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LOUDEYE CORP. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


	Six Months Ended
	June 30,
	2006			2005
	(in thousands)
OPERATING ACTIVITIES
Net income (loss)	$	714		$	(14,382	)
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Loss from discontinued operations		(8,045	)		5,975
Depreciation and amortization		950			925
Special charges (credits) and other non cash items		(79	)		(124	)
Stock-based compensation		633			127
Loss on disposal of equipment		2			90
Foreign currency transaction loss (gain)		79			(268	)
Operating cash flows from discontinued operations		(73	)		(2,256	)
Changes in operating assets and liabilities:
Accounts receivable		603			(787	)
Prepaid expenses and other assets		(813	)		(495	)
Accounts payable		1,050			(84	)
Accrued compensation and benefits and accrued and other liabilities		(193	)		260
Accrued special charges		—			(360	)
Deposits and deferred revenue		(514	)		33

Net cash used in operating activities		(5,686	)		(11,346	)

INVESTING ACTIVITIES
Purchases of property and equipment		(373	)		(249	)
Purchases of intangibles		(36	)		(81	)
Payments of accrued acquisition consideration		—			(2,524	)
Release of restricted cash		1,586			1,388
Purchases of marketable securities		—			(750	)
Sales of marketable securities		2,114			6,223
Investing cash flows from discontinued operations		11,046			(1,755	)

Net cash provided by investing activities		14,337			2,252

FINANCING ACTIVITIES
Proceeds from sale of stock and exercise of stock options		234			663
Proceeds from private equity financing, net		7,575			—
Penalty related to private equity financing		(155	)		(314	)
Principal payments on debt, line of credit and capital lease obligations		(1,000	)		(500	)
Financing cash flows of discontinued operations		—			(82	)

Net cash provided by (used in) financing activities		6,654			(233	)

Effect of foreign currency translation on cash		38			(153	)

Net increase (decrease) in cash and cash equivalents		15,343			(9,480	)
Cash and cash equivalents, beginning of period		6,932			28,978

Cash and cash equivalents, end of period	$	22,275		$	19,498

See notes to unaudited condensed consolidated financial statements

LOUDEYE CORP. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2006

1. Description of Business and Risks

Business

Loudeye is a worldwide leader in business-to-business digital media services that facilitate the distribution, promotion and sale of digital media content for media and entertainment, mobile communications, consumer products, consumer electronics, retail, and ISP customers. Loudeye’s services enable its customers to outsource the management and distribution of digital media content over the Internet and other electronic networks. Loudeye’s proprietary consumer-facing e-commerce services, combined with our technical infrastructure and back-end solutions, comprise an end-to-end service offering. These service offerings currently comprise turn-key, fully-outsourced digital media distribution and promotional services, such as private-labeled digital music services, including mobile music services. Loudeye’s outsourced solutions can decrease time-to-market while reducing the complexity and cost of digital distribution compared with internally developed alternatives, and they enable Loudeye’s customers to provide branded digital media service offerings to their users while supporting a variety of digital media technologies and consumer business models.

Through April 30, 2006, Loudeye also provided digital media content services, including encoding, samples, hosting and Internet radio services. Loudeye divested of the U.S.-based operating assets related to these service offerings, including its substantially redundant U.S.-based music store platform, on April 30, 2006. This transaction is described more fully in Note 3. Following the transaction, Loudeye continues to operate its OD2 digital music store services installed across more than 60 retailers in over 20 countries.

On August 7, 2006, Loudeye entered into a merger agreement with Nokia Inc. Refer to Note 11 for further discussion of this transaction.

Risks

Inherent in Loudeye’s business are various risks and uncertainties, including the limited operating history of certain of its service offerings and challenges involved with the licensing and distribution of digital media content over the Internet and mobile networks. Loudeye’s success will depend on the acceptance of its technology and services, the ability to generate related revenue and the ability to secure adequate funding to support ongoing operations.

Going Concern

The accompanying unaudited condensed consolidated financial statements have been prepared assuming that Loudeye will continue as a going concern, which contemplates realization of assets and the satisfaction of liabilities in the normal course of business for the next twelve month period following the date of these financial statements. However, Loudeye has incurred annual net losses from inception, has an accumulated deficit of approximately $241.9 million at June 30, 2006, and has experienced negative cash flows from operations in substantially all quarters of its operations since inception, and Loudeye expects to continue to incur net losses in future periods. In addition, in connection with the Loudeye-Nokia transaction described in Note 11, Loudeye expects to incur approximately $1.0 million in expenses regardless of whether the transaction is consummated. These factors, among others, raise substantial doubt about Loudeye’s ability to continue as a going concern if a sale transaction, such as the Loudeye-Nokia transaction, is not consummated.

If a sale transaction is not consummated, Loudeye expects to require additional capital to fund its ongoing operations. Any failure to consummate a sale transaction (which could result in Loudeye being required to pay a termination fee to Nokia under certain circumstances), combined with Loudeye’s history of declining market valuation and volatility in Loudeye’s stock price, could make it difficult for Loudeye to raise capital on favourable terms, or at all. Any financing Loudeye obtains may dilute or otherwise impair the ownership interest of its current stockholders. If Loudeye fails to generate positive cash flows or fails to obtain additional capital when required, Loudeye could modify, delay or abandon some or all of its business and expansion plans. The accompanying unaudited condensed consolidated financial statements do not include any adjustments that may result from the outcome of this uncertainty.

2. Summary of Significant Accounting Policies

Accounting Principles

The financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP).

Basis of Consolidation

The consolidated financial statements include the accounts of Loudeye Corp. and its wholly owned domestic and foreign subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation.

Estimates and Assumptions

The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported

amounts of revenue and expenses during the reporting period. These estimates and assumptions are affected by management’s application of accounting policies. Examples include estimates of loss contingencies, when technological feasibility is achieved, fair value of stock option grants, which includes estimates of Loudeye’s stock price volatility and the estimated lives and forfeiture rates of stock option and restricted stock grants, purchase accounting, music publishing rights and music royalty accruals, the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns, and determining when investment impairments are other-than-temporary. Actual results could differ materially from those estimates.

Management evaluates the potential loss exposure on various claims and lawsuits arising in the normal course of business. An accrual is made if the amount of a particular claim or lawsuit is probable and reasonably estimable.

Unaudited Interim Financial Information

These interim condensed consolidated financial statements are unaudited and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission, or SEC. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. These unaudited interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto for the year ended December 31, 2005, included in Loudeye’s Annual Report on Form 10-K as filed with the SEC on March 15, 2006. The interim financial information included herein reflects all adjustments (consisting only of normal recurring adjustments) that are, in the opinion of management, necessary for a fair presentation of the results of operations for the periods presented. Certain amounts from prior periods have been reclassified to conform to current year presentation. As discussed further in Note 8, Loudeye has restated all common stock and per share data for the May 22, 2006 one-for-ten reverse stock split.

The unaudited results of operations for the three and six months ended June 30, 2006 and 2005 are not necessarily indicative of the results to be expected for the full years or in future quarters.

Cash, Cash Equivalents and Marketable Securities

Loudeye considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. Cash and cash equivalents consist primarily of demand deposits and money market accounts maintained with financial institutions and certain other investment grade instruments, which at times exceed federally insured limits. Loudeye has not experienced any losses on its cash and cash equivalents.

Loudeye has classified as available-for-sale all marketable debt and equity securities for which there is a determinable fair market value and no restrictions on Loudeye’s ability to sell within the next 24 months. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a separate component of stockholders’ equity. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are included in other income (expense). Loudeye has classified securities with a remaining contractual maturity of greater than one year as long term marketable securities. The cost basis for determining realized gains and losses on available-for-sale securities is determined on the specific identification method.

The following table summarizes the composition of Loudeye’s cash, cash equivalents, and available-for-sale marketable securities at June 30, 2006 and December 31, 2005 (in thousands):


	June 30,		December 31,
	2006		2005
Cash and cash equivalents:
Cash	$	14,688	$	4,616
Money market mutual funds		3,217		2,316
Commercial paper & U.S. Agency notes		4,370		—

Total cash and cash equivalents		22,275		6,932

Marketable securities:
Corporate notes & bonds		—		2,113

Total marketable securities		—		2,113

Total cash, cash equivalents and marketable securities	$	22,275	$	9,045

The gross unrealized gains or losses on available-for-sale securities at June 30, 2006 and December 31, 2005 and the gross realized gains or losses on the sale of available-for-sale securities for the three and six months ended June 30, 2006 and 2005 were immaterial

and therefore are not shown. Loudeye has concluded that unrealized losses are temporary due to Loudeye’s ability to realize its investments at maturity.

Restricted Cash

At June 30, 2006, restricted cash represented approximately $234,000 of cash equivalents pledged as collateral in connection with agreements with certain financial institutions. In accordance with the terms of the agreements, the restricted cash has been classified as short-term in the accompanying unaudited condensed consolidated balance sheets.

Accounts Receivable

Accounts receivable are recorded at the invoiced amount and do not generally include interest. The allowance for doubtful accounts represents Loudeye’s best estimate of the amount of probable credit losses in Loudeye’s existing accounts receivable. Loudeye performs a periodic analysis to determine the appropriate allowance for doubtful accounts. This analysis includes various analytical procedures and a review of factors within the context of the overall economic environment including individual review of past due balances over 90 days and greater than a specified amount, Loudeye’s history of collections. Account balances are charged off against the allowance after the potential for recovery is considered remote.

Goodwill

Loudeye accounts for goodwill in accordance with Statement of Financial Accounting Standards (FAS) No. 142, “Goodwill and Other Intangible Assets” (FAS 142). Under FAS 142, goodwill deemed to have indefinite life is not amortized, but is subject to, at a minimum, annual impairment tests. Loudeye performs its annual impairment test of goodwill as of November 30 of each year or whenever events or changes in circumstances indicate that the fair value is less than its carrying value. Impairment is tested at the reporting unit level by comparing the fair value of a reporting unit with its carrying amount including goodwill. Fair values are determined based on valuations that rely on the market and income approaches. The market approach makes use of market price data of stocks of companies engaged in the same or similar lines of business as Loudeye. The income approach uses future projections of cash flows from each of our reporting units and includes, among other estimates, projections of future revenue and operating expenses, market supply and demand, projected capital spending and an assumption of our weighted average cost of capital. Our evaluations of fair values include analyses based on the future cash flows generated by the underlying assets, estimated trends and other relevant determinants of fair value for these assets. If the carrying amount of the reporting unit exceeds its fair value, goodwill of the reporting unit is considered impaired and the second step of the test is performed to determine the amount of impairment loss, if any. Loudeye has determined that its OD2 subsidiary is its only reporting unit for the purposes of FAS 142 in 2006. In 2005, Loudeye determined that it had two reporting units, its OD2 subsidiary, which was acquired in June 2004 and its Overpeer subsidiary, which was acquired in March 2004. In connection with the cessation of the Overpeer business during the fourth quarter of 2005, Loudeye determined that the goodwill related to the Overpeer acquisition was impaired as discussed further in Note 3. There have been no events or circumstances during 2006 that would indicate impairment.

Impairment of Long-Lived Assets

Long lived assets, other than goodwill, such as property, plant, and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Conditions that would necessitate an impairment assessment include a significant decline in the observable market value of an asset, a significant change in the extent or manner in which an asset is used, or any other significant adverse change that would indicate that the carrying amount of an asset or group of assets is not recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Long-lived assets are considered held for sale when certain criteria are met, including whether management has committed to a plan to sell the asset, whether the asset is available for sale in its immediate condition, and whether the sale is probable within one year of the reporting date. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet. As discussed further in Note 3, following Overpeer’s acknowledgment of default under the intercompany loan agreement, Loudeye took possession and foreclosed on Overpeer’s assets in partial satisfaction of Overpeer’s outstanding indebtedness to Loudeye. At June 30, 2006, a significant portion of the foreclosed Overpeer property and equipment was held for sale, and Loudeye anticipates selling these assets over the next twelve months. These “assets held for sale”,

net of estimated costs to sell, are included in “assets of discontinued operations” in the accompanying unaudited condensed consolidated balance sheet.

In connection with the cessation of the Overpeer business during the fourth quarter of 2005, Loudeye determined that the goodwill related to the Overpeer acquisition was impaired as discussed further in Note 3. Loudeye performs its annual impairment test of long-lived assets as of November 30 of each year. There have been no events or circumstances during 2006 that would impact this assessment.

Fair Value of Financial Instruments and Concentrations of Credit Risk

Financial instruments that potentially subject Loudeye to concentrations of credit risk consist of cash and cash equivalents, marketable securities, restricted cash, accounts receivable, accounts payable, accrued liabilities and debt and capital lease obligations. The fair values of these financial instruments approximate their carrying value based on their liquidity or short-term nature. The carrying value of Loudeye’s long-term obligations approximate fair value due to the variable nature of the interest.

Loudeye is exposed to credit risk due to its extension of credit to its customers. At June 30, 2006, one customer accounted for 38% and another customer accounted for 14% of Loudeye’s accounts receivable. Loudeye’s customer base is dispersed across Europe, North America, Australia, New Zealand and South Africa and consists of customers in numerous industries. Loudeye performs initial and ongoing evaluations of its customers’ financial condition and generally extends credit on open account, requiring deposits or collateral as deemed necessary.

Loudeye had sales to certain significant customers, as a percentage of revenue, as follows:


	For the three months ended						For the six months ended
	June 30,						June 30,
	2006			2005			2006			2005
Microsoft		28	%		27	%		32	%		27	%
KPN Telecom B.V.		16	%		4	%		15	%		3	%
Wanadoo		14	%		8	%		14	%		9	%
Coca-Cola		6	%		14	%		5	%		15	%

		64	%		53	%		66	%		54	%

Revenue Recognition

Loudeye derives substantially all of its revenue from its digital media store services offerings. Deferred revenue arises from payments received in advance of the culmination of the earnings process. Deferred revenue expected to be realized within the next twelve months is classified as current.

Loudeye’s basis for revenue recognition is substantially governed by SEC Staff Accounting Bulletin (SAB) 101, as superseded by SAB 104, “Revenue Recognition,” the FASB’s Emerging Issues Task Force (EITF) Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (EITF 00-21), and EITF 99-19, “Reporting Revenue as a Principal Versus Net as an Agent” (EITF 99-19), and in very limited cases as it relates to sales of software products, Statement of Position No. 97-2, “Software Revenue Recognition,” as amended by Statement of Position No. 98-4, 98-9, and related interpretations and Technical Practice Aids (SOP 97-2).

Determining Separate Elements and Allocating Value to Those Elements. If sufficient evidence of the fair values of the delivered and undelivered elements of an arrangement does not exist, revenue is deferred using revenue recognition principles applicable to the entire arrangement as if it were a single element arrangement under EITF 00-21 and is recognized on a straight-line basis over the term of the contract. For arrangements with multiple deliverables which are determined to have separate units of accounting, revenue is recognized upon the delivery of the separate units in accordance with EITF No. 00-21. Consideration from multiple element arrangements is allocated among the separate elements based on their relative fair values. In the event that there is no objective and reliable evidence of fair value for the delivered item, the revenue recognized upon delivery is the total arrangement consideration less

the fair value of the undelivered items. The maximum revenue recognized on a delivered element is limited to the amount that is not contingent upon the delivery of additional items.

In the limited circumstances where Loudeye sells software products, Loudeye recognizes revenue associated with the license of software in accordance with SOP 97-2. Under the provisions of SOP 97-2, in software arrangements that involve rights to multiple services, Loudeye allocates the total arrangement consideration among each of the deliverables using the residual method, under which revenue is allocated to the undelivered elements based on vendor-specific objective evidence of the fair value of such undelivered elements. Vendor-specific objective evidence is based on the price charged when an element is sold separately or, in the case of an element not sold separately, the price established by management, if it is probable that the price, once established, will not change before market introduction.

Some of Loudeye’s arrangements may include consulting services sold separately under professional services contracts. Professional services arrangements are billed on a time and materials basis and accordingly, revenue is recognized as the services are performed.

Digital media store services revenue. Loudeye derives its revenue from digital media store services in three primary areas:

• Loudeye charges its digital media store customers fixed business-to-business platform fees, which generally consist of enabling and hosting the service and maintenance of the service’s overall functionality during the term of the customer contract. Business-to-business platform services may include fees related to integration to a customer’s website, wireless sites, inventory, account management, and commerce and billing systems. Additionally, platform fees associated with Loudeye’s digital media store services include digital rights management, editorial services, usage reporting, and digital content royalty settlement. Loudeye charges platform fees to its customers in a variety of manners, including initial set-up fees, monthly only fees, or a combination of initial set-up and monthly fees.

• On behalf of its digital media store services customers, Loudeye provides transactional business-to-consumer services including prepaid voucher packages, streaming subscription packages, typically for a monthly fee, and à-la-carte digital downloads.

• Loudeye provides corporate clients with bundles of music vouchers as part of marketing promotions for distribution to their end consumers.

Although not a primary source of revenue, Loudeye also provides a number of consultancy services, including cover art and metadata publishing, and varied commerce and content consumption alternatives for digital media content.

Loudeye follows the guidance in EITF 00-21 for purposes of allocating the total consideration in its digital media store services arrangements to the individual deliverables. Loudeye evaluates whether each of the elements in these arrangements represents a separate unit of accounting, as defined by EITF 00-21, using all applicable facts and circumstances, including whether (i) the delivered item(s) has value to the customer on a standalone basis, (ii) there is objective and reliable evidence of the fair value of the undelivered item(s) and (iii) there is a general right of return relative to the delivered item(s), in which case performance of the undelivered item(s) is considered probable and substantially in Loudeye’s control.

If Loudeye determines a given agreement involves separate units of accounting, Loudeye allocates the arrangement consideration to the separate units of accounting based on their relative fair values, as determined by the price of the undelivered items when sold separately. Assuming all other criteria are met (i.e., evidence of an arrangement exists, collectibility is probable, and fees are fixed or determinable), revenue is recognized as follows:

• Business-to-business platform service fees are generally recognized as revenue over the term of the customer contract and represent charges in connection with enabling the service and maintaining its overall functionality during the term of the customer contract, which is generally one to three years. Loudeye charges platform fees to its customers in a variety of manners, including initial set-up fees, monthly only fees, or a combination of initial set-up and monthly fees.

• Loudeye also shares in the proceeds of business-to-consumer transactions such as digital downloads. Revenue from digital downloads is recognized at the time the content is delivered, digitally, to the consumer.

• A majority of Loudeye’s transactional revenue is generated through the sale of prepaid voucher packages which entitle a consumer to access a specified number of digital music downloads or streams for a fixed price during a fixed time period. Prepaid

voucher packages are also bundled with other end consumer offerings sponsored by Loudeye’s customers. Revenue from prepaid voucher packages and bundle promotions is deferred until the vouchers or promotional offers are utilized or expire. Loudeye’s margin on the sale of prepaid voucher packages fluctuates depending upon a number of factors, including the type of service for which the consumer redeems the vouchers (full downloads or streams), the royalty rate for the download purchased and breakage.

• Revenue from prepaid music voucher packages is deferred and then recognized as tracks are downloaded by the consumer or as vouchers expire, whichever occurs earlier.

If evidence of fair value cannot be established for the undelivered elements of an agreement, the revenue from the arrangement is recognized ratably over the period that these elements are delivered or, if appropriate, under the percentage of completion method based on the ratio of direct labor hours incurred to date to total projected labor hours.

Loudeye recognizes revenue gross or net in accordance with EITF 99-19. In most arrangements, Loudeye contracts directly with end user consumers, is the primary obligor and carries all collectibility risk. Revenue in these arrangements is recorded on a gross basis. In some cases, customers contract with music publishers and rights holders and sell products or services directly to end user consumers utilizing Loudeye’s services, and, as such, Loudeye carries no collectibility risk. In those instances, in accordance with EITF 99-19, Loudeye reports revenue net of amounts paid to the customer.

Software license revenue. In the limited circumstances in which Loudeye sells software products, Loudeye recognizes revenue associated with the license of software in accordance with SOP 97-2. Revenue from software license sales accounted for less than 1% of Loudeye’s revenue in 2006 and 2005. Under the provisions of SOP 97-2, in software arrangements that involve rights to multiple services, Loudeye allocates the total arrangement consideration among each of the deliverables using the residual method, under which revenue is allocated to the undelivered elements based on vendor-specific objective evidence of the fair value of such undelivered elements. Elements included in multiple element arrangements consist of software, intellectual property, implementation services, maintenance and consulting services. Vendor-specific objective evidence is based on the price charged when an element is sold separately or, in the case of an element not sold separately, the price established by management, if it is probable that the price, once established, will not change before market introduction.

Research and Development Costs

Loudeye accounts for research and development costs in accordance with several accounting pronouncements, including FAS No. 2, “Accounting for Research and Development Costs,” and FAS 86. Research and development costs associated with software development consist primarily of salaries, wages and benefits for development personnel and are generally charged to expense until technological feasibility has been established for the services. Once technological feasibility has been established, all software costs are capitalized until the services are available for general release to customers. Capitalized costs are then amortized on a straight-line basis over the term of the applicable contract, or based on the ratio of current revenue to total projected service revenue, whichever is greater. Technology acquired in business combinations is recorded in intangible assets and purchased software is recorded in property and equipment.

Stock-Based Compensation

On January 1, 2006, Loudeye adopted FAS No. 123 (revised 2004), “Share-Based Payment,” (FAS 123(R)) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock options and restricted stock based on estimated fair values. FAS 123(R) supersedes Loudeye’s previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) for periods beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (SAB 107) relating to FAS 123(R). Loudeye has applied the provisions of SAB 107 in its adoption of FAS 123(R).

Loudeye adopted FAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of Loudeye’s fiscal year 2006. The accompanying unaudited condensed consolidated financial statements as of and for the three and six months ended June 30, 2006 reflect the impact of FAS 123(R). In accordance with the modified prospective transition method, the prior periods presented have not been restated to reflect, and do not include, the impact of FAS 123(R). Stock-based compensation expense recognized under FAS 123(R) for the three and six months ended June 30, 2006 was approximately $296,000 and $633,000, which consisted of stock-based compensation expense related to employee stock options and restricted stock awards. There was no stock-based compensation expense related to employee stock options, restricted

stock or employee stock purchases recognized during the three and six months ended June 30, 2005. See Note 8 for additional information.

Loudeye is required under FAS 123(R) to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in Loudeye’s unaudited condensed consolidated statement of operations. Prior to the adoption of FAS 123(R), Loudeye accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (FAS 123). Under the intrinsic value method, no stock-based compensation expense had been recognized in Loudeye’s unaudited condensed consolidated statement of operations because the exercise price of Loudeye’s stock options granted to employees and directors equaled the fair market value of the underlying stock at the date of grant.

Stock-based compensation expense recognized during the three and six months ended June 30, 2006 is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in Loudeye’s unaudited condensed consolidated statement of operations for the first and second quarter 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of FAS 123 and compensation expense for the share-based payment awards granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of FAS 123(R). Loudeye uses the straight-line single-option method to recognize the value of stock-based compensation expense for all share-based payment awards. Expense is recognized using the graded-vesting multiple-option method for options granted prior to January 1, 2006. As stock-based compensation expense recognized in the unaudited condensed consolidated statement of operations for the three and six months ended June 30, 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. FAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In Loudeye’s pro forma information required under FAS 123 for the periods prior to fiscal 2006, Loudeye accounted for forfeitures as they occurred.

FAS 123(R) requires Loudeye to disclose pro-forma information for periods prior to its January 1, 2006 adoption of the standard. The following table illustrates the effect on net loss and loss per share for the three and six months ended June 30, 2005 if Loudeye had recognized compensation expense for all share-based payments to employees based on their fair values:


	Three months ended			Six months ended
	June 30, 2005			June 30, 2005
Net loss, as reported	$	(6,930	)	$	(14,382	)
Add: stock-based employee compensation expense under APB 25 included in reported net loss		21			42
Deduct: total stock-based employee compensation expense determined under fair value method for all awards		(990	)		(1,693	)

Pro forma net loss	$	(7,899	)	$	(16,033	)

Basic and diluted net loss per share, as reported	$	(0.64	)	$	(1.37	)
Pro forma basic and diluted net loss per share	$	(0.73	)	$	(1.52	)

Pro forma stock-based compensation amounts reported above reflect the correction of certain errors discovered in Loudeye’s stock option tracking software, which resulted in an overstatement of pro forma stock-based compensation disclosed in 2005. The most significant error was related to the expected life assumption used in the Black-Scholes pricing model during 2004. The errors caused an overstatement of the expected life variable used to value all stock options, which in turn resulted in a corresponding overstatement of pro forma stock-based compensation. These errors had the effect of overstating pro forma stock-based compensation reported for the three and six months ended June 30, 2005 by approximately $444,000 and $804,000, but had no material impact on pro forma net loss per share for the three and six months ended June 30, 2005.

Fair value was estimated at the date of grant using the Black-Scholes pricing model, with the following weighted average assumptions:


	2006			2005
Risk-free interest rates		4.8-5.16	%		2.33-5.71	%
Expected lives	2.0 years			2.5 years
Expected dividend yields		0	%		0	%
Expected volatility		90	%		120	%

These assumptions and weighted average fair values reflect the correction of the errors discussed above. The risk-free interest rate used in the Black-Scholes valuation method is based on the implied yield currently available in U.S. Treasury securities at maturity with an equivalent term. Loudeye has not declared or paid any dividends and does not currently expect to do so in the future. The expected term of options represents the period that Loudeye’s stock-based awards are expected to be outstanding and was determined based on historical weighted average holding periods and projected holding periods for the remaining unexercised shares. Consideration was given to the contractual terms of Loudeye’s stock-based awards, vesting schedules and expectations of future employee behavior. Expected volatility is based on the annualized daily historical volatility, including consideration of the implied volatility and market prices of traded options for comparable entities within Loudeye’s industry.

Loudeye’s stock price volatility and option lives involve management’s best estimates, both of which impact the fair value of the option calculated under the Black-Scholes methodology and, ultimately, the expense that will be recognized over the life of the option. FAS 123(R) also requires Loudeye to recognize compensation expense for only the portion of options expected to vest. Therefore, Loudeye applied an estimated forfeiture rate that it derived from historical employee termination behavior. If the actual number of forfeitures differs from Loudeye’s estimates, additional adjustments to compensation expense may be required in future periods.

Stock compensation expense for options or warrants granted to non-employees has been determined in accordance with EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” and is based on the fair value of the equity instruments issued.

Comprehensive Income (Loss)

Comprehensive income (loss) is comprised of net loss, foreign currency translation adjustments and net unrealized gains (losses) on available-for-sale marketable securities and is presented in the accompanying unaudited condensed consolidated statement of stockholders’ equity. For the three months ended June 30, 2006, comprehensive income was approximately $7.3 million, and was comprised of an unrealized gain on marketable securities totaling $1,000 and foreign currency translation adjustment of $1.9 million and net income of approximately $5.4 million. For the three months ended June 30, 2005, comprehensive loss was approximately $8.5 million, and was comprised of an unrealized gain on marketable securities totaling $31,000, a foreign currency translation adjustment of approximately $1.6 million and a net loss of approximately $6.9 million. For the six months ended June 30, 2006, comprehensive income was approximately $3.1 million, and was comprised of an unrealized gain on marketable securities totaling $11,000, a foreign currency translation adjustment of approximately $2.3 million and net income of approximately $714,000. For the six months ended June 30, 2005, comprehensive loss was approximately $17.0 million, and was comprised of an unrealized gain on marketable securities totaling $26,000, a foreign currency translation adjustment of approximately $2.7 million and a net loss of approximately $14.4 million.

Foreign Currencies

Loudeye considers the functional currency of its foreign subsidiaries to be the local currency of the country in which the subsidiary operates. Assets and liabilities of foreign operations are translated into U.S. dollars using rates of exchange in effect at the end of the reporting period. Income and expense accounts are translated into U.S. dollars using average rates of exchange. The net gain or loss resulting from translation is shown as foreign currency translation adjustment and included in accumulated other comprehensive loss in stockholders’ equity. Gains and losses from foreign currency transactions, which were a net loss of approximately $60,000 during the three months ended June 30, 2006 and a net gain of approximately $61,000 during the three months ended June 30, 2005, a net loss of approximately $79,000 during the six months ended June 30, 2006, and a net gain of approximately $268,000 during the six months ended June 30, 2005 are included in the unaudited condensed consolidated statements of operations.

Segments

Loudeye has adopted FAS No. 131, “Disclosure about Segments of an Enterprise and Related Information,” (FAS 131) which establishes annual and interim reporting standards for an enterprise’s operating segments and related disclosures about its services, geographic areas and major customers. Loudeye’s chief operating decision maker is considered to be its Chief Executive Officer and staff, or Senior Leadership Team (SLT). Management has determined that Loudeye operates in only one segment, digital media services.

Recent Accounting Pronouncements

In May 2005, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections” (FAS 154). FAS 154 is a replacement of APB No. 20, “Accounting Changes” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements — (an Amendment of APB Opinion No. 28)” and provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application as the required method for reporting a change in accounting principle. FAS 154 provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. The reporting of a correction of an error by restating previously issued financial statements is also addressed by FAS 154. FAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 31, 2005. Loudeye adopted this pronouncement January 1, 2006.

In November 2005, the FASB issued FASB Staff Position No. FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments” (FSP No. 115-1). FSP No. 115-1 amends FAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” and includes guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. FSP No. 115-1 also requires an other-than-temporary impairment of debt and equity securities to be written down to its impaired value, which becomes the new cost basis. Loudeye adopted this pronouncement January 1, 2006. Adoption of this standard did not have any impact on Loudeye’s financial position, results of operations or cash flows.

In July 2006, the FASB issued FASB Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes.” This interpretation establishes a “more-likely-than-not” recognition threshold that must be met before a tax benefit can be recognized in the financial statements. The Interpretation also offers guidelines to determine how much of a tax benefit to recognize in the financial statements. Under FIN 48, the largest amount of tax benefit that is greater than fifty percent likely of being realized upon ultimate settlement with the taxing authority should be recognized. The provisions of this Interpretation become effective for fiscal years beginning after December 15, 2006. Loudeye is currently evaluating the impact of the adoption of FIN 48 on its financial position and results of operations.

3. Discontinued Operations

Overpeer, Inc.

On December 9, 2005, Loudeye announced that Overpeer, its wholly-owned subsidiary, had ceased its content protection services operations effective immediately. Loudeye had been funding Overpeer’s operations under an intercompany loan agreement pursuant to which Loudeye held a security interest in all of the assets of Overpeer. In November 2005, Loudeye delivered Overpeer notice of default and acceleration of indebtedness pursuant to the intercompany loan agreement. Following Overpeer’s acknowledgment of default under intercompany loan agreement, Loudeye took possession of Overpeer’s assets and foreclosed on Overpeer’s assets in partial satisfaction of Overpeer’s outstanding indebtedness to Loudeye.

The closure of Overpeer met the criteria of a “component of an entity” as defined in FAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” (FAS 144). The operations and cash flow of those components have been eliminated from the ongoing operations of Loudeye as a result of the disposal, and Loudeye does not have any significant involvement in the operations of that component after the disposal transaction. Accordingly, in accordance with the provisions of FAS 144, the results of operations of Overpeer are reported as discontinued operations in the accompanying unaudited condensed consolidated financial statements. The prior-year results of operations for Overpeer have been reclassified to conform to this presentation.

Current liabilities from the discontinued Overpeer subsidiary of approximately $903,000 and $981,000 at June 30, 2006 and December 31, 2005 are comprised primarily of $903,000 and $977,000 in accounts payable related primarily to the Savvis Communications Corp. invoices as further discussed below. Revenue for Overpeer for the three and six months ended June 30, 2005 was $516,000 and $1.4 million and the net loss was $1.2 million and $1.7 million.

Impairment. During the fourth quarter 2005, Loudeye recorded certain non-cash impairment charges relating to a write-down of the carrying value of all of the goodwill and some of the long-lived assets associated with Overpeer, in connection with the discontinuance of the Overpeer business. The fair values of each of these assets were estimated using primarily a probability weighted discounted cash flow method. The impairment of goodwill was determined under the two-step process required by FAS 142. The Overpeer technology, Overpeer’s customer relationships, Overpeer employee non-compete agreements, and Overpeer trademarks with an aggregate net book value of $834,000 had no continuing value in ongoing operations as a result of the cessation of the Overpeer business. In addition, Loudeye determined that the net book value of certain Overpeer fixed assets and leasehold improvements exceeded their estimated fair market value as of November 30, 2005, by $591,000.

Severance. Overpeer incurred approximately $200,000 in severance and related payroll costs associated with the closing of its operations which was paid during December 2005. In addition, a non-cash stock compensation expense of approximately $40,000 was recorded relating to acceleration of vesting of a restricted stock award to a former Overpeer employee.

Overpeer Lease. Overpeer was a party to a lease agreement for premises located in New York City. The lease had a ten year term running through September 2015. Annual rent obligations under the lease were approximately $175,000, subject to annual adjustment. Under the lease, Loudeye was required to post an approximate $175,000 security deposit in the form of a letter of credit. In December 2005, the landlord drew down the letter of credit in full. In February 2006, Overpeer, Loudeye and the landlord reached a settlement pursuant to which the Landlord released Overpeer and Loudeye from any future obligations with respect to the lease in exchange for the landlord retaining the approximate $175,000 security deposit and certain Loudeye-owned furniture with a net book value of approximately $80,000. For the year ended December 31, 2005, Loudeye included a non-cash charge of $253,000 in loss from discontinued operations relating to the lease, offset in part by a deferred rent credit of approximately $80,000 resulting from the early lease termination.

Savvis Communications Corp. On December 15, 2005, Savvis Communications Corp. filed a complaint in Superior Court in Santa Clara County, California, against Overpeer and Loudeye relating to a May 2002 Master Services Agreement between Savvis and Overpeer for collocation and bandwidth services (the “Overpeer-Savvis Agreement”). The complaint alleges Overpeer breached the Overpeer-Savvis Agreement for non-payment. The complaint also contains alter ego allegations against Loudeye. The complaint seeks damages of $1.6 million consisting of $950,000 of allegedly unpaid invoices for services and approximately $600,000 in alleged early termination fees. The court has granted Savvis a writ of attachment over Overpeer assets located in the state of California. In February 2006, Overpeer and Loudeye filed a joint motion to compel arbitration of the dispute under the terms of the agreement between Savvis and Overpeer. The motion was denied in April 2006. Loudeye and Overpeer have appealed this decision and further proceedings in the case are stayed until resolution of this appeal except that Savvis may seek discovery relating to the writ of attachment over Overpeer assets. A hearing date has not been set for the appeal; Savvis has filed a motion to seek an expedited date for hearing the appeal. Loudeye assesses the probability of a judgment against Overpeer relating to the $950,000 in unpaid invoices as high. As of June 30, 2006, Overpeer had paid approximately $69,000 towards these invoices. As of June 30, 2006 and December 31, 2005, current liabilities from discontinued operations included approximately $883,000 and $952,000 related to unpaid invoices. Loudeye is not a party to the Overpeer-Savvis Agreement. Loudeye intends to defend itself vigorously concerning the alter ego claims brought by Savvis. However, Loudeye cannot assess at this time the probability of an unfavorable outcome with respect to the claims brought against Loudeye.

U.S.-Based Operating Assets

On April 28, 2006, Loudeye Corp. entered into an asset purchase agreement and related ancillary agreements pursuant to which Loudeye sold its U.S.-based operating assets to Muze Inc. for $11.0 million in cash. The transaction closed April 30, 2006.

Following the transaction, Loudeye continues to operate its OD2 digital music store services installed across more than 60 retailers in over 20 countries.

The transaction involved the transfer of the following U.S.-based operations, including associated customer relationships, license rights, music archive and physical assets:

• Muze assumed Loudeye’s web and mobile digital music commerce services, operating on Loudeye’s U.S.-based platform. Live customers of the service were O2 Germany, ATT Wireless mMode MusicStore (now Cingular Wireless mMode Music) and BurnLounge. Loudeye also assigned its rights under digital download license agreements with the four major record labels, as required for the live services now operated by Muze.

• Loudeye sold its encoding services operations, including encoding services for EMI Music. Loudeye previously announced that encoding services for EMI Music were being transitioned by EMI to a new service provider during the second quarter of 2006. Loudeye also transferred U.S. Patent No. 6,873,877 relating to a distributed production system for digitally encoding information to Muze, while Loudeye retained a non-exclusive license to this patent.

• Loudeye sold its music sound samples services and all associated liabilities. Transfer of the samples service operations was completed through sale of all outstanding shares of capital stock of Loudeye Sample Services, Inc., a wholly owned subsidiary of Loudeye.

• Loudeye sold its hosting and Internet radio services.

Loudeye retained all assets not defined as acquired assets in the asset purchase agreement, including its non-U.S.-based operations, patents and patent applications (other than the ‘877 patent described above), and certain physical assets relating to Loudeye’s webcasting services and Loudeye’s discontinued Overpeer operations.

The gross proceeds of $11.0 million were used to repay in full $671,000 owed to Silicon Valley Bank, or SVB, under the Amended and Restated Loan and Security Agreement between Loudeye and SVB dated March 30, 2005. In connection with the SVB payoff, restrictions on cash of $671,000 were released in April 2006. The remaining proceeds of approximately $10.3 million were paid to Loudeye and will be used for general working capital and corporate purposes.

Fifty Loudeye employees working in Loudeye’s Seattle, Washington offices accepted employment with Muze effective May 2, 2006. Loudeye did not incur any material severance or other termination obligations as a direct result of this transaction.

Loudeye and Muze have agreed to enter into a sublease arrangement for Loudeye’s facility in Seattle. Muze will reimburse Loudeye for 50% of the rent expense for the Seattle facility and Muze will generally reimburse Loudeye for facility related expenses on an as-used basis.

The asset purchase agreement contains limited representations and warranties by Loudeye and Loudeye Enterprise Communications, Inc., its wholly-owned subsidiary, on one hand, and Muze on the other. Loudeye and Muze each agreed to indemnify the other against breaches of these representations and warranties. In addition, Loudeye agreed to indemnify Muze against liabilities that were not specifically assumed by Muze in the transaction, and Muze agreed to indemnify Loudeye against liabilities it agreed to assume, as well as any liability arising out of ownership or operations of the assets it acquired post-closing of the transaction. The precise scope of representations, warranties, indemnification obligations and applicable liability limitations and exclusions is set out in detail in the asset purchase agreement.

The assets sold meet the criteria of a “component of an entity” as defined in FAS 144 and Loudeye does not have any significant involvement in the operations of the U.S.-based digital media service platform and digital media content services offerings after the sale transaction. In accordance with the provisions of FAS 144, the assets, liabilities and results of operations of the U.S.-based operating assets through the date of completion of the sale, as well as the gain recognized on the sale of approximately $9.0 million, are reported as discontinued operations in the accompanying unaudited condensed consolidated financial statements. The prior-year results of operations of the U.S.-based operating assets have been reclassified to conform to this presentation. Current liabilities from the discontinued U.S. operations of approximately $858,000 and $2.4 million at June 30, 2006 and December 31, 2005 are comprised primarily of $746,000 and $1.2 million in customer deposits and deferred revenue. Revenue and net income (loss) related to the U.S.-based operating assets for the three and six months ended June 30, 2006 and 2005 are presented in the table below.

For the three months ended

For the six months ended

June 30,

2006

2005

2006

2005

Revenue

550,000

$1.6 million

$3.1 million

$2.9 million

Net income (loss), net of gain on sale

$8.8 million

$(2.2) million

$8.0 million

$(4.3) million

4. Special Charges (Credits)

Net special charges (credits) for the three and six months ended June 30, 2006 were zero. Net special charges (credits) for the three and six months ended June 30, 2005 were zero and ($43,000) which represent the difference between the amounts recorded in accrued special charges and the final settlement amounts of the underlying liabilities. In January 2005, Loudeye paid $360,000 of the $403,000 then remaining accrued special charge balance, as a final payment related to Loudeye’s former leased facility at 414 Olive Way, Seattle, Washington.

5. Net Income (Loss) Per Share

Basic income (loss) per share is computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding during the period. Diluted income (loss) per share is computed by dividing net income (loss) by the weighted average number of common and dilutive common equivalent shares outstanding during the period. Common equivalent shares consist of shares issuable upon the exercise of stock options and warrants (using the treasury stock method). Common equivalent shares are

excluded from the calculation if their effect is antidilutive to net income (loss) from continuing operations, which is the case for all periods presented. Loudeye has excluded the following numbers of shares using this method (in thousands):


	Three months ended				Three months ended
	June 30,				June 30,
	2006		2005		2006		2005
Options outstanding under Loudeye stock option plans		873		1,363		873		1,363
Restricted stock outstanding under Loudeye stock option plans		102		15		102		15
OD2 options assumed		22		90		22		90
Warrants outstanding		1,833		595		1,833		595

Shares excluded		2,830		2,063		2,830		2,063

As discussed further in Note 8, Loudeye has restated all common stock and per share data for the May 22, 2006 one-for-ten reverse stock split.

6. Long-Term Debt

In March 2005, Loudeye entered into an Amended and Restated Loan and Security Agreement (the “Amended Term Loan”) with Silicon Valley Bank (“SVB”). The Amended Term Loan amended and restated Loudeye’s December 31, 2003 loan and security agreement with SVB (the “Original Loan Agreement”). The primary components of the Amended Term Loan were as follows:

• A term loan in the amount of $3.0 million, with a balance as of March 31, 2006, of approximately $750,000. The term loan bore interest at an annual rate of 0.5% above the prime interest rate (which rate was previously 1.25% above the prime interest rate under the terms of the December 31, 2003 loan and security agreement). Payments of principal and interest totaled $83,333 per month for 36 months from December 31, 2003. Once repaid, the term loan may not be reborrowed.

• An equipment term loan facility in the amount of $2.5 million, with a balance as of March 31, 2006, of zero. The equipment loan facility was available on or before October 31, 2005, in minimum draw amounts of $250,000. The equipment loan bore interest at an annual rate of 0.5% above the prime interest rate.

Borrowings under the Amended Term Loan were collateralized by substantially all of Loudeye and Overpeer’s assets. In addition, the Amended Term Loan restricted, among other things, Loudeye’s borrowings, dividend payments, stock repurchases, and sales or transfers of ownership or control, and contained certain other restrictive covenants that required Loudeye to maintain a certain quick ratio and tangible net worth, as defined in the Amended Term Loan.

In December 2005, Loudeye notified SVB that it was not in compliance with a restrictive financial covenant under the Amended Term Loan Agreement that required Loudeye to maintain a certain minimum tangible net worth financial covenant, as defined by the amended loan agreement. Loudeye subsequently established a certificate of deposit in the amount of approximately $1.0 million, which was equal to the then outstanding loan balance.

On April 28, 2006, in connection with the transaction described in Note 3, the outstanding balance of the Amended Term Loan of $671,000 was repaid in full and the Amended Term Loan Agreement was terminated. As a result, a certificate of deposit in the amount of $671,000 was released from restricted cash in April 2006.

7. Contingencies

Royalty Obligations. Loudeye has entered into various agreements that allow for incorporation of licensed or copyrighted material into its services. Under these agreements, Loudeye is required to make royalty payments to the recorded music companies (record labels), publishers and various other rights holders. Some of these agreements require quarterly or annual minimum payments which are not recoupable based upon actual usage. Other royalty agreements require royalty payments based upon a percentage of revenue earned from the licensed service. Royalty costs incurred under these agreements are recognized over the periods that the related revenue is recognized and are included in cost of revenue. These amounts totaled approximately $3.1 million and $7.1 million for the three and six months ended June 30, 2006 and $3.0 million and $6.1 million for the three and six months ended June 30, 2005.

Nasdaq Listing Compliance. On July 7, 2005, Loudeye received a notice from The Nasdaq Stock Market that Loudeye’s common stock is subject to delisting from the Nasdaq Capital Market as a result of failure to comply with the $1.00 per share bid price requirement for 30 consecutive days as required by Nasdaq Marketplace Rule 4310(c)(4) (the “Rule”). On January 4, 2006, Loudeye

received a further notice from Nasdaq noting that it had not regained compliance with the minimum bid price rule as of January 3, 2006. However, the Nasdaq notice also stated that as of January 3, 2006, Loudeye met all the initial inclusion criteria in Nasdaq Marketplace Rule 4310(c) (except for the bid price). As a result, Loudeye was provided an additional 180 day calendar compliance period, or until July 3, 2006, to regain compliance with Nasdaq minimum bid price requirements.

On May 22, 2006, Loudeye effected a one-for-ten reverse split of its capital stock, or the Reverse Stock Split, upon the filing of amended and restated articles of incorporation. Pursuant to the Reverse Stock Split, each holder of ten shares of Loudeye common stock immediately prior to the effectiveness of the Reverse Stock Split became the holder of one share of Loudeye common stock, and the number of authorized shares of Loudeye common stock was proportionally reduced, in both cases without any change in the par value of such shares. No fractional shares were issued in connection with the Reverse Stock Split. Stockholders who were entitled to fractional shares received cash in lieu of receiving fractional shares. Total cash payments for fractional shares were not material.

On June 9, 2006, Loudeye received notification from the Nasdaq Stock Market that the company regained compliance with the Nasdaq’s minimum bid price rule.

In February 2006, Loudeye and investors in a private placement transaction entered into a subscription agreement which contained a covenant by Loudeye that it will maintain its listing on the Nasdaq Capital Market. The subscription agreement further provided that if Loudeye implemented a reverse stock split within six months of the closing of the private placement and the volume weighted average trading price of Loudeye’s common stock on the Nasdaq Capital Market for the twenty trading days immediately following the date the effectiveness of such split was announced was less than the lesser of $0.50 or the closing price of our common stock on the Nasdaq Capital Market on the date of the announcement of the effectiveness of such stock split, then Loudeye would be required to pay an amount in cash or stock, at its election, to the investors in the private placement. Following announcement of Loudeye’s one-for-ten reverse stock split on May 23, 2006, Loudeye incurred an aggregate payment obligation of approximately $155,000 to participants in the February 2006 private placement transaction who continued to hold shares of Loudeye common stock purchase in the transaction as of June 20, 2006. This amount was paid in cash in June 2006.

Legal Proceedings

Settlement of Altnet Litigation Matter. On September 10, 2004, Loudeye was served in a patent infringement lawsuit brought by Altnet, Inc., and others against Loudeye, its Overpeer, Inc. subsidiary, Marc Morgenstern, Overpeer’s managing director, the Recording Industry Association of America, and others. The complaint, filed in federal district court in Los Angeles, California, involves two patents that plaintiffs alleged cover file identifiers for use in accessing, identifying and/or sharing files over peer-to-peer networks. The complaint alleged that the anti-piracy services previously offered by Loudeye’s Overpeer subsidiary infringed the patents in question. Effective May 3, 2006, Altnet and its affiliated companies Brilliant Digital Entertainment, Inc. and Kinentech, Inc., entered into a settlement agreement with Overpeer and Loudeye pursuant to which the suit against Overpeer and Loudeye will be dismissed with prejudice. As consideration for the settlement, Loudeye assigned to Brilliant rights to the Overpeer source code and granted Brilliant and its affiliates a non-exclusive, royalty-bearing (under certain circumstances) license under U.S. Patent No. 6,732,180. The settlement terms involved no cash payments from Loudeye or Overpeer.

the alter ego claims brought by Savvis. However, Loudeye cannot assess at this time the probability of an unfavorable outcome with respect to the claims brought against Loudeye.

IPO Class Action. Between January 11 and December 6, 2001, class action complaints were filed in the United States District Court for the Southern District of New York. These actions were filed against 310 issuers (including Loudeye), 55 underwriters and numerous individuals including certain of Loudeye’s former officers and directors. The various complaints were filed purportedly on behalf of a class of persons who purchased Loudeye’s common stock during the time period between March 15 and December 6, 2000. The complaints allege violations of the Securities Act of 1933 and the Securities Exchange Act of 1934, primarily based on allegations that Loudeye’s underwriters received undisclosed compensation in connection with our initial public offering and that the underwriters entered into undisclosed arrangements with some investors that were designed to distort and/or inflate the market price for Loudeye’s common stock in the aftermarket. These actions were consolidated for pre-trial purposes. No specific amount of damages has been claimed. Loudeye and the individual defendants have demanded to be indemnified by underwriter defendants pursuant to the underwriting agreement entered into at the time of the initial public offering. Presently all claims against the former officers have been withdrawn without prejudice. The Court suggested that the parties select six test cases to determine class-action eligibility. Loudeye is not a party to any of the test cases.

In March 2005, a proposed settlement among plaintiffs, issuer defendants, issuer officers and directors named as defendants, and issuers’ insurance companies, was approved by the Court. This proposed settlement provides, among other matters, that:

• issuer defendants and related individual defendants will be released from the litigation without any liability other than certain expenses incurred to date in connection with the litigation;

• issuer defendants’ insurers will guarantee $1.0 billion in recoveries by plaintiff class members;

• issuer defendants will assign certain claims against underwriter defendants to the plaintiff class members; and

• issuer defendants will have the opportunity to recover certain litigation-related expenses if plaintiffs recover more than $5.0 billion from underwriter defendants.

Our board of directors approved the final settlement terms in March 2005. A fairness hearing for final approval of the settlement terms was held on April 24, 2006, and a decision from the court is pending. Management does not anticipate that we will be required to pay any amounts under this settlement; however, Loudeye can give no assurance that the underwriter defendants will not bring a claim for indemnification against us under the terms of the underwriting agreement relating to Loudeye’s initial public offering.

SPEDIDAM. On March 6, 2006, On Demand Distribution SAS (France) (“OD2 France”), one of OD2’s wholly-owned subsidiaries, received a complaint filed by SPEDIDAM alleging damages for the reproduction of performances of background artists and performers on its servers and the making available of such performances in the form of downloadable files for sale. SPEDIDAM is an organization representing artists and performers in France. Simultaneously, SPEDIDAM filed suit against other leading digital music store operators in France including Apple Computer’s iTunes services, FNAC Music, eCompil, Sony Connect and Virgin Mega. The complaint alleges that OD2 France did not have prior authorization of SPEDIDAM or the relevant artists and performers for such reproduction and distribution. The complaint seeks damages of approximately €565,000 (approximately $709,000 based on June 30, 2006 exchange rates). Loudeye believes that OD2 France it is entitled to be indemnified against any loss arising from the claims alleged by SPEDIDAM by the four major recorded label companies under the terms of On Demand Distribution Limited (U.K.) (“OD2 UK”) license agreements with those labels. OD2 UK anticipates voluntarily joining the litigation to assert these indemnification rights. An initial procedural hearing occurred on June 22, 2006, at which representative of the major recorded music companies appeared and indicated orally their intention to join the proceedings in the French court. The court granted the labels until September 7, 2006 to file briefs in the case and to make an official declaration of their intention to join the proceedings. OD2 France intends to defend itself vigorously concerning the claims brought by SPEDIDAM in this matter; however, OD2 France cannot at this time assess the probability or the magnitude of an unfavorable outcome, if any.

Other. Loudeye is involved from time to time in various other claims and lawsuits incidental to the ordinary course of our operations, including contract and lease disputes and complaints alleging employment discrimination. While the results of these matters cannot be predicted with certainty, Loudeye believes that the outcome of any such pending claims or proceedings individually or in the aggregate, will not have a material adverse effect upon Loudeye’s business or financial condition, cash flows, or results of operations.

8. Stockholders’ Equity

Reverse Stock Split

On May 22, 2006, Loudeye effected a Reverse Stock Split. Pursuant to the Reverse Stock Split, each holder of ten shares of Loudeye common stock immediately prior to the effectiveness of the Reverse Stock Split became the holder of one share of Loudeye common stock, and the number of authorized shares of Loudeye common stock was proportionally reduced, in both cases without any change in the par value of such shares. No fractional shares were issued in connection with the Reverse Stock Split. Stockholders who were entitled to fractional shares received cash in lieu of receiving fractional shares. Total cash payments for fractional shares were not material.

February 2006 private placement transaction

On February 20, 2006, Loudeye entered into a Subscription Agreement with a limited number of institutional investors pursuant to which Loudeye agreed to sell and issue to such investors 1,650,000 shares of its common stock, together with warrants to purchase 1,237,500 shares of common stock at an exercise price of $6.80 per share, for an aggregate purchase price of $8.25 million. The warrants are not exercisable until six months after the closing date and are then exercisable until the fifth anniversary of the closing date. Loudeye paid a placement fee of approximately $557,000 in connection with the financing. The subscription agreement contains a covenant by Loudeye that it will maintain its listing on the Nasdaq Capital Market. Following announcement of Loudeye’s one-for-ten reverse stock split on May 23, 2006, Loudeye incurred an aggregate payment obligation of approximately $155,000 to participants in the February 2006 private placement transaction who continued to hold shares of Loudeye common stock purchase in the transaction as of June 20, 2006. This amount was paid in cash in June 2006.

The securities issued in the private placement were offered and sold without registration under the Securities Act of 1933 to a limited number of institutional accredited investors in reliance upon the exemption provided by Rule 506 of Regulation D thereunder, and may not be offered or sold in the United States in the absence of an effective registration statement or exemption from the registration requirements under the Securities Act. An appropriate legend was placed on the shares and the warrants issued, and will be placed on the shares issuable upon exercise of the warrants (and on Additional Shares, if any), unless registered under the Securities Act prior to issuance. Loudeye filed a registration statement covering the resale of the shares of common stock and the shares of common stock underlying the warrants and the registration was declared effective by the SEC on April 19, 2006.

Stock Option Plans

Under Loudeye’s 2005 Incentive Award Plan, the board and its compensation committee as its designee may grant to employees, consultants, and directors of Loudeye and its subsidiaries incentive and non-statutory options to purchase our common stock, restricted stock awards to purchase shares of Loudeye common stock that are subject to repurchase and are nontransferable until such shares have vested, and other forms of equity compensation awards. In addition, Loudeye maintains a 2000 Stock Option Plan, a 1998 Stock Option Plan, an Employee Stock Option Plan and a Director Stock Option Plan.

At June 30, 2006, options to purchase up to 873,000 shares of our common stock were outstanding under Loudeye’s various stock option plans and restricted stock awards for an aggregate of approximately 102,000 shares of our common stock were outstanding under Loudeye’s 2005 Incentive Award Plan. In addition, at June 30, 2006, an aggregate of 1.7 million shares were reserved for issuance under Loudeye’s 2005 Incentive Award Plan.

Loudeye’s 2005 Incentive Award Plan provides for an automatic annual increase on the first day of each of fiscal year beginning in 2006 equal to the lesser of 500,000 shares or 2% of our outstanding common stock on the last day of the immediately preceding fiscal year or a lesser number of shares as our board determines. As a result, on January 1, 2006, the number of shares reserved under Loudeye’s 2005 Incentive Award Plan automatically increased by 230,736 shares of our common stock. Option grants under the plans have terms of ten years and generally vest over three to four and one half years.

Restricted Stock Awards. As of June 30, 2006, Loudeye had issued an aggregate of 130,000 shares of restricted common stock, net of cancellations, to certain employees under the 2005 Incentive Award Plan. These restricted stock awards have a four-year vesting

period. The accrual for deferred compensation expense related to the restricted shares issued was recorded at the market value on the date of the grant and the related compensation expense is being amortized on a straight line basis over the vesting period.

During the three and six months ended June 30, 2006, Loudeye recorded stock based compensation expense related to the vesting of restricted stock grants of approximately $47,000 and $88,000. During the three and six months ended June 30, 2005, stock based compensation expense related to restricted stock grants was not material.

9. Segment Information

FAS 131 requires that companies report separately in the financial statements certain financial and descriptive information about operating segments profit or loss, certain specific revenue and expense items and segment assets. The method for determining what information is reported is based on the way that management organizes the operating segments for making operational decisions and assessments of financial performance. Loudeye operates in one business segment, digital media services. Members of Loudeye’s senior leadership team review financial information presented on a consolidated basis, accompanied by disaggregated information about services for purposes of making decisions and assessing financial performance.

The substantial majority of Loudeye’s revenue was derived from digital media services provided to external customers principally in Europe. Long-lived assets are comprised of property and equipment and intangible assets, net of related accumulated depreciation and amortization. The following table presents information about Loudeye’s long-lived assets by geographic location (in thousands):


	At		At
	June 30,		December 31,
	2006		2005
Long-lived Assets:
United States	$	1,507	$	1,548
United Kingdom		2,622		2,990
Other countries, principally Europe		28		20

Total long-lived assets	$	4,157	$	4,558

10. Income Tax Provision

During the three and six months ended June 30, 2006, Loudeye recorded a gain on sale of discontinued operations of approximately $9.0 million. As a result, net income for the three and six months ended June 30, 2006 was $5.4 million and $714,000. Loudeye has not recorded income tax expense for the three and six months ended June 30, 2006, as based on management’s current projections, Loudeye does not anticipate reporting GAAP net income or taxable income for the year ended December 31, 2006.

11. Subsequent Event

On August 7, 2006, Loudeye, Nokia Inc. and Loretta Acquisition Corporation, a wholly-owned subsidiary of Nokia, entered into an Agreement and Plan of Merger.

The Merger Agreement

The merger agreement provides that, upon the terms and subject to the conditions set forth in the merger agreement, Nokia’s wholly-owned subsidiary will merge with and into Loudeye, with Loudeye continuing as the surviving corporation and as a wholly-owned subsidiary of Nokia. At the effective time and as a result of the merger each share of Loudeye common stock issued and outstanding immediately prior to the effective time of the merger will be cancelled and extinguished and automatically converted into the right to receive $4.50 in cash, without interest.

Nokia is not assuming any of Loudeye’s stock option plans or agreements and, as a result and pursuant to the terms of Loudeye’s applicable stock option plans or agreements, all unvested options to purchase Loudeye common stock will vest in full effective immediately prior to the closing of the merger. All of the options to purchase Loudeye common stock that are vested as of the effective time of the merger, including those options that vest as a result of the merger, will be terminated in consideration for a cash payment equal to the product of (1) the excess, if any, of $4.50 over the applicable option exercise price and (2) the number of shares of Loudeye common stock subject to such option. Following the effective time of the merger, all warrants to purchase Loudeye common stock will represent only the right, upon exercise thereof, to receive the merger consideration payable with respect to the shares of Loudeye common stock previously issuable under such warrants immediately prior to the effective time.

Loudeye has made representations, warranties and covenants in the merger agreement, including, among others, covenants (i) to carry on its business in the ordinary course and in substantially the same manner as previously conducted during the interim period between the execution of the merger agreement and consummation of the merger, (ii) not to engage in certain kinds of transactions during such period, (iii) to cause a stockholder meeting to be held to consider approval of the merger and the other transactions contemplated by the merger agreement, (iv) subject to certain exceptions, for its board of directors to recommend adoption by its stockholders of the merger agreement and the transactions contemplated by the merger agreement, (v) not to solicit proposals relating to alternative business combination transactions, and (vi) subject to certain exceptions, not to enter into discussions concerning, or provide confidential information in connection with, alternative business combination transactions.

Consummation of the merger is subject to satisfaction or waiver (if applicable) of a number of conditions, including:

•

approval of Loudeye’s stockholders,

•

the absence of a material adverse effect with respect to Loudeye. A material adverse effect with respect to Loudeye is defined in the merger agreement to specifically include, among other things, the loss of more than 30 employees, the loss (or reasonable likelihood of loss) of 30% of the value of Loudeye’s current customer base and Loudeye’s failure to have a minimum cash balance (including cash equivalents, marketable securities and restricted cash) of $10.0 million as of October 31, 2006 before certain transaction related expenses,

•

receipt of third party consents to the continuation, modification, extension and/or termination of certain specified contracts, including the consent of the major record labels to continue to license content to Loudeye on substantially the same terms for a period of 12 months following the closing date of the merger,

•

absence of any law or order prohibiting the closing, and

•

expiration or termination of the Hart-Scott-Rodino waiting period and certain other regulatory approvals.

In addition, each party’s obligation to consummate the merger is subject to the accuracy of the representations and warranties of the other party and material compliance of the other party with its covenants.

The foregoing description of the merger and the merger agreement does not purport to be complete and is qualified in its entirety by reference to the merger agreement, which is filed as Exhibit 2.1 to a current report on Form 8-K filed on August 8, 2006.

Voting and Other Agreements

Concurrently with entering into the merger agreement, Nokia entered into a voting agreement with Loudeye’s directors and certain officers. These voting agreements provide that the directors and officers will vote their shares, which represented approximately two percent (2%) of the Loudeye’s outstanding shares as of March 2006, in favor of the merger. The voting agreements terminate on the earlier of (i) the date of the merger or (ii) termination of the merger agreement in accordance with its terms (including if Loudeye terminates the merger agreement to accept a superior offer).

Also, simultaneously with the execution of the merger agreement, certain key Loudeye employees entered into employment-related agreements with Nokia (which contain non-competition and non-solicitation provisions), which agreements will take effect as of the effective time of the merger.

The foregoing description of the voting agreements does not purport to be complete and is qualified in its entirety by reference to the form of voting agreement, filed as Exhibit 10.1 to a current report on Form 8-K filed on August 8, 2006.

On August 7, 2006, Loudeye’s board of directors approved a Retention Plan which provides for an aggregate of $600,000 in retention payments to seven employees (including Ed Averdieck, an executive officer) in the event the Loudeye-Nokia merger is consummated. Under the retention plan, payments would be made 50% upon closing of the Loudeye-Nokia transaction, and 50% on the one year anniversary of closing, in each case so long as the applicable individual remains employed by Loudeye or Nokia. Payments to an employee under the plan are accelerated if the employee is terminated without cause. Subject to satisfying the terms and conditions of the retention plan, Mr. Averdieck is entitled to receive aggregate payments of $168,000 under the plan.

IMPORTANT ADDITIONAL INFORMATION WILL BE FILED WITH THE SEC

Loudeye has agreed to file a proxy statement in connection with the proposed merger, which will be mailed to Loudeye stockholders. Investors and Loudeye’s stockholders are urged to read carefully the proxy statement and other relevant materials when they become available because they will contain important information about the merger. Investors and security holders may obtain free copies of these documents (when they are available) and other documents filed by Loudeye with the SEC through the web site maintained by the SEC at www.sec.gov. In addition, investors and security holders may obtain free copies of the documents filed with the SEC by Loudeye by going to Loudeye’s corporate website at www.loudeye.com or by contacting: Investor Relations, Loudeye Corp., 1130 Rainier Avenue South, Seattle, Washington 98144.

Loudeye and its directors and executive officers may be deemed to be participants in the solicitation of proxies in respect of the transactions contemplated by the merger agreement. A description of any interests that Loudeye’s officers and directors have in the merger will be available in the proxy statement. Information regarding certain of these persons and their beneficial ownership of Loudeye common stock as of March 1, 2006 is also set forth in the Schedule 14A filed by Loudeye on May 10, 2006 with the SEC with respect to Loudeye’s 2006 annual stockholders meeting. These documents are available free of charge at the SEC’s web site at www.sec.gov or by going to Loudeye’s corporate website at www.loudeye.com.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Forward-Looking Statements

The following discussion of our financial condition and results of operations contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are made under the safe harbor provisions thereof. Any statements about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and may be forward-looking. These statements are often, but not always, made through the use of words or phrases like “anticipate,” “estimates,” “plans,” “projects,” “continuing,” “ongoing,” “expects,” “will,” “management believes,” “Loudeye believes,” “Loudeye intends,” “we believe,” “we intend” and similar words or phrases. Accordingly, these statements involve estimates, assumptions and uncertainties which could cause actual results to differ materially from those expressed in them. Any forward-looking statements are qualified in their entirety by reference to the factors discussed in this quarterly report, including those factors discussed in Part II Item IA, Risk Factors, beginning on page 40 of this quarterly report.

Because the factors discussed in this quarterly report could cause actual results or outcomes to differ materially from those expressed in any forward-looking statement made by us or on behalf of us, you should not place undue reliance on any such forward-looking statement. Further, any forward-looking statement speaks only as of the date on which it is made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for us to predict which will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

You should assume that the information appearing in this quarterly report is accurate only as of the date of this quarterly report. Our business, financial condition, results of operations and prospects may have changed since that date.

Overview

The following management’s discussion and analysis is intended to provide information necessary to understand our unaudited condensed consolidated financial statements and highlight certain other information which, in the opinion of management, will

enhance a reader’s understanding of our financial condition, changes in financial condition and results of operations. In particular, the discussion is intended to provide an analysis of significant trends and material changes in our financial position and operating results of our business during the three and six months ended June 30, 2006 compared with the corresponding three and six months ended June 30, 2005. It is organized as follows:

• The section entitled “Recent Event” describes our recently announced proposed merger transaction with Nokia Inc.

• The section entitled “Loudeye Background” describes our principal operational activities and summarizes significant trends and developments in our business and in our industry.

• “Critical Accounting Policies and Estimates” discusses our most critical accounting policies.

• “Recently Issued Accounting Policies” discusses new accounting standards regarding accounting changes and error corrections and evaluating and recording other than temporary impairment losses on debt and equity investments.

• “Consolidated Results of Operations” discusses the primary factors that are likely to contribute to significant variability of our results of operations from period to period and then provides a detailed narrative regarding significant changes in our results of operations for the three months June 30, 2006 compared to the three months ended March 31, 2006, as well as the three and six months ended June 30, 2006 compared to the three and six month periods ended June 30, 2005.

• “Liquidity, Capital Resources and Going Concern” discusses our liquidity and cash flow and factors that may influence our future cash requirements.

• “Contractual Obligations” discusses our contractual obligations as of June 30, 2006.

• “Off-Balance Sheet Arrangements” discusses certain indemnification and other obligations.

Recent Event

As announced on August 8, 2006, under the merger agreement we entered into with Nokia Inc. on August 7, 2006, each issued and outstanding share of our common stock will be automatically converted into the right to receive $4.50 in cash per share at the effective time of the merger.

Consummation of the merger is subject to satisfaction or waiver (if applicable) of a number of conditions, including:

	•		approval of our stockholders;

	•		the absence of a material adverse effect with respect to Loudeye. A material adverse effect with respect to Loudeye is defined in the merger agreement to specifically include, among other things, the loss of more than 30 employees, the loss (or reasonable likelihood of loss) of 30% of the value of our current customer base and our failure to have a minimum cash balance (including cash equivalents, marketable securities and restricted cash) of $10.0 million as of October 31, 2006 before certain transaction related expenses;

	•		receipt of third party consents to the continuation, modification, extension and/or termination of certain specified contracts, including the consent of the major record labels to continue to license content to Loudeye on substantially the same terms for a period of 12 months following the closing date of the merger;

	•		absence of any law or order prohibiting the closing; and

	•		expiration or termination of the Hart-Scott-Rodino waiting period and certain other regulatory approvals.

We have made representations, warranties and covenants in the merger agreement, including, among others, covenants (i) to carry on our business in the ordinary course and in substantially the same manner as previously conducted during the interim period between the execution of the merger agreement and consummation of the merger, (ii) not to engage in certain kinds of transactions during such

period, (iii) to cause a stockholder meeting to be held to consider approval of the merger and the other transactions contemplated by the merger agreement, (iv) subject to certain exceptions, for our board of directors to recommend adoption by its stockholders of the merger agreement and the transactions contemplated by the merger agreement, (v) not to solicit proposals relating to alternative business combination transactions, and (vi) subject to certain exceptions, not to enter into discussions concerning, or provide confidential information in connection with, alternative business combination transactions.

Our Board of Directors unanimously approved of the merger and will recommend to our stockholders that they approve the merger. Concurrently with entering into the merger agreement, Nokia entered into a voting agreement with our directors and certain officers. These voting agreements provide that the directors and officers will vote their shares, which represented approximately two percent (2%) of our outstanding shares as of March 2006, in favor of the merger. The voting agreements terminate on the earlier of (i) the date of the merger or (ii) termination of the merger agreement in accordance with its terms (including if Loudeye terminates the merger agreement to accept a superior offer).

Also, in connection with the merger agreement, certain key Loudeye employees based in Europe entered into employment-related agreements with Nokia (which contain non-competition and non-solicitation provisions), which agreements will take effect as of the effective time of the merger.

Loudeye Background

We are a worldwide leader in business-to-business digital media services that facilitate the distribution, promotion and sale of digital media content for media and entertainment, mobile communications, consumer products, consumer electronics, retail, and ISP customers. Our services enable our customers to outsource the management and distribution of digital media content over the Internet and other electronic and wireless networks. Our proprietary consumer-facing e-commerce services, combined with our technical infrastructure and back-end solutions, comprise an end-to-end service offering. These service offerings currently comprise turn-key, fully-outsourced digital media distribution and promotional services, such as private-labeled digital media store services, including mobile music services. Our outsourced solutions can decrease time-to-market for our customers while reducing the complexity and cost of digital distribution compared with internally developed alternatives, and they enable our customers to provide branded digital media service offerings to their users while supporting a variety of digital media technologies and consumer business models.

The use of the Internet and wireless networks as a medium for media distribution has continued to evolve and grow in recent years. Traditional media and entertainment companies, such as major record labels, have in recent years faced significant challenges associated with the digital distribution of music. These companies have now licensed the rights to some of their content for certain forms of digital distribution over the Internet and wireless networks. Consumers enjoy this content by means of many different types of services and offerings, including purchased downloads, paid voucher packages, prepaid voucher offerings and streaming radio. Additionally, retailers and advertisers have expanded their use of digital content in the marketing and selling of their products and services. As such, traditional distribution channels for media have expanded as content owners have begun to license and distribute their content over the Internet and wireless networks through new and existing retail channels, and consumers have begun to purchase and consume content using personal computers, mobile devices and other digital devices. In addition, traditional media formats have expanded to include a variety of digital technologies, rich media formats and digital rights management. Despite the increasing popularity of these licensed sources of digital media content over the Internet, piracy over peer-to-peer networks remains a continuing challenge for the digital media distribution industry as a whole.

The growth in digital media distribution has been driven in large part by an increase in broadband adoption, growth in the market for portable digital media devices and significant improvements in streaming technologies capable of delivering high quality content in smaller file sizes. At the same time, content owners such as major media companies, film studios and record labels are providing more content in a digital format to capitalize on these opportunities.

We continue to develop our services to address the changing dynamics of digital media distribution, promotion and consumption. Our digital media store services offerings enable digital distribution of media over the Internet, mobile and wireless networks and other emerging technologies.

Our service offerings historically have been grouped into the two primary categories: digital media store services, concentrated in Europe and around emerging mobile distribution technologies and service offerings, and, through April 30, 2006, digital media content services. We divested all of the operating assets related to our digital media content services offerings on April 30, 2006. Please refer to Note 3 of the accompanying unaudited condensed consolidated financial statements for a detailed description of this transaction. Our financial statements as of and for the three and six month periods ended June 30, 2006, present the assets, liabilities

and results of operations relating to these divested assets as discontinued operations for all periods presented. After May 1, 2006, our business is offered from our European digital media store services platform.

Digital media store services. Digital media store services include our end-to-end digital music store solution provided on a “white-labeled” basis to retailers and brands throughout the world. As a business-to-business provider, our services enable brands of varying types, including retailers and e-tailers, mobile operators, portals, and ISPs, to outsource all or part of their digital media retailing activities.

In February 2006 we announced a realignment of our product development, engineering, information technology and operational resources relating to digital media store services behind our key markets and customers. On April 30, 2006, we sold our substantially redundant U.S.-based digital media services platform. Our digital media store service operations are now centralized at our European headquarters in Bristol, U.K.

We offer our customers a highly scalable consumer-facing digital media commerce and delivery services that include:

• hosting, publishing and managing digital media content, and delivering such content to end consumers on behalf of our customers;

• support for private label user interfaces that have the look, feel and branding of a customer’s existing commerce platform;

• delivery across both Internet and mobile delivery protocols, and in various forms, such as full-song download or streaming, for both Internet and mobile based applications;

• integration to a customer’s website and mobile applications, inventory, and account management;

• localized end-consumer experience and content offering in over 20 countries,

• integrated payment functionality supporting multiple end consumer payment alternatives; and

• digital rights management and licensing, usage reporting, digital content royalty settlement, customer support and publishing related services.

A small number of customers in Europe generate a substantial majority of our revenue from digital media store services, with one customer, Microsoft Corporation’s MSN Music accounting for approximately 28% and 32% of our revenue for the three and six months ending June 30, 2006. This customer concentration poses a significant risk to our business and results of operation if this customer were to terminate or not renew their service contract with us.

We believe future growth in our digital media store services depends significantly upon the growth of the mobile market for digital content services, including music. Our former mobile services customers, O2 Germany and AT&T Wireless mMode Service, were operated on the U.S.-based music store platform which we divested in April 2006. We continue to invest in our mobile music capabilities offered from our OD2 services platform. The OD2 platform will support over-the-air search, purchase and download of music files. The service will permit dual-delivery of downloaded music directly to end consumer’s mobile phones and personal computers. Our first customer for our new mobile music service is O2 U.K., the largest mobile carrier in the U.K. A launch date for this service has not yet been announced.

There are a number of industry challenges that could impact the adoption rate of mobile platforms as a leading method of digital music purchase, including the rate of adoption of compatible mobile handsets, availability of high speed mobile data networks, adoption by mobile consumers of mobile data plans, any pricing differential (both wholesale and retail) between content purchased over-the-air to a mobile device and purchased by other means, development of content and digital rights management standards and technologies acceptable to content licensors, and the impact on the economics of the mobile music business of certain issued patents. Significant growth in demand for our music store services is likely to also depend on significant growth in adoption of Windows compatible portable music devices.

As a business-to-business service provider, our growth and success depends in large part on growth in the proliferation and expanded music market share of digital media businesses generally and the willingness of those businesses to launch new digital services and to support their digital store initiatives with adequate marketing resources. While we do expect growth in our annual

music store services revenue, our customers and potential customers face a number of challenges in the current digital music market, including:

• the dominance of Apple Computer’s iTunes service in certain markets driven in part by sales of the market-share leading iPod portable music devices;

• a trend towards increasing wholesale cost of music content and the apparent willingness of certain music services to set a retail price to consumers that may be under the wholesale cost of music content; and

• a trend towards a requirement for substantial cash advances to content owners, in particular the four major music labels, in order to obtain some content distribution rights, such as use for music streaming subscription services.

We currently derive revenue from our music store services through a blend of higher margin business-to-business platform and consulting service fees and lower margin transaction related promotion, distribution or revenue sharing business-to-consumer fees. Platform service fees represent charges in connection with enabling the service and maintaining its overall functionality during the term of a customer contract (typically three years), including customer support, merchandising, publishing and other content management related services that we provide during the contract term. Growth in platform service fee revenue is directly related to our ability to renew existing service agreements as well as launch new digital media store services, and accordingly, competition for new services and saturation of digital media services in some markets may directly impact this revenue stream.

We also generally receive a fixed fee per transaction or percentage of the revenue generated from the sale of content to end consumers. The margin associated with transactional revenue is dependent in large part upon factors outside our control such as the wholesale rate charged for content by rights holders such as the major record labels and transactional processing fees such as credit card interchange fees. There is a trend towards record labels increasing wholesale content charges, in an apparent attempt to cause an increase in the retail price of popular digital music content. We cannot be certain that consumers will be willing to pay more than the current, prevailing market prices for digital music content. As a result, operating margins on transactional revenue for us and our customers may decrease and price sensitivities may impact the growth in digital music services. Beginning in 2006, we have increased the retail price of music in certain of our music services in an effort to improve our gross margins. We refer to these initiatives as “variable pricing” as we charge retail rates ranging from €0.79 per track to €0.99 per track (the prevailing market rate of our competitors, including Apple Computer’s iTunes services), to €1.29 per track. Charging prices at above the price charged by other competing services may slow our transactional revenue growth, even if our gross margin does improve.

The majority of our transactional revenue is generated through the sale of prepaid voucher packages which entitle a consumer to access a specified number of digital music downloads or streams for a fixed price during a fixed time period. Prepaid voucher packages are also bundled with other end consumer offerings sponsored by our customers. Revenue from prepaid voucher packages and bundle promotions is deferred until the vouchers or promotional offers are utilized or expire. Our margin on the sale of prepaid voucher packages is dependent, in part, upon consumers redeeming less than the full number of downloads or streams covered by the prepaid voucher packages, which we refer to as “breakage.” Historically breakage rates fluctuate causing variability in our transactional margins.

As part of our current end-to-end music store services, we have secured licenses, primarily for digital download and unlimited, streaming subscription, with the four major recorded music companies and many independent record labels around the globe, in the markets we currently serve. Our rights portfolio currently available for inclusion in our music store services encompasses licenses in over 20 countries. All of our significant licensing agreements require the content owner to pre-approve each of our customers in advance of launching a new service.

While we typically secure content licenses on behalf of our customers, there is a trend for certain of the major recorded music companies to want to provide licenses directly to new consumer music services, and some consumer music services, especially those of household brand names, may require direct licensing arrangements with the labels. If these trends continue our business may be significantly impacted including by extending our sales cycle and requiring us to assist our customers in obtaining licenses from content owners. This could change the way we report revenue because to the extent license rights do not pass through Loudeye and our customers are required or elect to license and pay content owners directly, we would report revenue on a net basis (net of third party content fees) rather than on a gross basis. As a result, our transactional revenue may decrease and gross margins as a percentage of revenue may increase. Gross margin as an absolute dollar amount would not be impacted by a change in revenue reporting from a gross basis to a net basis.

Discontinued Operations.

Overpeer, Inc. In March 2004, we completed the acquisition of Overpeer, Inc., a privately held company based in New York. On December 9, 2005, we announced that Overpeer had ceased its content protection services operations effective immediately. We had been funding Overpeer’s operations under an intercompany loan agreement pursuant to which we held a security interest in all of the assets of Overpeer. In November 2005, we delivered to Overpeer a notice of default and acceleration of indebtedness pursuant to the intercompany loan agreement. Following Overpeer’s acknowledgment of default under intercompany loan agreement, we took possession of Overpeer’s assets and foreclosed on Overpeer’s assets in partial satisfaction of Overpeer’s outstanding indebtedness to Loudeye.

During the fourth quarter 2005, we recorded certain non-cash impairment charges relating to a write-down of the carrying value of all of the goodwill and some of the long-lived assets associated with our Overpeer subsidiary, in connection with the discontinuance of the Overpeer business. The fair values of each of these assets were estimated using primarily a probability weighted discounted cash flow method. The impairment of goodwill was determined under the two-step process required by FAS 142. The Overpeer technology, Overpeer’s customer relationships, Overpeer employee non-compete agreements, and Overpeer trademarks with an aggregate net book value of $834,000 have no continuing value in ongoing operations as a result of the cessation of the Overpeer business. In addition, we determined that the net book value of certain Overpeer fixed assets and leasehold improvements exceeded their estimated fair market value as of November 30, 2005, by $591,000.

Overpeer incurred approximately $200,000 in severance and related payroll costs associated with the closing of its operations which was paid during December 2005. In addition, a non-cash stock compensation expense of approximately $40,000 was recorded relating to acceleration of vesting of a restricted stock award to a former Overpeer employee.

Overpeer was a party to a lease agreement for premises located in New York City. The lease had a ten year term running through September 2015. Annual rent obligations under the lease were approximately $175,000, subject to annual adjustment. Under the lease, Loudeye was required to post an approximate $175,000 security deposit in the form of a letter of credit. In December 2005, the landlord drew down the letter of credit in full. In February 2006, Overpeer, Loudeye and the landlord reached a settlement pursuant to which the Landlord released Overpeer and Loudeye from any future obligations with respect to the lease in exchange for the landlord retaining the approximate $175,000 security deposit and certain Loudeye-owned furniture with a net book value of approximately $78,000. For the year ended December 31, 2005, we included a non-cash charge of $253,000 in loss from discontinued operations relating to the lease, offset in part by a deferred rent credit of approximately $80,000 resulting from the early lease termination.

On December 15, 2005, Savvis Communications Corp. filed a complaint in Superior Court in Santa Clara County, California, against Overpeer and Loudeye relating to a May 2002 Master Services Agreement between Savvis and Overpeer for collocation and bandwidth services (the “Overpeer-Savvis Agreement”). The complaint alleges Overpeer breached the Overpeer-Savvis Agreement for non-payment. The complaint also contains alter ego allegations against Loudeye. The complaint seeks damages of $1.6 million consisting of $950,000 of allegedly unpaid invoices for services and approximately $600,000 in alleged early termination fees. The court has granted Savvis a writ of attachment over Overpeer assets located in the state of California. In February 2006, Overpeer and Loudeye filed a joint motion to compel arbitration of the dispute under the terms of the agreement between Savvis and Overpeer. The motion was denied in April 2006. Loudeye and Overpeer have appealed this decision and further proceedings in the case are stayed until resolution of this appeal except that Savvis may seek discovery relating to the writ of attachment over Overpeer assets. A hearing date has not been set for the appeal; Savvis has filed a motion to seek an expedited date for hearing the appeal. Loudeye assesses the probability of a judgment against Overpeer relating to the $950,000 in unpaid invoices as high. As of June 30, 2006, Overpeer had paid approximately $69,000 towards these invoices. As of June 30, 2006 and December 31, 2005, current liabilities from discontinued operations included approximately $883,000 and $952,000 related to unpaid invoices. Loudeye is not a party to the Overpeer-Savvis Agreement. Loudeye intends to defend itself vigorously concerning the alter ego claims brought by Savvis. However, Loudeye cannot assess at this time the probability of an unfavorable outcome with respect to the claims brought against Loudeye.

The closure of Overpeer meets the criteria of a “component of an entity” as defined in FAS 144. The operations and cash flow of those components have been eliminated from the ongoing operations of Loudeye as a result of the disposal, and we do not have any significant involvement in the operations of that component after the disposal transaction. Accordingly, in accordance with the provisions of FAS 144, the results of operations of Overpeer are reported as discontinued operations in the accompanying unaudited condensed consolidated financial statements. The prior-year results of operations for Overpeer have been reclassified to conform to this presentation. Revenue for Overpeer for the three and six months ended June 30, 2005 was $516,000 and $1.4 million and the net loss was $1.2 million and $1.7 million.

U.S.-Based Operating Assets. On April 28, 2006, Loudeye entered into an asset purchase agreement and related ancillary agreements pursuant to which Loudeye sold its U.S.-based operating assets to Muze Inc. for $11.0 million in cash. The transaction closed April 30, 2006.

Following the transaction, Loudeye continues to operate its OD2 digital music store services installed across more than 60 retailers in over 20 countries.

The transaction involved the transfer of the following U.S.-based operations, including associated customer relationships, license rights, music archive and physical assets:

• Loudeye sold its hosting and Internet radio services.

The assets sold meet the criteria of a “component of an entity” as defined in FAS 144 and Loudeye does not have any significant involvement in the operations of the U.S.-based digital media service platform and digital media content services offerings after the sale transaction. In accordance with the provisions of FAS 144, the assets, liabilities and results of operations of the U.S.-based operating assets through the date of completion of the sale, as well as the gain recognized on the sale, are reported as discontinued operations in the accompanying unaudited condensed consolidated financial statements. The prior-year results of operations of the U.S.-based operating assets have been reclassified to conform to this presentation. Revenue and net income (loss), net of the $9.0 million gain on sale recognized in the second quarter 2006, related to the U.S.-based operating assets for the three and six months ended June 30, 2006 and 2005 are presented in the table below.

For the three months ended

For the six months ended

June 30,

2006

2005

2006

2005

Revenue

550,000

$1.6 million

$3.1 million

$2.9 million

Net income (loss), net of gain on sale

8.8 million

$(2.2) million

$8.0 million

$(4.3) million

Critical Accounting Policies and Estimates

The SEC has defined a company’s critical accounting policies as the ones that are the most important to the portrayal of the company’s financial condition and results of operations, and those which require the company to make its most complex or subjective decisions or assessments. Our critical accounting policies and estimates include revenue recognition, the estimates used in determining the recoverability of goodwill and other intangible assets, exit costs, the amount of litigation accruals, stock-based compensation, and the amount of the allowance for income taxes. For a detailed discussion of our critical accounting policies and estimates, please refer to our Annual Report on Form 10-K for the year ended December 31, 2005. We have discussed the development and selection of these critical accounting policies and estimates with the Audit Committee of our board of directors.

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Some of the critical estimates we make may include amounts with respect to music publishing rights and music royalty accruals, litigation accruals, and the allowance for income taxes. Actual results could differ from those estimates.

Stock-Based Compensation Expense. On January 1, 2006, we adopted FAS 123(R) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock options and employee stock purchases related to the Employee Stock Purchase Plan (“employee stock purchases”) based on estimated fair values. FAS 123(R) supersedes our previous accounting under APB 25 for periods beginning in fiscal 2005. In March 2005, the SEC issued SAB 107 relating to FAS 123(R). We have applied the provisions of SAB 107 in our adoption of FAS 123(R).

Stock-based compensation expense recognized under FAS 123(R) for the three and six months ended June 30, 2006 was $296,000 and $633,000, which consisted of stock-based compensation expense related to employee stock options and restricted stock. There was no stock-based compensation expense related to employee stock options, restricted stock and employee stock purchases recognized during the three and six months ended June 30, 2005. Had we recognized compensation expense for the three and six months ended June 30, 2005 for all share-based payments to employees based on their fair values, as is now required by FAS 123(R), net loss would have increased by $969,000 and $1.7 million.

As of June 30, 2006, the total remaining unrecognized compensation cost related to unvested stock options amounted to $1.2 million, which will be amortized over the weighted-average remaining requisite service period of 1.4 years. See Note 8 to our unaudited condensed consolidated financial statements for additional information.

Recent Accounting Pronouncements

In May 2005, the FASB issued FAS No. 154, “Accounting Changes and Error Corrections” (FAS 154). FAS 154 is a replacement of APB No. 20, “Accounting Changes” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements — (an Amendment of APB Opinion No. 28)” and provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application as the required method for reporting a change in accounting principle. FAS 154 provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. The reporting of a correction of an error by restating previously issued financial statements is also addressed by FAS 154. FAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 31, 2005. We adopted this pronouncement January 1, 2006.

In November 2005, the FASB issued FASB Staff Position No. FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments” (FSP No. 115-1). FSP No. 115-1 amends FAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” and includes guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. FSP No. 115-1 also requires an other-than-temporary impairment of debt and equity securities to be written down to its impaired value, which becomes the new cost basis. We adopted this pronouncement January 1, 2006. Adoption of this standard did not have any impact on our financial position, results of operations or cash flows.

In July 2006, the FASB issued FASB Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes.” This interpretation establishes a “more-likely-than-not” recognition threshold that must be met before a tax benefit can be recognized in the financial statements. The Interpretation also offers guidelines to determine how much of a tax benefit to recognize in the financial statements. Under FIN 48, the largest amount of tax benefit that is greater than fifty percent likely of being realized upon ultimate settlement with the taxing authority should be recognized. The provisions of this Interpretation become effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact of the adoption of FIN 48 on our financial position and results of operations.

Consolidated Results of Operations

Overpeer, our wholly-owned subsidiary which provided content protection services, ceased operations in December 2005 and is presented as a discontinued operation in all periods presented.

On April 28, 2006, we sold our U.S.-based operating assets for $11.0 million in cash. The assets sold meet the criteria of a “component of an entity” as defined in FAS 144. In accordance with the provisions of FAS 144, we have reflected the results of these operations, along with the related gain on sale, as discontinued operations in all periods presented.

Comparison of Second Quarter 2006 Operating Results to First Quarter 2006

We had a gross profit margin of approximately $1.3 million or 24% of total revenue for the second quarter 2006, compared to a gross profit margin for first quarter 2006 of approximately $881,000 or 15% of total revenue. The gross profit margin improvement is due to higher gross margin on consulting revenue and on certain promotional voucher programs as well as higher gross margins being realized on our variable pricing and monthly subscription initiatives, which were launched during the first and second quarters of 2006. We reported net income of $5.4 million or $0.41 per share in the second quarter 2006, as a result of the $9.0 million gain recognized in the current quarter on the sale of the U.S.-based operating assets, compared to a net loss of $4.6 million or $0.39 per share in the first quarter 2006.

Revenue decreased by approximately 8% for the second quarter 2006 to $5.4 million from $5.8 million in the first quarter 2006. First quarter 2006 revenue included approximately $500,000 in promotional voucher revenue from one internet service provider in Europe related to a twelve month, €1.8 million (approximately $2.2 million based on March 31, 2006 exchange rates) promotion which ended during first quarter 2006. We also noticed a growing shift in the marketplace from web downloads to mobile downloads during the second quarter 2006, and a few of our customers did not renew their service agreements. These factors contributed to the decline in revenue which is expected to adversely impact our overall growth in revenue for the 2006 calendar year.

For the second quarter 2006, transactional volume, principally from the sale of digital downloads and prepaid voucher packages, represented approximately 80% of revenue, which is consistent with first quarter 2006. In the second quarter 2006, approximately 28% of our revenue was derived from Microsoft Corporation’s MSN music services offerings, compared to 36% in first quarter 2006.

Comparison of Three and Six Month Periods Ended June 30, 2006 and June 30, 2005

Percentage comparisons have been omitted within the following table where they are not considered meaningful. Certain information reported in previous periods has been reclassified to conform to current presentation. All amounts, except amounts expressed as a percentage, are presented in the following table in thousands.


	Three Months Ended												Six Months Ended
	June 30,						Variance						June 30,						Variance
	2006			2005			$			%			2006			2005			$			%
Revenue	$	5,382		$	4,892		$	490			10	%	$	11,202		$	8,764		$	2,438			28	%
Cost of revenue		4,112			4,016			96			2	%		9,051			7,825			1,226			16	%

Gross profit		1,270			876			394			45	%		2,151			939			1,212			129	%
Operating expenses
Sales and marketing		786			931			(145	)		(16	)%		1,663			2,051			(388	)		(19	)%
Research and development		839			647			192			30	%		1,675			1,228			447			36	%
General and administrative		2,869			3,005			(136	)		(5	)%		5,624			6,483			(859	)		(13	)%
Amortization of intangibles		84			51			33			65	%		147			109			38			35	%
Stock-based compensation		269			(2	)		271						565			42			523			1245	%
Special charges (credits) — other		—			—			—						—			(43	)		43			100	%

Total operating expenses		4,847			4,632			215			5	%		9,674			9,870			(196	)		(2	)%
Interest income		207			183			24			13	%		296			391			(95	)		(24	)%
Interest expense		(9	)		(28	)		19			68	%		(27	)		(102	)		75			74	%
Other income (expense), net		(109	)		75			(184	)		(245	)%		(77	)		235			(312	)		(133	)%

Loss from continuing operations		(3,488	)		(3,526	)		38			1	%		(7,331	)		(8,407	)		1,076			13	%
Income (loss) from discontinued operations, net of gain on sale		8,843			(3,404	)		12,247			360	%		8,045			(5,975	)		14,020			235	%

Net income (loss)	$	5,355		$	(6,930	)	$	12,285			177	%	$	714		$	(14,382	)	$	15,096			105	%

Comparison of Three and Six Month Periods Ended June 30, 2006 and June 30, 2005

Revenue. Revenue increased for the three and six month periods ended June 30, 2006, compared to the three and six month periods ended June 30, 2005, primarily as a result of strong growth in transactional and promotional voucher revenue, and to a lesser extent, to the monthly subscription initiative that we launched during the first six months of 2006.

During the three and six month periods ended June 30, 2006 and 2005, Loudeye had sales to certain significant customers, as a percentage of revenue, as follows:


	For the three months ended						For the six months ended
	June 30,						June 30,
	2006			2005			2006			2005
Microsoft		28	%		27	%		32	%		27	%
KPN Telecom B.V.		16	%		4	%		15	%		3	%
Wanadoo		14	%		8	%		14	%		9	%
Coca-Cola		6	%		14	%		5	%		15	%

		64	%		53	%		66	%		54	%

These customers remained with Loudeye following the sale of its U.S.-based operating assets. Most of the services that Loudeye provided to Wanadoo (now part of Orange) and Coca-Cola were terminated or not renewed during the second and third quarters of 2006. As recently announced, KPN Telecom B.V. and Microsoft have renewed their service agreements. All revenue in the periods presented was generated from our international operations, which is entirely related to the OD2 music store platform.

Deposits and deferred revenue. Deposits and deferred revenue is comprised of the unrecognized revenue related to unearned platform fees, unutilized prepaid music voucher purchases and other prepayments for which the earnings process has not been completed and is presented net of related receivables. Deposits and deferred revenue at June 30, 2006 was $4.6 million, net of related receivables of approximately $1.1 million, compared to approximately $5.2 million, net of related receivables of approximately $1.8 million, at December 31, 2005. In the first quarter 2006 we recognized approximately $500,000 in revenue, based on March 31, 2006 exchange rates, related to a twelve month agreement entered into in February 2005 with an internet service provider (ISP) in Europe, under which we provided the ISP’s customers promotional vouchers which were redeemed for a range of digital media download services through first quarter 2006. Deposits and deferred revenue will continue to fluctuate in the future based upon our service mix and the impact of our revenue recognition policies.

Cost of revenue. Cost of revenue includes the cost of production, including personnel, cost of royalties to content providers and publishers, technical support, transaction processing fees, bandwidth and hosting costs, depreciation and amortization of infrastructure assets related to our service offerings, amortization of acquired technology resulting from the June 2004 acquisition of OD2, and an allocated portion of equipment, information services personnel and facility-related costs. Since we acquired OD2 in June of 2004, we have continued to expand our digital media services work force in order to meet the demands of anticipated growth and new initiatives for our digital music store services. These new initiatives include development and enhancement of our mobile music platform, and custom development for certain of our music services. As a result of these factors, and as a result of our revenue increasing during the three and six months ended June 30, 2006 as compared to the same periods in 2005, cost of revenue as an absolute dollar amount has

increased. However, cost of revenue as a percentage of revenue has decreased in 2006 as compared to 2005. Factors resulting in improving margins include growth in higher margin revenue from promotional vouchers in 2006, launch of variable pricing and monthly subscription initiatives in 2006, and, to a lesser extent, an increase in higher margin consulting services revenue in 2006.

We expect content licensing costs to continue to increase as recorded music companies continue their efforts to raise wholesale content prices in an apparent attempt to cause an increase in prevailing retail prices of digital downloads of music content. There is also a trend, especially for mobile operators, for recorded music labels to license their content directly to our customers, rather than through master content licenses with us. The impact of this trend may be a reduction in transactional revenue, and an increase in gross margins as a percentage of revenue, if we report revenue on a net basis (net of third party content fees) rather than on a gross basis. Gross margin as an absolute dollar amount would not be impacted by a change in revenue reporting from a gross basis to a net basis. We earn a higher margin on platform service fees than on traditional digital download transactions, and our margins for our prepaid voucher packages and promotional bundling offerings will fluctuate, depending primarily upon breakage levels experienced. As revenue grows, we expect fluctuations in our overall gross profit margin percentage depending upon our overall mix of revenue. We expect cost of revenue related to our digital media services to continue to increase as revenue increases in 2006 as compared to 2005.

Depreciation included in cost of revenue increased to approximately $103,000 and $203,000 in the three and six month periods ended June 30, 2006 from $78,000 and $150,000 for the three months ended June 30, 2005. Amortization expense included in cost of revenue was $89,000 and $174,000 in the three and six month periods ended June 30 2006 as compared to $93,000 and $197,000 for the three and six months ended June 30, 2005, and is the result of the amortization of acquired technology related to the OD2 acquisition in June 2004.

Sales and marketing. Sales and marketing expenses consist primarily of salaries, bonuses, commissions and benefits earned by sales and marketing personnel, direct expenditures such as travel and communication, and marketing expenditures such as advertising, public relations costs and trade show expenses and an allocated portion of equipment, information services personnel and facility-related costs. Sales and marketing expenses for the three and six month periods ended June 30, 2006 decreased compared to the same periods of the prior year, due to personnel reductions undertaken during fourth quarter 2005 and first quarter 2006. Sales and marketing expenses as a percentage of total revenue declined to 15% for the three and six month periods ended June 30, 2006 as compared to 19% and 23% for the same periods in 2005, primarily as a result of our increased revenue and our cost reductions. We expect to continue to investing significantly in sales and marketing in 2006, as we believe that a substantial sales and marketing effort is essential for us to grow our market position and increase market acceptance of our digital media store services, in particular mobile music services.

Research and development. Research and development expenses include labor and other related costs of the continued development and support of our digital media services and an allocated portion of equipment, information services personnel and facility-related costs. To date, the substantial majority of research and development costs have been expensed as incurred. Research and development expenses for the three and six month periods ended June 30, 2006, both as an absolute dollar amount and as a percentage of revenue, continued to increase as compared to the same periods in 2005, due to expanded development efforts relating to our digital media store services offerings, including mobile service offerings. We believe that a significant research and development investment is essential for us to maintain our market position, to continue to expand our digital media store services offerings, in particular mobile music services, and to develop additional technologies and capabilities. Accordingly, we anticipate that we will continue to invest in research and development for the foreseeable future, and we anticipate research and development costs as an absolute dollar amount will fluctuate, depending primarily upon the volume of forecasted future revenue, customer needs, staffing levels, overhead costs and our assessment of market demands.

General and administrative. General and administrative expenses consist primarily of salaries, benefits and related costs for executive, finance, legal and administrative personnel, legal expenses, an allocated portion of equipment, information services personnel and facility-related costs, and costs associated with being a public company, including but not limited to, consulting, audit and legal fees related to the Sarbanes-Oxley internal control over financial reporting certification requirements, annual and other public-reporting costs, directors’ and officers’ liability insurance, investor relations, and professional services fees. General and administrative expenses for the three and six month periods ended June 30, 2006 decreased both as an absolute dollar amount and as a percentage of total revenue as compared to the same periods in 2005, primarily due to an increase in revenue, as well as decreases in professional fees in order to comply with the Sarbanes-Oxley Act of 2002, personnel costs as part of our cost reductions in the fourth quarter of 2005 and first quarter of 2006, costs related to filings with the SEC and severance costs. We expect to incur higher than typical general and administrative expenses for the remainder of 2006, as we are incurring and will

incur investment advisory, legal, accounting, and proxy solicitation fees and expenses in connection with the proposed merger with Nokia Inc. described further in Note 11. We will incur these expenses whether or not the proposed transaction is approved and closes.

In connection with the sale of our U.S.-based operating assets in April 2006, we entered into a sublease agreement for our Seattle facility with the acquirer of our U.S.-based operating assets, whereby the acquirer will reimburse us for 50% of the rent expense and will generally reimburse us for facility related expenses on an as-used basis, starting May 1, 2006. We have also delivered notice of termination of the lease for our Seattle facility effective December 31, 2006, and expect to lease office space in a different facility for our remaining Seattle-based personnel in the fourth quarter 2006.

Amortization of intangibles. Amortization of intangibles includes amortization of identified intangible assets other than acquired technology, which is included in cost of revenue. Beginning in the second quarter 2004, we incurred amortization expense related to our acquisition of OD2. In June 2005, we acquired a patent which defines a system for closely imitating digital media files on peer to peer networks. Accordingly, we expect amortization expense on an annual basis for 2006 to increase over 2005 levels.

Stock-Based Compensation Expense. On January 1, 2006, we adopted FAS 123(R) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock options based on estimated fair values. FAS 123(R) supersedes our previous accounting under (APB 25 for periods beginning in fiscal 2006. In March 2005, the SEC issued SAB 107 relating to FAS 123(R). We have applied the provisions of SAB 107 in our adoption of FAS 123(R).

We adopted FAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of our fiscal year 2006. Our consolidated financial statements as of and for the three and six month periods ended June 30, 2006 reflect the impact of FAS 123(R). In accordance with the modified prospective transition method, our consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of FAS 123(R). Stock-based compensation expense recognized under FAS 123(R) for the three and six month periods ended June 30, 2006 was approximately $296,000 and $633,000, which consisted of stock-based compensation expense related to employee stock options and restricted stock awards. There was no stock-based compensation expense related to employee stock options, restricted stock or employee stock purchases recognized during the three and six month periods ended June 30, 2005. See Note 8 to our unaudited condensed consolidated financial statements for additional information.

FAS 123(R) requires us to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our consolidated statement of operations. Prior to the adoption of FAS 123(R), we accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under FAS 123. Under the intrinsic value method, no stock-based compensation expense had been recognized for employee or director awards in our consolidated statement of operations because the exercise price of Loudeye’s stock options granted to employees and directors was equal to the fair market value of the underlying stock at the date of grant.

Special charges (credits). For the three and six month periods ended June 30, 2006, there were no special charges recorded. For the three and six months ended June 30, 2005, the amounts recorded as special charges (credits) related to facilities consolidations, and were charges (credits) of zero and ($43,000). In the first quarter 2005, as discussed in Note 4 to the unaudited condensed consolidated financial statements, we paid $360,000 of the $403,000 then remaining accrued special charge balance, as a final payment related to our former leased facility at 414 Olive Way, Seattle, Washington, and the $43,000 difference between the amount previously recorded in accrued special charges and the final settlement amounts of the underlying liabilities was reflected as a net credit to special charges (credits) in the unaudited condensed consolidated statements of operations.

Interest income. Interest income consists of interest income and realized gains and losses on sales of our marketable securities. Interest income for the three months ended June 30, 2006 increased as compared to the same period in 2005, primarily due to higher average investment balances, primarily as a result of our February 2006 private placement transaction and the April 2006 sale of our U.S.-based operating assets. Interest income for the six months ended June 30, 2006 and 2005 decreased as compared to the same period in 2005, primarily due to lower average investment balances over the six month period. We expect interest income will fluctuate during 2006 depending upon our average investment balances and yield rates throughout the year.

Interest expense. Interest expense for the three months ended June 30, 2006 continued to decrease as compared to the same periods in 2005, due to lower average debt balances but higher interest rates during 2006 as compared to 2005. We expect that interest expense will decrease in 2006 as compared to 2005, since the term loan was fully repaid in April 2006.

Other income (expense), net. Other expense for the three months ended June 30, 2006 consists principally of a net foreign exchange transaction loss of $60,000 and taxes paid by our international subsidiaries of $50,000. Other income for the three months ended June 30, 2005 consisted principally of a foreign currency transaction gain on the accrued acquisition consideration related to our acquisition of OD2 in June 2004. Other expense for the six months ended June 30, 2006 consists principally of a net foreign exchange transaction loss of $79,000. Other income for the six months ended June 30, 2005 consisted principally of a foreign currency transaction gain of $268,000. We expect that we will continue to experience period-to-period fluctuations in other income (expense) due to variations in foreign currency exchange rates, since we do not currently hedge this exposure.

Income taxes. We did not record an income tax provision related to our net income in the three and six month periods ended June 30, 2006. During the three and six months ended June 30, 2006, Loudeye recorded a gain on sale of discontinued operations of approximately $9.0 million. As a result, net income for the three and six months ended June 30, 2006 was $5.4 million and $714,000. Loudeye has not recorded income tax expense for the three and six months ended June 30, 2006, as based on management’s current projections, Loudeye does not anticipate reporting net income for the year ended December 31, 2006. We did not record an income tax benefit related to our net operating losses in the three and six month periods ended June 30, 2005, as a result of the uncertainties regarding the realization of such net operating losses. Our foreign operations had net operating losses for the three and six month periods ended June 30, 2006 and 2005. At June 30, 2006 and December 31, 2005, a valuation allowance equal to the deferred tax asset has been recorded.

Liquidity, Capital Resources and Going Concern

Historically we have financed our operations primarily through proceeds from public and private sales of our equity securities. To a lesser extent, we have financed our operations through equipment financing and traditional lending arrangements. We have incurred net losses since inception, have an accumulated deficit of $241.9 million at June 30, 2006, and have experienced negative cash flows from operations in substantially all quarters of our operations since inception. Our principal source of liquidity at June 30, 2006 was our cash, cash equivalents and marketable securities. As of June 30, 2006, we had approximately $22.3 million of unrestricted cash, cash equivalents and marketable securities.

We have prepared our unaudited condensed consolidated financial statements assuming that we will continue as a going concern, which contemplates realization of assets and the satisfaction of liabilities in the normal course of business for the next twelve month period following the date of these financial statements. However, we have incurred annual net losses from inception, have an accumulated deficit of approximately $241.9 million at June 30, 2006, and have experienced negative cash flows from operations in substantially all quarters of our operations since inception, and we expect to continue to incur net losses in future periods. In addition, in connection with the Loudeye-Nokia transaction described in Note 11, we expect to incur approximately $1.0 million in expenses regardless of whether the transaction is consummated. These factors, among others, raise substantial doubt about our ability to continue as a going concern if the Loudeye-Nokia transaction is not consummated. If the Loudeye-Nokia transaction is not consummated, we expect to require additional capital to fund our ongoing operations. Any failure to consummate the Loudeye-Nokia transaction (which could result in our being required to pay a termination fee to Nokia), combined with our history of declining market valuation and volatility in our stock price, could make it difficult for us to raise capital on favourable terms, or at all. Any financing we obtain may dilute or otherwise impair the ownership interest of our current stockholders. If we fail to generate positive cash flows or fail to obtain additional capital when required, we could modify, delay or abandon some or all of our business and expansion plans. The accompanying unaudited condensed consolidated financial statements do not include any adjustments that may result from the outcome of this uncertainty.

On April 28, 2006, we entered into an asset purchase agreement and related ancillary agreements pursuant to which we sold our U.S.-based services and operations for $11.0 million in cash. The transaction closed April 30, 2006. The gross proceeds of $11.0 million were used to repay in full $671,000 owed to Silicon Valley Bank, or SVB, under the Amended and Restated Loan and Security Agreement between Loudeye and SVB dated March 30, 2005 and the remaining proceeds of approximately $10.3 million were paid to Loudeye and will be used for general working capital and corporate purposes. In connection with the SVB payoff, restrictions on a certificate of deposit of $671,000 were released in April 2006. Loudeye and the acquirer also entered into a sublease arrangement for Loudeye’s facility in Seattle. The acquirer will reimburse us for 50% of the rent expense for the Seattle facility and will generally reimburse us for facility related expenses on an as-used basis.

On February 20, 2006, we entered into a Subscription Agreement with a limited number of institutional investors pursuant to which we agreed to sell and issue to such investors 1,650,000 shares of our common stock, together with warrants to purchase 1,237,500 shares of common stock at an exercise price of $6.80 per share, for an aggregate purchase price of $8.25 million. We consummated the transaction on February 22, 2006. The warrants are not exercisable until six months after the closing date and are then exercisable until the fifth anniversary of the closing date. We also granted the investors a one year right to purchase 30% of any securities sold by Loudeye in future financings, subject to exceptions. We paid a placement fee of approximately $557,000 in connection with the financing. The transaction resulted in net proceeds of approximately $7.6 million.

The transaction documents relating to the February 2006 private placement provided that if we implemented a reverse stock split within six months of the closing of the private placement and the volume weighted average trading price of Loudeye’s common stock on the Nasdaq Capital Market for the twenty trading days immediately following the date the effectiveness of such split was announced was less than the lesser of $0.50 or the closing price of Loudeye’s common stock on the Nasdaq Capital Market on the date of the announcement of the effectiveness of such stock split, then Loudeye would be required to pay an amount in cash or stock, at Loudeye’s election, to the investors in the private placement. Following announcement of Loudeye’s one-for-ten reverse stock split on May 23, 2006, Loudeye incurred an aggregate payment obligation of approximately $155,000 to participants in the February 2006 private placement transaction who continued to hold shares of Loudeye common stock purchase in the transaction as of June 20, 2006. This amount was paid in cash in June 2006.

While we will continue to implement cost containment efforts across our business, our operating expenses will consume a material amount of our cash resources. If we fail to generate positive cash flows or fail to obtain additional capital when and if required, we could modify, delay or abandon some or all of our business and expansion plans. Our consolidated financial statements do not include any adjustments that may result from the outcome of this uncertainty.

In March 2004, we completed the acquisition of Overpeer, Inc. (“Overpeer”), a privately held company based in New York. On December 9, 2005, we announced that Overpeer had ceased its content protection services operations effective immediately. We had been funding Overpeer’s operations under an intercompany loan agreement pursuant to which we held a security interest in all of the assets of Overpeer. In November 2005, we delivered to Overpeer a notice of default and acceleration of indebtedness pursuant to the intercompany loan agreement. Following Overpeer’s acknowledgment of default under intercompany loan agreement, we took possession of Overpeer’s assets and foreclosed on Overpeer’s assets in partial satisfaction of Overpeer’s outstanding indebtedness to Loudeye. At June 30, 2006, a significant portion of the foreclosed Overpeer property and equipment was held for sale, and we anticipate selling these assets over the next twelve months. These “assets held for sale”, net of estimated costs to sell, are included in “assets of discontinued operations” in the accompanying unaudited condensed consolidated balance sheet.

During 2005 and 2006, we implemented cost containment efforts and recorded special charges (included in discontinued operations) related to corporate restructurings and facilities consolidation. We continue to focus on maximizing the performance of our business and controlling costs and will continue to evaluate our underlying cost structure to improve our operating results and better position ourselves for growth. As such, we may incur further facility consolidations or restructuring charges, including severance, benefits and related costs due to a reduction in workforce and/or charges for assets disposed of or removed from operations as a direct result of a reduction in workforce.

In April 2006, Loudeye entered into an exclusive license agreement with TelSpan, Inc. for Loudeye’s LEX online presentation software. The transaction included sale of certain hardware assets supporting the LEX platform. Loudeye received an upfront fee of $50,000 and will receive a one-percent royalty on gross revenue generated by TelSpan from sale of the service, although Loudeye does not expect this royalty to be material in subsequent periods.

Net cash used in operating activities was approximately $5.7 million and $11.3 million for the six months ended June 30, 2006 and 2005. For 2006, cash used in operating activities resulted primarily from a gain on sale of U.S.-based operating assets for $9.0 million, offset by net income of $714,000, adjusted by non-cash charges for depreciation and amortization of $950,000, stock-based compensation charges and other non cash items aggregating $554,000, a net foreign currency transaction loss of $79,000, and other working capital changes. For 2005, cash used in operating activities resulted primarily from a net loss of approximately $14.4 million, partially offset by loss from discontinued operations of $6.0 million, non-cash charges for depreciation and amortization of $925,000, and a net foreign currency transaction gain of $268,000 and other working capital changes. Cash used in operations is dependent upon our ability to achieve positive earnings through a combination of increased revenue and reduced expense, and the timing of our payments and collections and we expect that it will continue to fluctuate from period to period.

Net cash provided by investing activities was approximately $14.3 million for the second half 2006, consisting principally of proceeds from the sale of the U.S.-based operating assets as discussed in Note 3 to the accompanying unaudited condensed consolidated financial statements, net sales of short-term marketable securities of $2.1 million and the release of restrictions on approximately $1.6 million of cash, offset partially by purchases of property and equipment and intangible assets of approximately $400,000. For the second half 2005, cash provided by investing activities was $2.3 million and consisted principally of net sales of short-term marketable securities of $5.5 million and the release of restrictions on approximately $1.4 million of cash, offset by payments made to former OD2 shareholders of $2.5 million, purchases of property and equipment and intangibles of approximately $330,000, and investing cash flows of discontinued operations, primarily representing the purchase of a patent.

Cash provided by financing activities in the first six months of 2006 was approximately $6.7 million, consisting primarily of net proceeds from private equity financing of $7.6 million and proceeds from the exercise of stock options of $234,000, partially offset by principal payments on our term loan of $1 million. Cash used by financing activities in the first six months of 2005 was $233,000, consisting primarily of principal payments on our debt and capital lease obligations of $500,000 and a penalty related to our private equity financing of $314,000, partially offset by proceeds from the exercise of stock options of $663,000.

In March 2005, we entered into an Amended and Restated Loan and Security Agreement with Silicon Valley Bank. On April 30, 2006, we repaid the outstanding balance on the loan of approximately $671,000 with proceeds from the sale of our U.S.-based operating assets. In connection with the SVB payoff, restrictions on cash of $671,000 were released in April 2006.

At June 30, 2006, restricted cash represented approximately $234,000 of cash equivalents pledged as collateral in connection with agreements with certain financial institutions.

We currently anticipate that we will continue to experience fluctuations in results of operations for the foreseeable future as we:

	•		Focus our European service offerings on our key markets and customers;

	•		Continue efforts to develop our mobile music services offerings;

	•		Increase or decrease research and development spending;

	•		Increase or decrease sales and marketing activities; and

	•		Improve our operational and financial systems.

We do not hold derivative financial instruments or equity securities in our investment portfolio. Our cash equivalents and marketable securities consist primarily of highly liquid money market funds, as specified in our investment policy guidelines. As a result, we would not expect our operating results or cash flows to be significantly affected by a sudden change in market interest rates in our securities portfolio.

Loudeye is involved in various litigation matters discussed more fully in Note 7 to our unaudited condensed consolidated financial statements contained in this quarterly report. Any adverse outcome in any or all of these litigation matters could have a material adverse impact on our liquidity and capital resources.

We primarily conduct our operations in the British pound. Since June 2004, fluctuations in foreign exchange rates have had a significant impact on our financial condition and results of operations. We currently do not hedge our foreign currency exposures and are therefore subject to the risk of exchange rate fluctuations. We invoice our international customers primarily in British pounds, except outside of the UK, where we invoice our customers primarily in euros. We are exposed to foreign exchange rate fluctuations as the financial results of foreign subsidiaries are translated into U.S. dollars in consolidation. In 2005 our exposure to foreign exchange rate fluctuations also arose as a result of accrued acquisition consideration relating to the OD2 transaction and from intercompany payables and receivables to and from our foreign subsidiaries.. In 2006 we expect our exposure to foreign exchange rate fluctuations to arise from intercompany payables and receivables to and from our foreign subsidiaries. For the three and six months ended June 30, 2006, we recognized a net transaction loss of $60,000 and $79,000. For the three and six months ended June 30, 2005 we recognized a net transaction gain of $61,000 and $268,000 primarily on accrued acquisition consideration related to the OD2 transaction.

We do not believe that our financial resources will be sufficient to meet our anticipated cash needs for working capital or other purposes until we achieve profitability and positive cash flow. As a result, we expect that we will require additional capital to fund our ongoing operations. The timing of our need for additional capital is variable, but we do not expect to need additional capital to fund our operations through at least the second quarter of 2007. There can be no assurance that capital will be available to us on acceptable terms, or at all. Our history of declining market valuation and volatility in our stock price could make it difficult for us to raise capital on favorable terms. Raising capital may also be subject to a required prior approval of our shareholders. Any financing we obtain may dilute or otherwise impair the ownership interest of our current stockholders. If we fail to generate positive cash flows or fail to obtain additional capital when required, we could modify, delay or abandon some or all of our business and expansion plans.

Contractual Obligations

The following table provides aggregated, consolidated information about our contractual obligations as of June 30, 2006 (in thousands).


	Payments Due by Period
			Less Than						After
	Total		1 Year		1-3 years		4-5 years		5 years
Operating leases (1)	$	816	$	579	$	147	$	90	$	—

Bandwidth and co-location purchase obligations (2)		276		213		63		—		—

Total contractual obligations	$	1,092	$	792	$	210	$	90	$	—


(1)		Our future minimum rental commitments under noncancellable leases comprise the majority of the operating lease obligations presented above. We expect to fund these commitments with existing cash and cash flows from operations. Rental commitments are presented net of sublease income.

(2)		Many of the contracts underlying these obligations contain renewal provisions, generally for a period of one year. In addition, amounts payable under these contracts may vary based on the volume of data transferred. The amounts in the table represent the base fee amount. We also have contracts for bandwidth and collocation services that run on a month-to-month basis and for which there are no unconditional obligations. Monthly amounts due under the month-to-month contracts are not material and have been excluded from the table above.

Excluded from the table above are the following:

• Deposits and deferred revenue of $4.6 million, net of related receivables, has been excluded from the table above as the liabilities will not be settled in cash.

• The expected issuance of up to approximately 22,000 additional shares of Loudeye common stock, representing shares to be issued to OD2 option holders issuable upon exercise of OD2 options assumed by Loudeye in connection with the OD2 acquisition in June 2004. The associated common stock payable of $321,000 has been excluded as the related liability will not be settled in cash.

• Purchase commitments represent obligations under agreements which are not unilaterally cancelable by us, are legally enforceable, and specifically fixed or minimum quantities of goods or services at fixed or minimum prices. We generally require purchase orders for vendor and third party spending. There were no other known contracts or purchase orders exceeding $100,000 in the aggregate.

Since inception, we have sustained substantial net losses to sustain our growth and establish our business. We expect the following additional items, among others, may represent significant uses of capital resources in the foreseeable future:

• We have continuing payment obligations under existing arrangements with certain licensors of copyrighted materials that will require payments for content fees and royalties on music delivered to end consumers. As of June 30, 2006, approximately $5.8 million of these amounts are included in accrued and other liabilities in the accompanying unaudited condensed consolidated balance sheets. Content fees and royalties on music are due to our partners based on net revenue and online music distribution volumes. As online service volumes fluctuate, our payment obligations for content fees and royalties fluctuate proportionally.

• Loudeye has entered into various agreements that allow for incorporation of licensed or copyrighted material into its services. Under these agreements, Loudeye is required to make royalty payments to the recorded music companies (record labels), publishers and various other rights holders. Some of these agreements require quarterly or annual minimum payments which are or are not recoupable based upon actual usage, based on the terms of the agreement. Other royalty agreements require royalty payments based upon a percentage of revenue earned from the licensed service. Royalty costs incurred under these agreements are recognized over the periods that the related revenue is recognized and are included in cost of revenue. As of the date of this filing, obligations under these agreements total $863,000 and are payable in various quarterly installments through March 2007. Advances made under the terms of these agreements are recoupable against future royalty costs incurred for the applicable agreement term.

• We may enter into future transactions where we acquire complementary businesses. Such acquisitions may require the use of our capital resources.

Off-Balance Sheet Arrangements

Indemnification Obligations. In the normal course of business, we indemnify other parties, including business partners, lessors and parties to other transactions with us. We have agreed to hold the other parties harmless against losses arising from a breach of representation or covenants, or out of intellectual property infringement or other claims made by third parties. These agreements may limit the time within which an indemnification claim can be made.

The asset purchase agreement between Loudeye and Loudeye Enterprise Communications, Inc., its wholly-owned subsidiary, on one hand, and Muze on the other, contains limited representations and warranties. Loudeye and Muze each agreed to indemnify the

other against breaches of these representations and warranties. In addition, Loudeye agreed to indemnify Muze against liabilities that were not specifically assumed by Muze in the transaction, and Muze agreed to indemnify Loudeye against liabilities it agreed to assume, as well as any liability arising out of ownership or operations of the assets it acquired post-closing of the transaction. The precise scope of representations, warranties, indemnification obligations and applicable liability limitations and exclusions is set out in detail in the asset purchase agreement which was filed as an exhibit to Loudeye’s current report on Form 8-K/A filed with the SEC on May 4, 2006.

In addition, we have entered into indemnification agreements with certain of our officers and directors and our amended and restated certificate of incorporation and amended bylaws contain similar indemnification obligations to our officers and directors. For all agreements entered into after December 31, 2002, the fair value of potential claims has not been recorded in our financial statements because they are not material.

Legal Proceedings

For a detailed discussion of material legal proceedings in which we are involved, please refer to the discussion in Note 7 to our unaudited condensed consolidated financial statements included in this quarterly report.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

We are exposed to the impact of interest rate changes and foreign currency exchange risk.

Interest Rate Risk. We typically invest our excess cash in high quality corporate and municipal debt instruments. As a result, our related investment portfolio is exposed to the impact of short-term changes in interest rates. Investments in both fixed rate and floating rate interest earning instruments carries a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted by a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. As a result, changes in interest rates may cause us to suffer losses in principal if forced to sell securities that have declined in market value or may cause our future investment income to fall short of expectations. Our investment portfolio is designated as available-for-sale, and accordingly is presented at fair value in the consolidated balance sheet.

We protect and preserve our invested funds with investment policies and procedures that limit default, market and reinvestment risk. We have not utilized derivative financial instruments in our investment portfolio.

During the three and six months ended June 30, 2006 and 2005, the impact of changes in interest rates on the fair market value of our cash and cash equivalents and marketable securities caused an insignificant change in our net income (loss). Based on our invested cash and cash equivalents, marketable securities and restricted cash balances of approximately $22.3 million at June 30, 2006, a one percent change in interest rates would cause a change in interest income of approximately $223,000 per year. Due to the investment grade level of our investments, we anticipate no material market risk exposure. We believe that the impact on the fair market value of our securities and on our operating results for 2006 from a hypothetical 1% increase or decrease in interest rates would not be material.

Foreign Currency Exchange Risk. Since June 2004, we have developed services in the United States and the U.K. for sale in North America and throughout Europe, and to a much lesser degree, in Australia, New Zealand, and South Africa. Following the sale of our U.S.-based operating assets in April of 2006, future development efforts will be concentrated in the U.K. and we will sell those services globally. In addition, we expect a substantial portion of our operating expenses to be incurred in the U.K. in future periods. As a result, our financial results could be affected by changes in foreign currency exchange rates in particular by any weakening of the U.S. dollar, or weak economic conditions in foreign markets. Our foreign subsidiaries’ expenses are incurred in their local currency, principally British Pounds (£) or Euros (€). As exchange rates vary, their expenses, when translated, may vary from expectations and adversely impact overall expected results.

As foreign currency exchange rates vary, the fluctuations in revenue and expenses may materially impact the financial statements upon consolidation. A weaker U.S. dollar would result in an increase to revenue and expenses upon consolidation, and a stronger U.S. dollar would result in a decrease to revenue and expenses upon consolidation.

During the three and six months ended June 30, 2006, we recorded a net foreign exchange transaction loss of approximately $60,000 and $79,000. During the three and six months ended June 30, 2005, we recorded a net foreign exchange transaction gain of

approximately $61,000 and $268,000. In addition, the results of operations of OD2 are exposed to foreign exchange rate fluctuations as the financial results of this subsidiary are translated from the local currency to U.S. dollars upon consolidation. Because of the significance of the operations of OD2 to our consolidated operations, as exchange rates vary, net sales and other operating results, when translated, may differ materially from our prior performance and our expectations. In addition, because of the significance of our overseas operations, we could also be significantly affected by weak economic conditions in foreign markets that could reduce demand for our services and further negatively impact the results of our operations in a material and adverse manner. As a result of these market risks, the price of our stock could decline significantly and rapidly.

Item 4. Controls and Procedures.

Disclosure Controls and Procedures

Our principal executive and principal financial officers, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of the end of the period covered by this quarterly report, have concluded that, based on such evaluation, our disclosure controls and procedures were effective as of June 30, 2006.

Changes in Disclosure Controls and Procedures

The sale of our U.S.-based operating assets in April 2006 resulted in the following changes in our disclosure controls and procedures, including our internal control over financial reporting, during the quarter ended June 30, 2006 that materially affected, or are reasonably likely to materially affect, our disclosure controls and procedures, including our internal control over financial reporting:

• Fifty Loudeye employees working in Loudeye’s Seattle, Washington offices accepted employment with Muze effective May 2, 2006. A number of these employees performed control activities related to the U.S. operations, such as control activities related to U.S. revenue or royalty transactions, which are no longer applicable after the transaction.

• Three U.S. employees who performed human resource related tasks and accounting tasks primarily related to payroll and accounts payable were among the employees who accepted employment with Muze.

• These three individuals’ tasks were reassigned to other existing personnel within the accounting department, and we believe that segregation of duties among the remaining finance and accounting staff in our U.S. offices was appropriately addressed.

PART II

OTHER INFORMATION

Item 1. Legal Proceedings.

See Note 7, Contingencies, to the unaudited condensed consolidated financial statements for information concerning legal proceedings.

Item 1A. Risk Factors.

As a result of the Loudeye-Muze transaction in April 2006, we updated the risk factor disclosure in our first quarter 2006 Form 10-Q to reflect changes in risks compared to those identified in our Form 10-K for the year ended December 31, 2005, resulting from the sale of our U.S.-based operating assets. Accordingly we have updated our risk factor disclosure from our first quarter 2006 Form 10-Q based on changes in our industry and management’s current view on the primary risks and uncertainties we face in our current business.

A summary of the primary, substantive changes in our risk factor disclosure from our quarterly report on Form 10-Q for the quarter ended March 31, 2006 follows:

• We added new risk factor disclosure concerning the primary risks and uncertainties we foresee from the announcement of, and risks of consummation surrounding, the proposed acquisition of Loudeye by Nokia.

• We updated our risk factor concerning risks we face due to customer concentration based on our current customer concentration metrics, including termination of one customer relationship that accounted for 14% of our revenue in the three and six months ended June 30, 2006;

• We updated our competition risk factor as a result of two of our customers recently terminating or not renewing their agreements with us in favor of relationships with Apple Computer’s iTunes services which dominate the digital music market;

• We updated our risk factor concerning our reliance on certain third parties and risks concerning catastrophic events to our third party data center provider out of which we operate all our servers for operation and delivery of our digital media store services, as we do not have a redundant, back-up facility in the event of a failure of our third party data center provider due to any catastrophic events or otherwise;

• We updated matters relating to our common stock in our risk factor disclosure to reflect the one-for-ten reverse stock split implemented on May 22, 2006;

• We updated various financial information appearing in our risk factor disclosure to June 30, 2006;

• We removed our prior risk factor disclosures concerning our reverse stock split and the potential delisting of our stock from the Nasdaq Capital Market as we regained compliance with the required $1 per share minimum bid price after our reverse stock split.

Loudeye operates in a dynamic and rapidly changing industry that involves numerous risks and uncertainties, both in our principal European markets and globally. The risks and uncertainties described below are not the only risks and uncertainties we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may impair our business operations in the future. If any of the following risks actually occur, our business, operating results and financial position could be harmed. Our risk factors are not necessarily listed in the order of importance or materiality and you should read all the risk factors in their entirety to appreciate the primary risks and uncertainties we face.

Risks Related to Our Business

We have a history of losses, negative cash flows on a quarterly and annual basis and we may experience greater losses from operations than we currently anticipate.

As of June 30, 2006, we had an accumulated deficit of $241.9 million. We have incurred net losses from inception, and we expect to continue to incur net losses in future periods. We had a working capital balance as of June 30, 2006 of $10.5 million. To achieve future profitability, we will need to generate additional revenue or reduce expenditures. We can give no assurance that we will achieve sufficient revenue or reduced expenditures to be profitable on either a quarterly or annual basis in the future. Even if we ultimately do achieve profitability, we may not be able to sustain or increase profitability on either a quarterly or annual basis.

If the Nokia merger is not consummated, we expect to require additional capital to fund ongoing operations which may not be available on acceptable terms or at all.

We have experienced negative cash flows from operations in substantially all quarters of our operations since inception, and we expect to continue to incur net losses in future periods. In addition, in connection with the proposed Loudeye-Nokia transaction, Loudeye expects to incur approximately $1.0 million in expenses regardless of whether the transaction is consummated. These factors, among others, raise substantial doubt about Loudeye’s ability to continue as a going concern if a sale transaction, such as the Loudeye-Nokia transaction, is not consummated.

If a sale transaction is not consummated, Loudeye expects to require additional capital to fund its ongoing operations. Any failure to consummate a sale transaction (which could result in Loudeye being required to pay a termination fee to Nokia under certain circumstances), combined with Loudeye’s history of declining market valuation and volatility in Loudeye’s stock price, could make it difficult for Loudeye to raise capital on favourable terms, or at all. Any financing Loudeye obtains may dilute or otherwise impair the ownership interest of its current stockholders. If Loudeye fails to generate positive cash flows or fails to obtain additional capital when required, Loudeye could modify, delay or abandon some or all of its business and expansion plans. Any inability to secure additional funding could force us to liquidate our business or otherwise seriously harm our business, results of operations and financial condition.

Our quarterly and annual financial results will continue to fluctuate making it difficult to forecast our operating results.

Our quarterly and annual operating results have fluctuated in the past and we expect our revenue and operating results may vary significantly from quarter to quarter and year to year due to a number of factors, many of which are beyond our control, including:

• Market acceptance of our services;

• Variability in demand for our digital media services;

• Competition from other companies entering our markets;

• Our customers’ commitment to adequately market and promote their digital media stores;

• Ability of our customers and us to procure necessary intellectual property rights for digital media content;

• Willingness of our customers to enter into longer-term volume or recurring revenue digital media services agreements and purchase orders in light of the economic and legal uncertainties related to their business models;

• Fluctuating wholesale costs for digital media content, especially from major record labels;

• Willingness of competitive consumer digital media services to maintain a consumer retail price below the wholesale cost of the content in an effort to gain market share or for other competitive reasons;

• Charges related to restructuring of our business, including personnel reductions and excess facilities; and

• Governmental regulations affecting use of the Internet, including regulations concerning intellectual property rights and security measures.

Our unproven business model and significant acquisitions and dispositions of businesses, in particular our acquisition of OD2 in June 2004 and sale of our U.S.-based operating assets in April 2006, further contribute to the difficulty of making meaningful quarterly comparisons and forecasts. Our current and future levels of operating expenses and capital expenditures are based largely on our growth plans and estimates of expected future revenue. These expenditure levels are, to a large extent, fixed in the short term and our sales cycle can be lengthy. Thus, we may not be able to adjust spending or generate new revenue sources in a timely manner to compensate for any shortfall in revenue, and any significant shortfall in revenue relative to planned expenditures could have an immediate adverse effect on our business and results of operations. If our operating results fall below the expectations of securities analysts and investors in some future periods, our stock price could decline significantly.

Failure to complete our proposed acquisition by Nokia could adversely affect our stock price and future business and operations.

On August 8, 2006, we announced that we had entered into a definitive agreement to be acquired by Nokia Inc. in an all-cash transaction. The proposed acquisition by Nokia is subject to the satisfaction of closing conditions, including:

	•		approval of our stockholders;

	•		the absence of a material adverse effect with respect to Loudeye. A material adverse effect with respect to Loudeye is defined in the merger agreement to specifically include, among other things, the loss of more than 30 employees, the loss (or reasonable likelihood of loss) of 30% of the value of our current customer base and our failure to have a minimum cash balance (including cash equivalents, marketable securities and restricted cash) of $10.0 million as of October 31, 2006 before certain transaction related expenses;

	•		receipt of third party consents to the continuation, modification, extension and/or termination of certain specified contracts, including the consent of the major record labels to continue to license content to Loudeye on substantially the same terms for a period of 12 months following the closing date of the merger;

	•		absence of any law or order prohibiting the closing; and

	•		expiration or termination of the Hart-Scott-Rodino waiting period and certain other regulatory approvals.

There are other circumstances described in the agreement and plan of merger that may also cause the acquisition to fail to be consummated. We cannot assure you that the conditions to the closing of the merger will be satisfied or that the acquisition will be successfully completed. In the event that the acquisition is not completed:

	•		we would not realize the potential benefits of the acquisition, including the potentially enhanced financial and competitive position of combining the Company with Nokia;

	•		the market price of shares of our common stock may decline to the extent that the current market price of those shares reflects an assumption that the acquisition by Nokia will be completed;

	•		management’s attention from our day-to-day business may be diverted and we may lose key employees;

	•		our relationships with current and prospective customers and partners may be disrupted as a result of uncertainties with regard to our business and prospects;

	•		to the extent the acquisition is not completed due to a lack of the requisite stockholder approval, we may face additional challenges in any attempt to engage in a similar transaction or any matter that may require our stockholder approval, including future acquisition proposals and material fund raising proposals; and

	•		we must pay significant costs related to the acquisition, such as investment advisory, legal, accounting and proxy solicitation fees and expenses and it is possible that we could trigger a requirement to pay Nokia a termination fee as set out in more detail in the agreement and plan of merger.

Any such events could adversely affect our stock price and harm our business and operating results.

Our business could suffer due to the announcement and/or consummation of the proposed acquisition by Nokia.

The announcement and/or consummation of the merger may have a negative impact on our ability to sell our services, attract and retain key management, technical, sales or other personnel, maintain and attract new customers and maintain strategic relationships

with third parties, including content licensors. For example, we may experience the deferral, cancellation or a decline in the size or rate of orders for our services or a deterioration in our customer relationships. In addition, pursuant to the agreement and plan of merger, Nokia has pre-approval rights over certain transactions we might otherwise undertake as a stand-alone entity. As a result, we may not be in a position to take certain actions while the proposed transaction is pending and prior to closing. Any such events could harm our operating results and financial condition. In addition, under the terms of the merger agreement, we have agreed to be bound by a number of restrictive operating covenants. As a result, we may require Nokia’s consent for certain types of commercial and other transactions. There can be no assurance Nokia will consent in a timely manner or at all, and absence of consent could materially and adversely affect our business and result of operations.

We have restructured our business to focus on our OD2 digital media store services operated out of Europe. Even after giving effect to this restructuring, we may not have sufficient cash to execute on our present operating plan.

We have taken steps to restructure our business, including through sale of our U.S.-based operating assets and discontinuing the operation of Overpeer Inc., with the related reduction in workforce and cost reductions from these actions. There can be no assurance that following these restructuring efforts we will have sufficient cash reserves to achieve the operating plan for our digital media store services until we achieve profitability.

We depend on a limited number of customers for a significant percentage of our digital media store services revenue. These customers may be able to terminate their service contracts with us on short notice, with or without cause. Accordingly, the loss of, or delay in payment from, one or a small number of customers could materially and adversely impact our revenue, results of operations and cash flows.

A small number of customers account for a significant percentage of our revenue, and may continue to do so for the foreseeable future. Microsoft Corporation’s MSN Music services accounted for approximately 28% and 32% of our revenue in the three and six months ended June 30, 2006, respectively. Wanadoo (now Orange) accounted for approximately 14% and KPN Telecom B.V. accounted for an additional approximately 16% and 15% of revenue in the three and six months ended June 30, 2006, respectively. Most of the services that we provided to Wanadoo were terminated in the second and third quarters of 2006. Microsoft operates its MSN Music service in North America within the MSN business unit. If Microsoft were to elect to bring the MSN Music services in Europe in-house to Microsoft, and thereby cancel our arrangement under which Loudeye operates the MSN Music services in Europe, the loss of MSN as a customer could materially and adversely impact our results of operations. Microsoft recently announced a new music initiative including an integrated music device, for launch in the North American market. Whether Microsoft will outsource certain services to third parties such as Loudeye in connection with any international expansion of its recently announced music initiatives is not yet clear. We have not been notified of any changes in the services we provide to Microsoft’s MSN Music in Europe and Microsoft recently renewed our services contract.

We believe that a small number of customers may continue to account for a significant percentage of certain of our revenue streams for the foreseeable future. Some of these customers, including Microsoft’s MSN, can terminate their service contracts with us on short notice, with or without cause, and in some cases, without penalty. Due to high revenue concentration among a limited number of customers, the cancellation, reduction or delay of a large customer order or our failure to complete or deliver a project on a timely basis could materially and adversely affect our business and results of operations. In addition, if any significant customer fails to pay amounts it owes us, or does not pay those amounts on time, our financial condition, revenue and operating results could suffer.

If we are unsuccessful in developing our mobile music store service offerings, we may fail to meet expectations of our business plan and our results of operations could be materially and adversely affected.

In the April 2006 sale of our U.S.-based operations, we transferred our two live mobile customer relationships, AT&T Wireless’ mMode Music Service and O2 Germany. While we recently announced that O2 UK will be our first mobile customer for our mobile music service, we do not currently have any mobile customers live on our OD2 services. We are developing mobile capabilities for our OD2 platform, but a launch date for the O2 UK service has not yet been announced. We expect to incur significant research and development expense in building out these mobile capabilities. We may experience delays in launching these services. If we are unsuccessful in signing up a sufficient number of mobile operators to our services, we may be unable to recoup our technology and infrastructure investments as rapidly as projected.

We believe future growth in our digital media store services depends significantly upon the growth of the mobile market for digital content services. There are a number of industry challenges that could impact the adoption rate of mobile platforms as a leading method of digital music purchase, including the rate of adoption of compatible mobile handsets, availability of high speed mobile data networks, adoption by mobile consumers of mobile data plans, any pricing differential (both wholesale and retail) between content purchased over-the-air to a mobile device and purchased by other means, development of content and digital rights management

standards and technologies acceptable to content licensors, and the impact on the economics of the mobile music business of certain issued patents. Significant growth in demand for our music store services is likely to also depend on significant growth in adoption of Windows compatible portable music devices. If we are unsuccessful in meeting the challenges and complexities of mobile music distribution or are unsuccessful in securing additional customers for our services, our results of operations could be harmed. Furthermore, our relationship with Nokia Corporation is an important element of our mobile music strategy. If we or Nokia were to terminate this relationship, our reputation and results of operations from mobile digital media store services could be harmed.

Individually or combined, any of these risks relating to our mobile service offerings could materially and adversely affect our business and results of operations.

Increases in wholesale rates for digital music content may negatively impact gross margins which could harm our business.

The costs associated with transactional revenue are highly dependent upon factors outside our control such as the wholesale rate charged for content by rights holders such as the major record labels and transactional processing fees such as credit card interchange fees. Some of the major record labels in certain territories have begun pricing their premium content at wholesale rates in excess of or very near to the prevailing retail price. Increased wholesale rates charged for popular digital music content may negatively impact our gross margins if retail rates do not increase, which in turn may harm our business. Furthermore, increased wholesale rates that do not translate into increased retail rates in the digital music market could limit the growth of new services.

Our efforts to institute variable pricing rates for digital content may result in loss of end consumers or a reduction in transactional revenue, which could harm our business, reputation and results of operations.

Costs of our digital media store services as a percentage of the revenue generated by those services are high, and our gross margin has suffered as a result. We have begun efforts to implement a variable price rate structure in some of our key markets and music stores in Europe designed to improve our margin associated with our transactional revenue. The immediate impact of these pricing changes is that the rates we charge for some digital content will be higher than the rates charged by our competitors, such as Apple Computer’s iTunes music service. A variable pricing strategy could slow our revenue and transaction growth rates, even as it improves our revenue margin. If we lose customers or experience a significant decrease in transactional revenue as a result of the higher prices we are charging, our business, reputation and results of operations could be harmed.

Our unlimited, monthly streaming music subscription service carries unique business risks.

We recently began providing an unlimited, monthly streaming music subscription service with certain of our music service partners in Europe. While monthly recurring subscriptions can provide higher gross margins than single track download transactions, content royalties for subscription services are fairly complex and pricing of these services to consumers requires that we make assumptions on expected consumer usage that may prove to be inaccurate in practice. For example, it is possible that our content license costs based on actual consumer usage of our unlimited streaming service could exceed the monthly subscription fees we charge.

Success of our digital music store services depends in part on our customers’ commitment to marketing the services we provide for them.

As a business-to-business services provider, we rely upon our customers to market the services we provide on their behalf. We have experienced difficulty in obtaining meaningful advertising and marketing commitments from some of our customers in the past, for reasons ranging from limited budgets to changing priorities. Many of our competitors—or their customers—have substantially more capital, longer operating histories, greater brand recognition, larger customer bases and significantly greater financial, technical and marketing resources than we do. If we do not succeed in securing increased backing from our customers for marketing and advertising campaigns, our business may not grow as fast as projected and our results of operations may be harmed.

Our music content licenses are generally for limited terms and limited territories. If we are unable to reach agreement with recorded music companies, especially with the four major recorded music companies, to renew existing licenses or to grant us expanded license rights, portions of our services could be interrupted and our business and results of operations could be harmed.

We have digital download content license arrangements through our OD2 services for content distribution in Europe, Australia, New Zealand and South Africa with all four major recorded music companies — EMI Music Marketing, Sony BMG Music Entertainment, UMG Recordings, and Warner Music Group. We are presently involved in discussions with Sony BMG Music Entertainment and EMI Music Marketing for renewal of our various agreements.

In the April 2006 sale of our U.S.-based operations we assigned our rights under our U.S. territorial digital download content licenses. In order to offer major label catalog in the U.S., we would need new licenses agreements from the major labels, which would likely involve significant upfront advance fees and could require us to establish a redundant content hosting facility in the U.S. to host the U.S.-label catalog. In each case our license grants are for finite terms and generally require the consent of the label to renew. Our licenses generally provide for the content owner to change wholesale content prices on advance notice and on renewal. In addition, these content licenses may be terminated by the recorded music companies at any time upon a specified period of advance notice or under circumstances such as our breach of these agreements.

Content owners may use renewal time periods as leverage for increasing wholesale content rates and making other changes such as demanding royalty advances. There can be no assurance we will be successful in renewing our content license agreements on commercially reasonable terms, if at all. If we are unsuccessful in securing renewals of these label license agreements before expiration of existing agreements, our digital media services with respect to any one or a number of the labels’ content could be interrupted, and our business and results of operations could be harmed.

In addition, we are seeking expanded license rights from the major record labels and other content owners for rights such as over-the-air deliveries and unlimited streaming. New license rights may be coupled with substantial up-front fees or advances and there can be no assurance we will be successful in negotiating these expanded content license agreements on commercially reasonable terms, if at all. If we are unsuccessful in obtaining additional license rights from the content owners for emerging distribution methods, such as over-the-air deliveries, our business and results of operations could be harmed.

Our music content licenses generally require prior approval for us to distribute content to our customers. If approval is delayed or withheld, portions of our services could be interrupted and our business and results of operations could be harmed.

Our content license agreements from the major recorded music companies generally require prior approval before we can distribute content to our customers. We have experienced delays and challenges in obtaining timely approval of certain new and existing customers. If approval is delayed or withheld, we may not be able to satisfy our contractual obligations to our customers. As a result, our reputation within the music industry could be harmed, our services could be interrupted and our business and results of operations could be harmed.

Recorded music companies or our customers may desire to have a direct license relationship. This trend may lengthen our sales cycle and may result in us reporting certain music store services revenue on a net basis rather than on a gross basis.

While we typically secure content licenses on behalf of our customers, there is a trend for certain of the major recorded music companies to want to provide licenses directly to new consumer music services, and some consumer music services, especially those of household brand names, are requiring direct licensing arrangements with the labels. If these trends continue our business may be significantly impacted including by extending our sales cycle and requiring us to assist our customers in obtaining licenses from content owners. This could change the way we report revenue because to the extent license rights do not pass through Loudeye and our customers are required or elect to license and pay content owners directly, our transactional revenue may decrease and gross margins as a percentage of revenue may increase if we report revenue on a net basis (net of third party content fees) rather than on a gross basis.

Our music content licenses could result in operational complexity that may divert resources or make our business more expensive to conduct.

The large number of licenses in Europe that we need to maintain in order to operate our music-related services creates operational difficulties in connection with tracking the rights that we have acquired and the complex structures under which we have royalty and reporting obligations. In addition, in some circumstances, we are responsible for obtaining licenses from professional rights organizations (holders of music publishing rights, and for tracking and remitting royalties to these rights organizations. There is uncertainty in certain geographies over what license rights, or corresponding rates, are required, as evidenced by a lawsuit brought by SPEDIDAM, a royalty collection agency in France, against OD2 and others alleging royalties due for digital content reproduction and distribution. The disparate types and shear quantity of licenses we must obtain and track adds to the complexity of the royalty structure in which we operate. The effort to obtain the necessary rights from such third parties is often significant, and could disrupt, delay, or prevent us from executing our business plans. Because of the large number of potential parties from which we must obtain licenses, we may never be able to obtain a sufficient number of licenses to allow us to provide services that will meet our customers’ expectations.

Our licensing agreements typically allow the third party to audit our royalty tracking and payment mechanisms to ensure that we are accurately reporting and paying royalties owed. If we are unable to accurately track amounts that we must pay to the numerous parties with whom we have licenses in connection with each delivery of digital music services or if we do not deliver the appropriate payment in a timely fashion, we may risk financial penalties and/or termination of licenses.

We make estimates of music publishing and performance rates; a determination of higher than estimated royalty rates could negatively impact our operating results.

We make estimates of our music publishing and certain other music royalties owed for our music services. Differences in judgments or estimates could result in material differences in the amount and timing of our music publishing and royalty expense for any period. Under applicable copyright laws, we may be required to pay licensing fees for digital sound recordings and compositions we make and deliver. Copyright law in the geographies where we conduct our business generally does not specify the rate and terms of the licenses, which are determined by voluntary negotiations among the parties or, for certain compulsory licenses where voluntary negotiations are unsuccessful, by arbitration or legislative action. There are certain geographies and agencies for which we have not yet completed negotiations with regard to the royalty rate to be applied to our current or historic sales of our digital music offerings. In addition, the arena of royalty negotiations is litigious, evidenced for example by a lawsuit brought by SPEDIDAM, a royalty collection society in France, against OD2 and others in March 2006. We may be required to pay a rate that is higher than we expect, or where we previously believed no royalty was due. Our estimates are based on contracted or statutory rates, when established, or management’s best estimates based on facts and circumstances regarding the specific music services and agreements in similar geographies or with similar agencies. While we base our estimates on historical experience, established industry practice and on various other assumptions that management believes to be reasonable under the circumstances, actual results may differ materially from these estimates under different assumptions or conditions.

We may be liable or alleged to be liable to third parties for music, software, and other content that we encode, distribute, archive or make available to our customers.

We may be liable or alleged to be liable to third parties, such as the recorded music companies, music publishers and performing rights organizations, for the content that we encode, distribute, archive or make available to our customers as samples, streams, downloads or otherwise:

• If the performance of our services is not properly licensed by the content owners or their representatives such as the recorded music companies, music publishers and performing rights organizations;

• If the content or the performance of our services violates third party copyright, trademark, or other intellectual property rights;

• If our customers violate the intellectual property rights of others by providing content to us or by having us perform digital media services;

• If the manner of delivery of content is alleged to violate terms of use of third party delivery systems, such as peer-to-peer networks; or

• If content that we encode or otherwise handle for our customers is deemed obscene, indecent, or defamatory.

Any alleged liability could harm our business by damaging our reputation, requiring us to incur legal costs in defense, exposing us to awards of damages and costs and diverting management’s attention which could have an adverse effect on our business, results of operations and financial condition.

In certain aspects of our business, we rely on well-established industry practice concerning rights matters. These industry practices could change over time or certain rights holders could become newly active in pursuing alleged licensing opportunities concerning certain areas of our business. Changing industry practices concerning intellectual property rights or any requirement that we litigate or settle questions of intellectual property rights as new matters arise could have a material adverse affect on our results of operations, business and prospects.

Because we host, stream and distribute digital content on or from our website and on other websites for customers and provide services related to digital media content, we face potential liability or alleged liability for negligence, infringement of copyright,

patent, or trademark rights, defamation, indecency and other claims based on the nature and content of the materials we host. Claims of this nature have been brought, and sometimes successfully prosecuted, against content distributors. Any imposition of liability that is not covered by insurance or is in excess of insurance coverage or any alleged liability could harm our business.

We cannot provide assurance that third parties will not claim infringement by us with respect to past, current, or future technologies or services. The music industry in particular has recently been the focus of infringement claims. We expect that participants in our markets will be increasingly subject to infringement claims as the number of services and competitors in our industry segment grows. In addition, these risks are difficult to quantify in light of the continuously evolving nature of laws and regulations governing the Internet. Any claim relating to proprietary rights, whether meritorious or not, could be time-consuming, result in costly litigation, cause service upgrade delays or require us to enter into royalty or licensing agreements, and we can not assure you that we will have adequate insurance coverage or that royalty or licensing agreements will be available on terms acceptable to us or at all.

Competition may decrease our market share, revenue, and gross margin.

We face intense and increasing competition in the global digital media services market. If we do not compete effectively or if we experience reduced market share from increased competition, our business will be harmed. In addition, the more successful we are in the emerging market for digital media services, the more competitors are likely to emerge.

To date, Apple Computer’s popular iPod line of portable digital media players and Apple’s iTunes music store service have dominated the market for digital audio and video content. The digital music stores we power compete with Apple’s iTunes services for end consumers. While we are implementing tiered-pricing for audio content across certain of our stores in response to increased wholesale rates for content, Apple is currently maintaining a flat retail rate for audio content of €0.99 in Europe. In addition, Apple Computer has not designed its popular iPod line of portable digital media players to function with our music services and users who purchase content through the digital music stores we power may not be able to play music they purchase there on their iPods.

Given Apple Computer’s dominance in the market for digital music content, our present and potential business-to-business customers may elect to partner with or otherwise promote Apple’s iTunes service to the exclusion of using our services to operate a competing digital store service. Two of our customers recently failed to renew or terminated our service arrangements in favor of relationships with Apple Computer’s iTunes services.

If we and the digital music services we power are unsuccessful in competing with Apple’s services or making our services compatible with Apple’s devices, our business and results of operations could be harmed.

For our business-to-business digital media store services, we compete against several companies providing similar levels of outsourced digital music services including Cable and Wireless plc., Digital World Services AG, Groove Mobile (formerly Chaoticom), Liquid Digital, Melodeo, Inc., MPO Group, Musicbrigade AB, MusicNet, Inc., MusicNow LLC, MusiWave, Muze Inc., PassAlong Networks, Siemens AG, Soundbuzz Pte Ltd., Widerthan Co., Ltd., as well as in-house efforts by our potential customers. Our customers face significant competition from “free” peer-to-peer services, such as MetaMachine Inc.’s eDonkey, Sharman Network Inc.’s KaZaA, StreamCast Networks, Inc.’s Morpheus, Grokster, Ltd. and a variety of other similar services that allow computer users to connect with each other and to copy many types of program files, including music and other media, from one another’s hard drives, all without securing licenses from content providers. The major record labels also have acquired or otherwise invested in digital music services and technologies that could compete with our services. Traditional and satellite radio broadcasters have developed online music and radio services which also compete with our solutions.

Many of our competitors have substantially more capital, longer operating histories, greater brand recognition, larger customer bases and significantly greater financial, technical and marketing resources than we do. These competitors may also engage in more extensive development of their technologies, adopt more aggressive pricing policies and establish more comprehensive marketing and advertising campaigns than we can. Our competitors may develop service offerings that we do not offer or that are more sophisticated or more cost effective than our own. For these and other reasons, our competitors’ services may achieve greater acceptance in the marketplace than our own, limiting our ability to gain or maintain market share and customer loyalty and to generate sufficient revenue to achieve a profitable level of operations. Our failure to adequately address any of the above factors could harm our business and results of operations.

If we do not continue to add customers for our services, our revenue and business will be harmed.

In order to achieve return on our investments in all of our service offerings, we must continue to add new customers, especially mobile service operators, while minimizing the rate of loss of existing customers. If our sales, marketing and promotional activities fail to add new customers at a rate significantly higher than our rate of loss, our business will suffer. In addition, if the costs of such sales, marketing and promotional activities increase in order to add new customers, our margins and operating results will suffer.

Our business will suffer if we do not anticipate and meet specific customer requirements or respond to technological change.

The market for digital media services is characterized by rapid technological change, frequent new service offerings, new device introductions, new digital rights management standards and changes in customer requirements, some of which are unique or on a customer by customer basis. We may be unable to respond quickly or effectively to these developments or requirements. Our future success will depend to a substantial degree on our ability to offer services that incorporate leading technology, address the increasingly sophisticated, varied or individual needs of our current and prospective customers and respond to technological advances and emerging industry standards and practices on a timely and cost-effective basis. You should be aware that:

• Our technology or systems may become obsolete upon the introduction of alternative technologies;

• We may not have sufficient resources to develop or acquire new technologies or the ability to introduce new services capable of competing with future technologies or service offerings; and

• The price of our services is likely to decline as rapidly as the cost of any competitive alternatives.

The development of new or enhanced services through technology development activities is a complex and uncertain process that requires the accurate anticipation of technological and market trends. We may experience design, manufacturing, marketing and other difficulties that could delay or prevent the development, introduction or marketing of new services and enhancements. In addition, our inability to effectively manage the transition from older services to newer services could cause disruptions to customer orders and harm our business and prospects.

Paid digital media content services face competition from “free” peer-to-peer services.

Our customers’ digital media store services face significant competition from “free” peer-to-peer services, such as MetaMachine Inc.’s eDonkey, Sharman Network Inc.’s KaZaA, StreamCast Networks, Inc.’s Morpheus, Grokster, Ltd., and a variety of other similar services that allow computer users to connect with each other and to copy many types of program files, including music and other media, from one another’s hard drives, all without securing licenses from content providers. While the U.S. Supreme Court’s July 2005 ruling in the peer-to-peer piracy case MGM Studios, Inc. v. Grokster, Ltd., may mean that peer-to-peer networks that do not filter for unlicensed content available over their networks could be liable for damages for copyright infringement, there can be no assurance that these services will ever be shut down. The U.S. Supreme Court’s decision may have little effect outside the U.S. and enforcement efforts against peer-to-peer networks have not effectively shut down all of these services to date. The ongoing presence of these “free” services substantially impairs the marketability of legitimate services, regardless of the ultimate resolution of their legal status.

Because digital recorded music formats, such as MP3, do not always contain mechanisms for tracking the source or ownership of digital recordings, users are able to download and distribute unauthorized or “pirated” copies of copyrighted recorded music over the Internet. This piracy is a significant concern to record companies and artists, and is a primary reason many record companies and artists are reluctant to digitally deliver their recorded music over the Internet. As long as pirated recordings are available, many consumers will choose free pirated recordings rather than paying for legitimate recordings. Continued illegal content downloading and sharing may slow growth in the market for paid digital music downloads, which could harm our results of operations.

Average selling prices of our services may decrease, which may negatively impact our gross margins.

The average selling prices of our services may be lower than expected as a result of competitive pricing pressures, promotional programs and customers who negotiate price reductions in exchange for longer term purchase commitments or otherwise. The pricing of services sold to our customers depends on the duration of the agreement, the specific requirements of the order, the sales and service support and other contractual agreements. We have experienced and expect to continue to experience pricing pressure and anticipate that the average selling prices and overall gross margins for our services may be impacted. We may not be successful in

developing and introducing on a timely basis new services with enhanced features or improved versions of our existing services that can be sold at higher gross margins.

Our music store services operating results fluctuate on a seasonal and quarterly basis.

Sales of recorded music tend to be seasonal in nature, with a disproportionate percentage of annual music purchases occurring in the fourth quarter. We expect transactional related revenue from our digital media stores services to be impacted by such seasonality long-term; however, increasing consumer adoption of digital media services should largely mitigate the impact of such seasonality in the near term. This sales seasonality may affect our operating results from quarter to quarter. Historically, our European operations tend to experience lower growth in the seasonally slow third calendar quarter each year. We cannot assure you that revenue from our music store services will continue at the level experienced in prior quarters or that they will be higher than such revenue for our other quarters. Seasonality in our business makes it more difficult to make meaningful period to period comparisons for our business.

A decline in current levels of consumer spending could reduce our music store service revenue.

Our music store services revenue is directly affected by the level of consumer spending. One of the primary factors that affect consumer spending is the general state of the local economies in which we operate. Lower levels of consumer spending in regions in which our customers operate music stores could have a negative impact on our business, financial condition or results of operations.

Efforts by record labels to shore up declining sales of CDs may impact sales of digital content.

Some record labels are refusing to license individual tracks of music for digital download in an effort to block so-called “unbundling” of album sales. Some new music releases are first being made available for purchase only on physical CDs, with a time delay before making the digital release available for sale. These efforts are apparently designed to shore up declining sales of CDs. These efforts could slow consumer adoption of digital media consumption alternatives, which could harm our results of operations.

Our success is dependent on the performance of our CEO and the cooperation, performance and retention of our executive officers and key employees.

Our business and operations are substantially dependent on the performance of our CEO, as well as the performance of our other executives. Our operations are geographically dispersed, with corporate offices in Seattle and our principal European office located in Bristol, U.K. We do not maintain “key person” life insurance on any of our executive officers. The loss of one or several key employees could seriously harm our business. Any reorganization or reduction in the size of our employee base could harm our ability to attract and retain other valuable employees critical to the success of our business.

We cannot be certain that we will be able to protect our intellectual property.

Our intellectual property is important to our business, and we seek to protect our intellectual property through copyrights, trademarks, patents, trade secrets, confidentiality provisions in our customer, supplier and strategic relationship agreements, nondisclosure agreements with third parties, and invention assignment agreements with our employees and contractors. There can be no assurance that measures we take to protect our intellectual property will be successful or that third parties will not develop alternative solutions that do not infringe upon our intellectual property.

We may be subject to intellectual property infringement claims which are costly to defend and could limit our ability to use certain technologies in the future.

We could be subject to intellectual property infringement claims by others. For example, in September 2004, Loudeye and Overpeer were named in a patent infringement lawsuit brought by Altnet, Inc., and others involving two patents that appear to cover file identifiers for use in accessing, identifying and/or sharing files over peer-to-peer networks. We have incurred material legal fees defending ourselves in this and other litigation matters.

In addition, we rely upon third party technologies in our service offerings. When we license third party technologies, we generally are indemnified by the third party service provider against liabilities arising from infringement of other proprietary rights, however there can be no assurance that these indemnification rights will be sufficient or that the third party will have sufficient resources to fulfill its indemnity obligations.

Several public companies such as Napster, Inc. and Realnetworks, Inc. that offer digital music distribution services in the U.S. over the Internet, especially through subscription services, have disclosed that lawsuits have been filed against them by several companies alleging that their music distribution services may infringe patents owned by those companies. Loudeye may be subject to similar claims, demands or litigation in the future, if Loudeye offers subscription services on behalf of its customers in the U.S.

Potential customers may be deterred from distributing content over the Internet for fear of infringement claims. The music industry in particular has recently been the focus of heightened concern with respect to copyright infringement and other misappropriation claims, and the outcome of developing legal standards in that industry is expected to affect music, video and other content being distributed over the Internet. If, as a result, potential customers forego distributing traditional media content over the Internet, demand for our digital media services could be reduced which would harm our business. The music industry in the U.S. is generally regarded as extremely litigious in nature compared to other industries and we could become engaged in litigation with others in the music industry. Claims against us, and any resultant litigation, should they occur in regard to any of our digital media services, could subject us to significant liability for damages including treble damages for willful infringement. In addition, even if we prevail, litigation could be time-consuming and expensive to defend and could result in the diversion of our time and attention. Any claims from third parties may also result in limitations on our ability to use the intellectual property subject to these claims. Further, we offer our digital media services to customers in foreign countries that may offer less protection for our intellectual property than the United States. Our failure to protect against misappropriation of our intellectual property, or claims that we are infringing the intellectual property of third parties could have a negative effect on our business, revenue, financial condition and results of operations.

We must enhance our existing digital media services and develop and introduce new services in a timely manner to remain competitive in that segment. Any failure to do so in a timely manner will cause our results of operations to suffer.

The market for digital media services is characterized by rapidly changing technologies and market offerings. This market characteristic is heightened by the emerging nature of the Internet and mobile networks and the continuing trend of companies from many industries to offer Internet and mobile applications and services. The widespread adoption of the new Internet, mobile, networking, streaming media, or telecommunications technologies or other technological changes could require us to incur substantial expenditures to modify or adapt our operating practices or infrastructure. Our future success will depend in large part upon our ability to:

• Identify and respond to emerging technological trends in the market;

• Enhance our services by adding innovative features that differentiate our digital media services from those of our competitors;

• Develop, acquire and license leading technologies;

• Bring digital media services to market and scale our business and operations on a timely basis at competitive prices; and

• Respond effectively to new technological changes or new service announcements by others.

We will not be competitive unless we continually introduce new services or enhancements to existing services that meet evolving industry standards and customer needs. We must bring new services and enhancements to market in a timely manner to satisfy needs of existing and potential customers. In the future, we may not be able to address effectively the compatibility and interoperability issues that arise as a result of technological changes and evolving industry standards. The technical innovations required for us to remain competitive are inherently complex, require long development schedules and are dependent in some cases on sole source suppliers. We will be required to continue to invest in research and development in order to attempt to maintain and enhance our existing technologies and services, but we may not have the funds available to do so. Even if we have sufficient funds, these investments may not serve the needs of customers or be compatible with changing technological requirements or standards. Most development expenses must be incurred before the technical feasibility or commercial viability of new or enhanced services and applications can be ascertained. Revenue from future services or enhancements to services may not be sufficient to recover the associated development costs.

Delays in technology enhancements, such as completion of mobile services for our OD2 platform, could result in customer terminations which could cause our results of operations to suffer.

We may experience delays in completing enhancements to our existing services required for current or potential customers. We continue developing mobile service offerings to enhance our web based service offerings from the OD2 platform, but completion of these development efforts could be delayed. Any delays in our development efforts could impact anticipated launch dates for customer services. In addition to customer satisfaction issues caused by delays, we may incur additional expenses associated with efforts directed at speeding delivery of technology enhancements and our customers may ultimately terminate their service agreements with us, either or both of which could negatively impact our results of operations.

The success of our digital media store services depends, in part, on interoperability with our customer’s music playback hardware.

In order for our digital music services to continue to grow we must design our services to interoperate effectively with a variety of hardware products, including personal computers, mobile handsets, portable digital media players, home stereos, and car stereos. We depend on significant cooperation with manufacturers of these products and with software manufacturers that create the operating systems for such hardware devices to achieve our business and design objectives. To date, Apple Computer has not designed its popular iPod line of portable digital media players to function with our music services and users who purchase content through the digital music stores we power may not be able to play music they purchase there on their iPods. If we cannot successfully design our service to interoperate with the music playback devices that our customers own, through relationships with manufacturers or otherwise, our business will be harmed.

The technology underlying our services is complex and may contain unknown defects that could harm our reputation, result in liability or decrease market acceptance of our services.

The technology underlying our digital media services is complex and includes software that is internally developed and software licensed from third parties, including open source software. These software products may contain errors or defects, particularly when first introduced or when new versions or enhancements are released. We may not discover software defects that affect our current or new services or enhancements until after they are sold or commercially launched. Furthermore, because our digital media services are designed to work in conjunction with various platforms and applications, we are susceptible to errors or defects in third-party applications that can result in a lower quality service for our customers. Because our customers depend on us for digital media management, any interruptions could:

	•		Damage our reputation;

	•		Cause our customers to initiate liability suits against us;

	•		Increase our service development resources;

	•		Cause us to lose revenue; and

	•		Delay market acceptance of our digital media services.

We do not have product liability insurance, and our errors and omissions coverage is not likely to be sufficient to cover our complete liability exposure.

More consumers are utilizing non-PC devices to access digital content, and we may not be successful in developing versions of our services that will gain widespread adoption by users of such devices.

In the coming years, the number of individuals who access digital content through devices other than a personal computer, such as cellular phones and other mobile communications devices, portable digital media players, personal digital assistants, television set-top devices, game consoles and Internet appliances, may increase dramatically. Manufacturers of these types of products are increasingly investing in media-related applications, but these devices are in an early stage of development and business models are new and unproven. If we are unable to offer our services on these alternative non-PC devices, we may fail to capture a sufficient share of an increasingly important portion of the market for digital media services or our costs may increase significantly.

In addition, growth in demand for our music store services is likely to depend on growth in adoption of Windows Media Player compatible portable music devices. For example, our digital music store service is not compatible with the iPod music player, the leader in the digital audio player market.

We provide guarantees to some of our customers under service level agreements and could be liable for service credits for failure to meet specified performance metrics.

In connection with certain of our digital media store services, we provide our customers with guaranteed service performance levels. If we fail to meet these guaranteed performance metrics, we could be liable for monetary credits or refunds of service fees previously paid or owed to us or the customers could have early contract termination rights. Any failure could also result in termination of service contracts and could damage our reputation and ability to attract or retain customers.

Our network and digital media store service operations are subject to security, stability, disaster and third party facility risks that could harm our business and reputation and expose us to litigation or liability.

Online commerce and communications depend on the ability to transmit confidential information and licensed intellectual property securely over private and public networks in. Any compromise of our ability to transmit such information and data securely or reliably, and any costs associated with preventing or eliminating such problems, could harm our business.

Our customer contracts and business reputation depend on our ability to provide continuous availability of our digital media store services, while avoiding system outages and loss of data.

Our systems and operations are susceptible to, and could be damaged or interrupted by a number of security, stability, disaster and third party facility risks, including: outages caused by fire, flood, power loss, telecommunications failure, Internet breakdown, earthquake and similar events. Our systems are also subject to human error, security breaches, power losses, computer viruses, break-ins, “denial of service” attacks, sabotage, intentional acts of vandalism and tampering designed to disrupt our computer systems, websites and network communications. A sudden and significant increase in traffic on our websites could strain the capacity of the software, hardware and telecommunications systems that we deploy or use. This could lead to slower response times or system failures.

Substantially all of our software and hardware systems supporting our digital media store operations for our customers are located and maintained in a single hosting facility with Telstra in the United Kingdom. We do not maintain a disaster recovery or other full back-up arrangement outside this one facility. As a result, our business relies on no interruptions in service from our hosting facility provider. Any meaningful outages to our operations at this facility caused by fire, flood, power loss, telecommunications failure, Internet breakdown, earthquake or any other event would have a material adverse impact on our business and operations.

Our operations also depend on receipt of timely content and data feeds from our content providers, and any failure or delay in the transmission or receipt of such feeds could disrupt our operations. We also depend on web browsers, ISPs and online service providers to provide access over the Internet to our service offerings. Many of these providers have experienced significant outages or interruptions in the past, and could experience outages, delays and other difficulties due to system failures unrelated to our systems. These types of interruptions could continue or increase in the future.

The occurrence of any of these or similar events could damage our business, hurt our ability to distribute services and collect revenue, threaten the proprietary or confidential nature of our technology, harm our reputation, and expose us to litigation or liability. We may be required to expend significant capital or other resources to build, operate and maintain redundant systems, protect against the threat of security breaches, hacker attacks or system malfunctions or to alleviate problems caused by such breaches, attacks or failures.

Our services are complex and are deployed in complex environments and therefore may have errors or defects that could seriously harm our business.

Our services are highly complex and are designed to be deployed in and across numerous large complex networks. Our digital distribution activities are managed by sophisticated software and computer systems. From time to time, we have needed to correct errors and defects. In addition, we must continually develop and update these systems over time as our business needs grow and change and these systems may not adequately reflect the current needs of our business. We may encounter delays in developing these systems, and the systems may contain undetected errors and defects that could cause system failures. Any system error or failure that causes interruption in availability of services or content or an increase in response time could result in a loss of potential or existing customers, users, advertisers or content providers. If we suffer sustained or repeated interruptions, our services and websites could be less attractive to such entities or individuals and our business could be harmed.

We are dependent on third parties to supply key music content. Delays or failures of these companies to provide content as requested could harm our business.

We rely on third parties to supply digital music content feeds, in particular for major label content. These third parties may experience delays or may cease providing services altogether. Any prolonged interruption in content availability to our OD2 services could harm our business.

Our transmission capacity is not entirely in our control, as we rely in part on transmission capacity provided by third parties. Insufficient transmission capacity could result in delays or interruptions in our services and loss of revenue.

Significant portions of our business are dependent on providing customers with efficient and reliable services to enable customers to broadcast content to large audiences on a live or on-demand basis. Our operations are dependent in part upon transmission capacity provided by third-party telecommunications network providers. Any failure of network providers to provide the capacity we require may result in a reduction in, or interruption of, service to our customers. If we do not have access to third-party transmission capacity, we could lose customers and if we are unable to obtain such capacity on terms commercially acceptable to us, our business and operating results could suffer.

We may seek to enforce indemnification obligations against third parties and there can be no assurance such third parties would have sufficient resources to satisfy any claims for indemnification.

Our agreements with customers typically include indemnification obligations relating to breaches of representations or warranties or unauthorized use of digital media content that we distribute on behalf of such customers. Also, the asset purchase agreement relating to our April 2006 sale of our U.S.-based operating assets includes indemnification obligations of the acquiring party against liabilities it agreed to assume, as well as any liability arising out of ownership or operations of the assets it acquired post-closing of the transaction. There can be no assurance that these third parties will have sufficient resources to satisfy their indemnification obligations to us by defending and holding us harmless against or satisfy any eventual judgment.

Our operations could be harmed by factors including political instability, natural disasters, fluctuations in currency exchange rates and changes in regulations that govern international transactions.

Currently, our revenue-generating operations are based outside the U.S., including in the U.K., France, Germany and Italy. The risks inherent in international trade may reduce our international sales and harm our business and the businesses of our customers and our suppliers. These risks include:

• Foreign currency exchange rate fluctuations;

• Changes in tariff regulations;

• Political instability, war, terrorism and other political risks;

• Establishing and maintaining relationships with local distributors and dealers;

• Lengthy accounts receivable payment cycles;

• Import and export licensing requirements;

• Compliance with a variety of foreign laws and regulations, including unexpected changes in taxation and regulatory requirements;

• Greater difficulty in safeguarding intellectual property than in the U.S.;

• Challenges caused by distance, language and cultural differences;

• Potentially adverse tax consequences;

• Difficulty in staffing and managing geographically diverse operations; and

• Higher costs associated with doing business internationally.

These and other risks may preclude or curtail international sales or increase the relative price of our services compared to those of local competitors in other countries, reducing the demand for our services.

We are subject to exchange rate risk in connection with our international operations.

We currently maintain substantially all our cash reserves denominated in U.S. dollars, however substantially all our expenses are denominated in British pounds. A weaker U.S. dollar would result in an increase to revenue and expenses upon consolidation, and a stronger U.S. dollar would result in a decrease to revenue and expenses upon consolidation. We may in the future engage in hedging activities and may as a result experience gains or losses from these hedging activities. As foreign currency exchange rates vary, the fluctuations in revenue and expenses may materially impact the financial statements upon consolidation.

The results of operations of OD2 are exposed to foreign exchange rate fluctuations as the financial results of this subsidiary are translated from the local currency to U.S. dollars upon consolidation. Because of the significance of the operations of OD2 to our consolidated operations, as exchange rates vary, net sales and other operating results, when translated, may differ materially from our prior performance and our expectations. In addition, because of the significance of our overseas operations, we could also be significantly affected by weak economic conditions in foreign markets that could reduce demand for our services and further negatively impact results of operations in a material and adverse manner. As a result of these market risks, the price of our stock could decline significantly and rapidly.

We may need to make additional future acquisitions to remain competitive. The process of identifying, acquiring and integrating these future acquisitions may have a material adverse effect on our operating results.

Integrating any potential future acquisitions could cause significant diversions of management time and company resources. Our ability to integrate operations of acquired companies will depend, in part, on our ability to overcome or address:

• The difficulties of assimilating the operations and personnel of the acquired companies and realizing anticipated operational and cost efficiencies without disruption to the ongoing business;

• Impairment of relationships with employees, affiliates, advertisers and content providers of our business and acquired businesses;

• The loss of key management and the difficulties in retaining key management or employees of acquired companies;

• Operational difficulties, including the need to attract and retain qualified personnel and the need to attract customers;

• The cost and challenges of integrating IT and financial systems;

• Diversion of management’s attention from other business concerns and the potential disruption of our ongoing business;

• The need to incorporate successfully the acquired or shared technology or content and rights into our services, including maintaining customer satisfaction while migrating to a single development platform; and

• The difficulties of maintaining uniform standards, systems, controls, procedures and policies.

In addition, completing acquisitions could require use of a significant amount of our available cash. Furthermore, financing for future acquisitions may not be available on favorable terms, if at all. If we identify an appropriate acquisition candidate for any of our businesses, we may not be able to negotiate the terms of the acquisition successfully, finance the acquisition or integrate the acquired business, technologies or employees into our existing business and operations. Future acquisitions may not be well-received by the investment community, which may cause our stock price to fall. We cannot ensure that we will be able to identify or complete any acquisition in the future.

Risks Related to Our Industry

We must provide digital rights management solutions that are acceptable to both content providers and consumers.

We must provide digital rights management solutions and other security mechanisms in order to address concerns of content providers and artists, and we cannot be certain that we can develop, license or acquire such solutions or that content licensors or consumers will accept them. Consumers may be unwilling to accept the use of digital rights management technologies that limit their use of content, especially with large amounts of free content readily available. No assurance can be given that such solutions will be available to us upon reasonable terms, if at all. If we are unable to acquire these solutions on reasonable or any terms, or if customers are unwilling to accept these solutions, our business and prospects could be harmed.

Our industry is experiencing consolidation that may intensify competition.

The Internet and digital media services industries are undergoing substantial change that has resulted in increasing consolidation and a proliferation of strategic transactions. Many companies in these industries have failed or are being acquired by larger entities. As a result, we are increasingly competing with larger competitors which have substantially greater resources than we do. We expect this consolidation and strategic partnering to continue. Acquisitions or strategic relationships could harm us in a number of ways. For example:

• Competitors could acquire or enter into relationships with companies with which we have strategic relationships and discontinue our relationship, resulting in the loss of distribution opportunities for our services or the loss of certain enhancements or value-added features to our services;

• Competitors could obtain exclusive access to desirable multimedia content and prevent that content from being available in certain formats or markets, thus impairing our content selection and our ability to attract customers;

• Suppliers of important or emerging technologies could be acquired by a competitor or other company which could prevent us from being able to utilize such technologies in our offerings, and disadvantage our offerings relative to those of competitors;

• A competitor could be acquired by a party with significant resources and experience that could increase the ability of the competitor to compete with our services; and

• Other companies with related interests could combine to form new, formidable competition, which could preclude us from obtaining access to certain markets or content, or which could significantly change the market for our services.

Any of these results could put us at a competitive disadvantage that could cause us to lose customers, revenue and market share. They could also force us to expend greater resources to meet the competitive threat, which could also harm our operating results.

Our business could be harmed by a lack of availability of popular content, or enough content.

Our digital media services business is affected by the release of “hit” music titles, which can create cyclical trends in sales distinctive to the music industry. Consumers also are drawn to music services with large numbers of tracks available. Some digital music services advertise significantly more content available for purchase than is available through our music store services. It is not possible to determine the timing of these cycles or the future availability of hit titles. We depend upon the music content providers to continue to produce hits. To the extent that new hits are not available, or not available at prices attractive to consumers, our sales and margins may be adversely affected. In addition, to the extent other music services obtain exclusive rights to certain popular content and we are unable to offer such content on our services, our revenue or operating results may be adversely impacted.

The growth of our business depends on the increased use of the Internet and wireless networks for communications, electronic commerce and advertising.

The growth of our business depends on the continued growth of the Internet and wireless networks as a medium for media consumption, communications, electronic commerce and advertising. Our business will be harmed if such usage does not continue to grow, particularly as a source of media information and entertainment and as a vehicle for commerce. Our success also depends on the efforts of third parties to develop the infrastructure and complementary services necessary to maintain and expand the Internet and wireless networks as viable commercial channels, and identifying additional viable revenue models for digital media-based

businesses. We believe that other Internet-related issues, such as security, privacy, reliability, cost, speed, ease of use and access, quality of service, and necessary increases in bandwidth availability and access on an affordable basis, remain largely unresolved and may affect the amount and type of business that is conducted over such mediums, and may adversely affect our ability to sell our services and ultimately impact our business results and prospects.

If usage of the Internet and wireless networks grows, the respective infrastructure may not be able to support the demands placed on them by such growth, specifically the demands of delivering high-quality media content. As a result, the performance and reliability of such mediums may decline. In addition, the Internet and wireless networks have experienced interruptions in service as a result of outages, system attacks and other delays occurring throughout the relevant network infrastructure. If these outages, attacks or delays occur frequently or on a broad scale in the future, overall usage, as well as the usage of our services could grow more slowly or decline.

If broadband technologies do not become widely available or widely adopted, our online media distribution services may not achieve broad market acceptance, and our business may be harmed.

We believe that increased Internet use and especially the increased use of media over the Internet may depend on the availability of greater bandwidth or data transmission speeds (also known as broadband transmission). If broadband technologies do not become widely available or widely adopted, our online media distribution services may not achieve broad market acceptance and our business and prospects could be harmed. Congestion over the Internet and data loss may interrupt audio and video streams, resulting in unsatisfying user experiences. The success of digital media distribution over the Internet depends on the continued rollout of broadband access to consumers on an affordable basis. To date, we believe that broadband technologies have been adopted at a slower rate than expected, which we believe has delayed broader-based adoption of the Internet as a media distribution medium. Our business and prospects may be harmed if the rate of adoption does not increase.

Government regulation could adversely affect our business.

We are not currently subject to direct regulation by any governmental agency, other than laws and regulations generally applicable to businesses. Export and import controls, including controls on the use of encryption technologies, may apply to our services. In general, our e-commerce services are also regulated by laws and regulations covering copyright, privacy and data protection and consumer rights. Changes in these laws and regulations could result in uncertainty and potentially adversely affect our business.

We may be subject to market risk and legal liability in connection with the data collection capabilities of our services.

Many of our services leverage interactive applications that by their very nature require communication between a client and server to operate. To provide better consumer experiences and to operate effectively, our services send information to servers. Many of the services we provide also require that a user provide certain information to us. We post an extensive privacy policy concerning the collection, use and disclosure of user data involved in interactions between our client and server products. Any failure by us to comply with our posted privacy policy and existing or new legislation regarding privacy issues could impact the market for our services, subject us to litigation and harm our business.

Risks Related to Our Common Stock

Our future capital-raising activities could involve the issuance of equity securities, which would dilute your investment and could result in a decline in the trading price of our common stock.

We may sell securities in the public or private equity markets if and when conditions are favorable, even if we do not have an immediate need for additional capital at that time. Raising funds through the issuance of equity securities will dilute the ownership of our existing stockholders. Furthermore, we may enter into financing transactions at prices that represent a substantial discount to the market price of our common stock. A negative reaction by investors and securities analysts to any discounted sale of our equity securities could result in a decline in the trading price of our common stock.

Some provisions of our amended and restated certificate of incorporation and amended bylaws and of Delaware law may deter takeover attempts, which may limit the opportunity of our stockholders to sell their shares at a favorable price.

Some of the provisions of our amended and restated certificate of incorporation and amended bylaws could make it more difficult for a third party to acquire us, even if doing so might be beneficial to our stockholders by providing them with the opportunity to sell their shares possibly at a premium over the then market price.

For example, our board of directors is divided into three classes. At each annual meeting of stockholders, the terms of approximately one-third of the directors will expire, and new directors will be elected to serve for three years. It will take at least two annual meetings to effect a change in control of our board of directors because a majority of the directors cannot be elected at a single meeting, which may discourage hostile takeover bids.

In addition, our amended and restated certificate of incorporation authorizes the board of directors to issue up to 5,000,000 shares of preferred stock. The preferred stock may be issued in one or more series, the terms of which may be determined at the time of issuance by our board of directors without further action by the stockholders. These terms may include voting rights including the right to vote as a series on particular matters, preferences as to dividends and liquidation, conversion rights, redemption rights and sinking fund provisions. No shares of preferred stock are currently outstanding and we have no present plans for the issuance of any preferred stock. The issuance of any preferred stock, however, could diminish the rights of holders of our common stock, and therefore could reduce the value of our common stock. In addition, specific rights granted to future holders of preferred stock could be used to restrict our ability to merge with, or sell assets to, a third party. The ability of our board of directors to issue preferred stock could make it more difficult, delay, discourage, prevent or make it more costly to acquire or effect a change in control, thereby preserving the current stockholders’ control.

Our amended bylaws contain provisions that require stockholders to act only at a duly-called meeting and make it difficult for any person other than management to introduce business at a duly-called meeting by requiring such other person to follow certain notice procedures.

Finally, we are also subject to Section 203 of the Delaware General Corporation Law which, subject to certain exceptions, prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years following the date that the stockholder became an interested stockholder. The preceding provisions of our certificate of incorporation and bylaws, as well as Section 203 of the Delaware General Corporation Law, could discourage potential acquisition proposals, delay or prevent a change of control and prevent changes in our management, even if such things would be in the best interests of our stockholders.

Securities analysts may not continue to cover our common stock or may issue negative reports, and this may have a negative impact on our common stock’s market price.

There is no guarantee that securities analysts will continue to cover our common stock. If securities analysts do not cover our common stock, the lack of research coverage may adversely affect our common stock’s market price. The trading market for our common stock relies in part on the research and reports that industry or financial analysts publish about our business or us. If one or more of the analysts who cover us downgrades our stock, our stock price may decline rapidly. If one or more of these analysts ceases coverage of our company, we could lose visibility in the market, which in turn could cause our stock price to decline. In addition, recently adopted rules mandated by the Sarbanes-Oxley Act of 2002, and a global settlement reached between the SEC, other regulatory analysts and a number of investment banks in April 2003, may lead to a number of fundamental changes in how analysts are reviewed and compensated. In particular, many investment banking firms will now be required to contract with independent financial analysts for their stock research. It may be difficult for companies with smaller market capitalizations, such as our company, to attract independent financial analysts that will cover our common stock, which could have a negative effect on our market price.

Market fluctuations and volatility could cause the trading price of our common stock to decline and limit our ability to raise capital.

Our common stock trades on the Nasdaq Capital Market. Our common stock has experienced extreme price and volume fluctuations to date. To illustrate, since January 1, 2003, the highest bid price for our common stock was $34.80, while the lowest bid price was $1.56. In the future, the market price and trading volume of our common stock could be subject to significant fluctuations due to general market conditions and in response to quarter-to-quarter variations in:

	•		Our anticipated or actual operating results;

	•		Developments concerning our technologies and market offerings;

	•		Technological innovations or setbacks by us or our competitors;

	•		Conditions in the digital media and Internet markets;

	•		Announcements of merger or acquisition transactions; and

	•		Other events or factors and general economic and market conditions.

In the past, securities class action litigation has been brought against companies that experienced volatility in the trading price of their securities. Market fluctuations in the price of our common stock could also adversely affect our ability to sell equity securities at a price we deem appropriate.

Future sales of our common stock, or the perception that future sales could occur, may adversely affect our common stock price.

If a large number of shares of our common stock are sold in the open market, or if there is a perception that such sales could occur, the trading price of our common stock could decline materially. In addition, the sale of these shares, or possibility of such sale, could impair our ability to raise capital through the sale of additional shares of common stock.

We currently have effective registration statements covering the resale of 2,547,715 shares of our common stock and shares of common stock issuable upon exercise of outstanding options and warrants.

Sales of shares pursuant to exercisable options and warrants could also lead to subsequent sales of the shares in the public market. These sales, together with sales of shares by the selling stockholders, could depress the market price of our stock by creating an excess in supply of shares for sale. Availability of these shares for sale in the public market could also impair our ability to raise capital by selling equity securities.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

None.

Item 3. Defaults Upon Senior Securities.

None.

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

Loudeye Corp. held its annual meeting of stockholders on June 28, 2006. Of the 13,259138 pre-split shares of Loudeye common stock outstanding as of the May 1, 2006 record date for the annual meeting, 11,027,690 pre-split shares, or 83.17%, were represented in person or by proxy at the annual meeting.

At the annual meeting, Michael A. Brochu and Frank A. Varasano were each elected to serve as Class III members of Loudeye’s board of directors, each to serve until the annual meeting of stockholders to be held in 2009 or until their successors have been elected and qualified, or until the earlier of their death, resignation or removal. Each of the Class III incumbent directors who stood for reelection was elected with the following voting results:

• Michael A. Brochu, 10,738,728 pre-split shares voted for, representing 97.38% of the shares voted, and 288,962 pre-split votes withheld, representing 2.62% of the shares voted.

• Frank A. Varasano, 10,755,065 pre-split shares voted for, representing 97.53% of the shares voted, and 272,625 pre-split votes withheld, representing 2.47% of the shares voted.

No other matters were submitted to a vote of the stockholders at the annual meeting.


Delaware		91-1908833
(State or other jurisdiction of		(I.R.S. Employer Identification No.)
incorporation or organization)


Common		13,251,531
(Class)		(Outstanding at August 4, 2006)


	June 30,			December 31,
	2006			2005
	(in thousands, except per
	share amounts)
ASSETS
Cash and cash equivalents	$	22,275		$	6,932
Marketable securities		—			2,113
Accounts receivable, net of allowances of $179 and $142 respectively		2,565			3,109
Prepaid expenses and other current assets		2,079			1,048
Restricted cash		234			1,810
Current assets of discontinued operations		659			2,192

Total current assets		27,812			17,204
Property and equipment, net		1,254			1,442
Goodwill		46,667			44,213
Intangible assets, net		2,903			3,116
Other assets, net		18			189
Assets of discontinued operations		301			3,244

Total assets	$	78,955		$	69,408

LIABILITIES AND STOCKHOLDERS’ EQUITY
Accounts payable	$	4,415		$	3,201
Accrued compensation and benefits		655			642
Accrued and other liabilities		6,072			6,033
Deposits and deferred revenue		4,418			4,842
Current portion of long-term debt		—			1,000
Current liabilities of discontinued operations		1,761			3,381

Total current liabilities		17,321			19,099
Deposits and deferred revenue, net of current portion		174			350
Common stock payable related to acquisition		321			321

Total liabilities		17,816			19,770
Commitments and contingencies
STOCKHOLDERS’ EQUITY
Preferred stock, $0.001 par value, 5,000 shares authorized, none outstanding		—			—
Common stock, warrants and additional paid-in capital; for common stock $0.001 par value, 25,000 shares authorized; 13,255 shares issued and outstanding in 2006, 11,537 issued and outstanding in 2005		303,574			296,020
Deferred stock compensation		—			(888	)
Accumulated deficit		(241,931	)		(242,645	)
Accumulated other comprehensive loss		(504	)		(2,849	)

Total stockholders’ equity		61,139			49,638

Total liabilities and stockholders’ equity	$	78,955		$	69,408


	LOUDEYE CORP.
	BY:		/s/ MICHAEL A. BROCHU
			Michael A. Brochu
			President and Chief Executive Officer (Principal Executive Officer)



	BY:		/s/ CHRIS J. POLLAK
			Chris J. Pollak
			Chief Financial Officer (Principal Financial and Accounting Officer)


þ		Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934


o		Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934


	Page
PART I. Financial Information		3
Item 1. Financial Statements		3
Unaudited Condensed Consolidated Balance Sheets		3
Unaudited Condensed Consolidated Statements of Operations		4
Unaudited Condensed Consolidated Statement of Stockholders’ Equity		5
Unaudited Condensed Consolidated Statements of Cash Flows		6
Notes to Unaudited Condensed Consolidated Financial Statements		7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		23
Item 3. Quantitative and Qualitative Disclosures About Market Risk		39
Item 4. Controls and Procedures		40
PART II. Other Information		40
Item 1. Legal Proceedings		40
Item 1A. Risk Factors		40
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		59
Item 3. Defaults Upon Senior Securities		59
Item 4. Submission of Matters to a Vote of Security Holders		59
Item 5. Other Information		60
Item 6. Exhibits		60
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2


(1)		Stock-based compensation, consisting of the fair value of equity instruments issued for services rendered, is attributable as follows:


	Common Stock,
	Warrants and												Accumulated
	Additional Paid-in						Deferred						Other			Total
	Capital						Stock-based			Accumulated			Comprehensive			Stockholders’
	Shares			Amount			Compensation			Deficit			Loss			Equity
							(in thousands)
BALANCES, December 31, 2005		11,537		$	296,020		$	(888	)	$	(242,645	)	$	(2,849	)	$	49,638
Stock option exercises		83			234			—			—			—			234
Private equity transaction, net		1,650			7,575												7,575
Vesting of restricted stock, net of cancellations		(15	)		88						—			—			88
Implementation of FAS 123(R)		—			(888	)		888			—			—			—
Stock-based compensation		—			545			—			—			—			545
Comprehensive loss:
Unrealized gain on marketable securities		—			—			—			—			11			11
Foreign currency translation adjustment		—			—			—			—			2,334			2,334
Net income		—			—			—			714			—			714

Total comprehensive income		—			—			—			—			—			3,059

BALANCES, June 30, 2006		13,255		$	303,574		$	—		$	(241,931	)	$	(504	)	$	61,139