Securities held by such Holders; second, all securities that the Company proposes to sell for its own account; and third, pro rata on the basis of the number of Other Shares held by the other selling stockholders; provided, however, that each allocation in Section 1.14(a), (b) and (c) shall not operate to reduce the aggregate number of Registrable Securities and Other Shares to be included in such registration, if any Holder or other selling stockholder does not request inclusion of the maximum number of shares of Registrable Securities and Other Shares allocated to him pursuant to the above-described procedures, the remaining portion of his allocation shall be reallocated among those requesting Holders and other selling stockholders whose allocations did not satisfy their requests on the basis of the foregoing priority, and this procedure shall be repeated until all of the shares of Registrable Securities and Other Shares which may be included in the registration on behalf of the Holders and other selling stockholders have been so allocated. The Company shall not limit the number of Registrable Securities to be included in a registration pursuant to this Agreement in order to include shares held by stockholders with no registration rights or to include securities owned by the Olims or any other shares of stock issued to employees, officers, directors, or consultants pursuant to the Company's 1996 Equity Compensation Plan, or with respect to registrations under Sections 1.6 or 1.9 hereof, in order to include in such registration securities registered for the Company's own account. 1.15 Termination. The Holders rights to request registration pursuant to Sections 1.3(a)(i) and 1.6(a) shall expire six years after the effective date of a Qualified Public Offering. 2. COVENANTS OF THE COMPANY The Company hereby covenants and agrees as follows: 2.1 Right of First Refusal. The Company hereby grants to each Holder, the right of first refusal to purchase a Pro Rata Share of New Securities (as defined in this Section 2.3) which the Company may, from time to time, propose to sell and issue. Each Holder shall have a right of over- allotment such that if any Holder fails to exercise its right hereunder to purchase its share of New Securities, the other Holders may purchase the non- purchasing Holder's portion on a pro rata basis within ten (10) days from the date such non-purchasing Holder fails to exercise its right hereunder to purchase its share of New Securities. The right of first refusal in this Section 2.1 shall be subject to the following provisions: (a) "New Securities" shall mean any capital stock (including Common Stock and/or Preferred Stock) of the Company whether now authorized or not, and rights, options or warrants to purchase such capital stock, and securities of any type whatsoever that are, or may become, convertible into capital stock; provided that the term "New Securities" does not include (i) securities purchased under the Stock Purchase Agreement; (ii) securities issued upon conversion of the Shares; (iii) securities issued pursuant to the acquisition of another business entity or business segment of any such entity by the -18- Company by merger, purchase of substantially all the assets or other reorganization whereby the Company will own more than fifty percent (50%) of the voting power of such business entity or business segment of any such entity; (iv) any borrowings, direct or indirect, from financial institutions or other persons by the Company, whether or not presently authorized, including any type of loan or payment evidenced by any type of debt instrument, provided such borrowings do not have any equity features including warrants, options or other rights to purchase capital stock and are not convertible into capital stock of the Company; (v) securities issued to employees, consultants, officers or directors of the Company pursuant to the 1996 Equity Compensation Plan; (vi) Conversion Shares; (vii) securities issued upon exercise of the Agent Warrant; (viii) securities issued in a Qualified Public Offering or pursuant to a registration under the Securities Act as a result of a request made pursuant to Section 1.3; (ix) securities issued in connection with any stock split, stock dividend or recapitalization of the Company; (x) any right, option or warrant to acquire any security convertible into the securities excluded from the definition of New Securities pursuant to subsections (i) through (ix) above. (b) In the event the Company proposes to undertake an issuance of New Securities, it shall give each Holder written notice of its intention, describing the type of New Securities, and their price and the general terms upon which the Company proposes to issue the same. Each Holder shall have thirty (30) days after any such notice is delivered to agree to purchase such Holder's share of such New Securities for the price and upon the terms specified in the notice by giving written notice to the Company and stating therein the quantity of New Securities to be purchased. (c) In the event the Holders fail to exercise fully the right of first refusal within said thirty (30) day period and after expiration of the 10- day period for the exercise of their over-allotment rights of this Section 2.1, the Company shall have sixty (60) days thereafter to sell or enter into an agreement (pursuant to which the sale of New Securities covered thereby shall be closed, if at all, within sixty (60) days from the date of said agree ment) to sell the New Securities respecting which the Holders right of first refusal option set forth in this Section 2.1 was not exercised, at a price and upon terms no more favorable to the purchasers thereof than specified in the Company's notice to Holders pursuant to Section 2.1(b). In the event the Company has not sold within said 60-day period or entered into an agreement to sell the New Securities in accordance with the foregoing within sixty (60) days from the date of said agreement, the Company shall not thereafter issue or sell any New Securities, without first again offering such securities to the Holders in the manner provided in this Section 2.1. (d) The rights of first refusal granted under this Agreement shall expire upon the consummation of a Qualified Public Offering. 3. COVENANTS OF CERTAIN PARTIES. 3.1 Termination. The parties hereto who are parties to the Shareholders Agreement and the 1996 Agreement hereby covenant and agree that the 1996 Agreement and -19- Sections 4.6 (excluding the third paragraph of Section 4.6(a) therein) 4.8 and 4.11 of the Shareholders' Agreement are hereby superseded and replaced in their entirety by this Agreement. All other provisions of the Shareholders' Agreement shall remain in full force and effect. In the event of any conflict between the terms of this Agreement and the Shareholders' Agreement, the terms of this Agreement shall control. 3.2 Co-Sale. (a) The Company and the Olims shall deliver to each Holder not less than sixty (60) days prior to the proposed closing date or the proposed effective date of any proposed sale, transfer, or conveyance of shares of the Common Stock by either of the Olims (any such proposed transaction, a "Shareholder Sale") a written notice (the "Sale Notice") which shall state (i) the name of the Person (the "Buyer") acquiring such shares of Common Stock and (ii) the terms and conditions of such sale, including, the price, payment terms, number of shares of Common Stock to be sold, proposed closing date or proposed effective date of such transaction and that the consideration to be paid upon consummation of the Shareholder Sale is to be in cash or by promissory note. In connection with any Shareholder Sale, each Holder shall have the right (the "Co- Sale Right"), following the conversion of Shares and the exercise of warrants held by such Holder, to sell, at the same price and on the same terms as such proposed Shareholder Sale, such Holder's Pro Rata Co-Sale Share of Co-Sale Securities held by such Holder. (b) Not less than thirty (30) days prior to the closing date or effective date of such proposed Shareholder Sale, each Holder electing to exercise Co-Sale Rights shall deliver to the Company and to each of the Olims a written notice setting forth the aggregate number of shares of Co-Sale Securities which such Holder elects to sell in connection with such Shareholder Sale. (c) Subject to compliance by the Company and each of the Olims with the provisions of this Section 3.2, the Olims may consummate the Shareholder Sale on the terms and conditions set forth in the Sale Notice; provided that if such Shareholder Sale is not consummated within ninety (90) days of the date of the Sale Notice, the Company and each of the Olims must comply again with the provisions of this Section 3.2 with respect to such Shareholder Sale. (d) The provisions of this Section 3.2 shall not apply to, and shall terminate, upon the consummation of a Qualified Public Offering. 3.3 Key Person Life Insurance. The Company has as of the date hereof obtained from financially sound and reputable insurers policies of term life insurance on the life of Jason Olim in the amount of at least $2,000,000. Such policies name the Company as loss payee and shall not be cancelable without the prior approval of 90% of the Holders. The Company shall cause to be maintained such life insurance policies. The provisions of this Section 3.3 shall terminate upon the consummation of a Qualified Public Offering. -20- 3.4 Obligations. The Company and the Olims covenant that none of them will enter into any agreement that would restrict any of the Company and the Olims' ability to perform any of their obligations under this Agreement. 3.5 Election of Directors. (a) The Company and each of the Olims agree that, so long as the voting agreement set forth in this Section 3.5 remains in effect, and subject in all events to the applicable provisions of the Company's Articles as in effect from time to time, each of them shall take all action necessary from time to time (including, without limitation, the voting of Common Stock or preferred stock, the execution of written consents, the calling of special meetings, the removal of directors, the filling of vacancies on the Board, the waiving of notice and attendance at meetings) to maintain the membership of the Board as follows: (i) The number of directors composing the Board shall be fixed at no more than eight (8) members, two of which shall have one-half vote each and either (A) six of which shall have one whole vote or (B) if and as so designated by Olims, two of which shall have two whole votes and four of which shall have one whole vote, each for all actions taken by the Board. (ii) At all times that the Series A Preferred Stock outstanding is at least fifty percent (50%) of the Series A Preferred Stock issued and outstanding on the First Closing Date, the holders of Series A Preferred Stock ("Series A Holders") (acting by the consent of the Series A Holders holding a majority of the Series A Conversion Stock), shall have the right to designate one (1) person to serve as a director of the Company whom shall have one whole vote for all actions taken by the Board and shall be as designated in writing to the Company by the Series A Holders holding a majority of the Series A Conversion Stock. (iii) At all times that the Series B Preferred Stock outstanding is at least fifty percent (50%) of the Series A Preferred Stock issued and outstanding on the last Subsequent Closing Date, the holders of Series B Preferred Stock and the Agent Warrant (collectively, the "Series B Holders") (acting by the consent of the Series B Holders holding a majority of the Series B Conversion Stock), shall have the right to designate one (1) person to serve as a director, whom shall have one whole vote for all actions taken by the Board and shall be as designated in writing to the Company by the Series B Holders holding a majority of the Series B Conversion Stock. (b) The persons entitled to name a director pursuant to Section 3.5(a) above are referred to in this Section 3.5 as the "Principals" with respect to that director. If Principals give notice at any time to the Company and the Olims that an individual then serving as a director of the Company at the designation of such Principals is no longer their designee, then the Company and the Olims shall take all action necessary to remove the director so designated. -21- (c) If an individual designated under this Section 3.5 and then serving as a director of the Company dies, resigns or is removed as a director of the Company, then the Company and the Olims shall take all action in accordance with Section 3.5 necessary to elect as a director of the Company any individual newly designated by the Principals, if any, with respect to the director who died, resigned or was removed. (d) This Section 3.5 is intended to be a voting agreement within the meaning of Section 1768(b) of the Pennsylvania Business Corporation Law. (e) The Company agrees to reimburse each non-employee director for the reasonable out-of-pocket expenses incurred by such director in performing his or her services as a director of the Company, including expenses incurred in connection with attendance at meetings of the Board. (f) The parties acknowledge that upon the addition of the members to the Board pursuant to Sections 3.5 (a)(ii) and (iii) the Board will consist of 6 members, two of whom will have one-half vote for all actions taken by the Board, and that at such time the Olims will collectively possess only two of the five whole votes of the entire Board, despite owning in excess of 50% of the total voting capital stock of the Company. Therefore, upon any request by the Olims, the parties hereto shall take all action necessary (including, without limitation, the voting of common stock or preferred stock, the execution of written consents, the calling of special meetings, the filling of vacancies on the Board, the expansion of the number of members on the Board to such number permitted by the Company's Articles, the waiving of notice and attendance at meetings) so that either (i) the Olims will be entitled at their option to nominate two additional members to the Board, each of whom would be entitled to one whole vote on all actions taken by the Board or (ii) the voting rights attendant to the Board positions occupied by each of the Olims would be expanded from one whole vote to two whole votes on all actions taken by the Board. (g) The provisions of this Section 3.5 shall terminate upon the consummation of a Qualified Public Offering. 4. MISCELLANEOUS. 4.1 Governing Law. This Agreement shall be governed in all respects by the laws of the State of Pennsylvania. 4.2 Successors and Assigns. Except as otherwise expressly provided herein, the provisions hereof shall inure to the benefit of, and be binding upon, the successors, assigns, heirs, executors and administrators of the parties hereto. 4.3 Entire Agreement; Amendment; Waiver. This Agreement constitutes the full and entire understanding and agreement between the parties with regard to the subjects hereof and thereof. Neither this Agreement nor any term hereof may be amended, waived, discharged or terminated, except by a written instrument signed by the Company and the -22- holders of at least ninety percent (90%) of the Registrable Securities and any such amendment, waiver, discharge or termination shall be binding on all the Holders, but in no event shall the obligation of any Holder hereunder be materially increased, except upon the written consent of such Holder. 4.4 Notices, etc. Notices and other communications required or permitted hereunder shall be in writing and shall be mailed by United States first-class mail, postage prepaid, sent by facsimile or delivered personal by hand or nationally recognized courier addressed (a) if to a Holder, as indicated on the list of Holders attached hereto as Exhibit A, or at such other address as such holder or permitted assignee shall have furnished to the Company in writing, or (b) if to the Company, at such address or facsimile number as the Company shall have furnished to each Holder in writing. All such notices and other written communications shall be effective on the date of mailing, facsimile transfer or delivery. 4.5 Delays or Omissions. No delay or omission to exercise any right, power or remedy accruing to any Holder, upon any breach or default of the Company under this Agreement shall impair any such right, power or remedy of such Holder nor shall it be construed to be a waiver of any such breach or default, or an acquiescence therein, or of or in any similar breach or default thereafter occurring; nor shall any waiver of any single breach or default be deemed a waiver of any other breach or default therefore or thereafter occurring. Any waiver, permit, consent or approval of any kind or character on the part of any Holder of any breach or default under this Agreement or any waiver on the part of any Holder of any provisions or conditions of this Agreement must be made in writing and shall be effective only to the extent specifically set forth in such writing. All remedies, either under this Agreement or by law or otherwise afforded to any Holder, shall be cumulative and not alterative. 4.6 Rights; Separability. Unless otherwise expressly provided herein, a Holder's rights hereunder are several rights, not rights jointly held with any of the other Holders. In case any provision of the Agreement shall be invalid, illegal or unenforceable, the validity, legality and enforceability of the remaining provisions shall not in any way be affected or impaired thereby. 4.7 Information Confidential. Each Holder acknowledges that the information received by them pursuant hereto may be confidential and for its use only, and it will not use such confidential information in violation of the Exchange Act or reproduce, disclose or disseminate such information to any other person (other than its employees or agents having a need to know the contents of such information, and its attorneys), except in connection with the exercise of rights under this Agreement, unless the Company has made such information available to the public generally or such Holder is required to disclose such information by a governmental body. 4.8 Titles and Subtitles. The titles of the paragraphs and subparagraphs of this Agreement are for convenience of reference only and are not to be considered in construing or interpreting this Agreement. -23- 4.9 Counterparts. This Agreement may be executed in any number of counterparts, each of which shall be an original, but all of which together shall constitute one instrument. -24- IN WITNESS WHEREOF, the parties hereto have executed this Investors' Rights Agreement effective as of the day and year first above written. CDNOW, INC. /s/ Jason Olim By: /s/ Jason Olim Jason Olim /s/ Matthew Olim Name: Jason Olim Matthew Olim /s/ Jeffrey McClusky Title: President Jeffrey McClusky /s/ Anthony Lucenti MBL ENTERTAINMENT, INC. Anthony Lucenti /s/ William Brennan By: /s/ Jeffrey McClusky William Brennan /s/ Alan Meltzer Name: Alan Meltzer ---------------------------------------- Title: --------------------------------------- KEYSTONE VENTURE IV, L.P. By: Keystone Venture IV Mgmt. Co., the G.P. of Keystone Venture IV, L.P. By: KVM IV MCGP, Inc., the G.P. of Keystone Venture IV Mgmt. Co. By: /s/ John R. Regan John R. Regan Vice President EXHIBIT A ADDITIONAL SECURITYHOLDERS GROTECH PARTNERS IV, L.P. By: Grotech Capital Group IV, LLC, its General Partner By: /s/ Patrick Kerins Patrick Kerins, Managing Director ABS EMPLOYEES' VENTURE FUND LIMITED PARTNERSHIP By: Alex. Brown Investments, Inc., its General Partner By: /s/ Mayo A. Shattuck, III Mayo A. Shattuck, III, President ALEX.BROWN & SONS INCORPORATED By: /s/ Thomas R. Hitchner Thomas R. Hitchner Managing Director EX-10.4 5 1996 EQUITY COMPENSATION PLAN CDNOW, INC. 1996 EQUITY COMPENSATION PLAN ----------------------------- Amended and Restated Effective as of January 1, 1997 ---------------------------------------------------- The purpose of the CDNow, Inc. 1996 Equity Compensation Plan, as amended and restated effective as of January 1, 1997 (the "Plan"), is to provide (i) designated officers (including officers who are also directors) and other employees of CDNow, Inc. (the "Company") and its subsidiaries, (ii) non-employee members of the Board of Directors of the Company (the "Board"), and (iii) independent contractors and consultants who perform valuable services for the Company or its subsidiaries, with the opportunity to receive grants of incentive stock options, nonqualified stock options, stock appreciation rights and restricted stock. The Company believes that the Plan will cause the participants to contribute materially to the growth of the Company, thereby benefitting the Company's shareholders and will align the economic interests of the participants with those of the shareholders. 1. Administration -------------- The Plan shall be administered and interpreted by a committee (the "Committee"), which shall consist of not less than two persons appointed by the Board of Directors of the Company (the "Board"). Prior to the effective date of an initial public offering of the Company's stock as described in Section 21(b)(a "Public Offering"), the Board may exercise any power or authority of the Committee under the Plan and, in such case, any reference to the Committee hereunder shall be deemed to include the Board as a whole. After a Public Offering, the Committee shall consist of two or more persons appointed by the Board, all of whom shall be "outside directors" as defined under section 162(m) of the Internal Revenue Code of 1986, as amended (the "Code") and related Treasury regulations, and the Committee may consist of "non- employee directors" as defined under Rule 16b-3 under the Securities Exchange Act of 1934 (the "Exchange Act"). However, notwithstanding anything in the Plan to the contrary, the Board 1 must ratify or approve any grants made to directors. References in the Plan to the "Committee" shall be deemed to include the Board if no committee is appointed, and with respect to ratification or approval of grants made to directors. The Committee shall have the sole authority to (i) determine the individuals to whom grants shall be made under the Plan, (ii) determine the type, size and terms of the grants to be made to each such individual, (iii) determine the time when the grants will be made and the duration of any applicable exercise or restriction period, including the criteria for vesting and the acceleration of vesting, and (iv) deal with any other matters arising under the Plan. The Committee shall have full power and authority to administer and interpret the Plan, to make factual determinations and to adopt or amend such rules, regulations, agreements and instruments for implementing the Plan and for the conduct of its business as it deems necessary or advisable, in its sole discretion. The Committee's interpretations of the Plan and all determinations made by the Committee pursuant to the powers vested in it hereunder shall be conclusive and binding on all persons having any interests in the Plan or in any awards granted hereunder. All powers of the Committee shall be executed in its sole discretion, in the best interest of the Company and in keeping with the objectives of the Plan and need not be uniform as to similarly situated individuals. 2. Grants ------ Incentives under the Plan shall consist of grants of incentive stock options, nonqualified stock options, stock appreciation rights and restricted stock (hereinafter collectively referred to as "Grants"). All Grants shall be subject to the terms and conditions set forth herein and to those other terms and conditions consistent with this Plan as the Committee deems appropriate and as are specified in writing by the Committee to the individual (the "Grant Letter"). The Committee shall approve the form and provisions of each Grant Letter to an individual. Grants under a particular Section of the Plan need not be uniform as among the grantees. 2 3. Shares Subject to the Plan -------------------------- (a) Subject to the adjustment specified below, the aggregate number of shares of common stock of the Company (the "Company Stock") that may be issued or transferred under the Plan is 100,000 shares. Notwithstanding anything in the Plan to the contrary, after a Public Offering, the maximum aggregate number of shares of Company Stock that shall be subject to Grants made under the Plan to any individual during any calendar year shall be 25,000 shares. The shares may be authorized but unissued shares of Company Stock or reacquired shares of Company Stock, including shares purchased by the Company on the open market for purposes of the Plan. If and to the extent options or stock appreciation rights granted under the Plan terminate, expire, or are cancelled, forfeited, exchanged or surrendered without having been exercised or if any shares of restricted stock are forfeited, the shares subject to such Grants shall again be available for purposes of the Plan. (b) If there is any change in the number or kind of shares of Company Stock outstanding by reason of a stock dividend, recapitalization, stock split, or combination or exchange of shares, or merger, reorganization or consolidation in which the Company is the surviving corporation, reclassification or change in par value or by reason of any other extraordinary or unusual events affecting the outstanding Company Stock as a class without the Company's receipt of consideration, or if the value of outstanding shares of Company Stock is substantially reduced due to the Company's payment of an extraordinary dividend or distribution, the maximum number of shares of Company Stock available for Grants, the maximum number of shares of Company Stock for which any one individual participating in the Plan may be granted over the term of the Plan, the number of shares covered by outstanding Grants, and the price per share or the applicable market value of such Grants shall be proportionately adjusted by the Committee to reflect any increase or decrease in the number or kind of issued shares of Company Stock to preclude the enlargement or dilution of rights and benefits under such Grants; provided, however, that any fractional shares resulting from such adjustment shall be eliminated. The adjustments determined by the Committee shall be final, binding and conclusive. Notwithstanding the foregoing, no adjustment shall be authorized or made pursuant to this Section to the extent that 3 such authority or adjustment would cause any incentive stock option to fail to comply with section 422 of the Code. 4. Eligibility for Participation ----------------------------- All employees of the Company and its subsidiaries ("Employees"), including Employees who are officers or members of the Board, shall be eligible to participate in the Plan. Members of the Board who are not employees of the Company or any of its subsidiaries ("Non-Employee Directors") shall be eligible to participate in the Plan, but shall not be eligible to receive incentive stock options. Any independent contractors or consultants who perform valuable services to the Company or any of its subsidiaries ("Consultants") shall be eligible to participate in the Plan, but shall not be eligible to receive incentive stock options. The Committee shall select the Employees, Non-Employee Directors and Consultants to receive Grants and determine the number of shares of Company Stock subject to a particular Grant in such manner as the Committee determines. Employees, Non-Employee Directors and Consultants who receive Grants under this Plan shall hereinafter be referred to as "Grantees". Nothing contained in this Plan shall be construed to (i) limit the right of the Committee to make Grants under this Plan in connection with the acquisition, by purchase, lease, merger, consolidation or otherwise, of the business or assets of any corporation, firm or association, including options granted to employees thereof who become Employees of the Company, or for other proper corporate purpose, (ii) limit the right of the Company to grant stock options or make other awards outside of this Plan. 5. Granting of Options ------------------- (a) Number of Shares. The Committee, in its sole discretion, shall ---------------- determine the number of shares of Company Stock that will be subject to each Grant of stock options. 4 (b) Type of Option and Price. The Committee may grant options intended to ------------------------ qualify as "incentive stock options" within the meaning of section 422 of the Code ("Incentive Stock Options") or options which are not intended to so qualify ("Nonqualified Stock Options") or any combination of Incentive Stock Options and Nonqualified Stock Options (hereinafter collectively the "Stock Options"), all in accordance with the terms and conditions set forth herein. The purchase price of Company Stock subject to a Stock Option shall be determined by the Committee and may be equal to, greater than, or less than the Fair Market Value (as defined below) of a share of such Stock on the date such Stock Option is granted; provided, however, that (i) the purchase price of Company Stock subject to an Incentive Stock Option shall be equal to, or greater than, the Fair Market Value of a share of such Stock on the date such Stock Option is granted and (ii) an Incentive Stock Option may not be granted to an Employee who, at the time of grant, owns stock possessing more than 10 percent of the total combined voting power of all classes of stock of the Company or any parent or subsidiary of the Company, unless the option price per share is not less than 110% of the Fair Market Value of Company Stock on the date of grant. If the Company Stock is not traded in a public market or subject to reported transactions or "bid" or "ask" quotations as set forth below, the Fair Market Value per share shall be as determined by the Committee. If the Company Stock is traded in a public market, then the Fair Market Value per share shall be (i) if the principal trading market for the Company Stock is a national securities exchange or the National Market segment of The NASDAQ Stock Market, the last reported sale price thereof on the relevant date or (if there were no trades on that date) the latest preceding date upon which a sale was reported, or (ii) if the Company Stock is not principally traded on such exchange or market, the mean between the last reported "bid" and "asked" prices thereof on the relevant date, as reported on NASDAQ (or, if applicable, by the exchange, if there was no reported sale on the relevant date) or, if not so reported, as reported by the National Daily Quotation Bureau, Inc. or as reported in a customary financial reporting service, as applicable and as the Committee determines. 5 (c) Option Term. The Committee shall determine the term of each Stock ----------- Option. The term of any Stock Option shall not exceed ten years from the date of grant. Notwithstanding the foregoing, an Incentive Stock Option may not be granted to an Employee who, at the time of grant, owns stock possessing more than 10 percent of the total combined voting power of all classes of stock of the Company or any parent or subsidiary of the Company, unless the option term does not exceed five years from the date of grant. (d) Exercisability of Options; Other Terms. Stock Options shall become -------------------------------------- exercisable in accordance with the terms and conditions determined by the Committee, in its sole discretion, and specified in the Grant Letter. The Committee, in its sole discretion, may accelerate the vesting or exercisability of any or all outstanding Stock Options at any time for any reason. The Committee may provide that Stock Options shall become vested over a period of time, and the Committee may impose such other conditions and restrictions as the Committee deems appropriate. (e) Manner of Exercise. A Grantee may exercise a Stock Option which has ------------------ become exercisable, in whole or in part, by delivering a notice of exercise to the Committee with accompanying payment of the option price in accordance with Subsection (g) below. If a Stock Option is exercised after a Public Offering, such notice may instruct the Company to deliver shares of Company Stock due upon the exercise of the Stock Option to any registered broker or dealer designated by the Committee in lieu of delivery to the Grantee. Such instructions must designate the account into which the shares are to be deposited. The Grantee may tender a notice of exercise, which has been properly executed by the Grantee and the aforementioned delivery instructions to the designated broker. (f) Termination of Employment, Disability or Death. ---------------------------------------------- (i) Except as provided below, a Stock Option may only be exercised while the Grantee is employed by the Company as an Employee, Non-Employee Director or Consultant. The Committee may establish in the Grant Letter (or an amendment thereto) the period after termination of employment during which a Grantee may exercise a Stock Option. In the event that a Grantee ceases to be employed by the Company for any reason other than a "disability", death, or "termination for cause", any Stock Option 6 which is otherwise exercisable by the Grantee shall terminate unless exercised within 90 days after the date on which the Grantee ceases to be employed by the Company (or within such other period of time as may be specified in the Grant Letter), but in any event no later than the date of expiration of the option term. Any of the Grantee's Stock Options which are not otherwise exercisable as of the date on which the Grantee ceases to be employed by the Company shall terminate as of such date, except as otherwise provided in the Grant Letter. (ii) In the event the Grantee ceases to be employed by the Company on account of a "termination for cause" by the Company, any Stock Option held by the Grantee shall terminate as of the date the Grantee ceases to be employed by the Company. (iii) In the event the Grantee ceases to be employed by the Company because the Grantee is "disabled", any Stock Option which is otherwise exercisable by the Grantee shall terminate unless exercised within one year after the date on which the Grantee ceases to be employed by the Company (or within such other period of time as may be specified in the Grant Letter), but in any event no later than the date of expiration of the option term. Any of the Grantee's Stock Options which are not otherwise exercisable as of the date on which the Grantee ceases to be employed by the Company shall terminate as of such date, except as otherwise provided in the Grant Letter. (iv) If the Grantee dies while employed by the Company or within not more than 90 days after the date on which the Grantee ceases to be employed by the Company on account of a termination of employment specified in Section 5(f)(i) above (or within such other period of time as may be specified in the Grant Letter), any Stock Option which is otherwise exercisable by the Grantee shall terminate unless exercised within one year after the date on which the Grantee ceases to be employed by the Company (or within such other period of time as may be specified in the Grant Letter), but in any event no later than the date of expiration of the option term. Any of the Grantee's Stock Options which are not otherwise exercisable as of the date on which the Grantee ceases to be employed by the Company shall terminate as of such date, except as otherwise provided in the Grant Letter. 7 (v) For purposes of this Section 5(f) and Section 6, the term "Company" shall include the Company's subsidiaries, and the following terms shall be defined as follows: (A) "disability" shall mean a Grantee's becoming disabled within the meaning of section 22(e)(3) of the Code and (B) "termination for cause" shall mean, except to the extent otherwise provided in a Grantee's Grant Letter, a finding by the Committee, after full consideration of the facts presented on behalf of both the Company and the Grantee, that the Grantee has breached his or her employment or service contract with the Company or any non- compete or confidentiality agreement with the Company, or has been engaged in disloyalty to the Company, including, without limitation, fraud, embezzlement, theft, commission of a felony or proven dishonesty in the course of his or her employment or service, or has disclosed trade secrets or confidential information of the Company. In such event, in addition to the immediate termination of the Stock Option, the Grantee shall automatically forfeit all option shares for any exercised portion of a Stock Option for which the Company has not yet delivered the share certificates upon refund by the Company of the option price. (g) Satisfaction of Option Price. The Grantee shall pay the option price ---------------------------- specified in the Grant Letter (i) in cash, (ii) with the approval of the Committee, by delivering shares of Company Stock owned by the Grantee (including Company Stock acquired in connection with the exercise of a Stock Option, subject to such restrictions as the Committee deems appropriate) and having a Fair Market Value on the date of exercise equal to the option price or (iii) through any combination of (i) and (ii). The Grantee shall pay the option price and the amount of withholding tax due, if any, at the time of exercise. Shares of Company Stock shall not be issued or transferred upon exercise of a Stock Option until the option price is fully paid and any required withholding is made. (h) Limits on Incentive Stock Options. Each Incentive Stock Option shall --------------------------------- provide that, to the extent that the aggregate Fair Market Value of the stock on the date of the grant with respect to which Incentive Stock Options are exercisable for the first time by a Grantee during any calendar year under the Plan or any other stock option plan of the Company or a parent or subsidiary exceeds $100,000, then such option as to the excess 8 shall be treated as a Nonqualified Stock Option. An Incentive Stock Option shall not be granted to any participant who is not an Employee of the Company or a parent or subsidiary (within the meaning of section 424(f) of the Code). 6. Restricted Stock Grants ----------------------- The Committee may issue or transfer shares of Company Stock to an Employee, Non-Employee Director or Consultant under a Grant of restricted stock (a "Restricted Stock"), upon such terms as the Committee deems appropriate. The following provisions are applicable to Restricted Stock: (a) General Requirements. Shares of Company Stock issued pursuant to -------------------- Restricted Stock Grants may be issued for consideration or for no consideration, at the sole discretion of the Committee. The Committee shall establish conditions under which restrictions on the transfer of shares of Company Stock shall lapse over a period of time or according to such other criteria as the Committee deems appropriate. The period of years during which the Restricted Stock will remain subject to restrictions will be designated in the Grant Letter as the "Restriction Period." (b) Number of Shares. The Committee shall grant to each Grantee a number ---------------- of shares of Company Stock pursuant to a Restricted Stock Grant in such manner as the Committee determines. (c) Termination of Employment. If the Grantee ceases to be employed by the ------------------------- Company (as an Employee, Non-Employee Director or Consultant) during a period designated in the Grant Letter as the Restriction Period, or if other specified conditions are not met, the Restricted Stock Grant shall terminate as to all shares covered by the Grant as to which restrictions on transfer have not lapsed and those shares of Restricted Stock must be immediately returned to the Company. The Committee may, however, provide for complete or partial exceptions to this requirement as it deems equitable. 9 (d) Restrictions on Transfer and Legend on Stock Certificate. During the -------------------------------------------------------- Restriction Period, a Grantee may not sell, assign, transfer, pledge or otherwise dispose of the shares of Restricted Stock to which such Restriction Period applies except to a Successor Grantee under Section 8. Each certificate for a share of Restricted Stock shall contain a legend giving appropriate notice of the restrictions on the Stock. The Grantee shall be entitled to have the legend removed from the stock certificate or certificates covering any of the shares subject to restrictions when all restrictions on such shares have lapsed. The Committee may determine, in its sole discretion, that the Company will not issue certificates for shares of Restricted Stock, or that the Company will retain possession of certificates for shares of Restricted Stock, until all restrictions on such shares have lapsed. (e) Right to Vote and to Receive Dividends. During the Restriction Period, -------------------------------------- unless the Committee determines otherwise, the Grantee shall have the right to vote shares of Restricted Stock and to receive any dividends or other distributions paid on such shares, subject to any restrictions deemed appropriate by the Committee. (f) Lapse of Restrictions. All restrictions imposed under the Restricted --------------------- Stock Grant shall lapse upon the expiration of the applicable Restriction Period and the satisfaction of any conditions imposed by the Committee. The Committee may determine, as to any or all Restricted Stock, that all the restrictions shall lapse without regard to any Restriction Period. 7. Stock Appreciation Rights ------------------------- (a) General Requirements. The Committee may grant stock appreciation -------------------- rights ("SARs") to any Grantee in tandem with any Stock Option, for all or a portion of the applicable Stock Option, either at the time the Stock Option is granted or at any time thereafter while the Stock Option remains outstanding; provided, however, that in the case of an Incentive Stock Option, such rights may be granted only at the time of the Grant of such Stock Option. Unless the Committee determines otherwise, the base price of each SAR shall be equal to the greater of (i) the exercise price of the related Stock Option or (ii) the Fair 10 Market Value of a share of Company Stock as of the date of Grant of such SAR. An SAR is exercisable only during the period when the Stock Option to which it is related is also exercisable. (b) Number of SARs. The number of SARs granted to a Grantee which shall be -------------- exercisable during any given period of time shall not exceed the number of shares of Company Stock which the Grantee may purchase upon the exercise of the related Stock Option during such period of time. Upon the exercise of a Stock Option, the SARs relating to the Company Stock covered by such Stock Option shall terminate. Upon the exercise of SARs, the related Stock Option shall terminate to the extent of an equal number of shares of Company Stock. (c) Value of SARs. Upon a Grantee's exercise of some or all of the ------------- Grantee's SARs, the Grantee shall receive in settlement of such SARs an amount equal to the value of the stock appreciation for the number of SARs exercised, payable in cash, Company Stock or a combination thereof. The stock appreciation for an SAR is the amount by which the Fair Market Value of the underlying Company Stock on the date of exercise of the SAR exceeds the base price of the SAR as described in subsection (a). (d) Form of Payment. At the time of such exercise, the Grantee shall have --------------- the right to elect the portion of the amount to be received that shall consist of cash and the portion that shall consist of shares of Common Stock, which for purposes of calculating the number of shares of Company Stock to be received, shall be valued at their Fair Market Value on the date of exercise of such SARs. The Committee shall have the right to disapprove a Grantee's election to receive cash in full or partial settlement of the SARs exercised and to require that shares of Company Stock be delivered in lieu of cash. If shares of Company Stock are to be received upon exercise of an SAR, cash shall be delivered in lieu of any fractional share. 8. Breach of Non-Compete or Confidentiality Agreement. Notwithstanding -------------------------------------------------- anything in the Plan to the contrary, if a Grantee at any time breaches any non- compete or confidentiality agreement between the Grantee and the Company, the Grantee's Stock Options and SARs shall immediately terminate, and any Restricted Stock held by the Grantee shall be forfeited. In such event, in addition to the immediate termination of Stock Options, 11 SARs and Restricted Stock, the Grantee shall automatically forfeit all option shares for any exercised portion of a Stock Option for which the Company has not yet delivered the share certificates upon refund by the Company of the option price. 9. Transferability of Grants ------------------------- Only the Grantee or his or her authorized representative may exercise rights under a Grant. Such persons may not transfer those rights except by will or by the laws of descent and distribution or, with respect to Grants other than Incentive Stock Options, if permitted in any specific case by the Committee pursuant to a qualified domestic relations order (as defined under the Code or Title I of the Employee Retirement Income Security Act of 1974, as amended or the regulations thereunder). When a Grantee dies, the representative or other person entitled to succeed to the rights of the Grantee ("Successor Grantee") may exercise such rights. A Successor Grantee must furnish proof satisfactory to the Company of his or her right to receive the Grant under the Grantee's will or under the applicable laws of descent and distribution. Notwithstanding the foregoing, the Committee may provide, in a Grant Letter, that a Grantee may transfer Nonqualified Stock Options to his or her children, grandchildren or spouse or to one or more trusts for the benefit of such family members or to partnerships in which such family members are the only partners (a "Family Transfer"), provided that the Grantee receives no consideration for a Family Transfer and the Grant Letters relating to Nonqualified Stock Options transferred in a Family Transfer continue to be subject to the same terms and conditions that were applicable to such Nonqualified Stock Options immediately prior to the Family Transfer. 10. Right of First Refusal ---------------------- Prior to a Public Offering, if at any time an individual desires to sell, encumber, or otherwise dispose of shares of Company Stock distributed to him under this Plan, the individual shall first offer the shares to the Company by giving the Company written notice disclosing: (a) the name of the proposed transferee of the Company Stock; (b) the certificate number and number of shares of Company Stock proposed to be transferred or -12- encumbered; (c) the proposed price; (d) all other terms of the proposed transfer; and (e) a written copy of the proposed offer. Within 60 days after receipt of such notice, the Company shall have the option to purchase all or part of such Company Stock at the then current Fair Market Value (as defined in Section 5(b)) and may pay such price in installments over a period not to exceed four years, at the discretion of the Committee. In the event the Company (or a shareholder, as described below) does not exercise the option to purchase Company Stock, as provided above, the individual shall have the right to sell, encumber, or otherwise dispose of his shares of Company Stock on the terms of the transfer set forth in the written notice to the Company, provided such transfer is effected within 15 days after the expiration of the option period. If the transfer is not effected within such period, the Company must again be given an option to purchase, as provided above. The Board, in its sole discretion, may waive the Company's right of first refusal pursuant to this Section 10 and the Company's repurchase right pursuant to Section 11 below. If the Company's right of first refusal or repurchase right is so waived, the Board may, in its sole discretion, pass through such right to the remaining shareholders of the Company in the same proportion that each shareholder's stock ownership bears to the stock ownership of all the shareholders of the Company, as determined by the Board. To the extent that a shareholder has been given such right and does not purchase his or her allotment, the other shareholders shall have the right to purchase such allotment on the same basis. On and after a Public Offering, the Company shall have no further right to purchase shares of Company Stock under this Section 10 and Section 11 below, and its limitations shall be null and void. Notwithstanding the foregoing, the Committee may require that a Grantee execute a shareholder's agreement, with such terms as the Committee deems appropriate, with respect to any Company Stock distributed pursuant to this Plan, in which case the provisions of this Section 10 and Section 11 below shall not apply to such Company Stock. -13- 11. Purchase by the Company ----------------------- Prior to a Public Offering, if a Grantee ceases to be employed by the Company, the Company shall have the right to purchase all or part of any Company Stock distributed to him under this Plan at its then current Fair Market Value (as defined in Section 5(b)); provided, however, that such repurchase shall be made in accordance with applicable accounting rules to avoid adverse accounting treatment. 12. Change of Control of the Company -------------------------------- As used herein, a "Change of Control" shall be deemed to have occurred if: (a) As a result of any transaction, any one shareholder, other than an existing shareholder as of the effective date of the Plan (or his beneficiary or estate), becomes a beneficial owner, directly or indirectly, of securities of the Company representing more than 40% of the common stock of the Company or the combined voting power of the Company's then outstanding securities; (b) The shareholders of the Company approve (or, if shareholder approval is not required, the Board approves) an agreement providing for (i) the merger or consolidation of the Company with another corporation where the shareholders of the Company, immediately prior to the merger or consolidation, will not beneficially own, immediately after the merger or consolidation, shares entitling such shareholders to 40% or more of all votes to which all shareholders of the surviving corporation would be entitled in the election of directors (without consideration of the rights of any class of stock to elect directors by a separate class vote), or where the members of the Board, immediately prior to the merger or consolidation, would not, immediately after the merger or consolidation, constitute a majority of the board of directors of the surviving corporation, (ii) the sale or other disposition of all or substantially all of the assets of the Company, or (iii) a liquidation, dissolution or statutory exchange of the Company; -14- (c) Any person has commenced a tender offer or exchange offer for 40% or more of the voting power of the then outstanding shares of the Company; or (d) At least a majority of the Board does not consist of individuals who were elected, or nominated for election, by the directors in office at the time of such election or nomination. 13. Consequences of a Change of Control ----------------------------------- (a) If a Change of Control occurs after a Public Offering, unless the Committee determines otherwise, (i) all outstanding Stock Options and SARs shall become fully vested and exercisable and (ii) the restrictions and conditions on all outstanding Restricted Stock shall immediately lapse. If the Change of Control is one where the Company is not the surviving corporation (or survives only as a subsidiary of another corporation), all outstanding Stock Options and SARs shall be assumed or replaced with comparable options or rights by the surviving corporation. (b) If a Change of Control occurs before a Public Offering, unless the Committee determines otherwise: (i) The restrictions and conditions on all outstanding Restricted Stock shall immediately lapse. (ii) If the Change of Control is one where the Company is not the surviving corporation (or survives only as a subsidiary of another corporation), all outstanding Stock Options and SARs shall be assumed or replaced with comparable options or rights by the surviving corporation. If the Change of Control is not one described in the preceding sentence, all outstanding Stock Options and SARs shall continue in effect according to their terms. (iii) Notwithstanding the foregoing, the Committee may (x) accelerate the vesting and exercisability of Stock Options and SARs, (y) determine that all outstanding Stock Options and SARs shall terminate as of the Change of Control (without payment to the Grantees) or (z) take actions described in Subsection (c) below. -15- (c) Notwithstanding the foregoing, in the event of a Change of Control, the Committee may, in its sole discretion, (i) require that Grantees surrender their outstanding Stock Options and SARs in exchange for a payment by the Company, in cash or Company Stock as determined by the Committee, in an amount equal to the amount by which the then Fair Market Value of the shares of Company Stock subject to the Grantee's outstanding Stock Options or SARs exceeds the option purchase price of the Stock Options or the base price of the SARs, as applicable, and (ii) terminate any or all outstanding Stock Options and SARs at such time as the Committee deems appropriate. Such surrender shall take place as of the date of the Change of Control or such other date as the Committee may specify. (d) Notwithstanding anything in the Plan to the contrary, in the event of a Change of Control, the Committee shall not have the right to take any actions described in the Plan (including without limitation the actions described in Subsections (b) and (c) above) that would make the applicable Change of Control ineligible for pooling of interest accounting treatment or that would make such Change of Control ineligible for desired tax treatment if, in the absence of such right, the Change of Control would qualify for such treatment and the Company intends to use such treatment with respect to the Change of Control. 14. Amendment and Termination of the Plan ------------------------------------- (a) Amendment. The Board may amend or terminate the Plan at any time; --------- provided, however, that, after a Public Offering, the Board shall not amend the Plan without shareholder approval if such approval is required by Section 162(m) of the Code, if applicable. (b) Termination of Plan. The Plan shall terminate on the day immediately ------------------- preceding the tenth anniversary of its effective date unless terminated earlier by the Board or unless extended by the Board with the approval of the shareholders. (c) Termination and Amendment of Outstanding Grants. A termination or ----------------------------------------------- amendment of the Plan that occurs after a Grant is made shall not materially impair the rights of a Grantee unless the Grantee consents or unless the Committee acts under Section 22(b) hereof. The termination of the Plan shall not impair the -16- power and authority of the Committee with respect to an outstanding Grant. Whether or not the Plan has terminated, an outstanding Grant may be terminated or amended under Section 22(b) hereof or may be amended by agreement of the Company and the Grantee consistent with the Plan. (d) Governing Document. The Plan shall be the controlling document. No ------------------ other statements, representations, explanatory materials or examples, oral or written, may amend the Plan in any manner. The Plan shall be binding upon and enforceable against the Company and its successors and assigns. 15. Funding of the Plan ------------------- This Plan shall be unfunded. The Company shall not be required to establish any special or separate fund or to make any other segregation of assets to assure the payment of any Grants under this Plan. In no event shall interest be paid or accrued on any Grant, including unpaid installments of Grants. 16. Rights of Participants ---------------------- Nothing in this Plan shall entitle any Employee, Non-Employee Director, Consultant or other person to any claim or right to be granted a Grant under this Plan. Neither this Plan nor any action taken hereunder shall be construed as giving any individual any rights to be retained by or in the employ of the Company or any other employment rights. 17. No Fractional Shares -------------------- No fractional shares of Company Stock shall be issued or delivered pursuant to the Plan or any Grant. The Committee shall determine whether cash, other awards or other property shall be issued or paid in lieu of such fractional shares or whether such fractional shares or any rights thereto shall be forfeited or otherwise eliminated. -17- 18. Withholding of Taxes -------------------- The Company shall have the right to deduct from all Grants paid in cash, or from other wages paid to the Grantee, any federal, state or local taxes required by law to be withheld with respect to such cash awards and, in the case of Grants paid in Company Stock, the Grantee or other person receiving such shares shall be required to pay to the Company the amount of any such taxes which the Company is required to withhold with respect to such Grants or the Company shall have the right to deduct from other wages paid by the Company the amount of any withholding due with respect to such Grants. 19. Requirements for Issuance of Shares ----------------------------------- No Company Stock shall be issued or transferred in connection with any Grant hereunder unless and until all legal requirements applicable to the issuance or transfer of such Company Stock have been complied with to the satisfaction of the Committee. The Committee shall have the right to condition any Grant made to any Grantee hereunder on such Grantee's undertaking in writing to comply with such restrictions on his or her subsequent disposition of such shares of Company Stock as the Committee shall deem necessary or advisable as a result of any applicable law, regulation or official interpretation thereof and certificates representing such shares may be legended to reflect any such restrictions. Certificates representing shares of Company Stock issued under the Plan will be subject to such stop-transfer orders and other restrictions as may be applicable under such laws, regulations and other obligations of the Company, including any requirement that a legend or legends be placed thereon. 20. Headings -------- Section headings are for reference only. In the event of a conflict between a title and the content of a Section, the content of the Section shall control. -18- 21. Effective Date of the Plan. -------------------------- (a) Plan Effective Date. Subject to the approval of the Company's ------------------- shareholders, this Plan shall be effective as of June 1, 1996. The amendment and restatement of the Plan shall be effective as of January 1, 1997. (b) Effective Date of Public Offering. The provisions of the Plan that --------------------------------- refer to a Public Offering, or that refer to, or are applicable to persons subject to, Section 16 of the Exchange Act or Section 162(m) of the Code, shall be effective, if at all, upon the initial registration of the Company Stock under Section 12(g) of the Exchange Act, and shall remain effective thereafter for so long as such stock is so registered. 22. Miscellaneous ------------- (a) Substitute Grants. The Committee may make a Grant to an employee of ----------------- another corporation who becomes an Employee by reason of a corporate merger, consolidation, acquisition of stock or property, reorganization or liquidation involving the Company or any of its subsidiaries in substitution for a stock option or restricted stock grant made by such corporation ("Substituted Stock Incentives"). The terms and conditions of the substitute grant may vary from the terms and conditions required by the Plan and from those of the Substituted Stock Incentives. The Committee shall prescribe the provisions of the substitute grants. (b) Compliance with Law. The Plan, the exercise of Stock Options and the ------------------- obligations of the Company to issue or transfer shares of Company Stock under Grants shall be subject to all applicable laws and to approvals by any governmental or regulatory agency as may be required. With respect to persons subject to Section 16 of the Exchange Act, it is the intent of the Company that the Plan and all transactions under the Plan comply with all applicable provisions of Rule 16b-3 or its successors under the Exchange Act. The Committee may revoke any Grant if it is contrary to law or modify a Grant to bring it into compliance with any valid and mandatory government regulation. The Committee may also adopt rules regarding the withholding of taxes on payments to Grantees. The Committee may, in its sole discretion, agree to limit its authority under this Section. -19- (c) Ownership of Stock. A Grantee or Successor Grantee shall have no ------------------ rights as a shareholder with respect to any shares of Company Stock covered by a Grant until the shares are issued or transferred to the Grantee or Successor Grantee on the stock transfer records of the Company. (d) Governing Law. The validity, construction, interpretation and effect ------------- of the Plan and Grant Letters issued under the Plan shall exclusively be governed by and determined in accordance with the law of the Commonwealth of Pennsylvania. -20- EX-10.5 6 AMENDMENT NO. 1 TO 1996 EQUITY COMPNSATION PLAN AMENDMENT 1997-1 TO THE CDNOW, INC. 1996 EQUITY COMPENSATION PLAN CDNow, Inc. (the "Company") maintains the 1996 Equity Compensation Plan (the "Plan"), and the Company now wishes to amend the Plan. Now, therefore, the Plan is amended as follows: 1 The first sentence of Section 3(a) is amended to read as follows: Subject to adjustment as specified below, the aggregate number of shares of common stock of the Company (the "Company Stock") that may be issued or transferred under the Plan is 800,000 shares. Notwithstanding anything in the Plan to the contrary, after a Public Offering, the maximum aggregate number of shares of Company Stock that may be subject to Grants made under the Plan to any individual during any calendar year shall be 100,000 shares. 2 The amendment shall be effective as of July 15, 1997. 3 In all other respects, the Plan is hereby ratified and confirmed. CDNOW, INC. By: /s/ Jason Olim Date: July 15, 1997 EX-10.6 7 WARRANTS DATED 08/05/97 THIS WARRANT AND THE SHARES OF SERIES B PREFERRED STOCK PURCHASABLE HEREUNDER HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED, OR UNDER THE SECURITIES LAWS OF ANY STATE OR OTHER JURISDICTION AND MAY NOT BE SOLD, OFFERED FOR SALE OR OTHERWISE TRANSFERRED UNLESS REGISTERED OR QUALIFIED UNDER SAID ACT AND APPLICABLE STATE SECURITIES LAWS OR UNLESS AN EXEMPTION IS AVAILABLE AND AN OPINION OF COUNSEL REASONABLY ACCEPTABLE TO THE ISSUER IS DELIVERED TO SUCH EFFECT. Void after 5:00 p.m. New York, New York Time, on August 5, 2002. WARRANT TO PURCHASE SHARES OF SERIES B PREFERRED STOCK OF CDNOW, INC. This is to certify that, FOR VALUE RECEIVED, Alex.Brown & Sons Incorporated or its registered assigns pursuant to Section (d) hereof ("Holder"), is entitled to purchase, subject to the provisions of this Warrant, from CDNOW, INC., a Pennsylvania corporation (the "Company"), up to 103,211 fully paid, validly issued and nonassessable shares of Series B Convertible Preferred Stock, no par value per share (the "Series B Preferred Stock"), at the exercise price of $5.45 per share until August 5, 2002. The number of shares of Series B Preferred Stock to be received upon the exercise of this Warrant and the price to be paid for each share of Series B Preferred Stock are subject to adjustment from time to time as hereinafter set forth. The shares of Series B Preferred Stock deliverable upon such exercise, and as adjusted from time to time, are hereinafter sometimes referred to as "Warrant Shares," and the exercise price for a share of Series B Preferred Stock, as adjusted from time to time, is hereinafter sometimes referred to as the "Exercise Price." In the event the outstanding shares of Series B Preferred Stock are automatically converted into shares of the Company's Common Stock in accordance with the terms of the Series B Preferred Stock as set forth in the Company's Amended and Restated Articles of Incorporation, as amended on August 5, 1997 ("Articles"), this Warrant shall immediately become exercisable for shares of the Company's Common Stock on terms identical to those applicable to the Series B Preferred Stock. (a) EXERCISE OF WARRANT; NOTIFICATION OF EXPIRATION DATE OF WARRANT. The --------------------------------------------------------------- Warrant may be exercised in whole or in part at any time or from time to time, until 5:00 P.M. New York, New York Time on August 5, 2002 (the "Expiration Date"), provided, however, that if such day is a day on which banking institutions in the State of New York are authorized by law to close, then on the next succeeding day which shall not be such a day. The Warrant may be exercised by presentation and surrender hereof to the Company at its principal office, or at the office of its stock transfer agent, if any, with the purchase form annexed hereto duly executed (with signature guaranteed if required by the Company or, if any, its stock transfer agent) and accompanied by payment of the Exercise Price for the number of Warrant Shares specified in such form and any applicable taxes. The purchase price for any Warrant Shares purchased pursuant to the exercise of this Warrant shall be paid in full upon such exercise in cash or by certified or bank check or by cancellation by the Holder of indebtedness or other debt obligations of the Company to the Holder. Alternatively, this Warrant may be exchanged for Warrant Shares as described in Section (k) hereof. As soon as practicable after each such exercise of this Warrant, but not later than seven (7) business days from the date of such exercise, the Company shall issue and deliver to the Holder a certificate or certificates for the Warrant Shares issuable upon such exercise, registered in the name of the Holder or the Holder's designee (subject to the terms of this Warrant). If the Warrant should be exercised in part only, the Company shall, upon surrender of the Warrant for cancellation, execute and deliver a new Warrant evidencing the rights of the Holder thereof to purchase the balance of the Warrant Shares purchasable thereunder. Upon receipt by the Company of the Warrant at its office, or by the stock transfer agent of the Company at its office, in proper form for exercise, together with the exercise price thereof and taxes as aforesaid in cash or certified or bank check and the investment letter described below, the Holder shall be deemed to be the holder of record of the Warrant Shares issuable upon such exercise, notwithstanding that the stock transfer books of the Company shall then be closed or that certificates representing such Warrant Shares shall not then be physically delivered to the Holder. Each stock certificate so delivered shall be in such denomination as may be reasonably requested by the Holder hereof and shall be registered in the name of the Holder or such other name as shall be designated by the Holder (subject to the terms of this Warrant). The Company shall pay all expenses, taxes and other charges payable in connection with the preparation, execution and delivery of stock certificates and new Warrants, pursuant to this Section (a), except that, in case such stock certificates shall be registered in a name or names other than the name of the Holder of this Warrant, funds sufficient to pay all stock transfer taxes which shall be payable upon the execution and delivery of such stock certificate or certificates shall be paid by the Holder hereof to the Company. In order to assure the availability of an exemption from registration under the federal or applicable state securities laws, the Company may condition the exercise of the Warrant upon the Holder delivering to the Company an investment letter in the form as customarily used by the Company from time to time in connection with the exercise of unregistered options and warrants issued by the Company. It is further understood that certificates for the Warrant Shares, if any, to be issued upon exercise of the Warrant may contain a restrictive legend in accordance with Section (j) hereof. Notwithstanding anything herein to the contrary, the Company shall use reasonable efforts to mail to the original Holder, by certified mail, return receipt requested, notice of the Expiration Date of this Warrant, no later than 15 days prior to the Expiration Date. -2- (b) RESERVATION OF SHARES. The Company shall at all times reserve for --------------------- issuance and/or delivery upon exercise of this Warrant such number of shares of its Series B Preferred Stock as shall be required for issuance and delivery upon exercise of this Warrant. If any shares of the Series B Preferred Stock are or become listed on any national securities exchange or The Nasdaq Stock Market, the Company shall also list the Warrant Shares, as the case may be, on such exchange or system, as the case may be, subject to notice of issuance. (c) FRACTIONAL SHARES. Fractional shares or scrip representing fractional ----------------- shares may be issued upon the exercise of this Warrant. Alternatively, the Company may, at its option, with respect to any fraction of a share issuable upon any exercise hereof, pay to the Holder an amount in cash equal to such fraction multiplied by the greater of (i) the initial Exercise Price per share or (ii) the current market value of the shares of the Company's Series B Preferred Stock. The current market value of a share of Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) shall be determined as follows: (1) If the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) is listed on a national securities exchange or admitted to unlisted trading privileges on such exchange or listed for trading on The Nasdaq Stock Market, the current market value shall be the last reported sale price of the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) on such exchange or system on the last business day prior to the date of exercise of this Warrant or if no such sale is made on such day, the average closing bid and asked prices for such day on such exchange or system; (2) If the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) is not so listed or admitted to unlisted trading privileges, the current market value shall be the mean of the last reported bid and asked prices for the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) reported by the National Quotation Bureau, Inc., on the last business day prior to the date of the exercise of this Warrant; or (3) If the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) is not so listed or admitted to unlisted trading privileges and bid and asked prices are not so reported, the current market value shall be an amount reasonably determined by the Board of Directors of the Company. (d) EXCHANGE, TRANSFER, ASSIGNMENT OR LOSS OF WARRANT. This Warrant is ------------------------------------------------- exchangeable, without expense, at the option of the Holder, upon presentation and surrender hereof to the Company or at the office of its stock transfer agent, if any, for other warrants of different denomination (which may be reasonably requested by the Holder) entitling -3- the Holder thereof to purchase in the aggregate the same number of shares of Series B Preferred Stock purchasable hereunder. Subject to Section (j) hereof, the Holder may transfer or assign this Warrant, in whole or in part and from time to time. In addition to the rights of the Holder set forth in this Warrant, the Holder has additional registration and other rights pursuant to the Investors' Rights Agreement described in Section (1) hereof. To effect a transfer of such registration rights, certain notice and assumption obligations are imposed by the Investors' Rights Agreement. Upon surrender by the Holder of this Warrant to the Company at its principal office or at the office of its stock transfer agent, if any, with the Assignment Form annexed hereto duly executed (with signature guaranteed, if required by the Company or its stock transfer agent) and funds sufficient to pay any transfer tax, the Company shall, without charge, execute and deliver a new Warrant in the name of the assignee or assignees named in such instrument of assignment and this Warrant shall promptly be canceled. This Warrant may be divided into or combined with other Warrants which carry the same rights upon presentation hereof at the principal office of the Company or at the office of its stock transfer agent, if any, together with a written notice specifying the names and denominations in which new Warrants are to be issued and signed by the Holder hereof. The term "Warrant" as used herein includes any Warrants into which this Warrant may be divided or exchanged, and the term "Holder" includes any subsequent holder or holders of this Warrant or any warrant for which this Warrant is exchanged or into which it is divided. Upon receipt by the Company of evidence satisfactory to it of the loss, theft, destruction or mutilation of this Warrant, and in the case of loss, theft or destruction, of reasonable satisfactory indemnification, and upon surrender and cancellation of this Warrant, if mutilated, the Company will execute and deliver a new Warrant of like tenor, date and amount. Any such new Warrant executed and delivered shall constitute an additional contractual obligation on the part of the Company, whether or not the original Warrant shall be at any time enforceable by anyone. (e) RIGHTS OF THE HOLDER. Subject to the provisions of Section (1), the -------------------- Holder shall not, by virtue hereof, be entitled to any rights of a shareholder in the Company, either at law or equity (including, without limitation, any rights to dividends) and the rights of the Holder with respect to the shares of Series B Preferred Stock purchasable pursuant to this Warrant are limited to those expressed in the Warrant and are not enforceable against the Company except to the extent set forth herein. (f) ANTI-DILUTION PROVISIONS. So long as this Warrant shall be ------------------------ outstanding, the Exercise Price in effect at any time and the number and kind of securities purchasable upon the exercise of this Warrant shall be subject to adjustment from time to time upon the happening of certain events as follows: (1) In case the Company shall: (i) declare a dividend or make a distribution on its outstanding shares of Common Stock in shares of Common Stock; (ii) issue shares of Common Stock or securities convertible into Common Stock (other than shares of Common Stock issued upon: (A) the conversion of outstanding shares of Series B Preferred Stock, (B) the exercise of warrants to purchase Common Stock outstanding prior -4- to July 15, 1997, or (C) the exercise of any option granted or hereafter granted to any officer, director, employee, agent or consultant of the Company pursuant to a stock option plan approved by a majority of the independent directors of the Company's Board of Directors) for consideration less than the Exercise Price of this Warrant on the date of issuance of such shares of Common Stock; (iii) subdivide or reclassify its outstanding shares of Common Stock into a greater number of shares; or (iv) combine or reclassify its outstanding shares of Common Stock into a smaller number of shares, then the Exercise Price in effect at the time of the record date for such dividend or distribution, the issuance of such shares of Common Stock or the effective date of such subdivision, combination or reclassification (such dividend or distribution, issuance of securities, subdivision, combination or reclassification, collectively a "Dilution Event") shall be proportionately adjusted as of the effective date of such Dilution Event by multiplying such Exercise Price by a fraction, the denominator of which shall be the outstanding number of shares of Common Stock determined on a fully-diluted basis immediately following such event and the numerator of which shall be the outstanding number of shares of Common Stock determined on a fully- diluted basis immediately prior thereto plus, in the case of an adjustment pursuant to clause (ii), the number of shares of Common Stock that would be purchasable at the Exercise Price for the consideration being paid for the shares being issued. Such adjustment shall be made successively whenever any Dilution Event shall occur. (2) Whenever the Exercise Price payable upon exercise of this Warrant is adjusted pursuant to subsection (1) above, the number of Warrant Shares purchasable upon exercise of this Warrant shall simultaneously be adjusted by multiplying the number of Warrant Shares issuable upon exercise of this Warrant immediately prior to the Dilution Event by the Exercise Price in effect immediately prior to the Dilution Event and dividing the product so obtained by the Exercise Price, as adjusted pursuant to subsection (1). (3) No adjustment in the Exercise Price shall be required unless such adjustment would require an increase or decrease of at least $.05 in such price; provided, however, that any adjustments which by reason of this Section (f)(3) are not required to be made shall be carried forward and taken into account in any subsequent adjustment required to be made hereunder. (4) Each computation required by this Section (f) for purposes of determining whether the Exercise Price shall be adjusted shall be performed by the Company's Chief Financial Officer or Controller and shall be reasonably acceptable to the Holder. -5- (5) Whenever the Exercise Price is adjusted, as herein provided, the Company shall promptly cause a notice (certified as correct by the Company's Chief Financial Officer or Controller) setting forth the adjusted Exercise Price and adjusted number of Warrant Shares issuable upon exercise of this Warrant to be mailed to the Holder, at its address appearing in the Company's Warrant Register, and shall cause a certified copy thereof to be mailed to its transfer agent, if any. (6) All calculations under this Section (f) shall be made to the nearest cent or to the nearest Warrant Share, as the case may be. (7) In the event that, as a result of application of Section (i) of this Warrant, this Warrant shall become exercisable for securities other than the Series B Preferred Stock, thereafter the number of shares of Series B Preferred Stock receivable upon exercise of this Warrant shall be subject to adjustment from time to time in a manner and on terms as nearly equivalent as practicable to the provisions with respect to the Common Stock contained in this Section (f). (8) Irrespective of any adjustments in the Exercise Price or the number kind of Warrant Shares purchasable upon exercise of this Warrant, Warrants theretofore or thereafter issued may continue to express the same price and number and kind of shares as are stated in this Warrant initially issued. (9) The adjustment provisions set forth in this Section (f) are intended to preserve the relative equity interest in the Company which the Holder is permitted to acquire upon conversion of this Warrant into securities of the Company. The parties hereby acknowledge and agree that, assuming no changes are made to the conversion rights of the holders of Series B Preferred Stock (the "Series B Conversion Rights") as set forth and described in the Articles, the provisions relating to adjustment of the exercise price and the number and kind of securities purchasable upon exercise of the Warrant contained in this Section (f) (the "Antidilution Provisions") shall be deemed to apply to distributions, issuances, subdivisions, reclassifications or other changes with respect to the Series B Preferred Stock, but not to distributions, issuances, subdivisions, reclassifications or other changes with respect to the Company's Common Stock and that, in particular, in the application of this Section (f)(1) respecting the occurrence of a Dilution Event, the term "Series B Preferred Stock" shall in each instance be substituted for the term "Common Stock." In the event that any change to the Series B Conversion Rights is made which affects the conversion rights of the Series B Preferred Stock, the -6- parties agree that the Antidilution Provisions shall be deemed to apply to distributions, issuances, subdivisions, reclassifications or other changes with respect to both the Company's Series B Preferred stock and Common Stock. In no event shall both the provisions of this Section (f) and the Articles be applied concurrently to effect an increase in the relative equity interest in the Company of the holder of this Warrant over the amount of increase which would have occurred if the Holder had acquired shares of Series B Preferred Stock rather than the Warrant on August 5, 1997. (g) OFFICER'S CERTIFICATE. Whenever the Exercise Price shall be adjusted --------------------- as required by the provisions of the foregoing, the Company shall forthwith file in the custody of its Secretary or an Assistant Secretary at its principal office and with its stock transfer agent, if any, a certificate of the Company's Chief Financial Officer or Controller showing the adjusted Exercise Price determined as herein provided, setting forth in reasonable detail the facts requiring such adjustment, including a statement of the number of additional shares of Series B Preferred Stock, if any, and such other facts as shall be necessary to show the reason for and the manner of computing such adjustment. Each such officer's certificate shall be made available at all reasonable times for inspection by the Holder or any holder of this Warrant, and the Company shall, forthwith after each such adjustment, mail, by certified mail, a copy of such certificate to the Holder or any such holder. (h) NOTICES TO WARRANT HOLDERS. So long as this Warrant shall be -------------------------- outstanding, (i) if the Company shall declare any dividend or make any distribution upon the Common Stock, or (ii) if any capital reorganization of the Company, reclassification of the capital stock of the Company, consolidation or merger of the Company with or into another corporation, sale, lease or transfer of all or substantially all of the property and assets of the Company to another corporation, or voluntary or involuntary dissolution, liquidation or winding up of the Company shall be effected, then in any such case, the Company shall cause to be mailed by certified mail to the Holder of this Warrant, at least 10 days prior to the date specified in (x) or (y) below, as the case may be, a notice containing a brief description of the proposed action and stating the date on which (x) a record is to be taken for the purpose of such dividend, distribution or offer for subscription or purchase, or (y) such reorganization, reclassification, consolidation, merger, sale, lease, transfer, dissolution, liquidation or winding up is to take place and the date, if any is to be fixed, as of which the holders of the Common Stock or other capital stock of the Company shall receive cash or other property deliverable upon such reclassification, reorganization, consolidation, merger, conveyance, dissolution, liquidation or winding up. (i) RECLASSIFICATION, REORGANIZATION OR MERGER. In case of any ------------------------------------------ reclassification, conversion or capital reorganization of outstanding shares of either the Series B Preferred Stock or the Common Stock of the Company, or in case of any consolidation or merger of the Company with or into another corporation (other than a merger with another corporation in which merger the Company is the continuing corporation and which does not result in any reclassification or capital reorganization of outstanding shares of Series B Preferred Stock of the series issuable upon exercise of this Warrant) or in case of any sale, lease or conveyance -7- to another corporation of the property of the Company substantially as an entirety, the Company shall, as a condition precedent to such transaction, cause effective provisions to be made so that the Holder shall have the right thereafter by exercising this Warrant at any time prior to the expiration of this Warrant, to purchase the kind and amount of shares of stock and other securities and property receivable upon such reclassification or capital reorganization and consolidation, merger, sale or conveyance which would have been deliverable to the Holder of this Warrant on the effective date of the reclassification, reorganization or merger had the Holder exercised the Warrant immediately prior to the event described in this Section (i). Any such provision shall include provision for subsequent adjustments which shall be as nearly equivalent as may be practicable to the adjustments provided for in this Warrant. The foregoing provisions of this Section (i) shall similarly apply to successive reclassifications or capital reorganizations of shares of either the Series B Preferred Stock or the Common Stock and to successive consolidations, mergers, sales or conveyances. In the event that in connection with any such capital reorganization or reclassification, consolidation, merger, sale or conveyance, additional shares of Series B Preferred Stock shall be issued in exchange, conversion, substitution or payment, in whole or in part, for a security of the Company other than Series B Preferred Stock, any such issue shall be treated as an issue of Common Stock covered by the provisions of Section (f)(1) hereof. (j) SECURITIES LAW COMPLIANCE ------------------------- (1) The Holder of this Warrant, by acceptance hereof, acknowledges that this Warrant and the Warrant Shares to be issued upon exercise hereof are being acquired solely for the Holder's own account and not as a nominee for any other party, and for investment, and that the Holder will not offer, sell, transfer, assign or otherwise dispose of this Warrant or any Warrant Shares to be issued upon exercise hereof except under circumstances that will not result in a violation of the Securities Act of 1933, as amended (the "Act"), or any state securities laws. Upon exercise of this Warrant, the Holder shall, if requested by the Company, confirm in writing, in a form satisfactory to the Company, that the shares of Series B Preferred Stock so purchased are being acquired solely for the Holder's own account and not as a nominee for any other party, for investment, and not with a view toward distribution or resale. (2) If deemed necessary by counsel to the Company, this Warrant, and all Warrant Shares issued upon exercise hereof shall be stamped or imprinted with legends setting forth the restrictions on transfer arising under applicable federal and state securities laws. -8- (k) RIGHT TO CONVERT WARRANT INTO SERIES B PREFERRED STOCK. ------------------------------------------------------ (1) Right to Convert. As an alternative to payment of the Exercise ---------------- Price in cash, the Holder shall have the right, at any time and from time to time, to convert this Warrant into shares of Series B Preferred Stock (the "Conversion Right"). Upon exercise of the Conversion Right, the Company shall deliver to the Holder (without payment by the Holder of any Exercise Price or of any other cash or other consideration) that number of shares of Series B Preferred Stock equal to the quotient obtained by dividing (x) the value of this Warrant at the time the Conversion Right is exercised (determined by subtracting the aggregate Exercise Price in effect immediately prior to the exercise of the Conversion Right from the aggregate fair market value of the shares of Series B Preferred Stock issuable upon exercise of this Warrant immediately prior to the exercise of the Conversion Right) by (y) the fair market value of one share of Series B Preferred Stock immediately prior to the exercise of the Conversion Right. For purposes hereof, the fair market value of a share of Series B Preferred Stock shall be the greater of (i) a price per share of Series B Preferred Stock equal to the initial Exercise Price or (ii) the current market value of the shares of the Company's Series B Preferred Stock. The current market value of a share of Series B Preferred Stock shall be determined as follows: (a) If the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) is listed on a national securities exchange or admitted to unlisted trading privileges on such exchange or listed for trading on The Nasdaq Stock Market, the current market value shall be the last reported sale price of the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) on such exchange or system on the last business day prior to the date of exercise of this Warrant or if no such sale is made on such day, the average closing bid and asked prices for such day on such exchange or system; (b) If the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) is not so listed or admitted to unlisted trading privileges, the current market value shall be the mean of the last reported bid and asked prices for the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) reported by the National Quotation Bureau, Inc., on the last business day prior to the date of the exercise of this Warrant; or -9- (c) If the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) is not so listed or admitted to unlisted trading privileges and bid and asked prices are not so reported, the current market value shall be an amount reasonably determined in such reasonable manner as may be prescribed by the Board of Directors of the Company. (2) Method of Exercise. The Conversion Right may be exercised by the ------------------ Holder by the surrender of this Warrant at the principal office of the Company together with a written statement specifying that the Holder thereby intends to exercise the Conversion Right. Certificates for the shares of Series B Preferred Stock issuable upon exercise of the Conversion Right shall be delivered to the Holder within five (5) days following the Company's receipt of this Warrant together with the aforesaid written statement. (l) ADDITIONAL RIGHTS OF THE HOLDER. So long as this Warrant shall be ------------------------------- outstanding, the Holder shall be entitled to (i) registration, co-sale and similar rights with respect to the shares of Series B Preferred Stock purchasable hereunder and (ii) the receipt of various financial and related information from the Company, each to the same extent as those purchasers purchasing shares of the Company's Series B Preferred Stock pursuant to the Stock Purchase Agreement, as amended as of August 4, 1997 and the Investors' Rights Agreement dated as of July 15, 1997 by and between the Company, the purchasers listed therein and the other parties thereto. (m) REPRESENTATION OF HOLDER. ------------------------ (i) The Holder hereby represents and warrants to the Company that it has substantial knowledge, skill and experience in making investment decisions of the type represented by this Warrant and the Warrant Shares, it is capable of evaluating the risk of its investment in this Warrant and the Warrant Shares and is able to bear the economic risk of such investment, including the risk of losing the entire investment, that it is acquiring this Warrant and the Warrant Shares for its own account, and that this Warrant and the Warrant Shares are being acquired by it for investment and not with a present view to any distribution thereof in violation of applicable securities law. If the Holder should in the future decide to dispose of any of this Warrant and the Warrant Shares, it is understood that it may do so only in compliance with the Act and applicable state securities laws. The Holder represents and warrants that it is an "accredited investor" as defined in Rule 501(a) under the Act. (ii) The Holder understands that (i) this Warrant and the Warrant Shares have not been registered under the Act by reason of their issuance in a -10- transaction exempt from the registration requirements of the Act, (ii) this Warrant and the Warrant Shares must be held indefinitely unless a subsequent disposition thereof is registered under the Act and applicable state securities laws or is exempt from such registrations (and evidence satisfactory to the Company is provided by such Holder of the availability of such exemptions, including the delivery to the Company of opinions of counsel to such Holder, which opinions and counsel is satisfactory to the Company), and (iii) this Warrant and the Warrant Shares may bear a legend to such effect. (n) AMENDMENTS. Neither the Warrant nor any term hereof may be changed, ---------- waived, discharged or terminated without the prior written consent of the Holder. (o) NO IMPAIRMENT. The Company will not avoid or seek to avoid the ------------- observance or performance of any of the terms to be observed or performed hereunder by the Company, but will at all times in good faith assist in the carrying out of all the provisions of this Warrant and in the taking of all such action as may be necessary or appropriate in order to protect the rights of any Holder. (p) GOVERNING LAW. This Agreement shall be governed by and construed ------------- under the laws of the State of Maryland. (q) NOTICES. All notices and other communications required or permitted ------- hereunder shall be in writing and shall be mailed by first class mail, postage prepaid, addressed (a) if to the Holder, to Alex.Brown & Sons Incorporated, One South Street, Baltimore, Maryland 21202, Attention: Thomas R. Hitchner, Managing Director, or (b) if to the Company, to CDnow, Inc., 610 Old York Road, Suite 300, Jenkintown, Pennsylvania 19046, Attention: Jason Olim, President, or at such other address as the Company shall have furnished to the Holder in writing. IN WITNESS WHEREOF, CDnow, Inc. has caused this Warrant to be executed by its officer thereunto duly authorized. Dated: _______________, 1997 CDNOW, INC. By: /s/ Jason Olim Name: Jason Olim Title: President PURCHASE FORM ------------- Dated _____________, 19__ The undersigned hereby irrevocably elects to exercise its rights pursuant to this Warrant to the extent of purchasing ___________ shares of Series B Preferred Stock of CDnow, Inc., and hereby makes payment of $_________________, in cash or in satisfaction of indebtedness, in payment of the exercise price thereof. The undersigned hereby irrevocably elects to exercise its rights pursuant to this Warrant to the extent of purchasing ____ shares of Series B Preferred Stock and hereby authorizes you to deliver such shares of Series B Preferred Stock for sale to ______________, and to retain from the proceeds of such sale $_________________, in cash, in payment of the exercise price thereof and to remit to the undersigned the balance of such proceeds. -------------------------------- INSTRUCTIONS FOR REGISTRATION OF STOCK Name - -------------------------------------------------------------------------------- (Please typewrite or print in block letters) Address ------------------------------------------------------------------------- Signature ----------------------------------------------------------------------- -12- ASSIGNMENT FORM --------------- FOR VALUE RECEIVED, ________________________________ hereby sells, assigns and transfers unto Name ---------------------------------------------------------------------------- (Please typewrite or print in block letters) Address ------------------------------------------------------------------------- the right to purchase Series B Preferred Stock of CDnow, Inc. (the "Company"), represented by this Warrant to the extent of _________ shares as to which such right is exercisable and does hereby irrevocably constitute and appoint _______________________________ as Attorney, to transfer the same on the books of the Company with full power of substitution in the premises. Date _____________, 19__ Signature ------------------------------------- -13- EX-10.7 8 WARRANTS DATED 08/05/97 - GROTECH CAPITAL GROUP THIS WARRANT AND THE SHARES OF SERIES B PREFERRED STOCK PURCHASABLE HEREUNDER HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED, OR UNDER THE SECURITIES LAWS OF ANY STATE OR OTHER JURISDICTION AND MAY NOT BE SOLD, OFFERED FOR SALE OR OTHERWISE TRANSFERRED UNLESS REGISTERED OR QUALIFIED UNDER SAID ACT AND APPLICABLE STATE SECURITIES LAWS OR UNLESS AN EXEMPTION IS AVAILABLE AND AN OPINION OF COUNSEL REASONABLY ACCEPTABLE TO THE ISSUER IS DELIVERED TO SUCH EFFECT. Void after 5:00 p.m. New York, New York Time, on August 5, 2002. WARRANT TO PURCHASE SHARES OF SERIES B PREFERRED STOCK OF CDNOW, INC. This is to certify that, FOR VALUE RECEIVED, Grotech Capital Group IV, L.L.C. or its registered assigns pursuant to Section (d) hereof ("Holder"), is entitled to purchase, subject to the provisions of this Warrant, from CDNOW, INC., a Pennsylvania corporation (the "Company"), up to 18,349 fully paid, validly issued and nonassessable shares of Series B Convertible Preferred Stock, no par value per share (the "Series B Preferred Stock"), at the exercise price of $5.45 per share until August 5, 2002. The number of shares of Series B Preferred Stock to be received upon the exercise of this Warrant and the price to be paid for each share of Series B Preferred Stock are subject to adjustment from time to time as hereinafter set forth. The shares of Series B Preferred Stock deliverable upon such exercise, and as adjusted from time to time, are hereinafter sometimes referred to as "Warrant Shares," and the exercise price for a share of Series B Preferred Stock, as adjusted from time to time, is hereinafter sometimes referred to as the "Exercise Price." In the event the outstanding shares of Series B Preferred Stock are automatically converted into shares of the Company's Common Stock in accordance with the terms of the Series B Preferred Stock as set forth in the Company's Amended and Restated Articles of Incorporation, as amended on August 5, 1997 ("Articles"), this Warrant shall immediately become exercisable for shares of the Company's Common Stock on terms identical to those applicable to the Series B Preferred Stock. (a) EXERCISE OF WARRANT; NOTIFICATION OF EXPIRATION DATE OF WARRANT. The --------------------------------------------------------------- Warrant may be exercised in whole or in part at any time or from time to time, until 5:00 P.M. New York, New York Time on August 5, 2002 (the "Expiration Date"), provided, however, that if such day is a day on which banking institutions in the State of New York are authorized by law to close, then on the next succeeding day which shall not be such a day. The Warrant may be exercised by presentation and surrender hereof to the Company at its principal office, or at the office of its stock transfer agent, if any, with the purchase form annexed hereto duly executed (with signature guaranteed if required by the Company or, if any, its stock transfer agent) and accompanied by payment of the Exercise Price for the number of Warrant Shares specified in such form and any applicable taxes. The purchase price for any Warrant Shares purchased pursuant to the exercise of this Warrant shall be paid in full upon such exercise in cash or by certified or bank check or by cancellation by the Holder of indebtedness or other debt obligations of the Company to the Holder. Alternatively, this Warrant may be exchanged for Warrant Shares as described in Section (k) hereof. As soon as practicable after each such exercise of this Warrant, but not later than seven (7) business days from the date of such exercise, the Company shall issue and deliver to the Holder a certificate or certificates for the Warrant Shares issuable upon such exercise, registered in the name of the Holder or the Holder's designee (subject to the terms of this Warrant). If the Warrant should be exercised in part only, the Company shall, upon surrender of the Warrant for cancellation, execute and deliver a new Warrant evidencing the rights of the Holder thereof to purchase the balance of the Warrant Shares purchasable thereunder. Upon receipt by the Company of the Warrant at its office, or by the stock transfer agent of the Company at its office, in proper form for exercise, together with the exercise price thereof and taxes as aforesaid in cash or certified or bank check and the investment letter described below, the Holder shall be deemed to be the holder of record of the Warrant Shares issuable upon such exercise, notwithstanding that the stock transfer books of the Company shall then be closed or that certificates representing such Warrant Shares shall not then be physically delivered to the Holder. Each stock certificate so delivered shall be in such denomination as may be reasonably requested by the Holder hereof and shall be registered in the name of the Holder or such other name as shall be designated by the Holder (subject to the terms of this Warrant). The Company shall pay all expenses, taxes and other charges payable in connection with the preparation, execution and delivery of stock certificates and new Warrants, pursuant to this Section (a), except that, in case such stock certificates shall be registered in a name or names other than the name of the Holder of this Warrant, funds sufficient to pay all stock transfer taxes which shall be payable upon the execution and delivery of such stock certificate or certificates shall be paid by the Holder hereof to the Company. In order to assure the availability of an exemption from registration under the federal or applicable state securities laws, the Company may condition the exercise of the Warrant upon the Holder delivering to the Company an investment letter in the form as customarily used by the Company from time to time in connection with the exercise of unregistered options and warrants issued by the Company. It is further understood that certificates for the Warrant Shares, if any, to be issued upon exercise of the Warrant may contain a restrictive legend in accordance with Section (j) hereof. Notwithstanding anything herein to the contrary, the Company shall use reasonable efforts to mail to the original Holder, by certified mail, return receipt requested, notice of the Expiration Date of this Warrant, no later than 15 days prior to the Expiration Date. -2- (b) RESERVATION OF SHARES. The Company shall at all times reserve for --------------------- issuance and/or delivery upon exercise of this Warrant such number of shares of its Series B Preferred Stock as shall be required for issuance and delivery upon exercise of this Warrant. If any shares of the Series B Preferred Stock are or become listed on any national securities exchange or The Nasdaq Stock Market, the Company shall also list the Warrant Shares, as the case may be, on such exchange or system, as the case may be, subject to notice of issuance. (c) FRACTIONAL SHARES. Fractional shares or scrip representing fractional ----------------- shares may be issued upon the exercise of this Warrant. Alternatively, the Company may, at its option, with respect to any fraction of a share issuable upon any exercise hereof, pay to the Holder an amount in cash equal to such fraction multiplied by the greater of (i) the initial Exercise Price per share or (ii) the current market value of the shares of the Company's Series B Preferred Stock. The current market value of a share of Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) shall be determined as follows: (1) If the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) is listed on a national securities exchange or admitted to unlisted trading privileges on such exchange or listed for trading on The Nasdaq Stock Market, the current market value shall be the last reported sale price of the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) on such exchange or system on the last business day prior to the date of exercise of this Warrant or if no such sale is made on such day, the average closing bid and asked prices for such day on such exchange or system; (2) If the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) is not so listed or admitted to unlisted trading privileges, the current market value shall be the mean of the last reported bid and asked prices for the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) reported by the National Quotation Bureau, Inc., on the last business day prior to the date of the exercise of this Warrant; or (3) If the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) is not so listed or admitted to unlisted trading privileges and bid and asked prices are not so reported, the current market value shall be an amount reasonably determined by the Board of Directors of the Company. (d) EXCHANGE, TRANSFER, ASSIGNMENT OR LOSS OF WARRANT. This Warrant is ------------------------------------------------- exchangeable, without expense, at the option of the Holder, upon presentation and surrender hereof to the Company or at the office of its stock transfer agent, if any, for other warrants of different denomination (which may be reasonably requested by the Holder) entitling -3- the Holder thereof to purchase in the aggregate the same number of shares of Series B Preferred Stock purchasable hereunder. Subject to Section (j) hereof, the Holder may transfer or assign this Warrant, in whole or in part and from time to time. In addition to the rights of the Holder set forth in this Warrant, the Holder has additional registration and other rights pursuant to the Investors' Rights Agreement described in Section (1) hereof. To effect a transfer of such registration rights, certain notice and assumption obligations are imposed by the Investors' Rights Agreement. Upon surrender by the Holder of this Warrant to the Company at its principal office or at the office of its stock transfer agent, if any, with the Assignment Form annexed hereto duly executed (with signature guaranteed, if required by the Company or its stock transfer agent) and funds sufficient to pay any transfer tax, the Company shall, without charge, execute and deliver a new Warrant in the name of the assignee or assignees named in such instrument of assignment and this Warrant shall promptly be canceled. This Warrant may be divided into or combined with other Warrants which carry the same rights upon presentation hereof at the principal office of the Company or at the office of its stock transfer agent, if any, together with a written notice specifying the names and denominations in which new Warrants are to be issued and signed by the Holder hereof. The term "Warrant" as used herein includes any Warrants into which this Warrant may be divided or exchanged, and the term "Holder" includes any subsequent holder or holders of this Warrant or any warrant for which this Warrant is exchanged or into which it is divided. Upon receipt by the Company of evidence satisfactory to it of the loss, theft, destruction or mutilation of this Warrant, and in the case of loss, theft or destruction, of reasonable satisfactory indemnification, and upon surrender and cancellation of this Warrant, if mutilated, the Company will execute and deliver a new Warrant of like tenor, date and amount. Any such new Warrant executed and delivered shall constitute an additional contractual obligation on the part of the Company, whether or not the original Warrant shall be at any time enforceable by anyone. (e) RIGHTS OF THE HOLDER. Subject to the provisions of Section (1), the -------------------- Holder shall not, by virtue hereof, be entitled to any rights of a shareholder in the Company, either at law or equity (including, without limitation, any rights to dividends) and the rights of the Holder with respect to the shares of Series B Preferred Stock purchasable pursuant to this Warrant are limited to those expressed in the Warrant and are not enforceable against the Company except to the extent set forth herein. (f) ANTI-DILUTION PROVISIONS. So long as this Warrant shall be ------------------------ outstanding, the Exercise Price in effect at any time and the number and kind of securities purchasable upon the exercise of this Warrant shall be subject to adjustment from time to time upon the happening of certain events as follows: (1) In case the Company shall: (i) declare a dividend or make a distribution on its outstanding shares of Common Stock in shares of Common Stock; (ii) issue shares of Common Stock or securities convertible into Common Stock (other than shares of Common Stock issued upon: (A) the conversion of outstanding shares of Series B Preferred Stock, (B) the exercise of warrants to purchase Common Stock outstanding prior -4- to July 15, 1997, or (C) the exercise of any option granted or hereafter granted to any officer, director, employee, agent or consultant of the Company pursuant to a stock option plan approved by a majority of the independent directors of the Company's Board of Directors) for consideration less than the Exercise Price of this Warrant on the date of issuance of such shares of Common Stock; (iii) subdivide or reclassify its outstanding shares of Common Stock into a greater number of shares; or (iv) combine or reclassify its outstanding shares of Common Stock into a smaller number of shares, then the Exercise Price in effect at the time of the record date for such dividend or distribution, the issuance of such shares of Common Stock or the effective date of such subdivision, combination or reclassification (such dividend or distribution, issuance of securities, subdivision, combination or reclassification, collectively a "Dilution Event") shall be proportionately adjusted as of the effective date of such Dilution Event by multiplying such Exercise Price by a fraction, the denominator of which shall be the outstanding number of shares of Common Stock determined on a fully- diluted basis immediately following such event and the numerator of which shall be the outstanding number of shares of Common Stock determined on a fully-diluted basis immediately prior thereto plus, in the case of an adjustment pursuant to clause (ii), the number of shares of Common Stock that would be purchasable at the Exercise Price for the consideration being paid for the shares being issued. Such adjustment shall be made successively whenever any Dilution Event shall occur. (2) Whenever the Exercise Price payable upon exercise of this Warrant is adjusted pursuant to subsection (1) above, the number of Warrant Shares purchasable upon exercise of this Warrant shall simultaneously be adjusted by multiplying the number of Warrant Shares issuable upon exercise of this Warrant immediately prior to the Dilution Event by the Exercise Price in effect immediately prior to the Dilution Event and dividing the product so obtained by the Exercise Price, as adjusted pursuant to subsection (1). (3) No adjustment in the Exercise Price shall be required unless such adjustment would require an increase or decrease of at least $.05 in such price; provided, however, that any adjustments which by reason of this Section (f)(3) are not required to be made shall be carried forward and taken into account in any subsequent adjustment required to be made hereunder. (4) Each computation required by this Section (f) for purposes of determining whether the Exercise Price shall be adjusted shall be performed by the Company's Chief Financial Officer or Controller and shall be reasonably acceptable to the Holder. -5- (5) Whenever the Exercise Price is adjusted, as herein provided, the Company shall promptly cause a notice (certified as correct by the Company's Chief Financial Officer or Controller) setting forth the adjusted Exercise Price and adjusted number of Warrant Shares issuable upon exercise of this Warrant to be mailed to the Holder, at its address appearing in the Company's Warrant Register, and shall cause a certified copy thereof to be mailed to its transfer agent, if any. (6) All calculations under this Section (f) shall be made to the nearest cent or to the nearest Warrant Share, as the case may be. (7) In the event that, as a result of application of Section (i) of this Warrant, this Warrant shall become exercisable for securities other than the Series B Preferred Stock, thereafter the number of shares of Series B Preferred Stock receivable upon exercise of this Warrant shall be subject to adjustment from time to time in a manner and on terms as nearly equivalent as practicable to the provisions with respect to the Common Stock contained in this Section (f). (8) Irrespective of any adjustments in the Exercise Price or the number or kind of Warrant Shares purchasable upon exercise of this Warrant, Warrants theretofore or thereafter issued may continue to express the same price and number and kind of shares as are stated in this Warrant initially issued. (9) The adjustment provisions set forth in this Section (f) are intended to preserve the relative equity interest in the Company which the Holder is permitted to acquire upon conversion of this Warrant into securities of the Company. The parties hereby acknowledge and agree that, assuming no changes are made to the conversion rights of the holders of Series B Preferred Stock (the "Series B Conversion Rights") as set forth and described in the Articles, the provisions relating to adjustment of the exercise price and the number and kind of securities purchasable upon exercise of the Warrant contained in this Section (f) (the "Antidilution Provisions") shall be deemed to apply to distributions, issuances, subdivisions, reclassifications or other changes with respect to the Series B Preferred Stock, but not to distributions, issuances, subdivisions, reclassifications or other changes with respect to the Company's Common Stock and that, in particular, in the application of this Section (f)(1) respecting the occurrence of a Dilution Event, the term "Series B Preferred Stock" shall in each instance be substituted for the term "Common Stock." In the event that any change to the Series B Conversion Rights is made which affects the conversion rights of the Series B Preferred Stock, the -6- parties agree that the Antidilution Provisions shall be deemed to apply to distributions, issuances, subdivisions, reclassifications or other changes with respect to both the Company's Series B Preferred stock and Common Stock. In no event shall both the provisions of this Section (f) and the Articles be applied concurrently to effect an increase in the relative equity interest in the Company of the holder of this Warrant over the amount of increase which would have occurred if the Holder had acquired shares of Series B Preferred Stock rather than the Warrant on August 5, 1997. (g) OFFICER'S CERTIFICATE. Whenever the Exercise Price shall be adjusted --------------------- as required by the provisions of the foregoing, the Company shall forthwith file in the custody of its Secretary or an Assistant Secretary at its principal office and with its stock transfer agent, if any, a certificate of the Company's Chief Financial Officer or Controller showing the adjusted Exercise Price determined as herein provided, setting forth in reasonable detail the facts requiring such adjustment, including a statement of the number of additional shares of Series B Preferred Stock, if any, and such other facts as shall be necessary to show the reason for and the manner of computing such adjustment. Each such officer's certificate shall be made available at all reasonable times for inspection by the Holder or any holder of this Warrant, and the Company shall, forthwith after each such adjustment, mail, by certified mail, a copy of such certificate to the Holder or any such holder. (h) NOTICES TO WARRANT HOLDERS. So long as this Warrant shall be -------------------------- outstanding, (i) if the Company shall declare any dividend or make any distribution upon the Common Stock, or (ii) if any capital reorganization of the Company, reclassification of the capital stock of the Company, consolidation or merger of the Company with or into another corporation, sale, lease or transfer of all or substantially all of the property and assets of the Company to another corporation, or voluntary or involuntary dissolution, liquidation or winding up of the Company shall be effected, then in any such case, the Company shall cause to be mailed by certified mail to the Holder of this Warrant, at least 10 days prior to the date specified in (x) or (y) below, as the case may be, a notice containing a brief description of the proposed action and stating the date on which (x) a record is to be taken for the purpose of such dividend, distribution or offer for subscription or purchase, or (y) such reorganization, reclassification, consolidation, merger, sale, lease, transfer, dissolution, liquidation or winding up is to take place and the date, if any is to be fixed, as of which the holders of the Common Stock or other capital stock of the Company shall receive cash or other property deliverable upon such reclassification, reorganization, consolidation, merger, conveyance, dissolution, liquidation or winding up. (i) RECLASSIFICATION, REORGANIZATION OR MERGER. In case of any ------------------------------------------ reclassification, conversion or capital reorganization of outstanding shares of either the Series B Preferred Stock or the Common Stock of the Company, or in case of any consolidation or merger of the Company with or into another corporation (other than a merger with another corporation in which merger the Company is the continuing corporation and which does not result in any reclassification or capital reorganization of outstanding shares of Series B Preferred Stock of the series issuable upon exercise of this Warrant) or in case of any sale, lease or conveyance -7- to another corporation of the property of the Company substantially as an entirety, the Company shall, as a condition precedent to such transaction, cause effective provisions to be made so that the Holder shall have the right thereafter by exercising this Warrant at any time prior to the expiration of this Warrant, to purchase the kind and amount of shares of stock and other securities and property receivable upon such reclassification or capital reorganization and consolidation, merger, sale or conveyance which would have been deliverable to the Holder of this Warrant on the effective date of the reclassification, reorganization or merger had the Holder exercised the Warrant immediately prior to the event described in this Section (i). Any such provision shall include provision for subsequent adjustments which shall be as nearly equivalent as may be practicable to the adjustments provided for in this Warrant. The foregoing provisions of this Section (i) shall similarly apply to successive reclassifications or capital reorganizations of shares of either the Series B Preferred Stock or the Common Stock and to successive consolidations, mergers, sales or conveyances. In the event that in connection with any such capital reorganization or reclassification, consolidation, merger, sale or conveyance, additional shares of Series B Preferred Stock shall be issued in exchange, conversion, substitution or payment, in whole or in part, for a security of the Company other than Series B Preferred Stock, any such issue shall be treated as an issue of Common Stock covered by the provisions of Section (f)(1) hereof. (j) SECURITIES LAW COMPLIANCE ------------------------- (1) The Holder of this Warrant, by acceptance hereof, acknowledges that this Warrant and the Warrant Shares to be issued upon exercise hereof are being acquired solely for the Holder's own account and not as a nominee for any other party, and for investment, and that the Holder will not offer, sell, transfer, assign or otherwise dispose of this Warrant or any Warrant Shares to be issued upon exercise hereof except under circumstances that will not result in a violation of the Securities Act of 1933, as amended (the "Act"), or any state securities laws. Upon exercise of this Warrant, the Holder shall, if requested by the Company, confirm in writing, in a form satisfactory to the Company, that the shares of Series B Preferred Stock so purchased are being acquired solely for the Holder's own account and not as a nominee for any other party, for investment, and not with a view toward distribution or resale. (2) If deemed necessary by counsel to the Company, this Warrant, and all Warrant Shares issued upon exercise hereof shall be stamped or imprinted with legends setting forth the restrictions on transfer arising under applicable federal and state securities laws. -8- (k) RIGHT TO CONVERT WARRANT INTO SERIES B PREFERRED STOCK. ------------------------------------------------------ (1) Right to Convert. As an alternative to payment of the Exercise ---------------- Price in cash, the Holder shall have the right, at any time and from time to time, to convert this Warrant into shares of Series B Preferred Stock (the "Conversion Right"). Upon exercise of the Conversion Right, the Company shall deliver to the Holder (without payment by the Holder of any Exercise Price or of any other cash or other consideration) that number of shares of Series B Preferred Stock equal to the quotient obtained by dividing (x) the value of this Warrant at the time the Conversion Right is exercised (determined by subtracting the aggregate Exercise Price in effect immediately prior to the exercise of the Conversion Right from the aggregate fair market value of the shares of Series B Preferred Stock issuable upon exercise of this Warrant immediately prior to the exercise of the Conversion Right) by (y) the fair market value of one share of Series B Preferred Stock immediately prior to the exercise of the Conversion Right. For purposes hereof, the fair market value of a share of Series B Preferred Stock shall be the greater of (i) a price per share of Series B Preferred Stock equal to the initial Exercise Price or (ii) the current market value of the shares of the Company's Series B Preferred Stock. The current market value of a share of Series B Preferred Stock shall be determined as follows: (a) If the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) is listed on a national securities exchange or admitted to unlisted trading privileges on such exchange or listed for trading on The Nasdaq Stock Market, the current market value shall be the last reported sale price of the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) on such exchange or system on the last business day prior to the date of exercise of this Warrant or if no such sale is made on such day, the average closing bid and asked prices for such day on such exchange or system; (b) If the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) is not so listed or admitted to unlisted trading privileges, the current market value shall be the mean of the last reported bid and asked prices for the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) reported by the National Quotation Bureau, Inc., on the last business day prior to the date of the exercise of this Warrant; or -9- (c) If the Series B Preferred Stock (or shares of Common Stock into which the Series B Preferred Stock may be converted) is not so listed or admitted to unlisted trading privileges and bid and asked prices are not so reported, the current market value shall be an amount reasonably determined in such reasonable manner as may be prescribed by the Board of Directors of the Company. (2) Method of Exercise. The Conversion Right may be exercised by ------------------ the Holder by the surrender of this Warrant at the principal office of the Company together with a written statement specifying that the Holder thereby intends to exercise the Conversion Right. Certificates for the shares of Series B Preferred Stock issuable upon exercise of the Conversion Right shall be delivered to the Holder within five (5) days following the Company's receipt of this Warrant together with the aforesaid written statement. (l) ADDITIONAL RIGHTS OF THE HOLDER. So long as this Warrant shall be ------------------------------- outstanding, the Holder shall be entitled to (i) registration, co-sale and similar rights with respect to the shares of Series B Preferred Stock purchasable hereunder and (ii) the receipt of various financial and related information from the Company, each to the same extent as those purchasers purchasing shares of the Company's Series B Preferred Stock pursuant to the Stock Purchase Agreement, as amended as of August 4, 1997 and the Investors' Rights Agreement dated as of July 15, 1997 by and between the Company, the purchasers listed therein and the other parties thereto. (m) REPRESENTATION OF HOLDER. ------------------------ (i) The Holder hereby represents and warrants to the Company that it has substantial knowledge, skill and experience in making investment decisions of the type represented by this Warrant and the Warrant Shares, it is capable of evaluating the risk of its investment in this Warrant and the Warrant Shares and is able to bear the economic risk of such investment, including the risk of losing the entire investment, that it is acquiring this Warrant and the Warrant Shares for its own account, and that this Warrant and the Warrant Shares are being acquired by it for investment and not with a present view to any distribution thereof in violation of applicable securities law. If the Holder should in the future decide to dispose of any of this Warrant and the Warrant Shares, it is understood that it may do so only in compliance with the Act and applicable state securities laws. The Holder represents and warrants that it is an "accredited investor" as defined in Rule 501(a) under the Act. (ii) The Holder understands that (i) this Warrant and the Warrant Shares have not been registered under the Act by reason of their issuance in a -10- transaction exempt from the registration requirements of the Act, (ii) this Warrant and the Warrant Shares must be held indefinitely unless a subsequent disposition thereof is registered under the Act and applicable state securities laws or is exempt from such registrations (and evidence satisfactory to the Company is provided by such Holder of the availability of such exemptions, including the delivery to the Company of opinions of counsel to such Holder, which opinions and counsel is satisfactory to the Company), and (iii) this Warrant and the Warrant Shares may bear a legend to such effect. (n) AMENDMENTS. Neither the Warrant nor any term hereof may be changed, ---------- waived, discharged or terminated without the prior written consent of the Holder. (o) NO IMPAIRMENT. The Company will not avoid or seek to avoid the ------------- observance or performance of any of the terms to be observed or performed hereunder by the Company, but will at all times in good faith assist in the carrying out of all the provisions of this Warrant and in the taking of all such action as may be necessary or appropriate in order to protect the rights of any Holder. (p) GOVERNING LAW. This Agreement shall be governed by and construed ------------- under the laws of the State of Maryland. (q) NOTICES. All notices and other communications required or permitted ------- hereunder shall be in writing and shall be mailed by first class mail, postage prepaid, addressed (a) if to the Holder, to Grotech Partners IV, L.P. 9690 Deereco Road, Timonium, Maryland 21093, Attention: Patrick J. Kerins, Managing Director, or (b) if to the Company, to CDnow, Inc., 610 Old York Road, Suite 300, Jenkintown, Pennsylvania 19046, Attention: Jason Olim, President, or at such other address as the Company shall have furnished to the Holder in writing. IN WITNESS WHEREOF, CDnow, Inc. has caused this Warrant to be executed by its officer thereunto duly authorized. Dated: _______________, 1997 CDNOW, INC. By: /s/ Jason Olim Name: Jason Olim Title: President -11- PURCHASE FORM ------------- Dated _____________, 19__ The undersigned hereby irrevocably elects to exercise its rights pursuant to this Warrant to the extent of purchasing ___________ shares of Series B Preferred Stock of CDnow, Inc., and hereby makes payment of $_________________, in cash or in satisfaction of indebtedness, in payment of the exercise price thereof. The undersigned hereby irrevocably elects to exercise its rights pursuant to this Warrant to the extent of purchasing ____ shares of Series B Preferred Stock and hereby authorizes you to deliver such shares of Series B Preferred Stock for sale to ______________, and to retain from the proceeds of such sale $_________________, in cash, in payment of the exercise price thereof and to remit to the undersigned the balance of such proceeds. -------------------------------- INSTRUCTIONS FOR REGISTRATION OF STOCK Name - -------------------------------------------------------------------------------- (Please typewrite or print in block letters) Address ------------------------------------------------------------------------- Signature ----------------------------------------------------------------------- -12- ASSIGNMENT FORM --------------- FOR VALUE RECEIVED, ________________________________ hereby sells, assigns and transfers unto Name ---------------------------------------------------------------------------- (Please typewrite or print in block letters) Address ------------------------------------------------------------------------- the right to purchase Series B Preferred Stock of CDnow, Inc. (the "Company"), represented by this Warrant to the extent of _________ shares as to which such right is exercisable and does hereby irrevocably constitute and appoint _______________________________ as Attorney, to transfer the same on the books of the Company with full power of substitution in the premises. Date _____________, 19__ Signature ------------------------------ -13- EX-10.8 9 LINKING AGREEMENT - DATED 09/30/97 Exhibit 10.8 LINKING AGREEMENT THIS LINKING AGREEMENT made this 30th day of September, 1997, by and between EXCITE, INC., a corporation organized under the laws of California ("Excite") and CDNOW, INC., a corporation organized under the laws of Pennsylvania ("CDnow"). RECITALS WHEREAS, CDnow is a retailer of compact discs and other entertainment related products for sale through its Web service which is accessible through the URL www.cdnow.com (the "CDnow Site"); and WHEREAS, Excite is the owner or licensee of certain Web services and other search and content areas (collectively, "WebCrawler"), which are accessible at the URL webcrawler.com; and WHEREAS, CDnow desires that Excite integrate links from WebCrawler and certain other areas on WebCrawler to a co-branded version of CDnow's Site so that users of WebCrawler will have access to CDnow's Site through WebCrawler. NOW, THEREFORE, the parties hereto for good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged, and intending to be legally bound hereby agree as follows: 1. Definitions "Above-the-Fold" shall mean situated within the portion of a page that is designed to be visible on a standard computer screen with a resolution of 640 pixels by 480 pixels without requiring the user to scroll horizontally or vertically through the page. "Buyweb Link" shall mean a link, promoting CDnow's name/and or brand which will take WebCrawler users to designated pages on the Pages. Excite and CDnow will collaborate in good faith on the design, appearance and placement of all Buyweb Links. Excite shall have final approval over the "look and feel" of the Buyweb Links, which approval will not be unreasonably withheld or delayed. "Carry-through Bar" shall mean a bar containing one or more of the Proprietary Features of each of the parties which connects the Pages to WebCrawler. "Click-through" shall mean a user presence at the Pages which originated from WebCrawler, and which initiates a Session, which is defined as the delivery of any and all pages of the Pages to such user, where no two pages are delivered more than two hours apart. [Confidential Treatment requested for redacted portions of document.] "Co-branded Pages" shall mean pages of CDnow's Site which a visitor from WebCrawler will link to and which shall display certain Proprietary Features of both Excite and CDnow. The Co-branded Pages can only be viewed by a user who links to them directly from WebCrawler or through a stored URL (e.g. bookmark or similar technological storage mechanism). The Co-branded Pages will reside on CDnow's server(s). "Competitive Advertising" is any link (which does not transfer to the Pages or CDnow's Site) and/or displayed message which promotes an entity which sells pre- recorded music, promotes the sale of pre-recorded music, or, in the case of a link, transfers to a page which promotes the sale of pre-recorded music or enables the user to purchase pre-recorded music, excepting simple listings in WebCrawler's standard search indices and "Guide" directory of Web sites. "Guaranteed Impressions" shall have the meaning set forth in Paragraph 2(g). "Home Page" shall mean the primary entranceway to WebCrawler for users. "Impression" shall mean any Buyweb Link and/or banner advertisement. "Intermediary Pages" shall mean any pages that WebCrawlers users are directed to prior to entering the Co-branded Pages and which shall display certain Proprietary Features of both Excite and CDnow. The Intermediary Pages will reside on CDnow's server(s). "Keywords" are those words/phrases including, without limitation, music and movie related terms and names set forth on the list attached hereto as Exhibit A and made a part hereof which shall not exceed [XXX] words/phrases at any given time. CDnow may request in writing that Excite update Exhibit A as required, at least twice a month, or more often as reasonable, and Excite will not unreasonably withhold or delay approval and implementation of such request. Upon such approval, Exhibit A will be deemed by the parties to be so amended. "Launch Date" shall mean the date on which Excite shall deliver [XXX] correctly functioning Impressions per day on WebCrawler in accordance with Paragraph 2(a). CDnow and Excite shall use their best efforts to develop and deliver as necessary to each other any and all URLs, URL formats (as applicable), content, and other materials necessary for Excite to make available the Impressions to WebCrawler users within three (3) weeks of the Effective Date. Subsequent to the delivery of such materials to Excite, Excite shall use its best efforts to make available the Impressions to WebCrawler users within three (3) weeks of such delivery. "Pages" shall mean the Co-branded Pages and the Intermediary Pages. "Page View" shall mean a WebCrawler user's viewing of any Included Page. [Confidential Treatment requested for redacted portions of document.] "Promotion Schedule" shall mean a written term sheet signed by an authorized representative of each party pertaining to a promotion or special marketing event entered into by both parties and describing the obligations of each party with regard to such promotion or special marketing event. "Proprietary Feature" shall mean any trademark, service mark, trade name, domain name, navigational element or design logo which is proprietary to Excite and/or CDnow. "Term" shall have the meaning set forth in Paragraph 10. 2. Integrated Links (a) Excite and CDnow will work in good faith to expand the number of opportunities generated by music and music related spaces for Impressions. Excite and CDnow will work together in good faith to identify and implement mutually agreeable Impressions throughout WebCrawler. (b) CDnow banner, button and/or link placement will include, but not be limited to, the following locations in WebCrawler at the following targeted delivery rates: (i) CDnow Buyweb Links as developed and mutually agreed upon will be featured in [XXX] rotation in the "Services" module of the WebCrawler Home Page (approximately [XXX] Impressions per month for the first year). (ii) Once every quarter, Excite will display CDnow Buyweb Links through [XXX] weeks of rotation in the "Promotion" module of the WebCrawler home page (approximately [XXX] Impressions per [XXX] week promotion for the first year). Excite and CDnow will mutually determine the timing and content of these promotional placements. (iii) Excite will implement the database of CDnow Keywords that will trigger the display of "Shortcuts" in WebCrawler Search results pages. These Shortcuts will contain mutually agreed upon, branded Buyweb Links that transfer WebCrawler users to the Pages (approximately [XXX] Impressions per month for the first year). (iv) CDnow will be the sole provider and sponsor of the Music Search functions within the Music Search sections of the Entertainment Channel (approximately [XXX] Impressions per month for the first year). "Music Search" will allow users to enter search terms into a text search box and search CDnow's inventory of music-related transaction opportunities and content. (v) CDnow Buyweb Links as mutually agreed upon will be featured in the "Services" module within the Entertainment Channel (approximately [XXX] Impressions per month for the first year). (vi) Excite will deliver targeted advertising banners on [XXX] of pages within the [Confidential Treatment requested for redacted portions of document.] Entertainment Channel, the "Music" sections of the WebCrawler "Guide" directory of Web sites, the "Movies" sections of the WebCrawler "Guide" directory of Web sites, the News Channel's Entertainment pages and My Page's Entertainment area (approximately [XXX] Impressions per month for the first year). (vii) General rotation advertising banners will be implemented on a first-available basis to maximize impression guarantees and clickthrough targets (approximately [XXX] Impressions per months for the first year). It is understood that the targeted delivery rates are estimates, subject to programming opportunities mutually developed by the parties and growth of traffic over the course of each year of the Agreement. (c) More than one Impression may appear on a page on WebCrawler; however, not more than [XXX] Impressions per page will count towards delivery of the Guaranteed Impressions and, of these [XXX] Impressions, no more than [XXX] advertising banner will count as [XXX] of the [XXX] Impressions that counts towards delivery of the Guaranteed Impressions, and no more than [XXX] Buyweb Link will count as one of the [XXX] Impressions that counts towards delivery of the Guaranteed Impressions. In all events, Excite will make a good faith effort to avoid duplicate Impressions on a single page. d) Subject to the provisions of this Agreement, Excite will solely be responsible for the user interface and placement of the Buyweb Links and/or advertising banners on WebCrawler. e) Excite represents that it will place the Impressions on WebCrawler in a manner that is comparable to third party links that are of a similar nature and function to the Impressions on WebCrawler. f) Excite agrees that CDnow may vary the Impressions at least [XXX] per month with reasonable prior notice. The parties agree to cooperate with respect to testing the performance of the Impressions during the Term. Prior to implementing any modifications to the Impressions not requested by CDnow, Excite will consult with CDnow in good faith regarding such changes. g) Excite represents that it will deliver to users of WebCrawler a minimum of [XXX] Impressions during the first year of the Term and a minimum of [XXX] Impressions during the second year of the Term (the "Guaranteed Impressions"). In the event that Excite fails to deliver such Guaranteed Impressions during any quarter, Excite will "make good" the shortfall during the next quarter by providing CDnow with an equal number of "substitute" Impressions. Such "substitute" Impressions will be in addition to any Impressions otherwise intended to be delivered for such subsequent quarter. Such "substitute" Impressions will be delivered as standard advertising banners on pages of WebCrawler as reasonably available. In the event of a shortfall in Guaranteed Impressions as of the end of the first year of the Term, CDnow may exercise its options under [Confidential Treatment requested for redacted portions of document.] Paragraph 10(b). In the event of a shortfall in Guaranteed Impressions as of the end of the second year of Term, Excite's obligations under this Section 2(g) shall extend beyond the end of such second year of the Term until the Guaranteed Impressions have been delivered. (h) Excite will provide CDnow with a weekly report listing the number of Impressions and the number of Click-throughs for each Buyweb Link and/or advertising banner on each Included Page. 3. Linking Fees (a) Setup Fee CDnow will pay Excite [XXX] upon the execution of this Agreement as compensation for Excite's costs of initiating access to WebCrawler, programming costs, set-up costs and other expenses associated with Excite's initiation of the links, placements, advertisements and promotions contemplated by this Agreement. (b) Exclusive Fee CDnow will pay Excite [XXX] per each year of the Term as compensation for being the exclusive music store sponsor of WebCrawler. The [XXX] for the first year of the Term shall be due upon the Launch Date, and the [XXX] for the second year of the Term shall be combined with the yearly fee for the second year of the Term and due in accordance with the schedule set forth in 3(c)(ii) below. (c) Yearly Fees (i) CDnow will pay Excite [XXX] on December 31, 1997 as compensation for on-going programming, links, placements, advertisements and promotions contemplated by the Agreement for the first year of the Term. (ii) CDnow will pay Excite [XXX] as compensation for on-going programming, links, placements, advertisements and promotions contemplated by the Agreement for the second year of the Term, in accordance with the following schedule:
Date Payment ---- ------- First day of the second year of the Term [XXX] First day of the second quarter of the second year of the Term [XXX] First day of the third quarter of the second year of the Term [XXX] The later of the first day of the fourth quarter of the second year of the Term or when all Guaranteed Impressions have been delivered [XXX]
[Confidential Treatment requested for redacted portions of document.] (d) Referral Fees (i) In the first year of the Term, CDnow will pay Excite a referral fee of [XXX] per Click-through in excess of [XXX] Click-throughs. This payment will be due on the first anniversary of the Launch Date, and will be paid to Excite within thirty (30) days thereafter. With the payment, CDnow will provide to Excite documentation reasonably detailing the calculation of the payment. (ii) In the second year of the Term, CDnow will pay Excite a referral fee of [XXX] per Click-through in excess of [XXX] Click-throughs. This payment will be due on the second anniversary of the Launch Date and will be paid to Excite within thirty (30) days thereafter. With the payment, CDnow will provide to Excite documentation reasonably detailing the calculation of the payment. (e) Delivery Shortfalls in the First Year of the Term In the event that Excite fails to deliver the Guaranteed Impressions during the first year of the Term, CDnow may withhold the [XXX] that would otherwise have been due on the first anniversary of the Launch Date until Excite shall make good the shortfall of the Guaranteed Impressions for the first year of the Term. If Excite fails to make good the shortfall within [XXX] following the first year end, and CDnow chooses to exercise its right to terminate in accordance with Paragraph 10(b), no payment shall be due for the second year of the Term. If Excite fails to make good the shortfall within [XXX] following the first year end, and CDnow chooses not to exercise its right to terminate in accordance with Paragraph 10(b), CDnow shall pay the [XXX] that would otherwise have been due on the first anniversary of the Launch Date. (f) Audit Rights; Under/Over Payments Each party shall maintain complete and accurate records in accordance with US Generally Accepted Accounting Principles (GAAP) for all transactions which are the subject of this Agreement for not less than (3) years after the last payment is due under this Agreement. A "big six" independent accounting firm retained by a party (the auditing party) shall have access to such records of the other party (the audited party), upon reasonable notice, for the purposes of audit during normal business hours, for so long as such records are required to be maintained. If such accounting firm determines that any additional payment is due the auditing party by the audited party and such payment is not the subject of a good faith dispute between the parties, then the audited party shall promptly make payment of such amount to the auditing party. If a party overpays the other party, the party that has made such overpayment shall be entitled to a credit against the next payment due to the other party in the amount of the overpayment, unless such overpayment is the subject of a good faith dispute between the parties or no further payments are due under this Agreement, in which case, the party that has received the overpayment will promptly refund to the other party the amount of the overpayment. 4. Exclusivity During the Term, Excite represents and warrants that (i) it shall not place any Competitive Advertising on WebCrawler; (ii) it will continue to expend at least the same amount [Confidential Treatment requested for redacted portions of document.] of resources (e.g. budget, staff ) as it is currently committing as of the time of execution of this Agreement for both the pages in which the Impressions appear and WebCrawler generally; and (iii) it will not develop or promote any space on and/or linked from WebCrawler which functions in a similar manner to or provides the user with a similar experience as the Music spaces on WebCrawler, and which would contain any Competitive Advertising. 5. The Pages CDnow shall place a Carry-through Bar on the Pages which will allow the user to return to WebCrawler. CDnow and Excite shall mutually agree upon the overall design of the Carry-through Bar within the specifications provided by CDnow in the Carry-through Bar Specifications, attached hereto as Exhibit B and made a part hereof. Excite shall produce the Buyweb Links and Carry-through Bar and CDnow will supply Excite with all information, artwork, logos, trademarks and technology needed by Excite to produce such Buyweb Links and Carry-through Bar. In the event that CDnow shall be requested by Excite to produce the Buyweb Links, Carry-through Bar or other elements of the Pages, Excite will supply CDnow with all information, artwork, logos, trademarks and technology necessary, in a format specified by CDnow. Excite will supply CDnow with the URLs corresponding to the Carry-through Bar displayed on the Pages and CDnow will supply Excite with the URLs corresponding to the Buyweb Links displayed on WebCrawler. 6. Promotions (a) Excite and CDnow shall make reasonable commercial efforts to develop, expand and improve the user's experience of the music spaces on WebCrawler, including the addition of listening booths, charts and other music- related content to the extent that CDnow is able to provide such enhancements that are "best of breed." (b) In addition, from time to time during the Term, the parties agree to discuss in good faith the possibility of promotional opportunities that may include the WebCrawler trademark and/or trade name, including, but not limited to, e-mail promotions such as e-mail gift certificates or coupons and the development of a content module for My Page. In the event that CDnow and Excite shall enter into any such special marketing and promotional activities together, the parties shall agree in advance in a Promotion Schedule as to the scope of such activities, use of either party's trademarks or other intellectual property and the amount of funds and/or other resources to be contributed to such activities by the parties. Any and all Promotion Schedules shall be appended to this Agreement. 7. Fulfillment CDnow shall have the sole right and responsibility for processing all orders through every aspect of the transaction, including receiving, filling, shipping and handling, collecting payment, tracking and transaction security. All orders for the products shall be placed by users directly with CDnow and shall be subject to acceptance by CDnow. All orders accepted shall be subject to the terms and conditions of CDnow's then current terms and conditions of sale. Such terms may be changed at any time, without notice to Excite. CDnow shall have no obligation to ship any orders unless payment in full is received in advance. Prices for the products shall be set solely by CDnow. CDnow reserves the right to change its prices at any time, without notice to Excite. [Confidential Treatment requested for redacted portions of document.] 8. Staffing Each party agrees to provide staffing sufficient for such party to meet its obligations under this Agreement in a timely manner. Further, each party shall appoint a relationship manager who shall have responsibility for managing the day-to-day activities of the party under this Agreement. 9. Ownership (a) Each party owns and shall retain all right, title and interest in its names, logos, trademarks and service marks, copyrights and proprietary technology including without limitation, those names, logos, trademarks and service marks, copyrights and proprietary technology currently used or any which may be developed in the future. Neither party shall copy, distribute, reproduce or use the other party's names, logos, trademarks and service marks, copyrights and proprietary technology except as expressly permitted under this Agreement. Upon notice from CDnow, Excite shall immediately terminate the use of any advertising materials using CDnow's name or logo. Upon notice from Excite, CDnow shall immediately terminate the use of any advertising materials using Excite's or the WebCrawler name or logo. (b) Neither party shall contest or impair, directly or indirectly, the other party's ownership of any of such other party's names, logos, trademarks and service marks, copyrights, Proprietary Features and proprietary technology, anywhere, nor the fact that the use of such names, logos, trademarks and service marks, copyrights, and proprietary technology by it will inure to the benefit of the other party. Neither party will assist others to contest or impair the same and each party hereby expressly acknowledges the other party's superior rights therein. 10. Term and Termination The term of this Agreement shall commence upon the Launch Date and shall continue for two (2) years thereafter ("Term"), unless terminated as set forth below: (a) This Agreement may be terminated at any time by either party: (i) immediately upon written notice if the other party becomes insolvent, files a petition in bankruptcy or makes an assignment for the benefit of its creditors; or (ii) thirty (30) days after written notice to the other party of such other party's breach of any of its obligations under this Agreement in any material respect, which breach is not remedied within such 30-day period. (b) If Excite fails to deliver the Guaranteed Impressions during the first year of the Term, Excite will use commercially reasonable efforts to make good the shortfall. If Excite fails to make good the shortfall within [XXX] following the first year end, CDnow may terminate this Agreement in accordance with Paragraph 10(a)(ii) and Excite will refund the pro-rata amount of the first year linking fee for any remaining undelivered Guaranteed Impressions. (c) If CDnow fails to deliver a minimum referral fee of [XXX] in the first year of the Term, Excite may terminate this Agreement in accordance with Paragraph 10(a)(ii). [Confidential Treatment requested for redacted portions of document.] (d) Upon the termination or expiration of this Agreement, each party will promptly (within ten (10) days) return all assets (digital, proprietary or otherwise) belonging to the other. (e) Paragraphs 1, 2(g), 3(f), 9, 10(b), 10(d), 11, 12, 13 and 14 shall survive termination of this Agreement. 11. Representations (a) Each party represents and warrants that it has, and will retain during the term hereof, all right, title and authority to enter into this Agreement, to grant the other party the rights and licenses herein granted and to perform all of its obligations under this Agreement. (b) CDnow represents and warrants that to the best of its knowledge any content provided by CDnow and displayed on CDnow's Site, the Pages or WebCrawler does not constitute defamation or invasion of the right of privacy or publicity, or infringement of the copyright, trademark or other intellectual property right, of any third party. This representation and warranty shall specifically not apply to content provided by third parties or visitors to the Pages, WebCrawler or CDnow's Site such as visitors who use chat rooms, bulletin boards, or other forums on such Sites which allow visitors to display material that is not within the control of CDnow. (c) Excite represents and warrants that to the best of its knowledge any content provided by Excite and displayed on the Pages, CDnow's Site or WebCrawler does not constitute defamation or invasion of the right of privacy or publicity, or infringement of the copyright, trademark or other intellectual property right, of any third party. This representation and warranty shall specifically not apply to content provided by third parties or by visitors to the Pages, WebCrawler or CDnow's Site such as visitors who use chat rooms, bulletin boards, or other forums on such Sites which allow visitors to display material that is not within the control of Excite. 12. Indemnification (a) Each party shall indemnify, defend and hold harmless the other party and its affiliates, and its respective directors, officers, employees and agents, from and against any and all liability, claim, loss, damage, injury or expense (including reasonable attorneys' fees) brought by a third party, arising out of a breach, or alleged breach, of any of its representations, warranties or obligations herein. (b) CDnow shall indemnify, defend and hold harmless Excite and its affiliates, and their respective directors, officers, employees and agents, against any and all claims, actions, liabilities, losses, and expenses (including reasonable attorneys' fees) brought by a third party relating to or arising out of any claim that any content provided by CDnow and displayed on the Pages, CDnow's Site or WebCrawler constitutes a defamation or invasion of the right of privacy or publicity, or [Confidential Treatment requested for redacted portions of document.] infringement of the copyright, trademark or other intellectual property right, of any third party. This indemnity shall specifically not apply to content provided by visitors to the Pages, CDnow's Site or WebCrawler such as visitors who use CDnow's chat rooms, bulletin boards, or other forums which allow visitors to display material that is not within the control of CDnow. (c) Excite shall indemnify, defend and hold harmless CDnow and its affiliates, and their respective directors, officers, employees and agents, against any and all claims, actions, liabilities, losses, and expenses (including reasonable attorneys' fees) brought by a third party relating to or arising out of any claim that any content provided by Excite and displayed on the Pages, CDnow's Site or WebCrawler constitutes a defamation or invasion of the right of privacy or publicity, or infringement of the copyright, trademark or other intellectual property right, of any third party. This indemnity shall specifically not apply to content provided by visitors to the Pages, WebCrawler or CDnow's Site such as visitors who use chat rooms, bulletin boards, or other forums on such Sites which allow visitors to display material that is not within the control of Excite. (d) The indemnified party shall promptly provide the indemnifying party with written notice of any claim which the indemnified party believes falls within the scope of this Paragraph; provided, however, that, except to the extent the indemnifying party is actually prejudiced by the indemnified party's failure to provide such prompt notice, such failure to provide prompt notice hereunder shall not limit the indemnified party's rights under this Paragraph. The indemnified party may, at its own expense, assist in the defense of any such claim if it so chooses, provided that the indemnifying party shall control such defense and all negotiations relative to the settlement of any such claim. 13. Public Relations, Confidentiality (a) Neither party will make any announcements or statements to the public or create any written materials concerning the relationship between them without the prior written consent of the other, which is not to be unreasonably withheld or delayed. In no event shall either party or any content, products or services present on either party's Site disparage the other party or any of the other party's affiliates. (b) Neither party shall disclose directly or indirectly to any third party or any employee, agent or consultant of the party who does not have a need to know such information for the party to meet its obligations under this Agreement any of the confidential information of the other party without the prior, written consent of the other party, which consent the other party may decline to provide at its sole discretion. For purposes of this Agreement, "confidential information" will have the meaning it is given in the Confidentiality Agreement entered into between the parties, dated September 22, 1997 (which this Paragraph supplements but does not replace), but shall also mean all such information obtained as a result of the party's performance of this Agreement, including, without limitation, a party's business plans, product plans, performance data, usage data, financial information and customer lists. [Confidential Treatment requested for redacted portions of document.] 14. Miscellaneous (a) Indulgences, Etc. Neither the failure nor any delay on the part of either party to exercise any right, remedy, power or privilege under this Agreement shall operate as a waiver thereof, nor shall any single or partial exercise of any right, remedy, power or privilege preclude any other or further exercise of the same or of any other right, remedy, power or privilege, nor shall any waiver of any right, remedy, power or privilege with respect to any occurrence be construed as a waiver of such right, remedy, power or privilege with respect to any other occurrence or as a waiver of any other right, remedy, power or privilege. (b) Controlling Law This Agreement and all questions relating to its validity, interpretation, performance and enforcement, shall be governed by and construed in accordance with the laws of the Commonwealth of Pennsylvania, other than conflicting choice-of-law provisions. (c) Notices All notices, requests, demands, and other communications required or permitted under this Agreement and the transactions contemplated herein shall be in writing and shall be deemed to have been duly given, made and received when delivered against receipt or when sent by overnight courier or United States registered mail, return receipt requested, postage prepaid, addressed as set forth below: (i) If to CDnow: (ii) If to Excite: CDnow, Inc. Excite, Inc. Jenkins Court, Suite 300 555 Broadway 610 Old York Road Redwood City, CA 94063 Jenkintown, PA 19046 Attn: President/CEO Attn: General Counsel In addition, notice by mail shall be by air mail if posted outside of the continental United States. Any party may alter the address to which communications or copies are to be sent by giving notice of such change of address in the manner set forth herein. (d) Provisions Separable The provisions of this Agreement are independent of and separable from each other, and no provision shall be affected or rendered invalid or unenforceable by virtue of the fact that for any reason any other or others of them may be invalid or unenforceable in whole or in part. (e) Entire Agreement The terms and conditions of this Agreement represent the entire understanding between the parties hereto with respect to the subject matter hereof, and supersede all prior and contemporaneous agreements and understandings, inducements or conditions, express or implied, oral or written, except as herein contained, other than the Confidentiality Agreement entered into by the parties and dated September 22, 1997 which shall remain in effect and the terms of which [Confidential Treatment requested for redacted portions of document.] shall be and are hereby incorporated herein and attached hereto as Exhibit C. The express terms hereof control and supersede any course of performance and/or usage of trade inconsistent with any of the terms hereof. This Agreement may not be modified or amended other than by an agreement in writing signed by both parties. (f) Paragraph Headings The paragraph headings in this Agreement are for convenience only; they form no part of this Agreement and shall not affect its interpretation. (g) Telefaxes Constitute Valid Documents This Agreement and subsequent modifications may be transmitted by telecopy facsimile machine and such facsimile copy shall be deemed an original if all pages thereof are initialed and the Agreement or modifications are signed by the duly authorized representative of the parties. Such facsimiles shall constitute valid, binding documents and shall be regarded as such upon receipt. The original of the document sent by telefax shall be promptly sent within seventy-two (72) hours overnight courier or first class mail to the receiving party so that accurate files may be maintained. Failure to send timely any original document shall not affect the validity or binding nature of such document. (h) Force Majeure Neither party shall be held to be in breach of this Agreement by reason of any failure or delay in its performance hereunder if such failure is due to causes beyond its reasonable control, including but not limited to, acts of the other party, acts of God, delays in transportation, inability beyond its reasonable control to obtain necessary labor or materials, or events such as fires, floods, earthquakes, storms, war, act of public enemy, civil commotions and the like or by any law, rule, regulation, order or other action by any public authority. To the extent failure to perform is caused by such an event, such party shall be excused from performance hereunder so long as such event continues to prevent such performance, and provided the non- performing party takes all reasonable steps to resume full performance. (i) Independent Contractor Each party shall act as an independent contractor and shall have no authority to obligate or bind the other in any respect. Neither the employees of Excite nor the employees of CDnow shall represent themselves to be employees of the other. (j) Compliance With Laws Each party shall comply with all federal, state and local laws, licensing regulations and rulings of governmental bodies having jurisdiction over its business. Nothing in this Agreement shall be construed to require either party to perform any act in violation of any laws, regulations or rulings. (k) Disclaimer of Warranty EXCEPT AS OTHERWISE PROVIDED FOR IN THIS AGREEMENT, CDNOW'S SITE AND WEBCRAWLER ARE EACH PROVIDED ON AN AS IS BASIS WITHOUT WARRANTIES OF ANY KIND, EITHER EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO WARRANTIES OF TITLE OR IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE, OTHER THAN THOSE WARRANTIES WHICH ARE IMPLIED BY OR INCAPABLE OF EXCLUSION, [Confidential Treatment requested for redacted portions of document.] RESTRICTION OR MODIFICATION UNDER THE LAWS APPLICABLE TO THIS AGREEMENT. (l) Limitation of Liability WITH THE EXCEPTION OF INDEMNITY OF THIRD PARTY CLAIMS, IN NO EVENT SHALL EITHER PARTY BE LIABLE FOR ANY INDIRECT, SPECIAL, EXEMPLARY, CONSEQUENTIAL OR INCIDENTAL DAMAGES, WHETHER SUCH ALLEGED DAMAGES ARE ALLEGED IN TORT, CONTRACT OR INDEMNITY, ARISING OUT OF THE USE OR INABILITY TO USE CDNOW'S SITE OR THE PAGES OR WEBCRAWLER, THE FAILURE FOR ANY REASON TO RETURN USERS TO WebCrawler OR THE LOSS OF DATA, EVEN IF CDNOW OR EXCITE IS INFORMED OF THE POSSIBILITY OF SUCH DAMAGES, UNLESS SUCH DAMAGES ARE DUE TO CDNOW'S OR EXCITE'S GROSS NEGLIGENCE OR WILLFUL MISCONDUCT. Notwithstanding the FOREGOING, EACH PARTY expressly excludes liability for consequential loss or damage TO THE OTHER including but not limited to loss of profit, business, revenue, goodwill or anticipated savings. IN NO EVENT (OTHER THAN INDEMNITY OF THIRD PARTY CLAIMS or an unauthorized use or disclosure of the other party's confidential information) WILL EITHER PARTIES' LIABILITY TO THE OTHER UNDER ANY THEORY EXCEED THE AMOUNTS ACTUALLY PAID BY CDNOW. (m) Liability for Termination In the event of proper termination as set forth herein, the terminating party shall not be liable for reimbursement of damages on account of any loss of prospective profits or on account of expenditures, investments, leases or other commitments relating to the other party's business or good will. (n) Expenses Except as otherwise provided for in this Agreement, each party shall be responsible for any and all expenses, charges and fees incurred by it in connection with its duties hereunder, and it shall not be reimbursed for the same by the other party. (o) Binding Nature of Agreement This Agreement shall be binding upon the parties hereto and their respective heirs, executors, successors and assigns. Neither party may, without the prior written consent of the other party, assign or transfer this Agreement or any obligation incurred hereunder. Any attempt to do so in contravention of this Paragraph shall be void and of no force and effect. [Confidential Treatment requested for redacted portions of document.] IN WITNESS WHEREOF, the parties hereto intending to be legally bound do hereby set their hands as of the day and year first above written. CDNOW, INC. EXCITE, INC. By:/s/ Jason Olim By: /s/ Robert C. Hood Jason Olim, President Robert C. Hood, Executive Vice President, Chief Administrative Officer [Confidential Treatment requested for redacted portions of document.] EXHIBIT A KEYWORDS [approximately 20,000 words intentionally omitted] [Confidential Treatment requested for redacted portions of document.] EXHIBIT B Carry-through Bar Specifications as of 4/15/97 Size Total Carry-through Bar Size: 468(w) x 25(h) pixels as of April 1, 1997 all Carry-through Bar sizes must be 468(w) x 25(h) to comply with the Internet Advertising Bureau's (IAB) banner standards. Live area for Partner Logo: 360(w) x 24(h) pixels Color Bar is black at all times. Only partner logos/icons can be as many colors as desired with a black background Return to... copy is mandatory and must be set up as white Helvetica Neue Black 10pt type, centered and 5 pixels in from the left-hand side of the first black bar We recommend all copy to be white To pick up a template go to http://cdnow.com/cobrand_template Format Must be saved in a gif file format Placement Carry-through bar is placed on the top and bottom of each CDnow page. Only those people who visit CDnow from your site will see the Carry-through bar URL/Address Partners have the option of 1 to 3 links on their Carry-through bar The URLs will be provided by the partner If more than one link is desired, the bar must consist of multiple gif images that reference previous Carry-through bar specifications. When using multiple gif images keep two pixels between each bar. No image maps are permitted. Please see the following page for more examples of possible banner solutions. [Confidential Treatment requested for redacted portions of document.] [graphic depicting carry-through bar sample] Source Code CDnow will provide the partner with a from equals (from=) tag. This tag allows us to identify customers coming from the Partners site to CDnow. Timing CDnow requires a minimum of five business days from when we receive the Carry- through bar to implement it on our site. Carry-through Bar Samples [Graphic depicting carry-through bar samples] [Confidential Treatment requested for redacted portions of document.] EXHIBIT C CONFIDENTIALITY AGREEMENT THIS CONFIDENTIALITY AGREEMENT is entered into this 22nd day of September, 1997 by and between CDNOW, INC. and EXCITE NETWORK. 1. The purpose of this Agreement is to set forth the terms and conditions for the disclosure of confidential information between the parties. 2. "Confidential Information" means any and all data, documentation and other information, in whatever form disclosed, relating co either of the parties hereto, including but not limited to, sales information, statistical compilations, visitor information, financial statements, financial projections, business plans, listings and contractual obligations and terms thereof, components of intellectual property, unique designs, or other technology and trade secrets disclosed by one party (for the purpose of this Section, the "Disclosing Party") or any affiliate of the Disclosing Party to the other party (for the purpose of this Section, the "Receiving Party") or any affiliate or other person acting on behalf of the Receiving Party. Notwithstanding the foregoing, Confidential Information shall not include any information: a. that is or becomes readily available in public records or documents, other than is a result of a disclosure by the Receiving Party or any affiliate or other person acting on behalf of the Receiving Party; or b. which can be shown to have been known by Receiving Party prior to its disclosure by Disclosing Party; or c. which must be disclosed by Receiving Party under applicable laws or regulations or judicial or administrative proceedings (such requirement to be confirmed by a legal opinion); or d. that is or becomes available to the Receiving Party on a nonconfidential basis from a source (other than the Disclosing Party or its agents) which is not prohibited from disclosing such information to the Receiving Party by legal, contractual or fiduciary obligation to the Disclosing Party; or e. is independently developed by the Receiving Party without use of any of the Confidential Information. 3. Receiving Party shall and shall cause its affiliates and any other person acting on its behalf to, (i) hold the Confidential Information in strict confidence, (ii) exercise the highest [Confidential Treatment requested for redacted portions of document.] degree of care in safeguarding the Confidential Information against any and all loss, theft or other inadvertent disclosure, and (iii) take such steps as are necessary to ensure and maintain such confidentiality. 4. Receiving Party shall not, and shall cause its affiliates and any other person acting on its behalf not to use the Confidential Information other than for purposes intended by the parties hereto upon disclosure of the Confidential Information, or disclose, transfer or in any way divulge, directly or indirectly, any of the Confidential Information, under any circumstances or by any means, to any third party without the prior written consent of Disclosing Party. Receiving Party shall not, and shall cause its affiliates and any other person acting on its behalf not to, copy, transmit, reproduce, summarize, quote, or make any commercial use whatsoever of any of the Confidential Information without the prior written consent of Disclosing Party. 5. The Confidential Information shall remain the exclusive property of Disclosing Party, and upon termination of this Agreement, or at any time requested by Disclosing Party, Receiving Party promptly will return to Disclosing Party or destroy all of Disclosing Party's Confidential Information, in whatever form, including without limitation any copies, summaries or compilations made. 6. Receiving Party shall reveal the Confidential Information only to agents, representatives and employees who need to know the Confidential Information for purposes intended by the parties hereto upon execution of this Agreement. The actions or negligence of the Receiving Party's affiliates, employees or agents shall be deemed to be the actions or negligence of Receiving Party with respect to the Confidential Information. 7. The Receiving Party understands that the Disclosing Party has endeavored to include in the Confidential Information those materials which the Disclosing Party believes to be relevant for the purposes intended by the parties hereto upon execution of this Agreement, but the Receiving Party acknowledges that neither the Disclosing Party nor any of its agents, representatives or employees makes any representation or warranty either express or implied as to the accuracy or completeness of the Confidential Information. 8. In the event that the Receiving Party or anyone to whom the Receiving Party transmits the Confidential Information pursuant to this Agreement becomes legally compelled to disclose any of the Confidential Information, the Receiving Party will provide the Disclosing Party with prompt notice so that the Disclosing Party may seek a protective order or other appropriate remedy and/or waive compliance with the provisions with this Agreement. In the event that such protective order or other remedy is not obtained, or that the Disclosing Party waives compliance with the provisions of this Agreement, the Receiving Party will furnish only that portion of the Confidential Information which the Receiving Party is advised by opinion of counsel is legally required and will exercise Receiving Party's best efforts to obtain reliable assurance that confidential treatment will be accorded the Confidential Information. [Confidential Treatment requested for redacted portions of document.] 9. Should Receiving Party breach any of its obligations contained in this Section, Disclosing Party will be irreparably harmed and entitled to specific performance, including immediate issuance of a temporary restraining order or preliminary injunction enforcing the terms of this Section, and to judgment for damages caused by breach, and to any other remedies provided for by applicable law. 10. The Receiving Party agrees that this Agreement shall not be assigned without the prior written consent from the Disclosing Party, except by merger, reorganization, consolidation, or sale of all or substantially all of such party's assets. Any attempt to do so in contravention of this Paragraph shall be void and of no force and effect. No right or license is granted by the Disclosing Party to the Receiving Party except as expressly set forth in this Agreement. This Agreement represents the entire understanding between the parties hereto with respect to the subject matter hereof, and supersedes all prior and contemporaneous agreements, express or implied, oral or written, except as herein contained. This Agreement may not be modified or amended other than by an agreement in writing signed by both parties. This Agreement and all questions relating to its validity, interpretation, performance and enforcement, shall be governed by and construed in accordance with the laws of the Commonwealth of Pennsylvania, other than conflicting choice-of-law provisions. IN WITNESS WHEREOF, the parties hereto intending to be legally bound to hereby set their hands and seals as of the day and year first above written. CDNOW, INC. EXCITE NETWORK By: /s/ Jason Olim By: /s/ Kenneth Wachtel ----------------------------- ----------------------------- Jason Olim, President Kenneth Wachtel, Senior VP, Advertising Sales [Confidential Treatment requested for redacted portions of document.] EX-10.9 10 ADVERTISING AND PROMOTION AGREEMENT - 08/21/97 EXHIBIT 10.9 ADVERTISING AND PROMOTION AGREEMENT This Advertising and Promotion Agreement (the "Agreement") is entered into --------- as of August 21, 1997 (the "Effective Date") between Yahoo! Inc., a California -------------- corporation ("Yahoo") and CDnow, Inc., a Pennsylvania corporation ("CDnow"). In ----- ----- consideration of the mutual promises contained in this Agreement, Yahoo and CDnow hereby agree as follows: 1. Definitions. ----------- The following terms are used in this Agreement with the respective meanings set forth below: "Above-the-Fold" shall mean situated within the portion of a page that is -------------- designed to be visible on a standard computer screen with a resolution of 640 pixels by 480 pixels without requiring the user to scroll horizontally or vertically through the page. "Buyweb Link" shall mean a link which: (a) contains the CDnow logo, with ----------- dimensions no larger than 89 pixels wide by 31 pixels high (which is as large as Yahoo's standard navigational buttons), and a tag line, with no more than 16 characters, plus the artist name, as set forth in Exhibit D; (b) is placed near --------- any appropriate references to music on the Included Pages; and (c) will permit users to navigate directly from the Included Page to a music related page on the CDnow Site, where such users may purchase the referenced Recorded Music items, as reasonably designated by CDnow (which page may be different for each Buyweb Link). "CDnow Competitor" shall mean, collectively: (i) the Recorded Music ---------------- merchants listed on Exhibit B to this Agreement, solely if such Recorded Music --------- merchant derives more than [XXX] of its annual gross revenues directly from the sale of Recorded Music; and (ii) any business entity, including without limitation, corporations, business units, and corporate services divisions that derives more than [XXX] of its annual gross revenues directly from the sale of Recorded Music. "CDnow Site" shall mean the on-line store owned by CDnow and currently ---------- located at http://www.cdnow.com. "Click-through" shall mean a user presence at the CDnow Site, which ------------- originated from the Included Pages, the Netscape Guide, or the Visa Shopping Guide, including any banner ads that are part of this Agreement pursuant to Section 2.2. "Included Pages" shall mean, collectively: (i) certain results pages in the -------------- Yahoo Main Site, My Yahoo and Yahoo Metro Sites with the music related key words identified in Exhibit A attached hereto; (ii) certain Recorded Music related --------- pages of My Yahoo! to reasonably be [Confidential Treatment requested for redacted portions of document.] 1 determined by Yahoo (by way of example, but not limitation, attached hereto in Exhibit D is a sample page from My Yahoo! illustrating an Included Page); and - --------- (iii) certain Recorded Music related pages, as identified in Exhibit A, of ---------- Yahoo's Metro Sites and Yahoo Main Site. In the event that Yahoo adds additional relevant Recorded Music related pages to the Yahoo Main Site or the Yahoo Metro Sites and/or modifies the existing Recorded Music related pages currently listed in Exhibit A, such pages shall be deemed to be incorporated --------- into Exhibit A upon receipt by CDnow of written notification thereof. CDnow may --------- request in writing that Yahoo add to Exhibit A any pages, existing as of the --------- Effective Date, on the Yahoo Main Site or the Yahoo Metro Sites relevant to recorded music artists or musical genres, and Yahoo will not unreasonably withhold or delay approval and implementation of such request. Upon such approval, Exhibit A will be deemed by the parties to be so amended. In the --------- event that Yahoo materially restructures the nature of the Yahoo Service, Yahoo warrants that such restructuring will not result in any material change in Yahoo's representations under Section 2.1.1 regarding the delivered number of Page Views. "Initial Term" shall mean the period beginning on the Effective Date, and ------------ continue for a period of twelve (12) full calendar months following the Launch Date. "Launch Date" shall mean the date on which Yahoo makes the Buyweb Links ----------- available to users on each Included Page, which shall be no more than two (2) weeks after Yahoo receives from CDnow any and all URLs, URL formats (as applicable), content, and other materials necessary for Yahoo to provide the Buyweb Links described in this Section; provided, however, that CDnow delivers -------- ------- to Yahoo such URLs, URL formats, content, and other materials necessary for Yahoo to provide the Buyweb Link no later than September 15, 1997. In the event that CDnow fails to deliver such materials to Yahoo by September 15, 1997, then in any event the "Launch Date" shall be September 30, 1997. "Netscape Guide" shall mean that property currently referred to as -------------- "Netscape Guide by Yahoo", and located at http://netscape.yahoo.com/guide, maintained by Yahoo pursuant to the agreement between Yahoo and Netscape Corporation, in effect as of the Effective Date of this Agreement. "Page View" shall mean a web site user's viewing of any Included Page, and --------- any discrete page on the Netscape Guide or the Visa Shopping Guide, which includes CDnow as a featured site or content module as described in Section 5. "Recorded Music" shall mean any musical sound performance pre-recorded on -------------- any of the following media, which (except as set forth below) does not include any textual, video, or software elements: vinyl, compact disc, magnetic tape (cassette, reel-to-reel, or 8-track), DAT, music only DVD recordings, music only ROM (except such ROM may include animation or video clips intended by the music ------ recording artist as part of the musical sound recording), and [Confidential Treatment requested for redacted portions of document.] 2 digitally distributed musical sound recordings of the same recited above, and expressly excluding other media and ancillary music-related merchandise, including without limitation, books, videos, laser discs, clothing, musical instruments, sheet music, musical scores, computer software, and technology used to deliver or render such sound recording. "Subsequent Term" shall mean the twelve (12) calendar month period after --------------- the Initial Term of this Agreement. "Term" shall mean, collectively, the Initial Term and the Subsequent Term. ---- "Visa Shopping Guide" shall mean the Visa Shopping Guide by Yahoo as ------------------- described in Section 5.2 hereto. "Yahoo Main Site" shall mean Yahoo's principal directory to the World Wide --------------- Web, currently located at www.yahoo.com, and the Yellow Pages portion of the Yahoo Main Site, currently located at http://yp.yahoo.com. "Yahoo Metro Site" shall mean the following Yahoo! Metros: Atlanta, ----------------- Austin, Boston, Chicago, Dallas/Fort Worth, Los Angles, Miami, Minneapolis/St. Paul, New York, S.F. Bay, Seattle, Wash D.C., and any other similar United States metro sites that may be created by Yahoo and provided that such sites are wholly owned, created, and branded by Yahoo. "Yahoo Service" shall mean, collectively, the Yahoo Main Site, My Yahoo! ------------- and the Yahoo Metro Sites. 2. Marketing Links. --------------- 2.1 Buyweb Links on Included Pages. ------------------------------ (a) Yahoo will place a Buyweb Link Above-the-Fold on each Included Page and at the bottom of each Included Page which requires the user to scroll more than one standard computer screen (i.e., with a resolution of 640 pixels by 480 pixels), excluding any pages relating to My Yahoo!. Each such Buyweb Link --------- will permit users to navigate directly from the Included Page to a page on the CDnow Site to be reasonably designated by CDnow (which page may be different for each Buyweb Link), the substantial purpose of which page shall be to enable users to purchase referenced Recorded Music items relevant to the context of the Included Page. (b) On My Yahoo! Included Pages, Yahoo will include a so-called "Content Module" in a form similar to the example set forth in Exhibit D, with --------- content to be mutually agreed to by the parties. Such "Content Module" will appear as a default module on the [Confidential Treatment requested for redacted portions of document.] 3 "entertainment" section of all newly registered My Yahoo! users, and such "Content Module" will become an option available to My Yahoo! users registered prior to the Launch Date. (c) In addition, subject to any existing contractual obligations as set forth in Section 4 hereto, Yahoo represents that it will place the Buyweb Links on each Included Page in a manner that is comparable to third party links that are of a similar nature and function to the Buyweb Links on any such Included Page. By way of example, but not limitation, the parties attach hereto as Exhibit D, an example of: (i) a directory page link; and (ii) a search page --------- link. CDnow will discuss with Yahoo any material changes to such Buyweb Links from the examples set forth in Exhibit D prior to implementing any such changes. --------- (d) Subject to the provisions of this Agreement, Yahoo will solely be responsible for the user interface and placement of the Buyweb Links on the Included Pages. Prior to any modifications to Above-the-Fold Buyweb Links, Yahoo will consult with CDnow in good faith. Yahoo agrees that CDnow may vary the Buyweb Links up to [XXX] per month, unless otherwise agreed to in writing by Yahoo. The parties agree to cooperate with respect to testing the performance of the Buyweb Links during the Term of this Agreement. 2.1.1 Yahoo Representations. --------------------- (a) Initial Term. Yahoo represents that it will deliver to users of ------------ the Yahoo Service and the Netscape Guide a minimum of [XXX] Page Views, during the Initial Term of this Agreement, in accordance with the schedule set forth in Exhibit C. In the event that Yahoo fails to deliver such number of Page Views - --------- during any quarter set forth in Exhibit C, Yahoo will "make good" the shortfall --------- during the next quarter by [XXX]. Such "substitute" Page Views will be in addition to any Page Views otherwise stated in Exhibit C for such subsequent --------- quarter. In the event of a shortfall during the last quarter of the Initial Term, and if CDnow exercises its termination rights under Section 6 hereto, Yahoo's obligations under this Section 2.1.1(a) shall extend beyond the end of such Initial Term until such Page View obligation is satisfied. (b) Subsequent Term. During the Subsequent Term (if any), Yahoo --------------- represents that it will deliver to users of the Yahoo Service and the Netscape Guide a minimum number of Page Views equal to the number of actual Page Views during the last [XXX] months of the Initial Term multiplied by [XXX], but in no event less than [XXX] Page Views. Within thirty (30) days after the end of the Initial Term, Yahoo shall set forth the schedule, as reasonably agreed by CDnow, for the delivery of such Page Views of the Subsequent Term. In the event that Yahoo fails to deliver the scheduled number of Page Views during any quarter during the Subsequent Term, Yahoo will "make good" the shortfall during the next quarter by [XXX]. Such "substitute" Page Views will be in addition to any Page Views otherwise scheduled for such subsequent quarter. In the event [Confidential Treatment requested for redacted portions of document.] 4 of a shortfall during the last quarter of the Subsequent Term, Yahoo's obligations under this Section 2.1.1(b) shall extend beyond the end of such Subsequent Term until such Page View obligation is satisfied. The provisions set forth in this Section 2.1.1 set forth the entire liability of Yahoo, and CDnow's sole remedy, for Yahoo's breach of its representations under this Section 2.1.1. (c) Existing Contracts. Except as set forth in Exhibit E, Yahoo ------------------ --------- represents that none of the third party contracts referenced under Section 4 hereto, shall remain in effect after January 1, 1998. 2.1.2 Reports. On a monthly basis, or more frequently if available to ------- Yahoo, Yahoo will deliver to CDnow a written report within fifteen (15) days after the end of the month that describes (in reasonable detail) Yahoo's calculation of the Page Views delivered during the period. 2.1.3 User Estimates. During the Term of this Agreement, at CDnow's -------------- reasonable request, Yahoo will provide, up to once per month, to CDnow estimates and research results that Yahoo has readily available in the normal course of its business, solely for use by CDnow in determining usage pertaining to the Included Pages and Netscape Guide. All such estimates and research results shall be considered confidential Information under Section 7.3. 2.2 Banner Advertisements. --------------------- (a) CDnow has placed with Yahoo insertion order #7815 in accordance with Yahoo's standard terms and conditions for such insertion order. (b) Yahoo agrees to place a CDnow banner advertisement on [XXX] of the Included Pages ("Selected Pages"), on an as available basis, such that on -------------- each Selected Page, the banner advertisement will appear Above-the-Fold with a size, prominence, and placement equivalent to third-party banners placed on the relevant portion of the Yahoo Service for similar inventory. The content and functionality of the banner advertisements will be as reasonably determined by CDnow, subject to the provisions of this Section 2.2 and to Yahoo's generally applicable technical specifications and advertising guidelines. CDnow shall be entitled to vary the banners up to [XXX] per month. CDnow banner advertisements shall only promote CDnow in general or Recorded Music sold by CDnow at the CDnow Site, and shall not feature any non-Recorded Music items or merchandise. 2.3 Other Promotional Opportunities. From time to time during the Term of ------------------------------- this Agreement, the parties agree to discuss in good faith the possibility of additional promotional opportunities that may include the Yahoo trademark and/or trade name. [Confidential Treatment requested for redacted portions of document.] 5 2.4 [XXX] 3. Compensation; Audit Rights. -------------------------- 3.1 Initial Term. In consideration of Yahoo's performance and obligations ------------ as set forth herein, CDnow will pay Yahoo a total marketing fee of [XXX] for the Initial Term. Such fee shall be divided into: (i) a non-refundable slotting fee of [XXX] (the "Slotting Fee"); and (ii) a referral fee of at least [XXX] ------------ (the "Referral Fee"), as determined in Section 3.3. Such payments will be made ------------ in accordance with the terms of this Section 3. 3.2 Slotting Fee. During the Initial Term, CDnow shall pay to Yahoo [XXX] ------------ of the Slotting Fee, as a set-up, design, and consultation fee, on September 30, 1997. The balance of the Slotting Fee [XXX] shall be due and payable in accordance with the schedule set forth in Exhibit C. During the Subsequent --------- Term, CDnow shall pay Yahoo a Slotting Fee based upon the following formula: number of actual Page Views during the last [XXX] months of the Initial Term multiplied by [XXX], divided by [XXX] then multiplied by [XXX]. In addition, the Slotting Fee for the Subsequent Term will be adjusted in the following manner: (i) calculate the ratio defined by (number of actual Page Views during the last [XXX] months of the Initial Term multiplied by [XXX]) divided by [XXX]; (ii) if the ratio is greater than 1.0, then calculate the difference between the ratio of subsection (i) and 1.0 to determine a differential factor; (iii) multiply the differential factor from subsection (ii) by [XXX] to obtain the adjustment factor; and then (iv) multiply the Slotting Fee for the Subsequent Term calculated above in this Section 3.2 by such adjustment factor. In no event will the Subsequent Term Slotting Fee described in this Section 3.2 be less than [XXX]. 3.3 Referral Fee. CDnow shall pay to Yahoo the Referral Fee of [XXX] per ------------ quarter during the Term. In addition, CDnow shall pay to Yahoo: (i) [XXX] per Click-through for any Click-throughs over [XXX], during the Initial Term; and (ii) [XXX] per Click-through for any Click-throughs over [XXX], during the Subsequent Term. The payments under this Section 3.3 [Confidential Treatment requested for redacted portions of document.] 6 shall be due and payable within thirty (30) days after the last day of each calendar quarter during the Term of this Agreement. 3.4 Audit Rights. Yahoo shall maintain complete and accurate records in ------------ accordance with generally accepted methods of accounting for all transactions which are the subject of this Agreement for three (3) years after the last payment is due under this Agreement. An independent "Big Six" accounting firm retained by CDnow shall have access to such records, upon reasonable notice, for the purposes of auditing the number of Click-throughs and Page Views reported by Yahoo in support of Section 3.2, during normal business hours, for so long as such records are required to be maintained. CDnow shall pay the expenses of the accounting firm, unless the number of Click-throughs determined by the ------ accounting firm is in excess of ten percent (10%) of the Click-throughs reported by Yahoo over the prior twelve (12) month period or the life of the Agreement (whichever is shorter), in which case Yahoo shall promptly pay CDnow the accounting firm's reasonable fees for such audit, and shall promptly reimburse any amount overpaid by CDnow to Yahoo based on such excess Click-through amounts. 4. Exclusivity. ----------- 4.1 CDnow Competitors. During the Term, no CDnow Competitor will be ----------------- permitted to purchase: (a) advertising on the Included Pages; (b) banner advertisements on pages of the Netscape Guide described in Section 5.1; or (c) banner advertisements on pages of the Visa Shopping Guide which include CDnow's Merchant Spotlight Content Module as described in Section 5.2; provided, -------- however, that notwithstanding the foregoing: (i) Yahoo may honor its current - ------- contracts with CDnow Competitors or other entities, the terms of which contracts would otherwise constitute a breach of the obligations of Yahoo as set forth hereunder; and provided, further, that such contracts shall terminate in -------- ------- accordance with Yahoo's representations in Section 2.1.1(c), and shall not be renewed to the extent that such contracts include placement on Included Pages; (ii) CDnow Competitors may purchase advertisements on Included Pages relating to My Yahoo! as long as such advertisements are not targeted specifically to users that have expressed music as an interest as part of their My Yahoo! registration; and (iii) Yahoo may run banner advertisements of CDnow Competitors on the Netscape Guide to the extent such advertisements are bartered by Netscape Communications Corporation in connection with the agreement between Yahoo and Netscape relating to the Netscape Guide. In addition, and notwithstanding the foregoing, Yahoo may charge CDnow Competitors for listings or enhanced merchant listings or similar positioning in the normal course of business with respect to Included Pages relating to the Yellow Pages portion of the Yahoo Main Site. Except as otherwise set forth in this Agreement, Yahoo shall not be restricted from conducting its normal course of business with CDnow Competitors outside the Included Pages. 4.2 Recorded Music Advertisements. Except as set forth in Section 4.1, ----------------------------- during the Term of this Agreement, Yahoo shall not permit any third party to purchase advertising on the [Confidential Treatment requested for redacted portions of document.] 7 Included Pages, excluding Including Pages relating to My Yahoo!, or any banner --------- advertisements on pages of the Netscape Guide described in Section 5.1, or banner advertisements on pages of the Visa Shopping Guide which include CDnow's Merchant Spotlight Content Module, as described in Section 5.2, which such advertising, to Yahoo's knowledge: (a) promotes the sale of Recorded Music; or (b) takes the user on a direct link from an Included Page to the page of a third party site, the substantial purpose of such page is the promotion or sale of Recorded Music; provided, however, that Yahoo uses its commercially reasonable -------- ------- efforts to remove such link within five (5) business days after receipt by Yahoo of written notice by CDnow of such link; provided, further, that notwithstanding -------- ------- the foregoing: (i) Yahoo may honor its current contracts with third parties, the terms of which contracts would otherwise constitute a breach of the obligations of Yahoo as set forth hereunder; and provided, further, that such contracts -------- ------- shall terminate in accordance with Yahoo's representations made in Section 2.1.1(c), and shall not be renewed to the extent that such contracts include placement on Included Pages; (ii) Yahoo may run such banner advertisements of third parties on the Netscape Guide to the extent such advertisements are bartered by Netscape Communications Corporation in connection with the agreement between Yahoo and Netscape relating to the Netscape Guide. In addition, and notwithstanding the foregoing, Yahoo may charge any third party for listings or enhanced merchant listings or similar positioning in the normal course of business with respect to Included Pages relating to the Yellow Pages portion of the Yahoo Main Site. Except as otherwise set forth in this Agreement, Yahoo shall not be restricted from conducting its normal course of business with any third party. 5. Netscape Guide and Visa Shopping Guide. -------------------------------------- 5.1 Netscape Guide. Yahoo currently has an agreement with the Netscape -------------- Corporation to produce Netscape Guide by Yahoo. During the term of that agreement (including any renewal terms), Yahoo will include CDnow as a "Featured Site" and so-called "Content Module" on the Netscape Guide's "entertainment: music" and "shopping: music" pages. 5.2 Visa Shopping Guide. Yahoo currently has an agreement with the Visa ------------------- Corporation to produce Visa Shopping Guide by Yahoo. During the term of that agreement (including any renewal terms), Yahoo will include CDnow as a so-called "Merchant Spotlight Content Module" on the Visa Shopping Guide site (by way of example, but not limitation, attached hereto in Exhibit D is a sample page from --------- the Visa Shopping Guide illustrating a Merchant Spotlight Content Module.) Yahoo's obligations under this Section 5.2 are subject to CDnow meeting the generally applicable merchant standards as applied to merchants in the Visa Shopping Guide. [Confidential Treatment requested for redacted portions of document.] 8 6. Termination. ----------- 6.1 Termination with Cause. This Agreement may be terminated at any time ---------------------- by either party: (i) immediately upon written notice if the other party: (a) becomes insolvent; (b) files a petition in bankruptcy; or (c) makes an assignment for the benefit of its creditors; or (ii) thirty (30) days after written notice to the other party of such other party's breach of any of its obligations under this Agreement in any material respect, which breach is not remedied within such 30-day period. 6.2 Renewal; Termination without Cause. Upon completion of the Initial ---------------------------------- Term, this Agreement will automatically renew for the Subsequent Term, unless ------ CDnow notifies Yahoo in writing, at least ninety (90) days prior to the expiration of the Initial Term, that CDnow will not renew this Agreement. If Yahoo is unable to enter into a substantially similar advertising transaction with a third party prior to end of the Initial Term, and after using commercially reasonable efforts to do so, CDnow will pay Yahoo a non-refundable termination fee of [XXX] (the "Termination Fee"), which shall be paid to Yahoo --------------- within thirty (30) days after the expiration of the Initial Term. The Termination Fee shall be creditable toward advertising, on an as-available basis, on the Yahoo Service (except that such advertising will not be placed on ------ any Yahoo inventory that directly link to sites that are pornographic, racist, or indecent), within the first thirty (30) days after the Initial Term; provided, however, in the event that insufficient advertising is available to - -------- ------- CDnow under this Section 6.2, then such credit shall extend to first-available advertising through the end of calendar year 1998. In no event shall the Termination Fee credit toward advertising set forth in this Section 6.2 extend beyond December 31, 1998, and such credit will be considered fully discharged as of such date. CDnow shall execute standard insertion orders with respect to any advertising placed on the Yahoo Service. 6.3 Survival. The provisions of Sections 1, the "make good" provisions of -------- 2.1.1, 3.4 (as stated), 7, 8, 9 and 10 survive expiration or termination of this Agreement. 7. Confidential Information and Publicity. -------------------------------------- 7.1 Terms and Conditions. The terms and conditions of this Agreement -------------------- shall be considered confidential and shall not be disclosed to any third parties except to such party's accountants or attorneys, or except as otherwise required by law. Neither party shall make any public announcement regarding the existence of this Agreement without the other party's prior written approval and consent. 7.2 Publicity. Any and all publicity relating to this Agreement and --------- subsequent transactions between Yahoo and CDnow and the method of its release shall be approved in advance of the release by both Yahoo and CDnow, which approval shall not unreasonably be withheld or delayed. [Confidential Treatment requested for redacted portions of document.] 9 7.3 Nondisclosure Agreement. Yahoo and CDnow have previously entered into ----------------------- a Mutual Nondisclosure Agreement, dated August 4, 1997, and expressly acknowledge that such Mutual Nondisclosure Agreement remains in full force and effect in accordance with its terms during the Term of this Agreement. 8. Indemnification. --------------- CDnow, at its own expense, will indemnify, defend and hold harmless Yahoo ------------------------------------------------------------------------- and its employees, representatives, agents and affiliates, against any claim, - ----------------------------------------------------------------------------- suit, action, or other proceeding brought against Yahoo based on or arising from - -------------------------------------------------------------------------------- a claim any CDnow trademark, service mark or other brand feature, any material, - ------------------------------------------------------------------------------- product or service produced, distributed, offered or provided by CDnow, or any - ------------------------------------------------------------------------------ material presented on the CDnow Site, infringes in any manner any copyright, - ---------------------------------------------------------------------------- patent, trademark, trade secret or any other intellectual property right of any - ------------------------------------------------------------------------------- third party, is or contains any material or information that is obscene, - ------------------------------------------------------------------------ defamatory, libelous, slanderous, or that violates any law or regulation, or - ---------------------------------------------------------------------------- that otherwise violates any rights of any person or entity, including, without - ------------------------------------------------------------------------------ limitation, rights of publicity, privacy or personality, or has otherwise - ------------------------------------------------------------------------- resulted in any consumer fraud, product liability, tort, breach of contract, - ---------------------------------------------------------------------------- injury, damage or harm of any kind to any third party; provided, however, that - --------------------------------------------------------------- ------- in any such case: (x) Yahoo provides CDnow with prompt notice of any such claim; (y) Yahoo permits CDnow to assume and control the defense of such action upon CDnow's written notice to Yahoo of its intention to indemnify; and (z) upon CDnow's written request, and at no expense to Yahoo, Yahoo will provide to CDnow all available information and assistance necessary for CDnow to defend such claim. CDnow will not enter into any settlement or compromise of any such claim, which settlement or compromise would result in any liability to Yahoo, without Yahoo's prior written consent, which shall not unreasonably be withheld. CDnow will pay any and all costs, damages, and expenses, including, but not limited to, reasonable attorneys' fees and costs awarded against or otherwise incurred by Yahoo in connection with or arising from any such claim, suit, action or proceeding. 9. Limitation of Liability. ----------------------- EXCEPT AS PROVIDED IN SECTION 8, UNDER NO CIRCUMSTANCES SHALL CDNOW, YAHOO, OR ANY AFFILIATE BE LIABLE TO THE OTHER PARTY FOR INDIRECT, INCIDENTAL, CONSEQUENTIAL, SPECIAL OR EXEMPLARY DAMAGES ARISING FROM THIS AGREEMENT, EVEN IF THAT PARTY HAS BEEN ADVISED OF THE POSSIBILITY OF SUCH DAMAGES, SUCH AS, BUT NOT LIMITED TO, LOSS OF REVENUE OR ANTICIPATED PROFITS OR LOST BUSINESS. For purposes of this Agreement, the term "Affiliate" shall mean any company or any --------- other entity world-wide, including, without limitation, corporations, partnerships, joint ventures, limited liability companies, in which Yahoo or CDnow, as applicable, owns at least fifty (50%) ownership, equity or financial interest. [Confidential Treatment requested for redacted portions of document.] 10 10. General Provisions. ------------------ 10.1 Independent Contractors. It is the intention of Yahoo and CDnow that ----------------------- Yahoo and CDnow are, and shall be deemed to be, independent contractors with respect to the subject matter of this Agreement, and nothing contained in this Agreement shall be deemed or construed in any manner whatsoever as creating any partnership, joint venture, employment, agency, fiduciary or other similar relationship between Yahoo and CDnow. 10.2 Entire Agreement. This Agreement, together with all Exhibits, ---------------- represents the entire agreement between Yahoo and CDnow with respect to the subject matter hereof and thereof and shall supersede all prior agreements and communications of the parties, oral or written, including without limitation the Letter of Agreement dated July 31, 1997, between Yahoo and CDnow. 10.3 Amendment and Waiver. No amendment to, or waiver of, any provision of -------------------- this Agreement shall be effective unless in writing and signed by both parties. The waiver by any party of any breach or default shall not constitute a waiver of any different or subsequent breach or default. 10.4 Governing Law. This Agreement shall be governed by and interpreted in ------------- accordance with the laws of the State of California without regard to the conflicts of laws principles thereof. 10.5 Successors and Assigns. Neither party shall assign its rights or ---------------------- obligations under this Agreement without the prior written consent of the other party, which shall not unreasonably be withheld or delayed. Notwithstanding the foregoing, either party may assign this Agreement to an entity who acquires substantially all of the stock or assets of a party to this Agreement; provided that consent will be required in the event that the non-assigning party reasonably determines that the assignee will not have sufficient capital or assets to perform its obligations hereunder, or that the assignee is a direct competitor of the non-assigning party. All terms and provisions of this Agreement shall be binding upon and inure to the benefit of the parties hereto and their respective permitted transferees, successors and assigns. 10.6 Force Majeure. Neither party shall be liable for failure to perform ------------- or delay in performing any obligation (other than the payment of money) under this Agreement if such failure or delay is due to fire, flood, earthquake, strike, war (declared or undeclared), embargo, blockade, legal prohibition, governmental action, riot, insurrection, damage, destruction or any other similar cause beyond the control of such party. 10.7 Notices. All notices, requests and other communications called for by ------- this agreement shall be deemed to have been given immediately if made by telecopy or electronic [Confidential Treatment requested for redacted portions of document.] 11 mail (confirmed by concurrent written notice sent via overnight courier for delivery by the next business day), if to Yahoo at the physical and electronic mail addresses set forth on the signature page of this Agreement, with a copy to its General Counsel (e-mail:jplace@yahoo.com); and if to CDnow at the physical and electronic mail addresses set forth on the signature page of this Agreement, with a copy to its General Counsel, or to such other addresses as either party shall specify to the other. Notice by any other means shall be deemed made when actually received by the party to which notice is provided. 10.8 Severability. If any provision of this Agreement is held to be ------------ invalid, illegal or unenforceable for any reason, such invalidity, illegality or unenforceability shall not effect any other provisions of this Agreement, and this Agreement shall be construed as if such invalid, illegal or unenforceable provision had never been contained herein. 10.9 Sole Responsibility. CDnow will remain solely responsible for the ------------------- operation of the CDnow Site, and Yahoo will remain solely responsible for the operation of the Yahoo Services. Each Party: (a) acknowledges that the CDnow Site and the Yahoo Services may be subject to temporary shutdowns due to causes beyond the operating Party's reasonable control; and (b) subject to the terms of this Agreement, retains sole right and control over the programming, content and conduct of transactions over its respective Internet-based service. 10.10 Counterparts. This Agreement may be executed in two counterparts, ------------ both of which taken together shall constitute a single instrument. Execution and delivery of this Agreement may be evidenced by facsimile transmission. 10.11 Authority. Each of Yahoo and CDnow represents and warrants that the --------- negotiation and entry of this Agreement will not violate, conflict with, interfere with, result in a breach of, or constitute a default under any other agreement to which they are a party. [Signature Page Follows.] [Confidential Treatment requested for redacted portions of document.] 12 This Advertising and Promotion Agreement has been executed by the duly authorized representatives of the parties, effective as of the Effective Date. YAHOO! INC. CDNOW, INC. By: /s/ Jeffrey A. Mallett By: /s/ Jason Olim Name: Jeffrey A. Mallett Name: Jason Olim Title: Senior Vice President, Title: President Business Operations Address: Address: Attn: Senior VP, Business Operations Attn: General Counsel 3400 Central Expressway, Suite 201 Jenkins Court, Suite 300 Santa Clara, CA 95051 610 Old York Road Tel.: (408) 731-3300 Jenkintown, PA 19046 Fax: (408) 731-3302 Tel: (215) 517-7325 e-mail: jmallett@yahoo.com Fax: (215) 517-4499 email:nlefkovitz@cdnow.com [Confidential Treatment requested for redacted portions of document.] 13 EXHIBIT A Included Pages [approximately 20,000 words intentionally omitted] [Confidential Treatment requested for redacted portions of document.] 14 EXHIBIT B CDnow Competitors [the names of approximately 1,000 entities intentionally omitted] [Confidential Treatment requested for redacted portions of document.] 15 EXHIBIT C Page Views and Payment Schedule [XXX] [Confidential Treatment requested for redacted portions of document.] 16 EXHIBIT D Buyweb Link Examples Message specifications: 16 characters plus the name of the artists Directory Page: http://web.yahoo.com/tim/cdnow/beatles.com/ beatles.html (see attached) Search Page: http://web/tim/cdnow/mockup.html (see attached) My Yahoo! Page: http://web.yahoo.com/tim/cdnow/mycdnow.html (see attached) Visa Shopping Guide Page: http://web.yahoo.com/billyee/visa/visatop3.html (see attached) [graphics depicting buyweb link examples] The parties agree that the bottom portion of each sample page shall be subject to change. [Confidential Treatment requested for redacted portions of document.] 17 EXHIBIT E Schedule of Exceptions The following lists those advertising agreements with CDnow Competitors for the Included Pages which survive beyond January 1, 1998 ADVERTISER: Book Stacks Unlimited Agreement ends: 6/30/98 Non-exclusive keyword: music [Confidential Treatment requested for redacted portions of document.] 18 EX-11.1 11 COMPUTATION OF PER SHARE EARNINGS EXHIBIT 11.1 CDNOW, INC. COMPUTATION OF PER SHARE EARNINGS
Nine Month, September 30, 1997 ------------------ Net loss...................................................... $ ========== Weighted average shares outstanding........................... Incremental shares considered outstanding (1)................. ---------- Pro forma weighted average number of Common or Common equivalent shares........................................... ========== Pro forma net loss per share.................................. ==========
- ----------------------- (1) Pursuant to the requirements of the Securities and Exchange Commission, stock, stock options and warrants issued by the Company during the twelve months immediately preceding the initial public offering have been included in computing pro forma net loss per share as if they were outstanding for all periods using the treasury stock method. EX-23.1 12 CONSENT OF ARTHUR ANDERSEN LLP EXHIBIT 23.1 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the use of our report and all references to our firm included in or made part of this registration statement. /s/ Arthur Andersen LLP Arthur Andersen LLP Philadelphia, Pa. November 26, 1997 EX-27.1 13 FINANCIAL DATA SCHEDULE
5 12-MOS 9-MOS DEC-31-1996 DEC-31-1997 JAN-01-1996 JAN-01-1997 DEC-31-1996 SEP-30-1997 775,865 7,238,246 245,641 983,600 130,437 180,312 12,000 17,000 0 0 1,201,764 8,944,230 505,224 1,803,025 143,189 362,538 1,575,459 10,394,950 970,309 4,320,337 0 0 0 9,516,239 0 0 2,305,953 3,057,345 (2,819,970) 6,717,588 1,575,459 10,394,950 6,300,294 9,452,864 6,300,294 9,452,864 5,363,989 7,730,975 8,096,146 13,646,614 0 (94,045) 12,000 5,000 14,556 29,961 (1,810,408) (4,129,666) 0 0 (1,810,408) (4,129,666) 0 0 0 0 0 0 (1,810,408) (4,129,666) 0 0 0 0
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