10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark one)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 28, 2008

or

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission File Number: 0-26137

drugstore.com, inc.

(Exact Name of Registrant as Specified in its Charter)

Delaware	04-3416255
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)
411 108th Avenue NE, Suite 1400 Bellevue, Washington 98004	(425) 372-3200
(Address of Principal Executive Offices)	(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class	Name of Each Market on Which Listed
Common Stock, par value $0.0001 per share	NASDAQ Stock Market LLC (NASDAQ Global Market)

Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated filer  ¨	Accelerated filer  x
Non-accelerated filer  ¨	Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

The aggregate market value of common stock held by non-affiliates of the registrant was $186,145,404 as of June 29, 2008, the last business day of the registrant’s most recently completed second fiscal quarter.

As of March 5, 2009, the number of shares of the registrant’s common stock outstanding was 99,531,469.

DOCUMENTS INCORPORATED BY REFERENCE

The information required by Part III of this annual report, to the extent not set forth in this annual report, is incorporated by reference from the registrant’s definitive proxy statement relating to the registrant’s annual meeting of stockholders to be held on June 11, 2009, which definitive proxy statement will be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year to which this annual report relates.

DRUGSTORE.COM, INC.

ANNUAL REPORT ON FORM 10-K

For the Fiscal Year Ended December 28, 2008

Table of Contents

		Page
PART I
ITEM 1.	BUSINESS	3
ITEM 1A.	RISK FACTORS	11
ITEM 1B.	UNRESOLVED STAFF COMMENTS	26
ITEM 2.	PROPERTIES	27
ITEM 3.	LEGAL PROCEEDINGS	27
ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	27
PART II
ITEM 5.	MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES	28
ITEM 6.	SELECTED FINANCIAL DATA	30
ITEM 7.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	31
ITEM 7A.	QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK	48
ITEM 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA	48
ITEM 9.	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE	48
ITEM 9A.	CONTROLS AND PROCEDURES	48
ITEM 9B.	OTHER INFORMATION	51
PART III
ITEM 10.	DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE	52
ITEM 11.	EXECUTIVE COMPENSATION	52
ITEM 12.	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS	52
ITEM 13.	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE	52
ITEM 14.	PRINCIPAL ACCOUNTING FEES AND SERVICES	52
PART IV
ITEM 15.	EXHIBITS, FINANCIAL STATEMENT SCHEDULES	53
SIGNATURES		92

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ITEM 1. BUSINESS

Special Note Regarding Forward-Looking Statements

This annual report on Form 10-K and the documents incorporated into this annual report by reference contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 based on our expectations, estimates and projections as of the date of this filing. Actual results may differ materially from those expressed in forward-looking statements. All statements made in this annual report other than statements of historical fact, including statements regarding our future financial and operational performance, sources of liquidity and future liquidity needs, are forward-looking. Words such as “expects,” “believes,” “targets,” “may,” “will,” “outlook,” “continue,” “could,” “would,” “should,” and similar expressions or any variation of such expressions, are intended to identify forward-looking statements. Forward-looking statements are based on current expectations, and are not guarantees of future performance and involve assumptions, risks, and uncertainties. Actual performance may differ materially from those contained or implied in such forward-looking statements. Risks and uncertainties that could lead to such differences could include, among other things: effects of changes in the economy, changes in consumer spending, fluctuations in the stock market, changes affecting the Internet, online retailing and advertising, difficulties establishing our brand and building a critical mass of customers, the unpredictability of future revenues and expenses and potential fluctuations in revenues and operating results, risks related to business combinations and strategic alliances, possible tax liabilities relating to the collection of sales tax, consumer trends, the level of competition, seasonality, the timing and success of expansion efforts, changes in senior management, risks related to systems interruptions, possible governmental regulation, and the ability to manage a growing business. These and other risks and uncertainties that could cause our actual results to differ significantly from management’s expectations are described in the following discussion and in the section entitled “Risk Factors” in Part I, Item 1A of this annual report. You should not rely on a forward-looking statement as representing our views as of any date other than the date on which we made the statement. We expressly disclaim any intent or obligation to update any forward-looking statement after the date on which we make it.

Overview

drugstore.com, inc. is a leading online provider of health, beauty, vision, and pharmacy products. We offer health, beauty, sexual well-being, household, and other non-prescription products and prescription medications through our website at www.drugstore.com. We also offer prestige beauty products through our website located at www.beauty.com (which is also accessible through the drugstore.com^™ website); contact lenses through our wholly owned subsidiary Vision Direct, Inc., through websites located at www.visiondirect.com, www.lensmart.com, www.lensworld.com, and www.lensquest.com (which are also accessible through the drugstore.com website); and customized nutritional supplement programs through our wholly owned subsidiary, Custom Nutrition Services, Inc., or CNS. Our products are also available toll-free by telephone at 1-800-DRUGSTORE and 1-800-VISIONDIRECT. As of December 28, 2008, our lifetime customer base was 9.8 million customers.

We operate our business in three segments: over-the-counter, or OTC; vision; and mail-order pharmacy. Additional information regarding our business segments can be found in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of this annual report and in Note 12 of our consolidated financial statements included in Part IV, Item 15 of this annual report. In 2008, 2007, and 2006, approximately 99% of our net sales were made, and over 99% of our assets were located, in the United States.

drugstore.com, inc. was incorporated in April 1998 in the state of Delaware. We launched our web store at www.drugstore.com in February 1999 and completed our initial public offering in July 1999. Our common stock is listed on the NASDAQ Global Market under the symbol “DSCM.” Our principal corporate offices are located in Bellevue, Washington. As used in this annual report, “drugstore.com,” “we,” “our,” and similar terms refer to drugstore.com, inc. and its subsidiaries, unless the context indicates otherwise.

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Business Strategy

Our business strategy is to offer our customers a wide selection of products at competitive prices and a superior online shopping experience.

Convenience. Our online stores are available to consumers 24 hours a day, seven days a week through the Internet. All of our products are also available for purchase by phone. We offer additional convenience to our customers through easy-to-use websites, robust search technology, and a variety of features such as: Your List, a personal shopping list of the customer’s previous purchases that allows for quick and easy re-ordering, even without browsing the site; Auto Delivery, which enables customers to set up automatic shipments of frequently ordered products; the ability to schedule e-mail reminders about previously purchased products that are scheduled to run out or are on sale; and an automated flexible spending account, or FSA, manager that keeps track of FSA-eligible purchases and provides customers with downloadable receipts to submit to their FSA administrator.

Selection. We are able to offer a significantly broader assortment of products, with greater depth in each product category, because we do not have the shelf display space limitations of brick-and-mortar drugstores. With a single check-out, our customers are able to buy health, beauty and personal care products, prestige beauty brands, salon hair care, natural products, and other specialty items. In addition, we offer contact lenses and customized nutritional supplement programs through our subsidiary websites.

Information. We provide a broad array of interactive tools and information on our websites to help consumers make informed purchasing decisions. Our information services include detailed product information pages; personalized product recommendations; customer reviews and other editorial content; the eMedAlert program, which alerts customers to safety issues such as FDA and product manufacturer recalls; and extensive health- and pharmacy-related information, including a drug information database, a drug price index, information on generic drug alternatives, a drug interaction checker; and Ask Your Pharmacist, which is a database of our pharmacists’ responses to over 800 frequently-asked questions. Our customer care representatives and in-house pharmacists are available by phone or e-mail to provide personal guidance and answer customers’ questions.

Privacy. When shopping at a brick-and-mortar drugstore, many consumers may feel embarrassed or uncomfortable about buying items or asking questions that may reveal personally sensitive aspects of their health or lifestyle to pharmacists, store personnel, or other shoppers. Our customers avoid these problems by shopping from the privacy of their home or office.

Value. Our goal is to offer shoppers a broad assortment of health, beauty, vision, and pharmacy products with competitive pricing. We strive to improve our operating efficiencies and to leverage our fixed costs so that we can pass along the savings to our customers in the form of lower prices and exclusive deals. We also seek to inform customers of additional cost-saving opportunities when they become available. For example, in our pharmacy, we inform our customers of quantity price breaks for buying 90-day supplies of medication rather than 30-day supplies.

Business Segments

In 2008, our OTC segment accounted for 71% of our net sales, our vision segment accounted for 17%, and our mail-order pharmacy segment accounted for 12%. See Note 12 of our consolidated financial statements included in Part IV, Item 15 of this annual report.

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OTC

We stock approximately 36,000 non-prescription health, beauty, personal care, household, and other products. We also offer approximately 6,000 products through our arrangements with drop-ship vendors. We offer OTC products in a variety of categories, including:

•        Personal Care	•        Diet and Fitness
•        Makeup and Accessories	•        Household and Pets
•        Hair Care	•        Baby and Mom
•        Skin Care	•        Food and Gourmet
•        Men’s	•        FSA
•        Medicine Cabinet	•        Sexual Well-Being
•        Vitamins	•        Green and Natural
•        Home Medical	•        Toys and Games
•        Gifts •        Oral Care	•        Beauty.com (prestige beauty products, also accessible through www.beauty.com)
•        GNC

In addition, through our subsidiary CNS, we also provide personalized nutrition services to consumers in the form of an online assessment of an individual’s specific nutritional supplement needs, and deliver the personalized vitamins, minerals, herbs, and supplements in pharmaceutical-grade, daily dose packages. We are the exclusive online distributor of nutritional supplement programs for Dr. Barry Sears at www.ZoneDiet.com and The Pritikin Longevity Center & Spa at www.Pritikin.com. In addition, we act as the exclusive fulfillment provider for customized nutritional supplements sold through www.DrWeilVitaminAdvisor.com, www.DrWeil.com, and other Dr. Weil-related websites.

Vision

Through our subsidiary Vision Direct, we offer a broad assortment of contact lenses, in addition to reading glasses, contact lens cases, and other contact lens supplies. We believe that we offer these products at a substantial price savings over eye care practitioners, national optical chains, and many online competitors.

Our contact lens business is subject to the U.S. Fairness to Contact Lens Consumers Act, or FTCLCA, and the related regulations of the Federal Trade Commission, or FTC, which establish a national uniform standard for eye care practitioners and direct marketers with respect to the sale of contact lenses, including verification of contact lens prescriptions. In accordance with these guidelines, we ask the patient’s eye care professional to verify the prescription before we ship an order and allow eight business hours for the eye care professional to reply to our verification request. If the eye care professional approves the prescription, or does not respond to our verification request within eight business hours, we ship the order to the customer as expressly permitted by the FTCLCA.

Mail-Order Pharmacy

Our mail-order pharmacy segment includes prescription drugs and supplies, other than prescription contact lenses, sold online through the pharmacy section of the drugstore.com web store or over the telephone and delivered to customers through our mail-order facility.

We are a full-service pharmacy stocking over 5,500 prescription drugs. We employ licensed pharmacists and are licensed to ship prescriptions to all 50 states in the United States. We have received Verified Internet Pharmacy Practices Sites, or VIPPS, certification from the National Association of Boards of Pharmacy, or NABP. The voluntary VIPPS program sets standards for Internet pharmacies and certifies those online pharmacies that are licensed and in compliance with state pharmacy laws and the NABP’s stringent pharmacy practice standards.

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We serve both cash-paying pharmacy customers and customers with insurance coverage. In addition, we act as an outsourced mail-order pharmacy service provider for pharmacy benefit managers, or PBMs.

Discontinued Operations

On September 3, 2008, we entered into an amended and restated main agreement with Rite Aid whereby we transferred to Rite Aid the rights to our local pick-up pharmacy business (LPU), which includes prescription refills sold online through the drugstore.com web store or the Rite Aid online store and picked up by customers at Rite Aid stores, in exchange for $9.9 million, paid in ten monthly installments beginning in September 2008. We recorded the purchase price as a deferred gain that we are recognizing over the ten-month contractual payment period ending in June 2009. Additionally, Rite Aid will pay drugstore.com ongoing marketing service fees for the continued marketing of Rite Aid’s LPU offering on the drugstore.com site during the term of the agreement, which continues for two years unless extended for another year by either party. The marketing service fees are considered indirect cash inflows of our discontinued LPU segment as we anticipate the fees earned will not be a significant source of ongoing revenue in the future. The results of operations of our LPU segment have been classified as discontinued operations in the consolidated financial statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations for all periods presented.

Marketing and Promotions

Our marketing and promotion strategy is designed to build brand recognition, increase customer traffic to our store, add new customers, build strong customer loyalty, maximize repeat purchases, and develop incremental revenue opportunities. Our online advertising campaigns are focused on search engines, frequently visited Internet portals, health- and beauty-related websites, and direct-to-consumer e-mail marketing programs. We further extend our online market presence through our affiliate program, through which we permit certain websites to make our products and services available to their audiences through links to our websites.

We also employ a variety of marketing programs and promotions, such as discounted and free shipping promotions, dollar off and percentage discounts, free gifts with purchase, and the drugstore.com dollars^™ program, a loyalty program in which customers automatically earn a five percent rebate to be used for future non-prescription purchases.

Fulfillment and Customer Care

Order Fulfillment

We process most OTC orders and all mail-order pharmacy orders from our primary distribution center in Swedesboro, New Jersey, and all vision orders from our distribution center in Ferndale, Washington. We also process drop-ship orders for certain OTC products and arrange for our drop-ship vendor partners to ship these products directly from the vendor’s warehouse. Due to the relatively short lead time required to fill orders for our products, usually 24 to 48 hours, order backlog is not material to our business.

We ship OTC and pharmacy products to U.S., U.S. Territory, and APO/FPO military addresses. In addition, through an agreement with E4X, Inc., we offer international shipment of select OTC health, beauty, and wellness products to 34 countries, and expect to expand to more countries over time. Vision Direct ships contact lenses and other vision products worldwide, primarily to the United States and Canada.

Customer Care

Our customer care representatives operate from our call center in Halifax, Nova Scotia, Canada and from our Bellevue, Washington headquarters. Our customer care specialists are available 24 hours a day, seven days a week via e-mail or telephone to handle customer inquiries and assist customers in finding desired products. The Help section of our website outlines store policies and provides answers to customers’ frequently asked questions. In addition, our pharmacists provide advice to customers about medications and other health-related issues.

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Technology

We have implemented a broad array of services and systems for site management, product searching, customer interaction, transaction processing, and order fulfillment functions. These services and systems use a combination of our own proprietary technologies and commercially available, licensed technologies. We focus our internal development efforts on creating and enhancing the specialized, proprietary software that is unique to our business. For example, our core merchandise catalog, customer interaction, order collection, fulfillment, and back-end systems are proprietary to drugstore.com. Our systems are designed to provide real-time connectivity to the distribution center systems for both pharmacy and OTC products. They include an inventory-tracking system, a real-time order tracking system, an executive information system, and an inventory replenishment system.

To enhance the online and offline experience for our pharmacy customers, we have integrated some of our information and pharmacy systems with Rite Aid’s systems. Rite Aid has granted us a nonexclusive, fully paid license to the Rite Aid systems that are integrated with our systems, subject to third-party rights to such technology. We license database, operating system, and hardware components from third parties.

Relationship with Rite Aid

In June 1999, we entered into a strategic relationship with Rite Aid. Through our agreements with Rite Aid, which we renegotiated in September 2008, we have access to Rite Aid customers through the RiteAid.com website and the Rite Aid online store, which is powered by the drugstore.com website. Customers of the RiteAid.com website can purchase pharmacy products either from the drugstore.com mail-order pharmacy, which orders we ship to the customer from our distribution center or, in the case of refills of existing drugstore.com or Rite Aid prescriptions, from Rite Aid as an LPU order, which orders are purchased and picked up by the customer at any Rite Aid store. We transferred the rights to these LPU orders to Rite Aid in exchange for $9.9 million, paid in ten monthly installments beginning in September 2008. Rite Aid adjudicates and collects insurance reimbursement payments for prescription medications on our behalf.

Rite Aid also pays us ongoing marketing service fees for the continued marketing of Rite Aid’s LPU offering on the drugstore.com site. As part of our relationship with Rite Aid, we agreed to certain exclusivity provisions that limit our ability to promote, or to affiliate with, any service that would be competitive to the Rite Aid LPU pharmacy service.

We purchase most of our pharmaceutical inventory and our supply of Rite Aid private label products through Rite Aid or its wholesale partners. This arrangement enables us to take advantage of Rite Aid’s volume discounts and favorable credit terms. As a result of this agreement, Rite Aid is one of our largest suppliers. We also benefit from access to many of Rite Aid’s relationships with insurance companies and PBMs, which enables us to meet the needs of more customers because of the availability of insurance coverage to those customers.

We license certain Rite Aid information technology and pharmacy systems, which we currently use to adjudicate and process pharmacy orders.

In September 2008, we entered into an agreement to build, host, and process and fulfill all orders for Rite Aid’s online store for non-prescription, over-the-counter products, for which we receive a portion of the contribution margin, defined as net sales, less direct costs of these sales and the incremental cost of fulfilling, processing and delivering the orders, for each order. Under the terms of the agreement, Rite Aid will market the Rite Aid online store to its customer base through in-store, email, direct mail and other marketing vehicles to generate and maintain traffic to the Rite Aid online store.

Competition

The market for health, beauty, wellness, vision, and pharmacy products is intensely competitive and highly fragmented. Our competitors in the OTC segment include chain drugstores, mass market retailers, warehouse

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clubs, supermarkets, and, with respect to prestige beauty, health, and spa products, specialty retailers and major department stores. In our mail-order pharmacy segment, we compete with chain drugstores, PBMs, insurers and other health care providers, mail-order prescription drug providers, and other online pharmacies, both domestic and foreign. Foreign online pharmacies and “rogue” online pharmacies can often sell drugs to U.S. residents at a lower price because they do not comply with U.S. pharmacy regulations, are not subject to U.S. regulatory oversight, or both. Our competitors in the vision segment include other online providers of contact lenses, national optical chains, eye care professionals, and mass-market retailers and warehouse clubs that provide prescription vision services. In addition, we compete with Internet portals and online service providers that feature shopping services and with other online or mail-order retailers that offer products within one or more of our business segments.

As the current economic downturn has worsened, we have seen and expect to see continued price competition and elevated response rates to coupons and other promotional offers by increasingly price-conscious customers. That said, we are finding that overall orders are less affected by the economic slowdown, due in part to our value-pricing and the non-discretionary nature of many of our products.

We believe that the principal competitive factors in our market segments include: brand awareness and preference, company credibility, product selection and availability, convenience, price, actual or perceived value, website features, functionality and performance, ease of purchasing, customer service, privacy, quality and quantity of information supporting purchase decisions (such as product information and reviews), and reliability and speed of order shipment.

Intellectual Property

We regard our intellectual property as critical to our future success, and we rely on a combination of patent, copyright, trademark, service mark, and trade secret laws, as well as contractual restrictions to establish and protect our proprietary rights in products and services. We own a number of domain names, hold three patents and have applied for seven others, have registered several trademarks, and have filed applications for the registration of a number of our other trademarks and service marks in the United States as well as several other countries. We have licensed in the past, and expect to license in the future, some of our proprietary rights to third parties.

Seasonality

Our OTC business is subject to seasonal variations in demand. Historically, the fourth quarter of each year has been our strongest OTC sales quarter, primarily because of increased online shopping and our greater marketing efforts during the holiday season as well as increased purchases by customers using funds from flexible spending accounts. In the fourth quarter of 2008, we felt some impact from the current economic downturn, as we saw a less-than-normal seasonal increase in sales of our discretionary items, such as our holiday gift offerings, and greater utilization of free shipping offers. We do not believe that our mail-order pharmacy or vision business segments are substantially affected by seasonality.

Employees

As of December 28, 2008, we had approximately 814 full-time employees. However, employment levels fluctuate due to seasonal variations in our OTC business, and we hire independent contractors and temporary employees as needed to address demand. None of our employees is represented by a labor union, and we consider our employee relations to be good.

Available Information

We file with, and furnish to, the Securities and Exchange Commission, or SEC, periodic reports, proxy statements, and other information. We make these documents available, free of charge, on our website at www.investor.drugstore.com as soon as reasonably practicable after we electronically file them with, or furnish them to, the SEC.

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Directors and Officers

The following tables provide information regarding our directors and officers as of the date of this annual report:

Directors

Name	Age	Position
Dawn G. Lepore	54	President, Chief Executive Officer and Chairman of the Board, drugstore.com, inc.
Richard W. Bennet III	56	President and CEO, Direct Holdings Worldwide
Geoffrey R. Entress	45	Venture Partner, Voyager Capital
Jeffrey M. Killeen	55	Chairman and CEO, GlobalSpec, Inc.
William D. Savoy	44	Consultant
Gregory S. Stanger	44	Private Investor

Executive Officers

Name	Age	Position
Dawn G. Lepore	54	President, Chief Executive Officer, and Chairman of the Board
Robert Potter	43	Vice President, Chief Accounting Officer
Tracy Wright	37	Vice President, Chief Finance Officer
Yukio Morikubo	49	Vice President, Strategy, General Counsel and Secretary

Dawn G. Lepore has served as President, Chief Executive Officer and Chairman of the Board of drugstore.com since October 2004. Ms. Lepore served as Vice Chairman—Active Trader, Technology, Operations, Administration and Business Strategy of The Charles Schwab Corporation, or CSC, from August 2003 to October 2004. CSC, through Charles Schwab & Co., Inc., or Schwab, and its other operating subsidiaries, is a financial services firm. Ms. Lepore served as Vice Chairman—Technology, Active Trader, Operations, and Administration of CSC and Schwab from May 2003 until August 2003, as Vice Chairman—Technology, Operations and Administration of CSC and Schwab from July 2002 until May 2003, as Vice Chairman—Technology and Administration of CSC and Schwab from 2001 to 2002, as Vice Chairman and Chief Information Officer of CSC and Schwab from 1999 to 2001 and as Executive Vice President and Chief Information Officer of CSC and Schwab from 1993 to 1999. She joined Schwab in 1983. Ms. Lepore serves as a director of eBay Inc. and The New York Times Company.

Robert Potter has served as Vice President, Chief Accounting Officer of drugstore.com since May 2008, Chief Accountant since December 2006, and as Senior Director and Corporate Controller for drugstore.com from 2004 to 2006. Prior to joining drugstore.com, he served as Corporate Controller for Midstream Technologies, Inc., a technology company, from 2000 to 2004. Mr. Potter previously held senior positions with Mosaix, Inc., PHAMIS, Inc., Aldus Corporation and Ernst & Young LLP.

Tracy Wright has served as Vice President, Chief Finance Officer of drugstore.com since May 2008, Vice President of Financial Planning and Analysis since August 2007, and as Senior Director of Financial Planning and Analysis from 2003 to July 2007. Prior to joining drugstore.com, Ms. Wright held financial leadership roles at Western Wireless International, Freeinternet.com, and PriceWaterhouseCoopers.

Yukio Morikubo has served as Vice President, General Counsel and Secretary of drugstore.com since November 2006 and as Vice President, Strategy since April 2007. From April 2005 to September 2006, Mr. Morikubo was Vice President, General Counsel and Corporate Secretary of Advanced Digital Information Corporation, a provider of intelligent data storage hardware and software solutions that was acquired in

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August 2006 by Quantum Corporation. He served as Chief Counsel, International of Cingular Wireless, LLC, formerly AT&T Wireless Services, Inc., a wireless service provider, from 1996 to 1999 and again from 2000 until April 2005. Mr. Morikubo previously practiced with the law firm of Perkins Coie LLP and served as an auditor and tax consultant with KPMG LLP.

Non-Executive Officers

Robert Hargadon has served as Vice President, Human Resources of drugstore.com since November 2006. Mr. Hargadon served as the General Manager, Corporate Learning and Development for Microsoft Corporation, a software company, from 2005 to 2006. Mr. Hargadon was at Boston Scientific, a medical device developer and manufacturer, from 1997 to 2005, initially as the Vice President, International Human Resources and later as the Vice President, U.S. Human Resources. From 1993 to 1997, Mr. Hargadon was the Vice President, Training and Development, Retail for Fidelity Investments, a financial services company. He has also worked as a consultant on a wide range of leadership, human resource and organization development assignments.

Perry Evoniuk was appointed Vice President, Enterprise Architecture in January 2009. Mr. Evoniuk joined drugstore.com in 1999 and has held several positions managing development and implementation of our web store infrastructure. Prior to joining drugstore.com, Mr. Evoniuk served in research and development positions at Attachmate Corporation, a host connectivity provider, and at Hughes Aircraft, an aerospace and defense company.

Luke Friang has served as Vice President and Chief Information Officer of drugstore.com since January 2006. From 2001 to 2005, Mr. Friang was senior director of e-commerce technologies at Costco Wholesale Corporation, a membership warehouse retailer. Mr. Friang held a variety of positions from 1997 to 2001 in the e-commerce technology operations groups at The Spiegel Group, an apparel and home furnishings retailer.

Julie Johnston has served as Vice President, OTC Merchandising of drugstore.com since December 2006 and as the Senior Category Manager for Personal Care with drugstore.com from 2000 to 2006. From 1992 to 1999, Ms. Johnston served in a number of positions at Sears, Roebuck and Co., an international department store company, including Senior Buyer from 1996 to 1999.

Ronald E. Kelly has served as Vice President, Customer Care and Logistics of drugstore.com since June 2006, and as Senior Director of Site Development and Customer Care and Logistics for drugstore.com from 2003 to 2006. From 2001 to 2003, he served as Director of Customer Care with drugstore.com. From 1999 to 2001, Mr. Kelly served as a Senior Financial Analyst and later as Director of Procurement for drugstore.com.

David Lonczak was named as our Chief Marketing Officer in March 2007 and has served as our Vice President, Marketing since December 2006. In early 2006, Mr. Lonczak began serving as Senior Director of Marketing in Pharmacy for drugstore.com, and served as General Manager of Vision for drugstore.com from 2005 to 2006. From 2002 to 2005, Mr. Lonczak served in a number of positions with Cingular Wireless, LLC, formerly AT&T Wireless Services, Inc., a wireless service provider, including Vice President, eCommerce from 2004 to 2005.

Kathleen McNeill has served as our Vice President of Beauty since December 2006. Ms. McNeill joined drugstore.com in June 2006 as our General Manager, Beauty. From 2005 to June 2006, Ms. McNeill served as Vice President of Flagship Stores with Bath and Body Works, a division of Limited Brands, Inc., a specialty retail company. From 2000 to 2005, Ms. McNeill served in a number of positions, including Skincare Merchandise manager with Sephora, USA, Inc., the cosmetic retailer division of Moët Hennessy Louis Vuitton, an international luxury products retailer.

Stan Pavlovsky was appointed Vice President, Vision Direct, in January 2009. Mr. Pavlovsky joined drugstore.com in 2004, in our financial planning and analysis group before moving over to our vision business. Prior to joining the company, Mr. Pavlovsky held positions in financial and business analysis at Microsoft Corporation, a software company, and The Boeing Company, an aerospace company and aircraft manufacturer.

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ITEM 1A.  RISK FACTORS

You should carefully consider the following risks and uncertainties associated with our company and ownership of our securities. If any of the following risks actually occurs, our business, financial condition, or operating results could be materially adversely affected. This could cause the trading price of our common stock to decline, and you could lose all or part of your investment. Some statements in this annual report (including some of the following risk factors) are forward-looking statements. See the section entitled “Special Note Regarding Forward-Looking Statements” in Part I, Item 1 of this annual report.

We have a history of generating significant losses, and may not be able to sustain profitability.

We have an accumulated deficit of $770.1 million through December 28, 2008. To date, we have had only one profitable quarter, and we may never achieve profitability on a full-year or consistent basis. We expect to continue to incur net losses in the first quarter of 2009, and possibly longer. As a result, our stock price may decline and stockholders may lose all or a part of their investment in our common stock.

Our revenue growth and profitability depends on the continued growth of demand for the products we offer.

Demand for many of our products, and, therefore, our business, is affected by changes in consumer preferences, general economic and business conditions, and world events. For example, macro-economic trends in the United States and abroad, threatened or actual terrorist attacks or armed hostilities (or the resulting security concerns), or natural disasters could create economic and consumer uncertainty and delays in and increased costs of product shipments to and from us, which may decrease demand. A softening of demand, for whatever reason, may result in decreased revenue or growth, which could prevent us from achieving or sustaining profitability. Revenue growth or profitability may not be sustainable and our company-wide and by-segment percentage growth rates may decrease in the future.

Our revenues and operating results may vary significantly from quarter to quarter due to a number of factors, including:

• our ability to retain and increase sales to existing customers, attract new customers, and satisfy our customers’ demands;

• the frequency and size of customer orders and the quantity and mix of products our customers purchase;

• changes in consumer acceptance and usage of the Internet, online services, and e-commerce;

• the price we charge for our products and for shipping those products, or changes in our pricing policies or the pricing policies of our competitors;

• the extent to which we offer free shipping or other promotional discounts to our customers;

• our ability to acquire merchandise, manage inventory, and fulfill orders;

• technical difficulties, system downtime, or interruptions;

• timing and costs of upgrades and developments in our systems and infrastructure;

• timing and costs of marketing and other investments;

• disruptions in service by shipping carriers;

• the introduction by our competitors of websites, products, or services;

• the extent of reimbursements available from third-party payors;

• an increase in the price of fuel used in the transportation of packages, or an increase in the prices of other energy products, primarily natural gas and electricity, which are used in our operating facilities;

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• changes in the mix of products purchased by our customers. For example, if customers purchase a higher proportion of generic prescription drugs, which have lower prices and higher margins than branded drugs, our net sales may decrease while our product margins increase. Moreover, if our OTC net sales do not grow as much as we anticipate or the proportion of OTC net sales compared to net sales in other segments is lower than we anticipate, our margins will be lower than we currently plan;

• the effects of strategic alliances, potential acquisitions, and other business combinations, and our ability to successfully and timely integrate them into our business; and

• changes in government regulation.

In addition, our operating expenses are largely based on anticipated revenue trends and a high percentage of our expenses are fixed in the short term. As a result, a delay in generating or recognizing revenue for any reason could result in substantial additional operating losses.

A portion of our revenues is also seasonal in nature. Traditional retail seasonality affects our OTC business, resulting in higher revenues in the fourth quarter of each year as compared to other quarters. We may be unable to manage the increased sales effectively, and increases in inventory in anticipation of holiday sales could negatively affect our cash flow. In addition, sales of some health and beauty products are driven, to some extent, by seasonal purchasing patterns and seasonal product changes, such as diet products, cold and flu medications, and products with holiday-specific varieties. Consumer fads and other changes in consumer trends may also cause shifts in purchasing patterns, resulting in significant fluctuations in our operating results from one quarter to the next.

Our evolving business model and the unpredictability of our industry make it difficult for us to forecast accurately the level or source of our revenues and our rate of growth. We believe that, because of these factors, historical trends and quarter-to-quarter comparisons of our operating results are not necessarily meaningful and should not be relied on as an indicator of our future performance. In the past, our operating results have sometimes been, and it is likely that in some future quarter or quarters they will be, below the expectations of investors and securities analysts. In that event, the price of our common stock may fall substantially, and stockholders may lose all or a part of their investment.

If the recent global economic crisis has a disproportionate impact on our business or that of our significant partners and suppliers, our business and results of operations would be harmed.

The recent deterioration in the U.S. and global credit markets and the financial services industry could negatively affect our business or that of our significant partners and suppliers. Tightening of credit and the recent decline in the housing market has led to a lack of consumer confidence and a reduction in business activity generally, which could significantly harm our revenues and operating results. In addition, our vendors could experience serious cash flow or other financial or operational problems due to the current economic conditions. As a result, our vendors may attempt to increase prices, alter payment terms, or seek other relief in order to offset these problems. Vendors may further be forced to reduce production, shut down operations or file for bankruptcy protection, which in some cases could have a significant impact on our ability to serve the market’s needs. In addition, access to credit from financial institutions may not be available. We do not expect the current economic conditions to improve significantly in the near future, and any continuation and/or worsening of the economic environment could intensify the adverse affects of these difficult market conditions.

We may be unable to obtain the additional capital we need in the future to support our growth.

Our available funds may not be sufficient to meet all of our long-term business development requirements, and we may seek to raise additional funds through public or private debt or equity financings. Due to the recent tightening of the credit and equity markets, any additional financing that we may need may not be available on terms favorable to us, or at all. If adequate funds are not available or are not available on acceptable terms, our strategic flexibility or ability to develop and grow our business may be significantly limited.

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Our stock price is likely to continue to fluctuate, which could result in substantial losses for stockholders.

The market price of our common stock has been, and is likely to continue to be, extremely volatile. Our stock price could be subject to wide fluctuations in response to a number of factors, including those described in this annual report, some of which are beyond our control, and these fluctuations could result in substantial losses for stockholders.

In the past, securities class action and derivative litigation has often been brought against a company following periods of volatility in the market price of its securities. We have been named in such lawsuits in the past, including certain putative class action and derivative suits filed against us and certain of our current and former officers and directors in 2004. Although the courts dismissed these lawsuits, we may be the target of similar litigation in the future. Securities litigation could result in substantial costs and divert management’s attention and resources, which could seriously harm our business and operating results and cause the trading price of our stock to decline.

Our common stock could be delisted from the NASDAQ Global Market if our stock price continues to trade below $1.00 per share.

On several occasions in recent months, our stock price has dropped below the minimum $1.00 per share required for continued listing on the NASDAQ Global Market pursuant to NASDAQ Marketplace Rule 4450(a)(5). While NASDAQ has temporarily suspended enforcement of the minimum price requirement due to conditions in U.S. and world financial markets, enforcement of this requirement is currently scheduled to resume on April 20, 2009. If our stock price continues to trade below this minimum price once NASDAQ resumes enforcement of this requirement, our stock could be delisted from the NASDAQ Global Market.

Delisting from the NASDAQ Global Market could have an adverse effect on our business and on the trading of our common stock. If a delisting of our common stock from the NASDAQ Stock Market were to occur, our common stock would trade on the OTC Bulletin Board or on the “pink sheets” maintained by the National Quotation Bureau, Inc. Such alternatives are generally considered to be less efficient markets, and our stock price, as well as the liquidity of our common stock, may be adversely affected as a result.

We face significant competition from both traditional and online retailers.

The market segments in which we compete are rapidly evolving and intensely competitive, and we have many competitors in different industries, including both the retail and e-commerce services industries. These competitors include chain drugstores, mass-market retailers, warehouse clubs, supermarkets, specialty retailers, major department stores, PBMs, insurers and health care providers, mail-order pharmacies (legitimate and illegitimate), national optical chains, eye care professionals, Internet portals and online service providers that feature shopping services, and various online stores that offer products within one or more of our product categories. Many of our current and potential competitors have longer operating histories, larger customer bases, greater brand recognition, and significantly greater financial, marketing, and other resources than we have. They may be able to secure merchandise from vendors on more favorable terms, operate with a lower cost structure, adopt more aggressive pricing policies, or devote more resources to technology development and marketing than we do. In addition, other companies in the retail and e-commerce service industries may enter into business combinations or alliances that would strengthen their competitive positions and prevent them, their affiliated companies, or their strategic partners from entering into relationships with us. An inability to enter into or maintain relationships with major PBMs, insurance companies, or managed care organizations could be a major competitive disadvantage to us.

As various Internet market segments obtain large, loyal customer bases, participants in those segments may expand into the market segments in which we operate. In addition, new and expanded Web technologies may further intensify the competitive nature of online retail and allow our competitors to duplicate many of the

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products, services, and content offered on our site. We believe that the Internet facilitates entry into the retail market and comparison shopping and renders it inherently more competitive than conventional retailing formats. We expect competition in the e-commerce channel to intensify, and this increased competition may reduce our ability to grow and, as a result, reduce our revenue, increase our operating expenses, or both, and harm our business.

In addition, we face competition from online pharmacies outside the United States. Although it is currently illegal to re-import prescription drugs into the United States from any foreign country, a growing number of U.S. consumers seek to fill their prescriptions through Canadian and other foreign online pharmacies, and a number of state and local governments have set up websites directing their constituents to Canadian pharmacies. The U.S. Food and Drug Administration, or FDA, has taken only limited action to date, and may not take aggressive action in the future, against those who illegally re-import prescription drugs or support or facilitate illegal re-importation. The U.S. Congress has enacted legislation governing online pharmacies that imposes restrictions on operations and other regulatory requirements on online pharmacies that do not apply to our brick-and-mortar or foreign-based online counterparts. In addition, legislation allowing for re-importation of prescription drugs by individuals for personal use has repeatedly been introduced. If such legislation were to be enacted, or if consumers increasingly use foreign-based online prescription drug websites instead of U.S.-based online pharmacies, such as ours, to fill their prescription needs, our business and operating results could be harmed.

Our relationship with Rite Aid involves many risks and restricts our ability to promote, contract with, or operate traditional retail stores.

In June 1999, we entered into a series of agreements with Rite Aid that we renegotiated in September 2008. These agreements involve many aspects of our respective businesses and the operation of our respective websites, the fulfillment of orders, and the extension of Rite Aid’s insurance relationships to cover prescriptions processed by us. We currently use Rite Aid’s systems to process prescription orders in our mail-order pharmacy segment. If we were unable to maintain our relationship with Rite Aid and could not implement an alternative method for processing prescriptions, through either our own systems or those of a third party, we would be unable to maintain our pharmacy operations. The loss of our pharmacy sales, which comprised approximately 12% of our net sales in fiscal 2008, would greatly reduce our revenue and harm our business.

In September 2008, we transferred the rights to the local-pick up pharmacy (LPU) orders to Rite Aid in exchange for $9.9 million, paid in ten monthly installments beginning in September 2008. As of December 28, 2008, Rite Aid owed us approximately $5.9 million under this agreement. If we are unable to collect from Rite Aid our financial results and cash flows would be negatively affected.

Our arrangement with Rite Aid is complex and requires substantial effort and attention to operate and manage successfully. We may not be able to accommodate changes that Rite Aid may make to its systems that we use, which may limit our ability to operate our business.

While Rite Aid has committed to promoting the Rite Aid online store in its stores and in its advertising, we do not control the choice of ads, and this form of advertising may not generate traffic to or orders from the Rite Aid online store. In addition, a substantial alteration of Rite Aid’s marketing efforts, or a breach by Rite Aid of its marketing obligations, could adversely affect revenues generated by the Rite Aid online store. Our relationship with Rite Aid also substantially broadens our ability to provide prescription medications to consumers with insurance reimbursement plans, it may not allow all of our potential customers to purchase these medications from drugstore.com and receive insurance reimbursement, which could adversely affect consumer perceptions of us and our revenues. In addition, our relationship with Rite Aid contains limitations on the scope of our marketing activities, including restrictions on our ability to promote, or to affiliate with, any service that would be competitive to the Rite Aid LPU pharmacy service or Rite Aid online store. These restrictions could limit our flexibility and ability to grow our business if our relationship with Rite Aid is not successful.

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We are expanding into international markets, causing our business to be increasingly susceptible to international business risks and challenges that could affect our profitability.

Through our contract with E4X, Inc., we recently began selling certain OTC products in international markets and expect to expand more aggressively in the future. International sales are subject to inherent risks that could adversely affect our operating results, including:

• the risk that our marketing strategies will not translate well to international markets and that we will need to expend resources to adapt those strategies for a variety of new markets;

• the need to develop new supplier and manufacturer relationships;

• the need to comply with additional U.S. and foreign laws and regulations to the extent applicable, including but not limited to, restrictions on advertising practices, regulations governing online services, restrictions on importation of specified or proscribed items, importation quotas, consumer protection laws, enforcement of intellectual property rights, laws dealing with consumer and data protection, privacy, encryption, and restrictions on pricing or discounts; and

• unexpected changes in international regulatory requirements and tariffs, and geopolitical events such as war and terrorist attacks.

To the extent we generate significant international sales, any negative impact on our international operations could negatively affect our revenues and operating results. In addition, it is costly to establish, develop, and maintain international operations and websites that promote our brand internationally, which could further harm our revenues and operating results.

If our marketing efforts are not effective at attracting and retaining customers at an acceptable cost, we will be unable to achieve consistent profitability.

If we do not maintain our brand and continue to increase awareness of our products and services, we may not build a critical mass of customers. Promoting and positioning our brand depends largely on the success of our marketing efforts and our ability to provide consistent, high quality customer experiences. We believe that, because we are a small company with low public brand awareness, achieving significant market awareness will require significant marketing expense. To promote our brand and our products and services, we have incurred and expect to continue to incur substantial expense in our marketing efforts both to attract and to retain customers. Our promotional activities may not be effective at building our brand awareness and customer base to the extent necessary to generate sufficient revenue to become consistently profitable. Search engine and other online marketing initiatives comprise a substantial part of our marketing efforts, and our success depends in part on our ability to manage costs associated with these initiatives, or to find other channels to acquire and retain customers cost-effectively. The demand for and cost of online advertising has been increasing and may continue to increase. An inability to acquire and retain customers at a reasonable cost would increase our operating costs and prevent us from maintaining profitability.

Our network and communications systems are vulnerable to system interruption and damage, which could harm our operations and reputation.

Our ability to receive and fulfill orders promptly and accurately is critical to our success and largely depends on the efficient and uninterrupted operation of our computer and communications hardware and software systems. We experience periodic system interruptions that impair the performance of our transaction systems or make our websites inaccessible to our customers. These systems interruptions may prevent us from efficiently accepting and fulfilling orders, sending out promotional e-mails and other customer communications in a timely manner, introducing new products and features on our website, promptly responding to customers, or providing services to third parties. Frequent or persistent interruptions in our services could cause current or potential customers to believe that our systems are unreliable, which could cause them to avoid our websites, drive them to our competitors, and harm our reputation. To minimize future system interruptions, we need to

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continue to add software and hardware and to improve our systems and network infrastructure to accommodate increases in website traffic and sales volume, to replace aging hardware and software, and to make up for several years of underinvestment in technology. We may be unable to promptly and effectively upgrade and expand our systems and integrate additional functionality into our existing systems. Any unscheduled interruption in our services, especially during the holiday shopping season, could result in fewer orders, additional operating expenses, or reduced customer satisfaction, any of which would harm our revenues and operating results and could delay or prevent our becoming consistently profitable. In addition, the timing and cost of upgrades to our systems and infrastructure may substantially affect our ability to maintain profitability.

Our systems and operations, and those of our suppliers and Internet service providers, are vulnerable to damage or interruption from fire, flood, earthquakes, power loss, server failure, telecommunications and Internet service failure, acts of war or terrorism, computer viruses and denial-of-service attacks, physical or electronic break-ins, sabotage, and similar events. Any of these events could lead to system interruptions, service delays, and loss of critical data for us, our suppliers, or our Internet service providers, and could prevent us from accepting and fulfilling customer orders. For example, our Internet service provider recently experienced network outages that caused our website to be unavailable for several hours. Any significant interruption in the availability or functionality of our websites or our customer processing, distribution, or communications systems, for any reason, could seriously harm our business, financial condition, and operating results. While we do have backup systems for some aspects of our operations, we do not have fully redundant backup systems or a formal disaster recovery plan. Our business interruption insurance may be inadequate to compensate for all losses that may occur.

All of our fulfillment operations and inventory are located in our distribution facilities, and any significant disruption of these centers’ operations would hurt our ability to make timely delivery of our products.

We conduct all of our fulfillment operations from our distribution facilities in Swedesboro, New Jersey and Ferndale, Washington. Our primary distribution center in Swedesboro and our inventory storage facility in Logan Township, New Jersey house our entire product inventory except for our vision products, which are housed at our Washington facility. A natural disaster or other catastrophic event, such as an earthquake, fire, flood, severe storm, break-in, server or systems failure, terrorist attack, or other comparable event at either of these facilities, and in particular our New Jersey facilities, would cause interruptions or delays in our business and loss of inventory and could render us unable to process or fulfill customer orders in a timely manner, or at all. Further, we have no formal disaster recovery plan, and our business interruption insurance may not adequately compensate us for losses that may occur. In the event that a significant part of either of these facilities, and in particular our New Jersey facilities, were destroyed or our operations were interrupted for any extended period of time, our business, financial condition, and operating results would be harmed.

If we are unable to optimize management of our distribution centers, we may be unable to meet customer demand.

Our ability to meet customer demand may be significantly limited if we do not successfully operate our distribution centers. Because it is difficult to predict sales volume, we may be unable to manage our facilities in an optimal way, which may result in excess or insufficient inventory, warehousing, fulfillment, or distribution capacity. In addition, failure to control product damage and shrinkage effectively through security measures and inventory management practices could adversely affect our operating margins. Our margins and revenues may also be affected if we are unable to obtain products from manufacturers and wholesalers timely and on favorable terms. In addition, if we need to increase our distribution capacity sooner than anticipated, that expansion would require additional financing that may not be available to us on favorable terms when required, or at all.

Under our distribution agreement with GNC, and consignment arrangements with other partners, we maintain inventory of third parties’ products in our primary distribution center, thereby increasing the complexity of tracking inventory in, and the operation of, our distribution center. Our failure to properly handle third party inventory that we hold would result in unexpected costs and other harm to our business and reputation.

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We need to manage changing and expanding operations.

Over the past several years, we have significantly expanded our operations and anticipate that we will continue to expand. Our past growth has placed, and we expect that our anticipated future operations and expansion will continue to place, a significant strain on our managerial, operational, financial, and other resources. Some of the administrative and operational challenges we have faced in the past as a result of our expansion and seasonal growth include the management of an expanded number of product offerings; the assimilation of systems and technologies of acquired companies; increased pressure on our senior management; and increased demand on our systems and internal controls. Our ability to manage our operations and expansion effectively depends on the continued development and implementation of plans, systems, and controls that meet our operational, financial, and management needs. If we are unable to develop or implement these plans, systems, or controls or otherwise manage our operations and growth effectively, we will be unable to increase gross margins or achieve consistent profitability, and our business will be harmed.

The seasonality of our business places increased strain on our operations.

We expect the largest amount of our net sales to occur during our fourth quarter. If we do not stock or restock popular products in sufficient amounts such that we fail to meet customer demand, it could significantly affect our revenue and our future revenue. If we overstock products, we may be required to take significant inventory markdowns or write-offs, which could reduce our gross margins. We may experience an increase in our shipping cost due to complimentary upgrades, split-shipments, and additional long-zone shipments necessary to ensure timely delivery for the holiday season. If our systems and processes are not prepared to address peak volumes during high demand seasons, holidays, and events, we may experience system interruptions that make our websites unavailable or prevent us from efficiently fulfilling orders, which may reduce the volume of goods we sell and the attractiveness of our products and services. In addition, we may be unable to staff our distribution centers adequately during these peak periods, and delivery companies may be unable to meet the seasonal demand.

We are dependent on a limited number of fulfillment and distribution partners. If we are unable to obtain shipments of product from our vendors and deliver merchandise to our customers in a timely and cost-effective manner, our business and results of operations would be harmed.

We purchase most of our pharmaceutical inventory and our supply of Rite Aid private label products through Rite Aid or its wholesale partners. Our business could be significantly disrupted if Rite Aid were to breach its contract or suffer adverse developments that affect its ability to supply products to us. If for any reason Rite Aid is unable or unwilling to supply products to us in sufficient quantities and in a timely manner, we may not be able to secure alternative fulfillment partners on acceptable terms in a timely manner, or at all.

We cannot control all of the various factors that might affect our timely and cost-effective procurement of products from our vendors and delivery of products to our customers. We also rely on a limited number of third-party carriers for shipments of products to and from our distribution facilities and to customers. We are therefore subject to the risks, including increased fuel costs, security concerns, labor disputes, union organizing activity, and inclement weather, associated with our carriers’ ability to provide product fulfillment and delivery services to meet our distribution and shipping needs. Failure to procure and deliver merchandise, either to us or to our customers, in a timely and accurate manner would harm our reputation, the drugstore.com brand, our business, and our results of operations. In addition, any increase in fulfillment costs and expenses could adversely affect our business and operating results.

We have significant inventory risk.

We must maintain sufficient inventory levels to operate our business successfully and to meet our customers’ expectations that we will have the products they order in stock. However, we must also guard against the risk of accumulating excess inventory. We are exposed to significant inventory risks as a result of rapid

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changes in product cycles, changes in consumer tastes, uncertainty of success of product launches, seasonality, manufacturer backorders, and other vendor-related problems. In order to be successful, we must accurately predict these trends and events, which we may be unable to do, and avoid over- or under-stocking products. In addition, demand for products can change significantly between the time product inventory is ordered and the time it is available for sale. When we begin selling a new product, it is particularly difficult to forecast product demand accurately. A failure to optimize inventory would increase our expenses if we have too much inventory, and would harm our margins by requiring us to make split shipments for backordered items or pay for expedited delivery from the manufacturer if we had insufficient inventory. In addition, we may be unable to obtain certain products for sale on our websites as a result of general shortages (for example, in the case of some prescription drugs), manufacturer policies (for example, in the case of some contact lenses and prestige beauty items), manufacturer or distributor problems, or popular demand. Failure to have inventory in stock when a customer orders it could cause us to lose that order or that customer. The acquisition of some types of inventory, or inventory from some of our sources, may require significant lead time or prepayment, and this inventory may not be returnable. We carry a broad selection of products and significant inventory levels of a substantial number of products, and we may be unable to sell this inventory in sufficient quantities or during the relevant selling seasons. The occurrence of one or more of these inventory risks may adversely affect our business and operating results.

Our vendor relationships subject us to a number of risks.

We have significant vendors that are important to our sourcing of merchandise. We do not have long-term arrangements with most of our vendors to guarantee availability of merchandise, particular payment terms, or extension of credit limits. If our current vendors were to stop selling merchandise to us on acceptable terms, we may not be able to acquire merchandise from other vendors in a timely and efficient manner and on acceptable terms, or at all.

Any errors in filling or packaging the prescription drugs or contact lenses we dispense may expose us to liability and negative publicity.

Errors relating to prescriptions, dosage, and other aspects of the prescription medication and contact lens dispensing process may result in liability for us that our insurance may not cover. Because we distribute pharmaceutical products and contact lenses directly to the consumer, we are one of the most visible participants in the distribution chain and therefore have increased exposure to liability claims.

Our pharmacists are required by law to offer counseling, without additional charge, to our customers about medication, dosage, delivery systems, common side effects, and other information deemed significant by the pharmacists. Our pharmacists may have a duty to warn customers regarding any potential adverse effects of a prescription drug if the warning could reduce or negate those effects. In addition, our pharmacists provide information and respond to user inquiries on our websites and those of certain of our partners. This counseling is in part accomplished through e-mails to our customers, inserts included with the prescription, and in some circumstances, online postings, which may increase the risk of miscommunication because the customer is not personally present to receive the counseling or advice or may not have provided us with all relevant information. Although we also post product information on our website, customers may not read this information. Providing information on pharmaceutical and other products creates the potential for claims to be made against us for negligence, personal injury, wrongful death, product liability, malpractice, invasion of privacy, or other legal theories based on our product or service offerings. Our general liability, product liability, and professional liability insurance may not cover potential claims of this type or may not be adequate to protect us from all liabilities that may be imposed if any such claims were to be successful.

Errors by either us or our competitors may also produce significant adverse publicity either for us or for the online pharmacy or vision industries in general. Because of the significant amount of press coverage on Internet retailing and online pharmacies, we believe that we are subject to a higher level of media scrutiny than other

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pharmacy product channels. The amount of negative publicity that we or the online pharmacy or vision industries receive as a result of pharmacy or prescription processing errors could be disproportionate in relation to the negative publicity received by other pharmacies or eye care professionals making similar mistakes. We have no control over the pharmacy practices of our competitors, and we cannot ensure that our pharmacists or our prescription processing operate completely without error. We believe customer acceptance of our online shopping experience is based in large part on consumer trust, and errors by us or our competitors and related negative publicity could erode this trust or prevent it from growing. This could result in an immediate reduction in the amount of orders we receive, adversely affect our revenue growth, and harm our business and operating results.

Security breaches could damage our reputation, expose us to liability, or otherwise harm our business.

Our security measures may not prevent security breaches that could harm our business. To succeed, we must provide a secure transmission of confidential information over the Internet and protect the confidential customer and patient information we retain, such as credit card numbers and prescription records. A third party who compromises or breaches the physical and electronic security measures we use to protect transaction data and customer records could misappropriate proprietary information, cause interruptions in our operations, damage our computers or those of our customers, or otherwise harm our business. Any of these could harm our reputation and expose us to a risk of loss or litigation and possible liability. We may need to expend significant resources to protect against security breaches or to address problems caused by breaches, and our insurance may not be adequate to reimburse us for losses caused by security breaches.

If we fail to maintain or enhance our strategic relationships to help promote our website and expand our product offerings, our development could be hindered.

We believe that our relationships with Rite Aid and other strategic partners, Internet portals, third-party distributors, and manufacturers are critical to attract customers, to facilitate broad market acceptance of our products and the drugstore.com brand, and to enhance our sales and marketing capabilities. If we are unable to develop or maintain key relationships, our ability to attract customers would suffer and our business would be adversely affected. In addition, we are subject to many risks beyond our control that influence the success or failure of our strategic partners. Our business could be harmed if any of our strategic partners were to experience financial or operational difficulties or if other corporate developments adversely affect their performance under our agreements.

We may be unable to increase the migration of consumers of health, beauty, vision, and pharmacy products from brick-and-mortar stores to our online solution, which would harm our revenues and prevent us from becoming profitable.

If we do not continue to attract and retain higher volumes of online customers to our Internet stores at a reasonable cost, we will not be able to increase our revenues or achieve consistent profitability. Our success depends on our ability to continue to convert a large number of customers from traditional shopping methods to online shopping for health, beauty, wellness, vision, and pharmacy products. Specific factors that could prevent widespread customer acceptance of our online solution include:

• shipping charges, which do not apply to purchases made at a brick-and-mortar store;

• delivery time associated with Internet orders, as compared to the immediate receipt of products at a brick-and-mortar store;

• delays in deliveries to customers, particularly our West Coast customers;

• lack of consumer awareness of our websites;

• additional steps and delays in verifying prescriptions and ensuring insurance coverage for prescription products;

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• non-participation in the networks of some insurance carriers and PBMs;

• regulatory restrictions or reform at the state and federal levels that could affect our ability to serve our customers;

• the general acceptance or legalization of prescription drug re-importation;

• customer concerns about the security of online transactions, identity theft, or the privacy of their personal information;

• product damage from shipping or shipments of wrong or expired products from us or other vendors, resulting in a failure to establish, or loss of, customers’ trust in buying drugstore items online;

• inability to serve the acute care needs of customers, including emergency prescription drugs and other urgently needed products;

• delays in responses to customer inquiries;

• difficulties or delays in returning or exchanging orders; and

• activity that diminishes a user’s online experience or subjects online shoppers to security risks, such as viruses, spam, spyware, phishing (spoofing e-mails directed at Internet users), “denial of service” attacks directed at Internet service providers and online businesses, and breaches of data security.

Expanding the breadth and depth of our product and service offerings is expensive and difficult, and we may receive no benefit from our expansion.

We intend to continue to expand the breadth and depth of our product and service offerings by promoting new or complementary products or sales formats. Expansion of our offerings in this manner could require significant additional expenditures and could strain our management, financial, and operational resources. For example, we may need to incur significant marketing expenses, develop relationships with new fulfillment partners or manufacturers, or comply with new regulations. We may be unable to expand our product and service offerings or sales formats in a cost-effective or timely manner, and any new offerings or formats may not generate satisfactory revenues to offset the costs involved. Furthermore, any new product or service offering or sales format that is not favorably received by consumers could damage the reputation of our brand. A lack of market acceptance of our efforts or our inability to generate sufficient revenues to offset the cost of expanded offerings could harm our business.

We face uncertainty related to pharmaceutical costs and pricing, which could affect our revenues and profitability.

Pharmacy sales accounted for approximately 12% of our total revenue in fiscal year 2008. Sales of our pharmacy products depend in part on the availability of reimbursement from third-party payors such as government health administration authorities, private health insurers, managed care organizations, PBMs, and other organizations. These organizations are increasingly challenging the price and cost-effectiveness of medical products and services. The efforts of third-party payors to contain costs often place downward pressures on profitability from sales of prescription drugs. In addition, our products or services may not be considered cost-effective, and adequate third-party reimbursement may not be available to enable us to maintain price levels sufficient to realize a profit.

In 2006, the Medicare Part D prescription drug benefit under the Medicare Prescription Drug Improvement and Modernization Act of 2003, or DIMA, became effective. As we expected, the Medicare Part D prescription drug benefit has negatively affected, and is likely to continue to have a negative impact on, our business. Medicare Part D prescription drug coverage will likely increase the number of senior citizens with prescription drug coverage and reduce the number of customers who pay for their prescription drugs themselves. Customers who choose to obtain coverage under a Medicare Part D plan will likely purchase fewer drugs, or no longer

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purchase drugs, from us. Because we are not currently processing claims for Medicare Part D, we will be able to serve Medicare D customers only when those customers elect to purchase outside of their Medicare Part D plan and purchase their prescriptions out-of-pocket, such as when the particular medication is not covered by the customer’s Medicare plans or when the customer’s purchase is not covered because of a deductible, co-payment, or other exclusion. Moreover, the DIMA calls for significant changes to the formulas the Medicare program uses to calculate its payments for prescription drugs, as well as introduction of managed care elements and changes to the administration of the drug benefit program. When fully implemented, these changes could exert downward pressure on prescription drug prices and payments by the government, even as the number of people who use the Medicare benefits to pay for prescription drugs increases. All of these factors could adversely affect our drug prices and dispensing fees, and ultimately could reduce our profit margins.

In addition, our revenues from prescription drug sales may also be affected by health care reform initiatives of federal and state governments, including proposals designed to address other government programs, prescription drug discount card programs, changes in programs providing for reimbursement for the cost of prescription drugs by third-party payors, and regulatory changes related to the approval process for prescription drugs. These initiatives could lead to the enactment of additional federal and state regulations that may adversely affect our prescription drug sales.

If we are unable to obtain insurance reimbursement coverage for our customers, our ability to sell pharmacy products online could decrease, which would harm our revenues.

To obtain reimbursement on behalf of our customers for the prescription products that they purchase on our website, we must maintain relationships with insurance companies, managed health organizations, and PBMs, either directly or through our relationship with Rite Aid. Many of our direct agreements with insurance companies, PBMs, and third-party benefits companies are short-term, may be terminated with less than 30 days’ prior notice, and are subject to unilateral amendment by the other party. If we are unable to establish, maintain, and leverage our direct relationships with insurers, PBMs, and third-party benefit companies, and to the extent Rite Aid is unable to maintain its relationships or if these relationships do not extend to cover the prescriptions we process, our ability to obtain reimbursement coverage for our customers would be reduced. This would reduce the number of customers that fill prescriptions through our website, which would harm our business, financial condition, and results of operations.

In addition, we must process each customer’s insurance application, which raises the costs of processing prescription orders and may delay the customer’s initial prescription order. Customers may not embrace our online insurance coverage procedure.

Our future growth strategy may depend in part on our ability to acquire complementary or strategic businesses. Any such acquisitions could result in dilution, operating difficulties, difficulties in integrating acquired businesses, and other harmful consequences.

We have acquired, and may in the future acquire, complementary or strategic businesses, technologies, services, and products as part of our strategy to increase our net sales and customer base. The process of integrating acquisitions into our business and operations has resulted in, and may in the future result in, unforeseen operating difficulties and expenditures. Integration of an acquisition also requires significant management resources that would otherwise be available for operation, ongoing development, and expansion of our business. To the extent we miscalculate our ability to integrate and properly manage acquired businesses, technologies, services, and products, or we depend on the continued service of acquired personnel who choose to leave, we may have difficulty in achieving our operating and strategic objectives. In addition, we may not realize the anticipated benefits of any acquisition.

We may be unable to identify suitable acquisition opportunities or to negotiate and complete acquisitions on favorable terms, or at all. In addition, any future acquisitions may require substantial capital resources, and, to the

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extent it is available, we may need to obtain additional capital or financing, from time to time, to fund these activities. This could result in potentially dilutive issuances of equity securities or the incurrence of debt, contingent liabilities, or amortization or impairment expenses related to goodwill and other intangible assets, any of which could harm our business, financial condition, and results of operation. Sufficient capital or financing may not be available to us on satisfactory terms, or at all.

Our business could suffer if we are unsuccessful in integrating and maintaining strategic partnerships.

We have entered into a number of strategic partnerships to build, host, and process and fulfill orders, most recently, with Rite Aid and Medco Health Solutions, Inc. We expect to continue to evaluate and consider a wide array of potential strategic partnerships as part of our growth strategy. At any given time we may be engaged in discussions or negotiations with respect to one or more of these types of transactions. Any of these transactions could be material to our financial condition and results of operations. The process of integrating and maintaining strategic partnerships may create unforeseen operating difficulties and expenditures and is itself risky. Such risks include a diversion of management time, as well as a shift of focus from operating the businesses to issues related to integration and administration of the strategic partnerships, partners having interest, strategies or goals inconsistent with ours, business decisions or other actions of our partners may result in harm to our reputation or adversely affect the value of our investment in the partnership, and we may incur additional operating losses and expenses as a result of the operations of the strategic partnerships.

Governmental regulation of our business could require significant expenditures, and failure to comply with regulations could result in civil and criminal penalties.

Our business is subject to extensive federal, state and local regulations. For example:

• entities such as drugstore.com engaging in the practice of pharmacy are subject to numerous federal and state regulatory requirements, including those relating to traditional pharmacy licensing and registration as well as additional online pharmacy requirements, the dispensing of prescription drugs, pharmacy record keeping and reporting, and the confidentiality, security, storage, and release of patient records;

• the sale, advertisement, and promotion of, among other things, prescription, OTC and homeopathic medications, dietary supplements, medical devices, cosmetics, foods, and other consumer products that we sell are subject to regulation by the Food and Drug Administration, or FDA, the Federal Trade Commission, or FTC, the Consumer Product Safety Commission, and state regulatory authorities, as the case may be; and

• our vision business is subject to the Fairness to Contact Lens Consumers Act and related regulations of the FTC, which requires all patients to renew their contact lens prescriptions annually and requires third-party contact lens sellers, like Vision Direct, to verify these prescriptions in accordance with specified procedures.

As we expand our product and service offerings and more non-pharmaceutical products become subject to FDA, FTC, and other regulation, more of our products and services will likely be subject to regulation. In addition, regulatory requirements to which our business is subject may expand over time, and some of these requirements may have a disproportionately negative effect on Internet retailers. For example, the federal government and a majority of states now regulate the retail sale of OTC products containing pseudoephedrine that might be used as precursors in the manufacture of illegal drugs. As a result, we are currently unable to sell these products to customers residing in states that require retailers to obtain a physical form of identification or maintain a signature log. Some members of Congress have proposed additional regulation of Internet pharmacies in an effort to combat the illegal sale of prescription drugs over the Internet, and state legislatures could add or amend legislation related to the regulation of nonresident pharmacies. In addition to regulating the claims made for specific types of products, the FDA and the FTC may attempt to regulate the format and content of websites

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that offer products to consumers. In addition, recently proposed legislation would place severe burdens on verifying contact lens prescriptions, and such burdens might reduce our customer base or dramatically increase our costs. Complying with regulations is time-consuming, burdensome, and expensive and could delay our introduction of new products or services.

As our website is accessible over the Internet in multiple states and other countries, and if and when we expand our marketing strategies to other countries, we may be subject to their laws and regulations or may be required to qualify to do business in those locations. Our failure to qualify in a state or country in which we are required to do so could subject us to taxes and penalties and we could be subject to legal actions and liability in those jurisdictions. The restrictions or penalties imposed by, and costs of complying with, these laws and regulations could harm our business, operating results, and financial condition. Our ability to enforce contracts and other obligations in states and countries in which we are not qualified to do business could be hampered, which could harm our business.

The laws and regulations applicable to our business often require subjective interpretation, and we cannot be certain that our efforts to comply with these regulations will be deemed sufficient by the appropriate regulatory agencies. Violations of any regulations could result in various civil and criminal penalties, including suspension or revocation of our licenses or registrations, seizure of our inventory, or monetary fines, any of which could harm our business, financial condition, or operating results. Compliance with new laws or regulations could increase our expenses or lead to delays as we adjust our websites and operations.

Increasing concern about privacy, spam, and the use and security of customer information could restrict our marketing efforts and harm our business.

Internet retailers are also subject to increasing regulation and scrutiny relating to privacy, spam, and the use and security of personal user information. These regulations, along with increased governmental or private enforcement (for example, by Internet service providers), may increase the cost of growing our business. Current and proposed regulations and enforcement efforts may restrict our ability to collect and use demographic and personal information from users and send promotional e-mails, which could be costly or harm our marketing efforts. For example, if one or more Internet service providers were to block our promotional e-mails to customers, our ability to generate orders and revenue could be harmed. Further, any violation of privacy, anti-spam, or data protection laws or regulations may subject us to fines, penalties, and damages and may otherwise have a material adverse effect on our business, results of operations, and financial condition.

Restrictions imposed by, and costs of complying with, governmental regulation of the Internet and data transmission over the Internet could harm our business.

We are subject to the same federal, state, and local laws generally applicable to businesses, as well as those directly applicable to companies conducting business online, including consumer protection laws, user privacy laws, and regulations prohibiting unfair and deceptive trade practices. In particular, many government agencies and consumers are focused on the privacy and security of medical and pharmaceutical records. Further, the growth of online commerce could result in more stringent consumer protection laws that impose additional compliance burdens on us. Today there are an increasing number of laws specifically directed at the conduct of business on the Internet. Moreover, due to the increasing use of the Internet, many additional laws and regulations relating to the Internet are being debated at the state and federal levels. These laws and regulations could cover issues such as freedom of expression, pricing, user privacy, fraud, quality of products and services, taxation, advertising, intellectual property rights, and information security. Applicability of existing laws to the Internet relating to issues such as property ownership, copyrights and other intellectual property issues, taxation, libel, obscenity, and personal privacy could also harm our business. For example, U.S. and international laws regulate our ability to use customer information and to develop, buy, and sell mailing lists. The vast majority of these laws were adopted before the advent of the Internet, and do not contemplate or address the unique issues raised by the Internet. Those laws that do reference the Internet, such as the Digital Millennium Copyright Act,

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are only beginning to be interpreted by the courts, and their applicability and reach are therefore uncertain. The restrictions imposed by, and the costs of complying with, current and possible future laws and regulations related to businesses conducted on the Internet could harm our business, operating results, and financial condition.

We may be unable to protect our intellectual property, and we may be found to infringe proprietary rights of others, which could harm our business, brand, and reputation.

Our success depends in substantial part on our proprietary rights, including our technology, copyrights, trademarks, service marks, trade dress, trade secrets, and similar intellectual property. We rely on a combination of patent, trademark, trade secret, and copyright law, as well as contractual restrictions to protect our proprietary rights. Despite our efforts to protect our proprietary rights, however, unauthorized parties may attempt to copy, obtain, and use technology or information that we regard as proprietary, such as our sales formats, the technology used to operate our website, our website content, and our trademarks. In addition, the laws of many countries do not protect our proprietary rights to the same extent as the laws of the United States.

We own a number of domain names, hold three patents and have filed applications for seven others, and have registered several trademarks and filed applications for a number of other trademarks in the United States and several other countries. We may be unable to secure the trademark registrations or patents for which we have applied, which could negatively affect our business. Our competitors or others may adopt marks or service names similar to ours, which could impede our ability to build brand identity and lead to customer confusion, and owners of other registered trademarks or trademarks that incorporate variations of our marks could bring potential trade name or trademark infringement claims against us. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as do the laws of the United States, and effective patent, copyright, trademark, and trade secret protection may not be available in such jurisdictions. Our business could be harmed if we are unable to protect or preserve the value of our trademarks, patents, copyrights, trade secrets, or other proprietary rights for any reason, or if we are subject to any claims or customer confusion related to our intellectual property or any failure or inability to protect our proprietary rights.

Litigation or proceedings before the U.S. Patent and Trademark Office or the World Intellectual Property Organization may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets and domain names, or to determine the validity and scope of the proprietary rights of others. Any litigation or adverse priority proceeding or other efforts to protect our intellectual property could result in substantial costs and diversion of resources and could seriously harm our business and operating results. Third parties have in the past, and may in the future, also assert claims against us alleging infringement, misappropriation, or other violations of patent, trademark, or other proprietary rights held by them, whether or not their claims have merit. For example, one of our subsidiaries was sued over alleged copyright and trademark violations based on use of “pop-up” advertising, although this action was settled in June 2004 without any material adverse effects to us. 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. Any such claims, whether they are with or without merit or are determined in our favor, could be time-consuming, result in costly litigation, divert the attention of our management, cause service upgrade delays, and harm our business or operating results. Furthermore, as a result of infringement claims we may be required to enter into costly royalty or licensing agreements, which may not be available on terms that are acceptable to us, or at all. If a third party successfully asserts an infringement claim against us and we are required to pay monetary damages or royalties or we are unable to obtain suitable non-infringing alternatives or license the infringed or similar intellectual property on reasonable terms on a timely basis, our business could be adversely affected.

The third-party licenses on which we rely may not continue to be available to us on commercially reasonable terms. The loss of such licenses could require us to incur greater cost or change our business plans, either of which could harm our business.

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If people or property are harmed by the products we sell, product liability claims could damage our business and reputation.

Some of the products we sell may expose us to product liability claims relating to personal injury, death, or property damage caused by these products and may require us to take actions such as product recalls. Any such product liability claim or product recall may result in adverse publicity regarding us and the products we sell, which may harm our reputation. If we are found liable under product liability claims, we could be required to pay substantial monetary damages. Further, even if we successfully defend ourselves against this type of claim, we could be forced to spend a substantial amount of money in litigation expenses, our management could be required to spend valuable time in the defense against these claims, and our reputation could suffer, any of which could harm our business. Some of our vendors do not indemnify us against product liability. Further, our liability insurance may not be adequate to protect us from all liability that may be imposed as a result of these claims, and we cannot be certain that insurance will continue to be available to us on economically reasonable terms, or at all. Any imposition of product liability that is not covered by vendor indemnification or our insurance could harm our business, financial condition, and operating results.

If we do not respond to rapid technological changes, our services could become obsolete and our business would be seriously harmed.

As the Internet and online commerce industry evolve, we must license technologies useful in our business, enhance our existing services, develop new services and technologies that address the increasingly sophisticated and varied needs of our prospective customers and respond to technological advances and emerging industry standards and practices on a cost-effective and timely basis. We may not be able to successfully implement new technologies or adapt our web stores, proprietary technology, and transaction-processing systems to meet customer requirements or emerging industry standards. Failure to successfully and timely do so could adversely affect our ability to build the drugstore.com brand and attract and retain customers.

We are subject to a number of risks related to payments we accept.

We accept payments by a variety of methods, including credit cards, gift certificates, and third-party payors such as Pay Pal, Google Checkout, and Bill Me Later. As we offer new payment options to our customers, we may be subject to additional regulations, compliance requirements, and fraud. For credit card payments and other third-party payors, we pay interchange and other fees, which may increase over time, raising our operating costs and lowering our profit margins. We are also subject to payment card association operating rules and certification requirements, which could change or be reinterpreted to make compliance difficult or impractical. If we fail to comply with these rules or requirements, we may be subject to fines and higher transaction fees and lose our ability to accept credit card payments from our customers or facilitate other types of online payments, and our business and operating results could be adversely affected.

If we are required to collect sales and use taxes on the products we sell in additional jurisdictions, we may be subject to liability for past sales and our future sales may decrease.

In accordance with current industry practice and our interpretation of applicable law, historically, we have not collected sales and use taxes or other taxes with respect to shipments of goods into states other than Washington. However, the revenue agency of the state of New Jersey, where our primary distribution center is located, has asserted that we owe state sales tax on some of our prior sales to New Jersey residents from January 3, 2000 to December 29, 2001. On February 19, 2008, we were informed of the decision by the Tax Court of New Jersey against us in the case of drugstore.com, inc. vs. Director, Division of Taxation (the “NJ Tax Case”). The NJ Tax Case represented an appeal by us of an assessment made by the New Jersey Division of Taxation (the “Division”) for $221,626 in tax, plus penalties in the amount of $11,081 and interest. The Division alleged that we failed to collect and remit sales taxes to the Division on taxable sales made in New Jersey for the years 2000 and 2001. We did not believe that we were required to collect sales taxes on sales made to customers

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in New Jersey based on applicable law. In its decision, the Tax Court of New Jersey ruled otherwise. Prior to this ruling we had not collected sales tax in New Jersey. We are appealing the Tax Court’s decision in the NJ Tax Case, and considering our other legal options. In the meantime, we have begun collecting and remitting sales tax on taxable New Jersey sales. If we are unsuccessful in our appeal, the State of New Jersey may expand its assessment to include other years for which we did not collect sales tax. The operation of our distribution centers, the operations of any future distribution centers, our drop-shipping agreements with vendors, and other aspects of our evolving business, however, may result in additional sales and use tax collection obligations. In addition, one or more other states may successfully assert that we should collect sales and use or other taxes on the sale of our products in that state. One or more states or the federal government may seek, either through unilateral action or through federal legislation, to impose sales or other tax collection obligations on out-of-jurisdiction companies that engage in electronic commerce as we do. Effective July 2008, New York imposed such a sales tax obligation requirement on on-line retailers that use New York residents to directly or indirectly refer potential customers, via a link on an Internet Website or otherwise, to the online retailer. As a result, we began collecting and remitting sales tax in New York in July 2008. Moreover, one or more states could begin to impose sales taxes on sales of prescription products, which are not generally taxed at this time. While we believe we are in compliance with existing laws and regulations, we could be subject to significant fines or other payments for any unintentional past failure to comply with tax regulations. This could result in substantial tax liabilities for our past sales, decrease our ability to compete with traditional retailers, and otherwise harm our business, financial condition, and operating results.

Currently, decisions of the U.S. Supreme Court restrict the ability of states to collect state and local sales and use taxes with respect to sales made by companies lacking a physical presence in the state. However, a number of states have passed and have been considering various initiatives that could limit or supersede the Supreme Court’s position regarding sales and use taxes on Internet sales. If any of these initiatives addressed the Supreme Court’s constitutional concerns and resulted in a reversal of its current position, we could be required to collect and remit sales and use taxes in states other than Washington, New York and New Jersey. In addition, applicable law in most states does not currently require us to collect sales tax on the sales of prescription medications. If this law were to change, we would be required to collect and remit sales and use taxes for prescription products. The imposition of additional tax obligations on our business by state and local governments could create significant administrative burdens for us, decrease our future sales, and harm our cash flow and operating results.

Certain stockholders own a significant amount of our common stock, which could discourage an acquisition of drugstore.com or make removal of incumbent management more difficult.

Amazon.com beneficially owns approximately 13% of our outstanding stock, and is entitled to designate a director to serve on our board of directors, currently Geoffrey R. Entress. Kleiner Perkins Caufield and Byers, or KPCB, owns approximately 11% of our outstanding stock, and Samana Capital, L.P (formerly Ziff Asset Management, L.P.)., or Samana, owns approximately 10% of our outstanding stock. Because each owns a significant percentage of our capital stock, Amazon.com, KPCB, or Samana, or more than one of them, could significantly influence all matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions. Furthermore, because of these substantial equity stakes in drugstore.com, competitors of Amazon.com, KPCB, or Samana, or other potential acquirers could decide not to merge with, or acquire, us. In addition, in the case of a potential acquisition of drugstore.com by another party, a substantial equity stake in drugstore.com could prevent the tax-free treatment of an acquisition, making drugstore.com a less attractive acquisition candidate. In addition, if any of our significant stockholders were to sell a substantial quantity of their holdings in a short period of time, our stock price could decline.

ITEM 1B.  UNRESOLVED STAFF COMMENTS

None.

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ITEM 2. PROPERTIES

Our principal executive offices are located in Bellevue, Washington, where we lease approximately 53,000 square feet under a lease that expires in July 2013, with two separate five-year renewal options that, if exercised, would extend the lease expiration to July 2023. We also lease office space of approximately 1,400 square feet in Bellevue, Washington, under a sub-lease that expires in July 2009. Our primary distribution facility for our OTC and mail-order pharmacy segments is located in Swedesboro, New Jersey, where we lease approximately 270,000 square feet under a lease that expires in December 2010, with options to renew for two additional five-year periods. We also lease an inventory storage facility in Logan Township, New Jersey for 85,000 square feet through February 2011. The distribution facility for our vision segment is located in Ferndale, Washington, where we lease approximately 16,600 square feet under a lease that ends July 2009. We lease approximately 11,500 square feet under a lease that expires in March 2011 for our principal customer care center, which is located in Halifax, Nova Scotia, Canada.

In 2007, we made improvements to our existing New Jersey distribution center to improve capacity and increase efficiency, and entered into an agreement to lease an inventory storage facility to provide a temporary overflow solution. Our overall goal is to leverage our existing distribution center as much as possible. Management regularly reviews our anticipated requirements for all of our facilities and the costs and benefits associated with new facilities and, based on that review, may adjust other of our facilities needs, as well.

ITEM 3. LEGAL PROCEEDINGS

See Note 8 of our consolidated financial statements, “Commitments and Contingencies—Legal Proceedings,” included in Part IV, Item 15 of this annual report.

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

No matters were submitted to a vote of our stockholders during the fourth quarter of fiscal year 2008.

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PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON STOCK, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information

Our common stock is traded on the NASDAQ Global Market under the symbol “DSCM.” The following table sets forth, for the periods indicated, the high and low sales prices of our common stock, as reported by the NASDAQ Global Market.

	High		Low
Fiscal Year Ended December 28, 2008
First Quarter	$	3.38	$	2.03
Second Quarter	$	2.50	$	0.95
Third Quarter	$	2.89	$	1.66
Fourth Quarter	$	2.75	$	0.74
	High		Low
Fiscal Year Ended December 30, 2007
First Quarter	$	3.83	$	2.35
Second Quarter	$	2.90	$	2.40
Third Quarter	$	3.26	$	2.60
Fourth Quarter	$	3.74	$	2.90

Holders of Record

As of March 5, 2009, there were approximately 775 holders of record of our common stock, and a much larger number of beneficial owners.

Dividends

We have never declared or paid cash or stock dividends on our capital stock. We currently intend to retain all available funds and any future earnings for use in the operation and expansion of our business and do not anticipate paying any dividends in the foreseeable future.

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Performance Graph

The graph below shows the relative investment performance of our common stock, the NASDAQ Stock Market Index and the Morgan Stanley High-Technology Index for the last five years. The following graph is presented pursuant to SEC rules and is not meant to be an indication of our future performance.

	12/28/2003		1/2/2005		1/1/2006		12/31/2006		12/30/2007		12/28/2008
drugstore.com	$	100.00	$	67.19	$	56.32	$	72.33	$	64.82	$	22.73
NASDAQ Stock Market (U.S.) Index	$	100.00	$	110.25	$	111.77	$	122.41	$	135.54	$	77.55
Morgan Stanley High Tech Index	$	100.00	$	108.33	$	111.44	$	121.25	$	134.29	$	70.54

Recent Sales of Unregistered Securities

None.

Issuer Purchases of Equity Securities

None.

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ITEM 6. SELECTED FINANCIAL DATA

	Fiscal Year
	2008			2007			2006			2005			2004
	(in thousands, except share and per share data)
Consolidated Statements of Operations Data:
Net sales	$	366,579		$	339,331		$	315,123		$	303,304		$	267,659
Loss before income taxes		(16,367	)		(17,619	)		(17,608	)		(26,045	)		(52,634	)
Income tax benefit		—			—			—			—			980
Loss from continuing operations		(16,367	)		(17,619	)		(17,608	)		(26,045	)		(51,654	)
Gain from discontinued operations, net of tax (2)		8,080			6,108			4,582			5,146			3,919
Net loss (1)	$	(8,287	)	$	(11,511	)	$	(13,026	)	$	(20,899	)	$	(47,735	)
Basic and diluted loss from continuing operations per share	$	(0.17	)	$	(0.18	)	$	(0.19	)	$	(0.29	)	$	(0.67	)
Basic and diluted gain from discontinued operations per share	$	0.08		$	0.06		$	0.05		$	0.06		$	0.05
Basic and diluted net loss per share	$	(0.09	)	$	(0.12	)	$	(0.14	)	$	(0.23	)	$	(0.62	)
Weighted average shares outstanding		96,481,787			95,350,046			93,405,405			90,808,817			76,650,915
Consolidated Balance Sheet Data:
Cash, cash equivalents and marketable securities	$	38,194		$	36,249		$	40,639		$	46,463		$	34,219
Cash dividends declared per common share		—			—			—			—			—
Working capital		34,330			35,340			40,886			46,075			33,551
Total assets		152,549			175,408			168,322			170,563			158,511
Long-term debt obligations, less current portion		2,567			1,221			1,839			2,685			1,807
Total stockholders’ equity	$	94,200		$	94,368		$	92,678		$	96,271		$	87,128

(1) Includes impairment charges to long-lived assets of $27,460 in 2004.

(2) The results of operations of our LPU segment have been classified as discontinued operations in all periods presented.

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes included in Part IV, Item 15 of this annual report.

Overview

drugstore.com, inc. is a leading online provider of health, beauty, vision, and pharmacy products. We believe that we offer a better way for consumers to shop for these products through our web stores, including those located on the Internet at www.drugstore.com, www.beauty.com, www.riteaidonlinestore.com, www.visiondirect.com, www.lensmart.com, www.lensworld.com, and www.lensquest.com.

We operate on a 52/53-week retail calendar, with each quarter in a 52-week fiscal year representing a 13-week period. Fiscal years 2008, 2007, and 2006 were 52-week fiscal years. References in the following discussion to yearly periods are to fiscal years, unless the context indicates otherwise. The year “2008” refers to the fiscal year ended December 28, 2008, year “2007” refers to the fiscal year ended December 30, 2007, and “2006” refers to the fiscal year ended December 31, 2006.

Business Segments; Growth Strategies. We operate our business in three business segments: over-the-counter (OTC); vision; and mail-order pharmacy.

• OTC. Our OTC segment includes all non-prescription products sold online through our web stores at www.drugstore.com, www.beauty.com, www.riteaidonlinestore.com, www.visiondirect.com, www.lensmart.com, www.lensworld.com, and www.lensquest.com, or over the telephone at 1-800-DRUGSTORE or 1-800-VISIONDIRECT, including nutritional supplements sold through our subsidiary Custom Nutrition Services, Inc., or CNS. We source our OTC products from various manufacturers and distributors. We also sell advertising on our primary OTC site www.drugstore.com. Our business strategy is to offer our customers a wide selection of health, beauty, personal care, household, and other products at competitive prices and a superior online shopping experience. We are able to offer a significantly broader assortment of products, with greater depth in each product category, than brick-and-mortar drugstores, and provide a broad array of interactive tools and information on our websites to help consumers make informed purchasing decisions. We believe leveraging our strong capabilities in Internet marketing, merchandising, fulfillment, and customer care in the health, beauty, and wellness arena will be a key growth driver for our OTC segment. In 2009, we are focusing on key initiatives such as international market expansion and further development of our Medco, Rite Aid, and new beauty partnerships to accelerate OTC growth.

• Vision. The vision segment includes contact lenses sold through our wholly owned subsidiary Vision Direct Inc. (Vision Direct), through web stores located at www.visiondirect.com, www.lensmart.com, and www.lensquest.com, or over the telephone at 1-800-VISIONDIRECT. We purchase our contact lens inventory directly from various manufacturers and other distributors. In 2009, we will continue to focus on balancing customer acquisition with net margin in order to maximize our profits.

• Mail-Order Pharmacy. Our mail-order pharmacy segment includes prescription drugs and supplies, other than prescription contact lenses, sold online through the pharmacy section of the drugstore.com web store or over the telephone and delivered to customers through our mail-order facility. We procure our prescription inventory through Rite Aid Corporation as part of our ongoing relationship. We market to both cash-paying and insurance-covered individuals, and we also serve as a third-party provider of mail-order prescription fulfillment services for pharmacy benefit managers, or PBMs. We sell over 5,500 prescription drugs, including many specialty drugs for the treatment of chronic conditions such as cancer, HIV, and multiple sclerosis, which are not carried by brick-and-mortar pharmacies and require special handling or service. In this segment, we focus our marketing efforts directly on consumers online and through doctors to maximize growth in our cash prescription and specialty

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pharmacy business. In addition to the sale of prescription drugs, we sell advertising on our website to monetize the large volume of unique visitors per month researching drugs and other healthcare content provided on the site. In 2009, we anticipate that our mail-order pharmacy segment revenues will decline due to the loss of one of our PBM customers as a result of an acquisition in late 2008, but anticipate continued year-over-year contribution margin improvements.

Discontinued Operations. On September 3, 2008, we entered into an amended and restated main agreement with Rite Aid whereby we transferred to Rite Aid the rights to our local pick-up pharmacy business (LPU), which includes prescription refills sold online through the drugstore.com web store or the Rite Aid online store and picked up by customers at Rite Aid stores, in exchange for $9.9 million, paid in ten monthly installments beginning in September 2008. We recorded the purchase price as a deferred gain that we are recognizing over the ten-month contractual payment period ending in June 2009. Additionally, Rite Aid will pay drugstore.com ongoing marketing service fees for the continued marketing of Rite Aid’s LPU offering on the drugstore.com site during the term of the agreement, which continues for two years unless extended for another year by either party. The marketing service fees are considered indirect cash inflows of our discontinued LPU segment, as we anticipate the fees earned will not be a significant source of ongoing revenue in the future. The results of operations of our LPU segment have been classified as discontinued operations in the consolidated financial statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations for all periods presented.

Revenues. We generate revenue primarily from product sales and shipping fees. In 2008, we reported consolidated total net sales of $366.6 million, which reflected a $27.2 million, or 8%, increase over 2007. Our net sales growth was driven by a 7% year-over-year increase in our total order volume for 2008, to 5.3 million orders. Our average net sales per order increased to $69 in 2008, from $68 in 2007. Our revenues benefited from strong year-over-year growth in our largest segments, OTC and vision of 11% and 12%, respectively. These increases were partially offset by a year-over-year decrease in mail-order pharmacy net sales of 12%.

Expenses. Our operating expenses, including cost of goods sold, decreased as a percentage of net sales to 105% in 2008 compared to 106% in 2007. In 2008, our overall cost of goods sold as a percentage of net sales decreased year-over-year by 130 basis points due to a favorable shift in our product mix to higher margin OTC sales, as well as improvements in our OTC and mail-order pharmacy margins. As a percentage of net sales, our improved gross margins in 2008 were partially offset by increased fulfillment expenses incurred in our primary distribution center related to process improvement projects, increased marketing expenses resulting from increased paid order volume and increased employee-related costs, and increased technology and content expenses resulting from increased depreciation and software maintenance expense driven by the completion of internally developed software projects and the acquisition of software and computer equipment to enhance our websites and IT infrastructure, as well as increased IT employee-related costs. In 2008, general and administrative expenses as a percentage of net sales decreased primarily due to a $2.5 million charge in 2007 related to estimated sales taxes and interest on an unfavorable ruling on our New Jersey sales tax case, and lower stock-based compensation expenses, partially offset by increased professional fees related primarily to a consulting project focused on our profitability initiatives.

Net Loss; Cash Position. Our net loss for 2008 decreased by 28%, or $3.2 million, to $8.3 million, compared to $11.5 million for the year ended December 30, 2007. We ended 2008 with $38.2 million in cash, cash equivalents, and marketable securities, compared to $36.2 million at the end of 2007. This balance reflects cash provided by operating activities from continuing operations, and discontinued operations of $9.9 million in 2008, proceeds of $4.0 million from the sale of discontinued operations, proceeds from borrowings on our line of credit of $5.0 million, and proceeds received of $0.5 million from the exercise of employee stock options and purchases under our employee stock purchase plan, partially offset by $13.2 million for capital expenditures, and $4.4 million to repay debt obligations.

Economic Environment. In the fourth quarter, we felt some impact from the current economic downturn, as we saw a less-than-normal seasonal increase in sales of our discretionary items, such as our holiday gift offerings, and

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greater utilization of free shipping offers. We also saw and expect to see elevated response rates to coupons and other promotional offers by increasingly price-conscious customers. That said, we are finding that overall orders are less affected by the economic slowdown, due in part to our value-pricing and the non-discretionary nature of many of our products.

Results of Operations

Customer Data

We shipped approximately 1.4 million new customer orders during 2008, increasing our total customer base to 9.8 million customers since inception. Orders from repeat customers as a percentage of total orders remained consistent year-over-year at 72% for 2008 and 2007. Orders from repeat customers as a percentage of total orders decreased in 2007 from 73% in 2006, primarily as a result of a decrease in repeat orders in our mail-order pharmacy segment. Active customer base includes those customers who have purchased at least once within the last 12 months and the number of customer orders includes new and repeat orders made through the drugstore.com web store and the web stores of our subsidiaries, orders generated through the Rite Aid online store, orders generated through the beauty.com Amazon marketplace, and orders generated through our fulfillment agreement with Weil, under which we host a Weil-branded store and fulfill Weil vitamin orders made on the drugstore.com web store.

Net Sales

	Fiscal Year 2008		% Change		Fiscal Year 2007		% Change		Fiscal Year 2006
	(in thousands, except per order data)
Total net sales	$	366,579	8.0	%	$	339,331	7.7	%	$	315,123
Total customer orders shipped		5,325	7.3	%		4,964	11.1	%		4,468
Total average net sales per order	$	69	1.5	%	$	68	-4.2	%	$	71

Net sales include gross revenues from sales of product, shipping fees, and service fees, net of discounts and provision for sales returns, and other allowances. Net sales also include consignment service fees earned from our arrangement with GNC, under which we do not take title to the inventory and do not establish pricing. We record on a net basis consignment service fees, which constitute approximately 1% of total net sales in each period presented. We bill orders to the customer’s credit card or, in the case of prescriptions covered by insurance, we bill the co-payment to the customer’s credit card and the remainder of the prescription price to insurance. We record sales of pharmaceutical products covered by insurance as the sum of the amounts received from the customer and the third party insurer.

Total net sales increased in 2008 compared to the prior year, as a result of an increase in order volume and average net sales per order. Revenues from repeat customers decreased to 78% of net sales in 2008, compared to 79% in 2007, primarily as a result of a decrease in revenue from repeat customers in our mail-order pharmacy and vision segments. The year-over-year increase in average net sales per order in 2008 resulted from improvements in all of our segments’ net sales per order. Compared to 2007, net sales in our OTC and vision segments increased by $26.5 million and $6.5 million, respectively, and net sales in our mail-order pharmacy segment decreased by $5.8 million. Total net sales increased in 2007 compared to the prior year, as a result of an increase in order volume, partially offset by a decrease in the average net revenue per order. Revenues from repeat customers decreased to 79% of net sales in 2007, compared to 80% in 2006, primarily as a result of a decrease in revenue from repeat customers in our mail-order pharmacy segment. The year-over-year decrease in average net sales per order in 2007 resulted from a decrease in our mail-order pharmacy segment average net sales per order, partially offset by an increase in our average net revenue per order in our OTC and vision segments. Compared to 2006, net sales in our OTC and vision segments in 2007 increased by $36.3 million and $5.1 million, respectively, and net sales in our mail-order pharmacy segment decreased by $17.2 million.

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OTC Net Sales

	Fiscal Year 2008			% Change		Fiscal Year 2007			% Change		Fiscal Year 2006
	(in thousands, except per order data)
OTC net sales	$	260,794		11.3	%	$	234,282		18.3	%	$	197,964
Percentage of total net sales from OTC		71.1	%				69.0	%				62.8	%
OTC average net sales per order	$	58		1.8	%	$	57		1.8	%	$	56

Net sales in our OTC segment increased year-over-year in 2008 and 2007, as a result of an increase in order volume and average net sales per order. The number of orders in our OTC segment grew year-over-year by 10% to 4.5 million in 2008, compared to 4.1 million in 2007. Our core OTC net sales, which exclude CNS net sales of $1.8 million in 2008, increased by 12% to $259.0 million in 2008, compared to $232.4 million in 2007. The number of orders in our core OTC segment grew by 10% to 4.4 million in 2008, compared to 4.0 million in 2007. Average net sales per order for our OTC segment increased to $58 in 2008, compared to $57 in 2007, and average net sales per order for our core OTC segment remained consistent at $58. The number of orders in our OTC segment grew year-over-year by 16% to 4.1 million in 2007, compared to 3.5 million in 2006. Our core OTC net sales, which exclude CNS net sales of $1.9 million in 2007, increased by 19% to $232.4 million in 2007, compared to $195.6 million in 2006. The number of orders in our core OTC segment grew by 17% to 4.0 million in 2007, compared to just under 3.5 million in 2006. Average net sales per order for our OTC segment increased to $57 in 2007, compared to $56 in 2006, and average net sales per order for our core OTC segment increased to $58 in 2007, compared to $57 in 2006.

The year-over-year increase in OTC order volumes in 2008 and 2007 was driven by increased orders from both new and repeat customers as a result of our increasing active customer base and our continued efforts to improve customer retention and conversion by adding website enhancements and offering a broad selection of basic necessity items and hard-to-find specialty items through the addition of new SKUs, which encourages customers to return to our websites and make repeat, replenishment, and impulse purchases. The slight year-over-year increase in average net sales per order in our OTC segment in 2008 and 2007 resulted from selling higher-priced items, offset slightly by a decrease in the number of items per order.

Vision Net Sales

	Fiscal Year 2008			% Change		Fiscal Year 2007			% Change		Fiscal Year 2006
	(in thousands, except per order data)
Vision net sales	$	61,420		11.9	%	$	54,906		10.3	%	$	49,780
Percentage of total net sales from vision		16.8	%				16.2	%				15.8	%
Vision average net sales per order	$	111		12.1	%	$	99		10.0	%	$	90

Net sales in our vision segment increased year-over-year in 2008 and 2007, as a result of an increase in average net sales per order driven primarily by offering volume discounts, which resulted in an increase in the average number of items sold per order, selling higher priced, newer technology contact lenses, and price increases for certain SKUs, partially offset by increased discount and promotional offers (none of which were individually material). The number of orders, both new and repeat, in this segment remained relatively flat at 553,000 in 2008, 553,000 in 2007, and 551,000 in 2006, respectively.

Mail-Order Pharmacy Net Sales

	Fiscal Year 2008			% Change		Fiscal Year 2007			% Change		Fiscal Year 2006
	(in thousands, except per order data)
Mail-order pharmacy net sales	$	44,365		-11.5	%	$	50,143		-25.6	%	$	67,379
Percentage of total net sales from mail-order pharmacy		12.1	%				14.8	%				21.4	%
Mail-order pharmacy average net sales per order	$	161		1.3	%	$	159		-3.0	%	$	164

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Net sales in our mail-order pharmacy segment decreased year-over-year in 2008 and 2007, primarily as a result of a decrease in order volume. The number of orders in this segment decreased by 12% in 2008 to 276,000 orders, compared to 315,000 orders in 2007, and decreased 23% in 2007 from 411,000 orders in 2006. The 2008 decrease reflects a decrease in orders from both new and repeat customers, including a loss in the fourth quarter of $0.9 million in net sales from one PBM resulting from the sale of this PBM. The 2007 decrease reflects a 46% decrease in orders from PBMs, due to our decision to exit unprofitable partnerships, and a 19% decrease in orders from both new and repeat customers. Average net sales per order increased in 2008 compared to 2007, but decreased in 2007 compared to 2006. Included in net sales of our mail-order pharmacy segment in 2008 were wholesale orders to two parties totaling $1.8 million, which increased our average net sales per order by $7 in 2008; included in net sales of our mail-order pharmacy segment in 2007 were wholesale orders to two parties totaling $2.4 million, which increased our average net sales per order by $8 in 2007; and included in net sales in 2006 were wholesale orders to one party totaling $3.5 million, which increased our average net sales per order by $9 in 2006. Excluding the wholesale orders, average net sales per order increased by $3 in this segment in 2008 compared to the prior year, as a result of a price increases on certain brand and generic products as part of our profitability initiatives. Excluding the wholesale orders, average net sales per order decreased by $4 in this segment in 2007 compared to the prior year, as a result of a decrease in orders from PBMs which have higher net revenues per order but lower per order net margins.

Cost of Sales and Gross Margin

	Fiscal Year 2008			% Change		Fiscal Year 2007			% Change		Fiscal Year 2006
	($ in thousands)
Total cost of sales	$	263,697		6.2	%	$	248,308		5.0	%	$	236,382
Total gross profit dollars	$	102,882		13.0	%	$	91,023		15.6	%	$	78,741
Total gross margin percentage		28.1	%				26.8	%				25.0	%

Cost of sales consists primarily of the cost of products sold to our customers, including allowances for shrinkage and damaged, slow-moving, and expired inventory, outbound and inbound shipping costs, and expenses related to promotional inventory included in shipments to customers. Payments that we receive from vendors in connection with volume purchases or rebate allowances and payment discount terms are netted against cost of sales.

Total cost of sales increased year-over-year in absolute dollars in 2008 and 2007, as a result of growth in order volume and net sales. Gross margin percentage increased year-over-year in 2008 and 2007, as a result of a larger proportion of net sales in our OTC segment, which is our highest-margin segment, and improved gross margin percentages in our OTC and mail-order pharmacy segments in 2008, and in all of our business segments in 2007.

Shipping

	Fiscal Year 2008			% Change		Fiscal Year 2007			% Change		Fiscal Year 2006
	($ in thousands)
Shipping activity:
Shipping revenue	$	14,799		-3.9	%	$	15,403		13.1	%	$	13,618
Shipping costs		($26,803	)	8.1	%		($24,802	)	13.2	%		($21,905	)
Net shipping loss		($12,004	)	27.7	%		($9,399	)	13.4	%		($8,287	)
Percentage of net sales:
Shipping revenue		4.0	%				4.5	%				4.3	%
Shipping costs		-7.3	%				-7.3	%				-7.0	%
Net shipping loss		-3.3	%				-2.8	%				-2.6	%

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We include in net sales our revenues from shipping charges to customers, and we include in cost of sales outbound shipping costs. Our net shipping loss increased in absolute dollars and as a percentage of net sales in 2008 compared to the prior year, as a result of a decrease in shipping revenue resulting from a decrease in the number of customers choosing expedited shipping methods for their orders and the elimination of surcharges for APO/FPO and Alaska and Hawaii orders, combined with an increase in shipping costs resulting from a higher mix of OTC orders, which have a higher shipping cost than orders in our other business segments, and increasing fuel surcharges by our primary shipping carrier. In late 2007, we renegotiated lower contractual rates from our largest shipping carrier, which had a favorable impact on our net shipping loss in 2008, but was partially offset by increasing fuel surcharges. Our net shipping loss increased in absolute dollars and as a percentage of net sales in 2007 compared to the prior year, as a result of a higher mix of OTC orders. We expect to continue to subsidize a portion of customers’ shipping costs for the foreseeable future, through certain free shipping options, as a strategy to attract and retain customers.

OTC Cost of Sales and Gross Margin

	Fiscal Year 2008			% Change		Fiscal Year 2007			% Change		Fiscal Year 2006
	($ in thousands)
OTC cost of sales	$	180,252		9.6	%	$	164,469		17.8	%	$	139,674
OTC gross profit dollars	$	80,542				$	69,813				$	58,290
OTC gross margin percentage		30.9	%				29.8	%				29.4	%

Cost of sales in our OTC segment increased year-over-year in absolute dollars in 2008 and 2007, as a result of growth in order volume and net sales. Gross margin percentage increased in this segment in 2008 compared to the prior year, primarily as a result of improvements in product margins in a majority of our product categories as a result of our ongoing pricing and sourcing profitability initiatives, and to a lesser extent, a shift in sales mix to higher margin product categories. Gross margin percentage increased in this segment in 2007 compared to the prior year, primarily as a result of a shift in sales mix to higher margin prestige beauty products.

Vision Cost of Sales and Gross Margin

	Fiscal Year 2008			% Change		Fiscal Year 2007			% Change		Fiscal Year 2006
	($ in thousands)
Vision cost of sales	$	47,279		12.8	%	$	41,904		8.3	%	$	38,682
Vision gross profit dollars	$	14,141				$	13,002				$	11,098
Vision gross margin percentage		23.0	%				23.7	%				22.3	%

Cost of sales in our vision segment increased year-over-year in absolute dollars in 2008 and 2007, as a result of an increase in net sales. Gross margin percentage decreased in this segment in 2008 compared to the prior year, primarily from increased promotional offers, which increase the average net sales per order, but have an unfavorable impact on gross margin percentage. Gross margin percentage increased in this segment in 2007 compared to the prior year, as a result of a shift in product mix to higher margin contact lenses, and to a lesser extent, increased prices on certain products, offset by increased discount and promotional offers.

Mail-Order Pharmacy Cost of Sales and Gross Margin

	Fiscal Year 2008			% Change		Fiscal Year 2007			% Change		Fiscal Year 2006
	($ in thousands)
Mail-order pharmacy cost of sales	$	36,166		-13.8	%	$	41,935		-27.7	%	$	58,026
Mail-order pharmacy gross profit dollars	$	8,199				$	8,208				$	9,353
Mail-order pharmacy gross margin percentage		18.5	%				16.4	%				13.9	%

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Cost of sales in our mail-order pharmacy segment decreased year-over-year in absolute dollars in 2008 and 2007, as a result of a decrease in order volume and net sales. Gross margin percentage increased in this segment in 2008 compared to the prior year, primarily from our ongoing review of pricing and profitability of pharmaceutical products, and the loss of orders from one of our PBMs in late 2008, which had lower per order net margins. Gross margin percentage increased in this segment in 2007 compared to the prior year, as a result of improved margins from exiting unprofitable partnerships with certain PBMs in 2006 and our ongoing review of pricing and profitability of pharmaceutical products.

Fulfillment and Order Processing Expense

	Fiscal Year 2008			% Change		Fiscal Year 2007			% Change		Fiscal Year 2006
	($ in thousands)
Fulfillment and order processing expense	$	43,377		8.9	%	$	39,817		7.7	%	$	36,971
Percentage of net sales		11.8	%				11.7	%				11.7	%
Fixed and variable cost information:
Variable costs	$	29,754		3.2	%	$	28,829		8.5	%	$	26,567
Fixed costs	$	13,623		24.0	%	$	10,988		5.6	%	$	10,404

Fulfillment and order processing expenses include payroll and related expenses for personnel engaged in purchasing, fulfillment, distribution, and customer care activities (including warehouse personnel and pharmacists engaged in prescription verification activities), distribution center equipment and packaging supplies, credit card processing fees, and bad debt expenses. These expenses also include rent and depreciation related to equipment and fixtures in our distribution center and call center facilities. Variable fulfillment costs represent the incremental (variable) costs of fulfilling, processing, and delivering the order that are variable based on sales volume.

Variable fulfillment and order processing expenses increased by $925,000 in 2008 compared to the prior year, primarily as a result of a 10% increase in order volume in our OTC segment. Fixed fulfillment and order processing expenses increased by $2.6 million in 2008 compared to the prior year, primarily as a result of increased costs in our distribution facilities, including facility related costs of $832,000 resulting from the addition of our inventory storage facility in the second half of 2007 and increased routine repairs and maintenance, increased depreciation expense of $827,000 related to equipment and software purchases, increased professional fees of $779,000, related to process improvement projects, and increased employee related costs of $198,000. Fulfillment and order processing expenses as a percentage of net sales increased in 2008, as a result of an increase in fixed costs, partially offset by a year-over-year 40 basis point improvement in variable costs as a percentage of net sales in 2008, due to increased efficiencies in our primary distribution facility.

Variable fulfillment and order processing expenses increased by $2.3 million in 2007 compared to the prior year, primarily as a result of a 16% increase in order volume in our OTC segment, partially offset by a 23% decrease in order volume in our mail-order pharmacy segment. Fixed fulfillment and order processing expenses increased by $584,000 in 2007 compared to the prior year, primarily as a result of increased depreciation expense of $350,000 related to improvements made to our primary distribution center, and increased personnel costs of $204,000 resulting primarily from an increase in headcount. Fulfillment and order processing expenses as a percentage of net sales remained flat in 2007 compared to 2006.

Marketing and Sales Expense

	Fiscal Year 2008			% Change		Fiscal Year 2007			% Change		Fiscal Year 2006
	($ in thousands)
Marketing and sales expense	$	33,591		11.7	%	$	30,080		9.6	%	$	27,445
Percentage of net sales		9.2	%				8.9	%				8.7	%

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Marketing and sales expenses include advertising expenses, promotional expenditures, web analytical tools, web design, and payroll and related expenses for personnel engaged in marketing and merchandising activities. Advertising expenses include our obligations under various advertising contracts. In addition, marketing and sales expense include royalty expenses of $91,000 in 2008, $105,000 in 2007, and $62,000 in 2006. Advertising and promotional costs were $23.2 million in 2008, $20.7 million in 2007, and $18.7 million in 2006.

Marketing and sales expenses increased both in absolute dollars and as a percentage of net sales in 2008 compared to the prior year. The year-over-year increase of $3.5 million in 2008 resulted primarily from an increase of $2.5 million in paid search, affiliate, and portal costs, driven primarily by an increase in order volume in our OTC segment, an increase in the percentage of paid orders to total orders in both our OTC and vision segments, and an increase in cost per order in our vision segment, increased employee related costs of $832,000 driven by an increase in headcount and stock-based compensation, and an increase in other operating costs of $174,000. Marketing and sales expenses increased in absolute dollars and as a percentage of net sales in 2007 compared to the prior year. The year-over-year increase of $2.6 million resulted primarily from an increase of $4.0 million in paid search, affiliate, and portal costs, driven by an increase in order volume and cost per order, an increase in personnel expenses of $466,000, primarily due to increased stock-based compensation, an increase in professional fees of $160,000, partially offset by a reduction of costs of $2.0 million related to our brand awareness campaign, which we concluded in the first quarter of 2006, as a result of the brand campaign not producing results quickly enough to serve our near-term profitability goals.

Marketing and sales expense per new customer remained consistent between 2008 and 2007 at $23 and was higher in 2006 at $24, primarily as a result of the conclusion of our brand awareness campaign in the first quarter of 2006.

Technology and Content Expense

	Fiscal Year 2008			% Change		Fiscal Year 2007			% Change		Fiscal Year 2006
	($ in thousands)
Technology and content expense	$	23,011		26.0	%	$	18,258		12.8	%	$	16,190
Percentage of net sales		6.3	%				5.4	%				5.1	%

Technology and content expenses consist primarily of payroll and related expenses for personnel engaged in developing, maintaining, and making routine upgrades and improvements to our websites. Technology and content expenses also include Internet access and hosting charges, depreciation on hardware and IT structures, utilities, and website content and design expenses.

Technology and content expenses increased both in absolute dollars and as a percentage of net sales in 2008 compared to the prior year. The year-over-year increase of $4.8 million resulted primarily from increases in depreciation costs of $2.5 million and increases in software license and maintenance costs of $460,000, resulting from the completion of internally developed software projects and the acquisition of software and computer equipment to enhance our websites and IT infrastructure, and an increase in employee related costs of $1.7 million driven primarily by headcount and increased utilization of external IT contractors. Technology and content expenses increased both in absolute dollars and as a percentage of net sales in 2007 compared to the prior year. The year-over-year increase of $2.1 million resulted primarily from increases in depreciation costs of $1.1 million and increases in software license and maintenance costs of $675,000, resulting from the completion of internally developed software projects and the acquisition of software and computer equipment to enhance our websites and IT infrastructure, and to a lesser extent, an increase of $152,000 of stock-based compensation expense.

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General and Administrative Expense

	Fiscal Year 2008			% Change		Fiscal Year 2007			% Change		Fiscal Year 2006
	($ in thousands)
General and administrative expense	$	19,034		-9.1	%	$	20,928		35.8	%	$	15,413
Percentage of net sales		5.2	%				6.2	%				4.9	%

General and administrative expenses consist of payroll and related expenses for executive and administrative personnel, corporate facility expenses, professional service expenses, and other general corporate expenses.

General and administrative expenses decreased in both absolute dollars and as a percentage of net sales in 2008 compared to the prior year. The year-over-year decrease of $1.9 million resulted primarily from a $2.5 million expense in 2007 related to an estimate recorded for sales taxes and interest on an unfavorable ruling on our NJ sales tax case, and a decrease in stock-based compensation of $1.3 million, partially offset by a $1.6 million increase in professional fees, primarily related to a consulting project focused on our profitability initiatives and increased legal and tax and accounting fees, and an increase of $380,000 resulting from sales taxes and interest on the NJ sales tax case. General and administrative expenses increased in both absolute dollars and as a percentage of net sales in 2007 compared to the prior year. The year-over-year increase of $5.5 million in 2007 resulted primarily from the $2.5 million expense related to the unfavorable ruling on our NJ sales tax case, an increase in professional fees of $1.2 million, related primarily to a consulting project focused on our profitability initiatives, and an increase in stock-based compensation of $1.7 million, resulting from the issuance of warrants for services totaling $529,000 and the amortization of stock-based compensation under FAS 123(R).

Amortization of Intangible Assets

	Fiscal Year 2008			% Change		Fiscal Year 2007			% Change		Fiscal Year 2006
	($ in thousands)
Amortization of intangible assets	$	867		-29.7	%	$	1,234		-40.1	%	$	2,060
Percentage of net sales		0.2	%				0.4	%				0.7	%

Amortization of intangible assets includes the amortization expense associated with assets acquired in connection with our acquisitions of CNS and Acumins, Inc., and assets acquired in connection with our agreement with GNC, and other intangible assets, including a technology license agreement, domain names, and trademarks. In the third quarter of 2007, we acquired for $456,000 certain trademarks and intangibles associated with our private label de~luxe^™ brand of natural, spa quality personal care products.

Amortization expense decreased in 2008 and 2007 compared to the prior year, as a result of certain intangible assets being fully amortized in each of the three years.

Interest Income and Expense

	Fiscal Year 2008		% Change		Fiscal Year 2007		% Change		Fiscal Year 2006
	($ in thousands)
Interest income, net	$	631	-62.3	%	$	1,675	-3.2	%	$	1,730

Interest income consists of earnings on our cash, cash equivalents, and marketable securities, and interest expense consists primarily of interest associated with capital lease and debt obligations. Net interest income has decreased in 2008 compared to the prior year, as a result of receiving lower returns on cash, cash equivalents, and marketable securities balances and having a lower average balance. Net interest income remained consistent in 2007 compared to 2006.

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Gain from Discontinued Operations

	Fiscal Year 2008		% Change		Fiscal Year 2007		% Change		Fiscal Year 2006
	($ in thousands)
Gain from discontinued operations	$	8,080	32.3	%	$	6,108	33.3	%	$	4,582

The gain from discontinued operations in 2008 represents $5.7 million of income from discontinued operations and $2.3 million from the gain on the sale of discontinued operations, compared to 2007, which includes $6.1 million from the income from discontinued operations. The income from discontinued operations decreased in 2008 by $360,000 as a result of 2008 including only eight months of operations of our former LPU segment, compared to 2007, which included a full year of operations. This decrease was partially offset by increased order volume in 2008 compared to 2007. Orders in this segment were driven by Rite Aid through its marketing media, including Rite Aid store receipts, weekly Rite Aid advertising circulars, and e-mail refill reminders, and by Rite Aid’s adding of additional stores. In 2008, we recognized a gain from the sale of discontinued operations of $4.0 million, and a gain from the sale of inventory of $276,000, partially offset by the acceleration of $1.9 million of prepaid marketing costs.

Significant Accounting Judgments

The preparation of financial statements in conformity with U.S. generally accepted accounting principles, or GAAP, requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues, and expenses and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. The SEC defines a company’s critical accounting policies as the ones that are most important to the portrayal of the company’s financial condition and results of operations, and that require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified the significant accounting policies and judgments addressed below. We also have other key accounting policies that involve the use of estimates, judgments, and assumptions that are significant to understanding our results. We have included additional information about our significant accounting policies in Note 1 of our consolidated financial statements included in Part IV, Item 15 of this annual report. Although we believe that our estimates, assumptions, and judgments are reasonable, they are based on information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments, or conditions. In addition, any significant unanticipated changes in any of our assumptions could have a material adverse effect on our business, financial condition, and results of operations.

Revenue Recognition

We recognize revenues in accordance with SEC Staff Accounting Bulletin No. 104, Revenue Recognition. We recognize revenue from product sales or services rendered (including advertising revenues), net of sales tax, when the following revenue recognition criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) the selling price or fee earned is fixed or determinable; and (4) collection of the resulting receivable is reasonably assured.

OTC¸ Vision, and Mail-Order. We record revenues from sales of OTC, vision, and mail-order pharmacy when the products are shipped and title passes to customers, net of promotional discounts, cancellations, rebates, and returns allowances. We generally require payment by credit card at the point of sale. We estimate return allowances, which reduce product sales by our estimate of expected product returns, based on our historical experience. Historically, product returns have not been significant and have not differed significantly from our estimates.

From time to time, we provide incentive offers to our customers to encourage purchases. Such offers include discounts on specific current purchases, or future rebates based on a percentage of the current purchase, as well

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as other offers. We treat discounts, when our customers accept them, as a reduction in the sales price of the related transaction and we present them as a net amount in net sales. We treat rebates as a reduction in the sales price based on estimated redemption rates. We estimate redemption rates using our historical experience for similar offers. Historically, our redemption rates have not differed materially from our estimates, which we adjust quarterly.

Prescription Sales. For insured prescriptions in our mail-order segment, the co-payment and the insurance reimbursement (which together make up the amount due to drugstore.com) constitute the full value of the prescription drug sale, and we receive this entire amount as cash. We therefore recognize the entire amount as revenue when we ship the order to the customer.

We also evaluate the criteria of Emerging Issues Task Force Issue No. 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent, or EITF 99-19. Generally, when we are the primary party obligated in a transaction, are subject to inventory risk, have latitude in establishing prices and selecting suppliers, or have several but not all of these indicators, we record revenue on a gross basis. If we are not primarily obligated and amounts earned are determined using a fixed percentage, a fixed-payment schedule, or a combination of the two, we record revenue on a net basis.

Consignment and Drop-ship Arrangements. We record revenues generated by consignment arrangements with GNC and Rite Aid in our OTC segment on a net basis because we do not take title to the inventory and do not establish pricing. We record revenues generated from our drop-ship arrangements with vendors in our OTC segment on a gross basis when we are the primary party obligated in a transaction, are subject to inventory risk, have latitude in establishing prices and selecting suppliers, or have several but not all of these indicators.

Strategic Partnerships. We record revenues generated from the Amazon.com Marketplace in our OTC segment on a gross basis, because we act as a principal, based on the fact that we are subject to inventory risk, have latitude in establishing prices and selecting suppliers. We record revenues generated by the Weil agreement in our OTC segment on a net basis, because we act as an agent, based on the fact that we earn a fixed dollar amount per customer transaction regardless of the amount billed to the customer, and we do not bear general inventory risk associated with these sales. We record revenues generated from the Rite Aid online store in our OTC segment on a gross basis, because we act as a principal, based on the fact that we are subject to inventory and credit risk, have latitude in establishing prices and selecting suppliers. Rite Aid earns a percentage of the contribution margin, defined as net sales, less direct costs of these sales and the incremental cost of fulfilling, processing and delivering the order, from the Rite Aid online store, which is recorded in marketing and sales expense in the statements of operations.

We also evaluate the criteria of Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple Deliverables, or EITF 00-21, when we enter into arrangements with multiple deliverables. EITF 00-21 establishes three criteria that must be met in order for the deliverables in the arrangement to be treated as separate units of accounting; (1) the delivered item has value on a stand-alone basis; (2) there is objective and reliable evidence of the fair value of the undelivered item; and (3) delivery or performance of the undelivered item is considered probable and substantially in the control of the vendor. When the separation criteria are not met, the delivered item is accounted for as a combined unit of accounting with the undelivered item. Therefore, revenue for the delivered and undelivered items are recognized over the service period of the last delivered item or if it is not a service, when the last item is delivered.

Inventories

We value our inventories at the lower of cost (using the weighted-average cost method) or the current estimated market value. We regularly review inventory quantities on hand and adjust our inventories for shrinkage and slow-moving, damaged, and expired inventory, which we record as the difference between the cost of the inventory and the estimated market value based on management’s assumptions about future demand for

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the products we offer and market conditions. We use a variety of methods to reduce the quantity of slow-moving inventory, including reducing sales prices on our websites, negotiating returns to vendors, and liquidating inventory through third parties. If our estimates of future product demand or our assumptions about market conditions are inaccurate, we could understate or overstate the provision required for excess and obsolete inventory. Historically, inventory reserves have not differed materially from our estimates.

Goodwill and Other Intangible Assets

In accordance with Statement of Financial Accounting Standards No. 142, Accounting for Goodwill and Other Intangibles, or SFAS 142, we test for impairment of goodwill at the beginning of the fourth quarter and whenever indicators of impairment occur. The first phase of the test screens for impairment, while the second phase of the test (if necessary) measures the amount of impairment. The first phase is performed by comparing the implied fair value of the applicable reporting unit to its carrying value. Fair value is determined using either a discounted cash flow methodology or methodology based on comparable market prices. The second step of the goodwill impairment test compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to the excess.

We review our indefinite-lived intangible assets for impairment when indicators of impairment occur and annually at the beginning of the fourth quarter. We compare the carrying value of the asset to its estimated fair value and record an impairment charge when the carrying value of the asset exceeds the estimated fair value.

During fiscal 2008, we estimated the fair value of our reporting units by preparing a discounted cash flow analysis using forward looking projections of our estimated future operating results. Based on the results of the discounted cash flow analysis, we concluded that the fair value exceeds the carrying value, and therefore goodwill is not impaired. We also considered as an indicator of market value the market value of our common stock during the fourth quarter.

The significant assumptions used in our discounted cash flow analysis included: projected operating results, the discount rate used to present value future cash flows, and capital expenditures. Projected operating results assumptions include sales growth assumptions which are based on historical trends, and to a lesser extent, future sales growth from new strategic partnerships. Also included in projected operating results are gross margin and operating cost growth assumptions which are based on historical relationship of those measures compared to sales. Our discount rate is a “market participant” weighted average cost of capital (WACC) of 16%. Our capital expenditure assumptions are based on our planned capital expenditures for existing and new projects. Sensitivity tests were performed on our significant assumptions and determined that a reasonable, negative change in assumptions would not impact our conclusions.

In accordance with Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, or SFAS 144, we review the carrying values of our amortized long-lived assets, including definite-lived intangible assets, whenever an indicator of impairment occurs. When facts and circumstances indicate that the carrying values of long-lived assets may be impaired, we perform an evaluation of recoverability. We determine whether impairment exists based on any excess of the carrying value over the expected future cash flows, as estimated through undiscounted cash flows, excluding interest charges. We measure any resulting impairment charge based on the difference between the carrying value of the asset and its fair value, as estimated through expected future discounted cash flows, discounted at a rate of return for an alternate investment.

Stock-Based Compensation

We measure compensation cost for all stock-based awards at fair value on the date of grant and recognize compensation cost over the service period for awards expected to vest. We calculate the fair value of our stock

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options granted to employees using the Black-Scholes option pricing model using the single-option approach. This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. We base our computation of expected volatility on our historical volatility, adjusted for changes in capital structure and corporate changes, information available that may indicate future volatility, and observable mean reversion tendencies of historical volatility. Our expected term estimates are based on a comprehensive weighted average life (WAL) analysis. The WAL analysis provides a historical based platform for use in developing expected term estimates for the future based on the historically observed time periods from grant date through post-vesting activities, such as exercise and cancellation. Prior to our fourth quarter of 2007, our expected term was calculated using the simplified method outlined by SEC Staff Accounting Bulletin No. 107, Share-Based Payment (SAB 107). Under this method, our expected term was equal to the sum of the weighted average vesting term plus the original contractual term divided by two, which resulted in a six-year expected term. We base the risk-free interest rate on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term. Where the expected term of our stock-based awards does not correspond with the terms for which interest rates are quoted, we average the rates quoted for the closest available term maturities. A dividend yield of 0% is considered appropriate as we have not issued and do not anticipate issuing any dividends in the near future. When estimating forfeitures, we consider historical voluntary termination behavior in addition to actual option forfeitures. In conjunction with this analysis, we identified distinct subgroups: non-management employees, management employees, our chief executive officer, board members, and other non-employees. We apply an estimated forfeiture rate of approximately 35% to non-management and management employee subgroups, based on the weighted average termination behavior of those subgroups. We apply a forfeiture rate of 0% to our chief executive officer, board members, and non-employees. If our estimated forfeiture rate changes, we retrospectively increase or decrease stock-based compensation in the period of change. Any such revisions to the estimates we use to calculate the fair value of our stock-based awards could have a material impact on our results of operations and financial position. See Note 11 of our consolidated financial statements, Employee Benefit Plans, included in Part IV, Item 15 of this annual report.

Legal Proceedings

We are currently involved in various claims and legal proceedings. Periodically, we review the status of each significant matter and assess our potential financial exposure. If the potential loss from any claim or legal proceeding is considered probable and the amount can be estimated, we accrue a liability for the estimated loss. Because of uncertainties related to these matters, accruals are based only on the best information available at the time. As additional information becomes available, we reassess the potential liability related to our pending claims and legal proceedings and may revise our estimates. Any such revisions in the estimates of the potential liabilities could have a material impact on our future results of operations and financial position. For a description of our material legal proceedings, see Note 8 of our consolidated financial statements, Commitments and Contingencies, included in Part IV, Item 15 of this annual report.

Recent Accounting Pronouncements

See Note 1 of our consolidated financial statements, “The Company and Summary of Significant Accounting Policies—New Accounting Pronouncements,” included in Part IV, Item 15 of this annual report.

Liquidity and Capital Resources

We have an accumulated deficit of $770.1 million through December 28, 2008. To date, we have had only one profitable quarter, and we may never achieve profitability on a full-year or consistent basis. We expect to continue to incur net losses in the first quarter of 2009, and possibly longer. As a result, our stock price may decline and stockholders may lose all or a part of their investment in our common stock. From our inception through December 28, 2008, we have financed our operations primarily through the sale of equity securities, including common and preferred stock, yielding net cash proceeds of $421.3 million.

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Our primary source of cash is sales made through our websites, for which we collect cash from credit card settlements, or insurance reimbursements. Our primary uses of cash are purchases of inventory, salaries, marketing expenses, and overhead and fixed costs. Any projections of our future cash needs and cash flows are subject to substantial uncertainty for the reasons discussed in this section and in the section entitled “Risk Factors” in Part I, Item 1A of this annual report.

Our principal sources of liquidity are our cash, cash equivalents, and marketable securities. Historically, our principal liquidity requirements have been to meet our working capital and capital expenditure needs. Until required for other purposes, our cash and cash equivalents are maintained in deposit accounts or highly liquid investments with remaining maturities of 90 days or less at the time of purchase. Our marketable securities, which include commercial paper, U.S. government agency obligations, and corporate notes and bonds, are considered short-term as they are available to fund current operations. In addition, we have a revolving two-year line of credit allowing for borrowings up to $25.0 million through March 2011, which is available to fund operations, capital expenditures, or finance acquisitions, as needed. As of March 9, 2009, the available borrowings under the line of credit were approximately $21.0 million.

The following table provides information regarding our balances of cash and cash equivalents and marketable securities for the last three fiscal years:

	December 28,     2008		December 30,     2007		December 31,     2006
	(in thousands)
Cash and cash equivalents	$	25,197	$	18,572	$	13,393
Marketable securities		12,997		17,677		27,246
Total	$	38,194	$	36,249	$	40,639

We believe that our cash and marketable securities on hand plus our sources of cash will be sufficient to fund our operations and anticipated capital expenditures. However, any projections about our future cash needs and cash flows are subject to substantial uncertainty. As a result, we may need to raise additional monies to fund our operating activities or for strategic flexibility (if, for example, we decide to pursue business or technology acquisitions) or if our expectations regarding our operations and anticipated capital expenditures change. We have assessed in the past, and will continue to assess, opportunities for raising additional funds by selling equity, equity-related or debt securities, obtaining additional credit facilities, or obtaining other means of financing for strategic reasons or to further strengthen our financial position. We cannot be certain that additional financing will be available to us on acceptable terms when required, or at all. Furthermore, if we were to raise additional funds through the issuance of securities, such securities may have rights, preferences, or privileges senior to those of the rights of our common stock and our stockholders may experience additional dilution.

Discussion of Cash Flows

The following table provides information regarding our cash flows for the last three fiscal years:

	Fiscal Year
	2008			2007			2006
Net cash provided by (used in):
Continuing operating activities	$	10		$	(128	)	$	(7,769	)
Discontinued operating activities	$	9,903		$	7,906		$	6,686
Investing activities	$	(4,454	)	$	(5,108	)	$	(8,642	)
Financing activities	$	1,166		$	2,509		$	2,827
Net increase (decrease) in cash and cash equivalents	$	6,625		$	5,179		$	(6,898	)

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Cash provided by (used in) operating activities. Our operating cash flows result primarily from cash received from our customers, fulfillment partners, and advertising and other service revenue, offset by cash payments we make for products and services, employee compensation, payment processing and related transaction costs, and interest payments on our long-term debt obligations. Cash received from customers and other activities generally corresponds to our net sales and because our customers primarily use credit cards to buy from us, our receivables from customers settle quickly. Working capital at any specific point in time is subject to many variables, including seasonality, inventory management and category expansion, the timing of cash receipts and payments, vendor payment terms, and valuation of cash equivalents and marketable securities.

Net cash provided by operating activities increased by $2.1 million in 2008 compared to 2007, primarily due to an increase in cash provided by discontinued operations of $9.9 million in 2008, compared to $7.9 million in 2007. Net cash provided by continuing operations increased slightly to $10,000 in 2008 from cash used in continuing operations of $128,000 in 2007. Net cash provided by continuing operations in 2008 reflects non-cash expenses of $19.3 million, offset by net losses from continuing operations of $16.4 million and uses of other working capital of $2.9 million, primarily due to the timing of payments and increases in inventory to support our growth, partially offset by the collection of accounts receivable and other asset balances. Net cash provided by operating activities increased by $8.9 million in 2007 compared to 2006 primarily due to increases in working capital of $4.9 million, increases in non-cash expenses of $2.7 million, and net cash provided by discontinued operations of $1.2 million. Net cash used in continuing operations decreased to $128,000 in 2007 from cash used in continuing operations of $7.8 million in 2006. Net cash used in continuing operations in 2007 reflects net losses from continuing operations of $17.6 million, offset by non-cash expenses of $17.5 million. Net cash used in continuing operations in 2006 reflects net losses from continuing operations of $17.6 million and decreases in working capital of $5.0 million primarily due to the timing of payments and increases in inventory to support our growth, partially offset by non-cash expenses of $14.8 million. Net cash provided by discontinued operations totaled $9.9 million, $7.9 million and $6.7 million in 2008, 2007 and 2006, respectively, which reflects the gain recognized from discontinued operations and approximately $2.0 million of net cash provided each year from the assets and liabilities of discontinued operations due primarily from the timing of payments and collections.

Cash provided by (used in) investing activities. Our net cash provided by (used in) investing activities corresponds with to the purchase of marketable securities and the acquisition of fixed assets and intangible assets, partially offset by the net proceeds received from the sales and maturities of marketable securities and proceeds from the gain on sale of discontinued operations. In 2008, we recognized a gain of $9.9 million on the sale of discontinued operations of our LPU business and received $4.0 million of the cash proceeds from the gain, and in 2009, we will receive the remaining $5.0 million of cash proceeds. In 2009, we are targeting a range of $7.5 million to $9.0 million in capital expenditures.

Net cash used in investing activities decreased by $0.7 million in 2008 compared to 2007, due to an increase in sales and maturities of marketable securities of $14.6 million, proceeds received from the gain on the sale of discontinued operations of $4.0 million, and a decrease in the acquisition of fixed assets and intangible assets of $1.5 million, partially offset by an increase in purchases of marketable securities of $19.4 million. Net cash used in investing activities decreased by $3.5 million in 2007 compared to 2006, primarily due to an increase in sales and maturities of marketable securities of $15.4 million, partially offset by an increase in the acquisition of fixed assets and intangible assets of $7.2 million and an increase in purchases of marketable securities of $4.7 million.

Cash provided by (used in) financing activities. Our net cash provided by (used in) financing activities represents cash provided from borrowings under our revolving line of credit with a bank and asset financings to fund capital expenditures and operations, and the exercise of options and warrants, and shares purchased under our employee stock purchase plan, partially offset by payments on our debt obligations.

Net cash provided by financing activities decreased by $1.3 million in 2008 compared to 2007, due to a decrease in proceeds received from the exercise of stock options of $3.8 million due to our lower average stock price, partially offset by an increase in borrowings under our revolving line of credit of $1.0 million used to fund

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operations and capital expenditures, and a decrease in payments on debt obligations of $1.5 million. Net cash provided by financing activities decreased by $0.3 million in 2007 compared to 2006, due to an increase in payments on debt obligations of $3.6 million, partially offset by an increase in proceeds received from the exercise of stock options of $1.6 million due to an increasing stock price, and an increase in borrowings under our revolving line of credit of $1.7 million used to fund operations and capital expenditures.

Contractual Obligations and Commitments

In December 2004, we entered into an amended and restated loan and security agreement with a bank. In January 2005, we borrowed $1.0 million on the line of credit and in December 2005, we converted the $1.0 million line of credit into a term loan. The term loan totaled $361,000 as of December 30, 2007 and was payable in 36 monthly installments of principal and interest at a rate of prime rate plus 0.50%. In addition, the agreement included a $2.0 million term loan for capital equipment expenditures that accrued interest on the outstanding principal balance at a rate of prime rate plus 0.50%. This term loan was payable in 36 equal monthly installments of principal, plus accrued interest, beginning on February 1, 2005 and ending on January 1, 2008. The balance outstanding under this term loan was $55,000 as December 30, 2007.

In April 2007, we entered into an amended and restated loan and security agreement with our existing bank. The agreement included a revolving line of credit allowing for borrowings of up to $10.0 million, which accrue interest at the prime rate. The revolving line of credit matured in March 2008. The agreement allowed for the conversion of up to $2.5 million of the outstanding balance into a term loan within 60 days of maturity. For the year ended December 30, 2007, borrowings under the existing line of credit totaled $4.0 million, of which $1.0 million was converted into a term loan in April 2007, $2.5 million was repaid and $1.5 million remained outstanding as of December 30, 2007 and was payable in 36 monthly installments of principal and interest at a rate of prime rate plus 0.50%.

In March 2008, we entered into an amended and restated loan and security agreement with our existing bank. This agreement includes a revolving line of credit allowing for borrowings of up to $10.0 million, which accrue interest at the prime rate. The revolving line of credit matured in March 2009. The agreement allows for the conversion of up to $5.0 million of the outstanding balance into a term loan within 60 days of maturity. In March 2008, borrowings under the existing line of credit totaling $5.0 million and existing term loans totaling $972,222 were converted into one term loan totaling approximately $6.0 million under the amended and restated loan and security agreement. The term loan is payable in 36 monthly installments and accrues interest at the prime rate plus 0.50% (3.75% at December 28, 2008). The balance outstanding under the term loan totaled $5.5 million as of December 28, 2008, and there was no balance outstanding under the line of credit as of December 28, 2008. Our equipment, inventory, accounts receivable, cash, investments, and intangible assets collateralize the borrowings under the agreement. The agreement contains certain financial and non-financial covenants with which we were in compliance at December 28, 2008.

In March 2009, we entered into a loan and security agreement with our existing bank. This agreement includes a revolving two-year line of credit allowing for borrowings up to $25.0 million, which accrue interest at the prime rate, for general corporate purposes, including short-term working capital needs, and to finance certain potential acquisitions, should we elect to pursue any in the future. The agreement allows for the conversion of up to $15.0 million of the outstanding balance into a term loan, payable in 36 monthly installments of principal and interest at a rate equal to the greater of (a) the prime rate plus 0.50% or (b) 4.50%. Advances available under the revolving line of credit are limited, based on eligible inventory, accounts receivable, and cash and investment balances, and balances outstanding under our existing term loan. As of March 9, 2009, approximately $4.0 million in borrowings under our previous facility were considered outstanding under this facility. Accordingly, the available borrowings under the line of credit were approximately $21.0 million. The agreement contains certain covenants that are customary in transactions of this nature, including a prohibition on other debt and liens, requirements regarding the payment of taxes, and certain restrictions on mergers and acquisitions, investments, and transactions with our affiliates, as well as certain financial covenants related to our cash and cash equivalents

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and our free cash flow. The agreement identifies certain events of default that are customary for transactions of this nature and subject to materiality provisions and grace periods where appropriate, including failure to pay any principal or interest under this facility or other instruments when due, violations of any covenants, a material cross-default to our other debt, or a change of control.

In July 2006, we entered into an agreement to finance equipment in our distribution center totaling $1.9 million under a non-cancelable capital lease. The lease is payable in 36 monthly installments of approximately $60,000 beginning January 2007 and ending December 2009, and accrues interest at a rate of 8%. As of December 28, 2008 and December 30, 2007, the amount due under the agreement was $690,000 and $1.3 million, respectively.

We also lease computer equipment under non-cancelable capital leases. Capital lease obligations bear interest at rates ranging from 7% to 8% and mature 21 to 24 months from the date of funding. We secured additional funds of $524,000 during 2008 and $469,000 during 2007, through capital lease financing agreements, through which we financed certain computer equipment and software for periods of two and three years. We are in compliance with all covenants required by these agreements. These amounts are included in the table below within the category of capital leases.

As of December 28, 2008, our principal commitments consisted of obligations outstanding under capital and operating leases and our term loans, as follows (in thousands):

	Payment Due by Period
	Total		< 1 year		1-3 years		3-5 years		> 5 years
	($ in thousands)
Capital leases (1)	$	1,126	$	1,052	$	74	$	—	$	—
Term loans (2)		4,647		2,065		2,582		—		—
Operating leases (3)		9,998		3,042		6,080		876		—
	$	15,771	$	6,159	$	8,736	$	876	$	—

(1) Capital lease obligations consist primarily of technology and operations assets.

(2) Term loans include debt obligations with a bank.

(3) Operating lease obligations consist of office building, distribution center, and call center leases.

We do not have any future material noncancelable commitments to purchase goods or services.

Off-Balance Sheet Arrangements

We have no material off-balance sheet arrangements.

Management Outlook

For the first quarter of fiscal year 2009, we are targeting net sales in the range of $93.0 million to $97.0 million. We anticipate net loss for the first quarter in the range of $0.0 million to a net income of $2.0 million.

These projections are subject to substantial uncertainty. See “Risk Factors” in Part I, Item 1A of this annual report and “Special Note Regarding Forward-Looking Statements” above.

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ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

We have assessed our vulnerability to certain market risks, including interest rate risk associated with marketable securities, accounts receivable, accounts payable, capital lease obligations, and cash and cash equivalents. Due to the short-term nature of these investments and our investment policies and procedures, we have determined that the risk associated with interest rate fluctuations related to these financial instruments is not material to us.

We have interest rate exposure arising from our financing facilities, which have variable rates. These variable interest rates are affected by changes in short-term interest rates. We manage our interest rate exposure by maintaining a conservative debt-to-equity ratio. We believe that the effect, if any, of reasonably possible near-term changes in interest rates on our financial position, results of operations and cash flows will not be material. Our financing facilities expose our net earnings to changes in short-term interest rates because interest rates on the underlying obligations are variable. Borrowings outstanding under the variable interest-bearing financing facilities totaled $5.5 million at December 28, 2008, and the highest interest rate attributable to this outstanding balance was 3.75% at December 28, 2008. A change in net earnings resulting from a hypothetical 10% increase or decrease in interest rates would not be material.

We have investment risk exposure arising from our investments in marketable securities due to volatility of the stock market in general, company-specific circumstances, and changes in general economic conditions. As of December 28, 2008, we had $13.0 million of securities classified as “marketable securities.” We regularly review the carrying value of our investments and identify and record losses when events and circumstances indicate that declines in the fair value of such assets below our accounting basis are other-than-temporary.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The financial statements required pursuant to this item are filed under Part IV, Item 15(a)(1) of this annual report. The financial statement schedule required under Regulation S-X is filed under Part IV, Item 15(a)(2) of this annual report.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

ITEM 9A.  CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Under the supervision of and with the participation of our management, including our chief executive officer and chief accounting officer, we performed an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or the Exchange Act). Based on that evaluation, our management, including our chief executive officer and chief accounting officer, concluded that, as of December 28, 2008, our disclosure controls and procedures were effective to provide reasonable assurance that all material information required to be disclosed in reports filed or submitted by us under the Exchange Act is made known to management in a timely fashion.

The certifications required by Section 302 of the Sarbanes-Oxley Act of 2002 are filed as exhibits 31.1 and 31.2, respectively, in this Form 10-K.

Management’s Report on Internal Control over Financial Reporting

Management is responsible for establishing and maintaining an adequate system of internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f)) under the Exchange Act). Management evaluated

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the effectiveness of our internal control over financial reporting based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO. Based on its evaluation, management concluded that, as of December 28, 2008, our system of internal control over financial reporting was effective. Ernst & Young LLP, an independent registered public accounting firm, has issued an attestation report on the effectiveness of our internal control over financial reporting as of December 28, 2008, a copy of which is included in this annual report.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting during the most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

Limitations on Controls

Management does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all error and fraud. Any control system, no matter how well designed and operated, is based on certain assumptions and can provide only reasonable, not absolute, assurance that its objectives will be met. In addition, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within drugstore.com have been detected.

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

drugstore.com, inc.

We have audited drugstore.com, inc.’s internal control over financial reporting as of December 28, 2008, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). drugstore.com, inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, drugstore.com, inc. maintained, in all material respects, effective internal control over financial reporting as of December 28, 2008, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of drugstore.com, inc. as of December 28, 2008 and December 30, 2007, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 28, 2008 of drugstore.com, inc., and our report dated March 11, 2009 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Seattle, Washington

March 11, 2009

50

ITEM 9B.  OTHER INFORMATION

Entry into Loan and Security Agreement

On March 9, 2009, drugstore.com, inc. and its subsidiaries entered into a loan and security agreement, effective March 5, 2009, with Silicon Valley Bank. This agreement includes a revolving two-year line of credit allowing for borrowings up to $25.0 million, which accrue interest at the prime rate, for general corporate purposes, including short-term working capital needs, and to finance certain potential acquisitions, should we elect to pursue any in the future. The agreement allows for the conversion of up to $15.0 million of the outstanding balance into a term loan, payable in 36 monthly installments of principal and interest at a rate equal to the greater of (a) the prime rate plus 0.50% or (b) 4.50%. Advances available under the revolving line of credit are limited, based on eligible inventory, accounts receivable, and cash and investment balances, and balances outstanding under our existing term loan. As of March 9, 2009, approximately $4.0 million in borrowings under our previous facility were considered outstanding under this facility. Accordingly, the available borrowings under the line of credit were approximately $21 million. The agreement contains certain covenants that are customary in transactions of this nature, including a prohibition on other debt and liens, requirements regarding the payment of taxes, and certain restrictions on mergers and acquisitions, investments, and transactions with our affiliates, as well as certain financial covenants related to our cash and cash equivalents and our free cash flow. The agreement identifies certain events of default that are customary for transactions of this nature and subject to materiality provisions and grace periods where appropriate, including failure to pay any principal or interest under this facility or other instruments when due, violations of any covenants, a material cross-default to our other debt, or a change of control.

2009 Bonus Plan and Supplemental Long-term Disability Plan

On March 9, 2009, the compensation committee of the board of directors of drugstore.com, inc. approved an incentive bonus plan under which our executive officers may receive cash bonuses for fiscal year 2009 based on the individual’s performance, the achievement by drugstore.com of certain net revenue and adjusted EBITDA objectives, and the recommendation of the compensation committee or the board. The compensation committee established specific progressive net revenue and adjusted EBITDA targets at which executive officers would receive an increasing percentage, ranging from 0% of his or her target bonus amount, if we fail to meet the thresholds, to 140%, if we vastly exceed our expected performance for the year. The compensation committee reserved the right, and authorized Ms. Lepore with respect to executive officers other than herself, to exercise discretion in determining the final amounts to be paid under the bonus plan.

The officer’s target bonus level is a factor of his or her position and responsibilities. Under the new plan, each of our executive officers is eligible to receive up to the following target bonus percentage of his or her 2009 salary:

Executive Officer	Target Bonus Amount
Dawn G. Lepore President, Chief Executive Officer, and Chairman of the Board	150	%
Robert P. Potter Vice President, Chief Accounting Officer	35	%
Tracy Wright Vice President, Chief Finance Officer	35	%
Yukio Morikubo Vice President, Strategy and General Counsel	35	%
Robert Hargadon Vice President, Human Resources	30	%

In addition, the compensation committee approved a company-paid supplemental long-term disability insurance policy for the benefit of each of our executive officers, including our chief executive officer.

51

PART III

ITEM 10.  DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE

Directors and Executive Officers

Information regarding our executive officers required by Part III, Item 10 is set forth in the section entitled “Business—Directors and Officers” in Part I, Item 1 of this annual report. Information regarding our directors required by Part III, Item 10 is incorporated into this annual report by reference to the section entitled “Proposal No. 1—Election of Directors” in our proxy statement for our annual meeting of stockholders to be held on June 11, 2009, or the 2009 Proxy Statement.

Information relating to compliance with Section 16(a) of the Securities Exchange Act of 1934, as amended, required by Part III, Item 10 is incorporated into this annual report by reference to the section entitled “Section 16 Beneficial Ownership Reporting Compliance” in the 2009 Proxy Statement.

Code of Business Conduct and Ethics

Our board of directors has adopted a code of business conduct and ethics, or Code, applicable to all directors, officers and employees of drugstore.com, including our chief executive officer, chief finance officer, chief accounting officer, and controller. You may obtain a copy of the Code, without charge, on written request to Investor Relations, drugstore.com, inc., 411 108^th Avenue NE, Suite 1400, Bellevue, Washington 98004, or by calling (425) 372-3200.

ITEM 11. EXECUTIVE COMPENSATION

Information regarding executive compensation required by Part III, Item 11 is incorporated into this annual report by reference to the section entitled “Executive Compensation” in the 2009 Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

Information regarding our equity compensation plans required by Part III, Item 12 is set forth in the section entitled “Securities Authorized for Issuance under Equity Compensation Plans” in the 2009 Proxy Statement.

Information regarding security ownership of certain beneficial owners and management and related stockholder matters required by Part III, Item 12 is incorporated into this annual report by reference to the section entitled “Security Ownership of Certain Beneficial Owners and Management” in the 2009 Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

Information regarding certain relationships and related transactions required by Part III, Item 13 is incorporated into this annual report by reference to the section entitled “Transactions with Related Persons” in the 2009 Proxy Statement.

ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES

Information regarding principal accountant fees and services required by Part III, Item 14 is incorporated into this annual report by reference to the section entitled “Proposal No. 3—Ratification of Appointment of Independent Public Accounting Firm” in the 2009 Proxy Statement.

52

PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES.

(a) The following documents are filed as a part of this annual report on Form 10-K:

1. Index to Consolidated Financial Statements:

	Page
Report of Independent Registered Public Accounting Firm	57
Consolidated Balance Sheets	58
Consolidated Statements of Operations	59
Consolidated Statements of Stockholders’ Equity	60
Consolidated Statements of Cash Flows	61
Notes to Consolidated Financial Statements	62

2. Index to Financial Statement Schedules:

Schedule II—Valuation and Qualifying Accounts 91

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

3. Index of Exhibits:

Exhibit No.	Exhibit Description
3.1	Amended and Restated Certificate of Incorporation of drugstore.com, inc. (incorporated by reference to Exhibit 3.2 to drugstore.com, inc.’s Registration Statement on Form S-1 filed February 9, 2000 (Registration No. 333-96441)).
3.1a	Certificate of Designation of Series 1 Preferred Stock of drugstore.com, inc. (incorporated by reference to Exhibit 3.1a to drugstore.com, inc.’s Quarterly Report on Form 10-Q for the Quarter Ended July 2, 2000 (SEC File No. 000-26137)).
3.2	Amended and Restated Bylaws of drugstore.com, inc. dated January 26, 2009 (incorporated by reference to Exhibit 3.1 to drugstore.com inc.’s Current Report on Form 8-K dated January 26, 2009 (SEC File No. 000-26137)).
4.1	Warrant issued to Highbridge International LLC on December 8, 2003, on the cancellation of the warrant issued to Tel-Drug, Inc. on June 26, 2000 (incorporated by reference to Exhibit 4.1 to drugstore.com inc.’s Annual Report on Form 10-K for the Fiscal Year Ended January 2, 2005 (SEC File No. 000-26137)).
4.2	Warrant issued to Lehman Brothers, Inc. on November 16, 2006, on the cancellation of the warrant issued to Heidrick & Struggles, Inc. on February 14, 2005 (incorporated by reference to Exhibit 4.2 to drugstore.com inc.’s Annual Report on Form 10-K for the Fiscal Year Ended December 31, 2006 (SEC File No. 000-26137)).
4.3	Form of Warrant (incorporated by reference to Exhibit 4.1 to drugstore.com inc.’s Quarterly Report on Form 10-Q for the Quarter Ended July 1, 2007 (SEC File No. 000-26137)).
4.4	Form of Warrant (incorporated by reference to Exhibit 4.1 to drugstore.com inc.’s Quarterly Report on Form 10-Q for the Quarter Ended September 30, 2007 (SEC File No. 000-26137)).
4.5	1998 Stock Plan, as amended June 21, 2000 (incorporated by reference to Exhibit 10.2 to drugstore.com, inc.’s Quarterly Report on Form 10-Q for the Quarter Ended July 2, 2000) (SEC File No. 000-26137)).

53

Exhibit No.	Exhibit Description
4.6	2008 Equity Incentive Plan (incorporated by reference to Appendix A to the registrant’s proxy statement dated February 23, 2009).
4.7	Restricted Stock Agreement between the Company and Dawn G. Lepore dated October 3, 2008 (incorporated by reference to Exhibit 10.1 to drugstore.com, inc.’s Current Report on Form 8-K dated October 2, 2008 (SEC File No. 000-26137)).
4.8	Restricted Stock Agreement (under the 2008 Equity Incentive Plan) (incorporated by reference to Exhibit 10.2 to drugstore.com, inc.’s Current Report on Form 8-K dated October 2, 2008 (SEC File No. 000-26137)).
4.9	Form of Stock Option Agreement (under the 2008 Equity Incentive Plan) (incorporated by reference to Exhibit 10.3 to drugstore.com, inc.’s Current Report on Form 8-K dated October 2, 2008 (SEC File No. 000-26137))
4.10	1999 Employee Stock Purchase Plan, as amended (incorporated by reference to Exhibit 10.3 to drugstore.com, inc.’s Registration Statement on Form S-1 filed February 9, 2000 (Registration No. 333-96441)).
10.1	Form of Indemnification Agreement between drugstore.com, inc. and each of its officers and directors (incorporated by reference to Exhibit 10.1 to drugstore.com, inc.’s Registration Statement on Form S-1 filed May 19, 1999 (Registration No. 333-78813)).
10.2	Fourth Amended and Restated Investors’ Rights Agreement dated May 19, 1999, among drugstore.com, inc. and certain investors (incorporated by reference to Exhibit 10.12 to drugstore.com, inc.’s Registration Statement on Form S-1/A filed July 8, 1999 (Registration No. 333-78813)).
10.3	Addendum dated June 17, 1999, to Fourth Amended and Restated Investors’ Rights Agreement dated May 19, 1999, among drugstore.com, inc. and certain investors (incorporated by reference to Exhibit 10.25 to drugstore.com, inc.’s Registration Statement on Form S-1/A filed June 28, 1999 (Registration No. 333-78813)).
10.4	Form of Second Addendum to Fourth Amended and Restated Investors’ Rights Agreement dated May 19, 1999, among drugstore.com, inc. and certain investors (incorporated by reference to Exhibit 10.32 to drugstore.com, inc.’s Registration Statement on Form S-1/A filed July 20, 1999 (Registration No. 333-78813)).
10.5	Third Addendum dated January 24, 2000, to Fourth Amended and Restated Investors’ Rights Agreement dated May 19, 1999, among drugstore.com, inc. and certain investors (incorporated by reference to Exhibit 10.38 to drugstore.com, inc.’s Registration Statement on Form S-1 filed February 9, 2000 (Registration No. 333-96441)).
10.6	Fourth Addendum dated September 29, 2000, to Fourth Amended and Restated Investors’ Rights Agreement dated May 19, 1999, among drugstore.com, inc. and certain investors (incorporated by reference to Exhibit 10.7 to drugstore.com, inc.’s Registration Statement on Form S-3/A filed October 2, 2000 (Registration No. 333-45266)).
10.7	Fifth Amended and Restated Voting Agreement dated December 23, 1999, among drugstore.com, inc. and certain founders and investors (incorporated by reference to Exhibit 10.20 to drugstore.com, inc.’s Registration Statement on Form S-1 filed February 9, 2000 (Registration No. 333-96441)).
10.8	Amended and Restated Main Agreement by and between DS Pharmacy, Inc., a subsidiary of drugstore.com, inc., and Rite Aid Hdqtrs. Corp., a subsidiary of Rite Aid Corporation, dated September 3, 2008 (incorporated by reference to Exhibit 10.1 to drugstore.com, inc.’s Current Report on Form 8-K dated September 3, 2008 (SEC File No. 000-26137)).

54

Exhibit No.	Exhibit Description
10.9	Amended and Restated Pharmacy and Private Label Supply and Services Agreement by and between DS Pharmacy, inc., a subsidiary of the Registrant, and Rite Aid Hdqtrs. Corp., a subsidiary of Rite Aid, dated September 3, 2008 (incorporated by reference to Exhibit 10.2 to drugstore.com, inc.’s Current Report on Form 8-K dated September 3, 2008 (SEC File No. 000-26137)).
10.10	Main Agreement dated June 17, 1999, between drugstore.com, inc. and General Nutrition Corporation (incorporated by reference to Exhibit 10.28 to drugstore.com, inc.’s Registration Statement on Form S-1/A filed June 28, 1999 (Registration No. 333-78813)).
10.11	Governance Agreement dated June 17, 1999, among drugstore.com, inc., General Nutrition Corporation and General Nutrition Investment Company (incorporated by reference to Exhibit 10.30 to drugstore.com, inc.’s Registration Statement on Form S-1/A filed June 28, 1999 (Registration No. 333-78813)).
10.12	Registration Rights Agreement dated as of December 8, 2003 by and among drugstore.com, inc. and the other signatories thereto (incorporated by reference to Exhibit 10.1 to drugstore.com, inc.’s Current Report on Form 8-K filed December 23, 2003 (SEC File No. 000-26137)).
10.13	Lease Agreement dated August 30, 1999, between DS Distribution, Inc. and the Northwestern Mutual Life Insurance Company (incorporated by reference to Exhibit 10.1 to drugstore.com, inc.’s Quarterly Report on Form 10-Q for the quarter ended October 3, 1999 (SEC File No. 000-26137)).
10.14	Amendment No. 1 to Lease Agreement dated December 10, 2003, between DS Distribution, Inc. and Liberty Vendor I, L.P (as successor in interest to the Northwestern Mutual Life Insurance Company) (incorporated by reference to Exhibit 10.23 to drugstore.com inc.’s Annual Report on Form 10-K for the Fiscal Year Ended December 28, 2003 (SEC File No. 000-26137)).
10.15	Standard Industrial Lease—Multi-Tenant dated May 2, 2003 between Sam-Cher Holdings, Inc. and International Vision Direct, Inc. (incorporated by reference to Exhibit 10.24 to drugstore.com inc.’s Annual Report on Form 10-K for the Fiscal Year Ended December 28, 2003 (SEC File No. 000-26137)).
10.16	First Amendment to Lease dated August 1, 2008 between Sam-Cher Holdings, Inc. and Vision Direct, Inc., successor to International Vision Direct, Inc.
10.17	Industrial Building Lease dated June 20, 2007 between DS Distribution, Inc. and U.S. Industrial REIT II.
10.18	First Amendment to Industrial Building Lease dated October 10, 2007 between DS Distribution, Inc. and U.S. Industrial REIT II.
10.19	Sublease effective as of June 1, 2003 between Nova Scotia Power Incorporated and International Vision Direct Ltd. (incorporated by reference to Exhibit 10.25 to drugstore.com inc.’s Annual Report on Form 10-K for the Fiscal Year Ended December 28, 2003 (SEC File No. 000-26137)).
10.20	Office Lease Agreement dated August 16, 2004, between EOP-Northwest Properties, L.L.C. and drugstore.com, inc. (incorporated by reference to Exhibit 10.2 to drugstore.com, inc.’s Quarterly Report on Form 10-Q for the quarter ended September 26, 2004 (SEC File No. 000-26137)).
10.21	Sublease Agreement dated December 10, 2007 between Rod Asher and Associates, Ltd. and drugstore.com, inc.
10.22	Amended and Restated Loan and Security Agreement dated December 29, 2004 (incorporated by reference to Exhibit 10.2 to drugstore.com, inc.’s Quarterly Report on Form 10-Q for the quarter ended April 2, 2006 (SEC File No. 000-26137)).
10.23	Third Amendment to Loan and Security Agreement dated March 16, 2006 (incorporated by reference to Exhibit 10.1 to drugstore.com, inc.’s Quarterly Report on Form 10-Q for the quarter ended April 2, 2006 (SEC File No. 000-26137)).

55

Exhibit No.	Exhibit Description
10.24	Loan and Security Agreement dated March 5, 2009.
10.25	Offer letter of Dawn Lepore dated September 21, 2004 (incorporated by reference to Exhibit 10.1 to drugstore.com, inc.’s Current Report on Form 8-K/A filed November 3, 2004 (SEC File No. 000-26137)).
10.26	Letter agreement with Dawn Lepore dated December 28, 2006 (incorporated by reference to Exhibit10.1 to drugstore.com, inc.’s Current Report on Form 8-K filed December 29, 2006 (SEC File No. 000-26137)).
10.27	Letter agreement with Dawn Lepore dated December 31, 2008.
10.28	Letter agreement with Dawn Lepore dated January 26, 2009 (incorporated by reference to Exhibit 10.1 to drugstore.com, inc.’s Current Report on Form 8-K dated January 26, 2009)(SEC File No. 000-26137)).
10.29	Offer letter of Yukio Morikubo dated November 10, 2006 (incorporated by reference to Exhibit 10.2 to drugstore.com, inc.’s Current Report on Form 8-K filed December 4, 2006 (SEC File No. 000-26137)).
10.30	Offer letter of Thère du Pont dated May 15, 2007 (incorporated by reference to drugstore.com, inc.’s Current Report on Form 8-K filed May 21, 2007 (SEC File No. 000-26137)).
10.31	Change of Control Agreement of Thère du Pont dated May 15, 2007 (incorporated by reference to drugstore.com, inc.’s Current Report on Form 8-K filed May 21, 2007 (SEC File No. 000-26137)).
21.1	List of Subsidiaries.
23.1	Consent of Independent Registered Public Accounting Firm.
24.1	Powers of Attorney (included on the signature page of this Annual Report on Form 10-K).
31.1	Certification of Dawn G. Lepore, Chairman of Board, President and Chief Executive Officer of drugstore.com, inc., pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Robert P. Potter, Vice President, Chief Accounting Officer of drugstore.com, inc., pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of Dawn G. Lepore, Chairman of Board, President and Chief Executive Officer of drugstore.com, inc., pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of Robert P. Potter, Vice President, Chief Accounting Officer of drugstore.com, inc., pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

56

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

drugstore.com, inc.

We have audited the accompanying consolidated balance sheets of drugstore.com, inc. as of December 28, 2008 and December 30, 2007, and the related statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 28, 2008. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of drugstore.com, inc. at December 28, 2008 and December 30, 2007, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 28, 2008, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), drugstore.com, inc.’s internal control over financial reporting as of December 28, 2008, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 11, 2009 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Seattle, Washington

March 11, 2009

57

DRUGSTORE.COM, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

	December 28, 2008			December 30, 2007
Assets
Current assets:
Cash and cash equivalents	$	25,197		$	18,572
Marketable securities		12,997			17,677
Accounts receivable, net of allowances		9,108			10,999
Inventories		32,704			31,237
Other current assets		2,128			3,642
Assets of discontinued operations		5,954			30,763
Total current assets		88,088			112,890
Fixed assets, net		28,306			25,501
Other intangible assets, net		3,731			4,598
Goodwill		32,202			32,202
Other long-term assets		222			217
Total assets	$	152,549		$	175,408
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	31,208		$	36,446
Accrued compensation		4,416			4,657
Accrued marketing expenses		4,630			3,988
Other current liabilities		4,560			4,312
Current portion of long-term debt obligations		2,998			3,179
Liabilities of discontinued operations		5,946			24,968
Total current liabilities		53,758			77,550
Long-term debt obligations, less current portion		2,567			1,221
Deferred income taxes		953			947
Other long-term liabilities		1,071			1,322
Commitments and contingencies
Stockholders’ equity:
Preferred stock, $.0001 par value, 10,000,000 shares authorized, no shares issued and outstanding		—			—
Common stock, $.0001 par value, stated at amounts paid in: 250,000,000 shares authorized, 96,547,079 and 96,296,687 shares issued and outstanding		864,282			856,193
Accumulated other comprehensive income		57			27
Accumulated deficit		(770,139	)		(761,852	)
Total stockholders’ equity		94,200			94,368
Total liabilities and stockholders’ equity	$	152,549		$	175,408

See accompanying notes to consolidated financial statements.

58

DRUGSTORE.COM, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share data)

	For the year ended
	December 28, 2008			December 30, 2007			December 31, 2006
Net sales	$	366,579		$	339,331		$	315,123
Costs and expenses:
Cost of sales		263,697			248,308			236,382
Fulfillment and order processing		43,377			39,817			36,971
Marketing and sales		33,591			30,080			27,445
Technology and content		23,011			18,258			16,190
General and administrative		19,034			20,928			15,413
Amortization of intangible assets		867			1,234			2,060
Total costs and expenses		383,577			358,625			334,461
Operating loss		(16,998	)		(19,294	)		(19,338	)
Interest income, net		631			1,675			1,730
Loss from continuing operations		(16,367	)		(17,619	)		(17,608	)
Gain from discontinued operations, net of tax		8,080			6,108			4,582
Net loss	$	(8,287	)	$	(11,511	)	$	(13,026	)
Basic and diluted loss from continuing operations per share	$	(0.17	)	$	(0.18	)	$	(0.19	)
Basic and diluted gain from discontinued operations per share	$	0.08		$	0.06		$	0.05
Basic and diluted net loss per share	$	(0.09	)	$	(0.12	)	$	(0.14	)
Weighted average shares outstanding		96,481,787			95,350,046			93,405,405

See accompanying notes to consolidated financial statements.

59

DRUGSTORE.COM, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands, except share data)

	Common Stock			Accumulated Other Comprehensive Income (Loss)			Accumulated Deficit			Total
	Shares	Amount
Balance at January 1, 2006	92,904,652	$	833,589	$	(3	)	$	(737,315	)	$	96,271
Exercise of stock options	1,328,092		2,450		—			—			2,450
Employee stock purchase plan	102,283		266		—			—			266
Stock-based compensation	—		6,721		—			—			6,721
Net loss and comprehensive loss	—		—		(4	)		(13,026	)		(13,030	)
Balance at December 31, 2006	94,335,027		843,026		(7	)		(750,341	)		92,678
Exercise of stock options	1,869,075		4,142		—			—			4,142
Employee stock purchase plan	92,585		224		—			—			224
Stock-based compensation	—		8,801		—			—			8,801
Net loss and comprehensive loss	—		—		34			(11,511	)		(11,477	)
Balance at December 30, 2007	96,296,687		856,193		27			(761,852	)		94,368
Exercise of stock options and warrants	158,345		336		—			—			336
Employee stock purchase plan	92,047		189		—			—			189
Stock-based compensation	—		7,564		—			—			7,564
Net loss and comprehensive loss	—		—		30			(8,287	)		(8,257	)
Balance at December 28, 2008	96,547,079	$	864,282	$	57		$	(770,139	)	$	94,200

See accompanying notes to consolidated financial statements.

60

DRUGSTORE.COM, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

	For the year ended
	December 28, 2008			December 30, 2007			December 31, 2006
Operating Activities:
Net loss	$	(8,287	)	$	(11,511	)	$	(13,026	)
Less gain from discontinued operations		8,080			6,108			4,582
Loss from continuing operations		(16,367	)		(17,619	)		(17,608	)
Adjustments to reconcile loss from continuing operations to net cash provided by (used in) operating activities:
Depreciation		10,912			7,504			6,040
Amortization of intangible assets		867			1,234			2,060
Stock-based compensation		7,564			8,801			6,721
Other		(59	)		14			24
Changes in:
Accounts receivable		1,891			(337	)		(150	)
Inventories		(1,467	)		(5,155	)		(2,958	)
Other assets		1,514			(929	)		5
Accounts payable, accrued expenses and other liabilities		(4,845	)		6,359			(1,903	)
Net cash provided by (used in) continuing operations		10			(128	)		(7,769	)
Net cash provided by discontinued operations		9,903			7,906			6,686
Net cash provided by (used in) operating activities		9,913			7,778			(1,083	)
Investing Activities:
Purchases of marketable securities		(46,926	)		(27,544	)		(22,853	)
Sales and maturities of marketable securities		51,705			37,141			21,775
Purchases of fixed assets		(13,197	)		(14,249	)		(7,564	)
Proceeds from the sale of discontinued operations		3,964			—			—
Purchases of intangible assets		—			(456	)		—
Net cash used in investing activities		(4,454	)		(5,108	)		(8,642	)
Financing Activities:
Proceeds from exercise of stock options, warrants, and employee stock purchase plan		525			4,366			2,716
Proceeds from term loan, line of credit and asset financings		5,000			4,000			2,325
Principal payments on capital leases, line of credit and term loan obligations		(4,359	)		(5,857	)		(2,214	)
Net cash provided by financing activities		1,166			2,509			2,827
Net increase (decrease) in cash and cash equivalents		6,625			5,179			(6,898	)
Cash and cash equivalents at beginning of year		18,572			13,393			20,291
Cash and cash equivalents at end of year	$	25,197		$	18,572		$	13,393
Supplemental Cash Flow Information:
Cash paid for interest	$	360		$	402		$	398
Equipment acquired in capital lease agreements		524			469			963

See accompanying notes to consolidated financial statements.

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1. The Company and Summary of Significant Accounting Policies

The Company

drugstore.com, inc. (drugstore.com) is a leading online provider of health, beauty, vision, and pharmacy products. We offer health, beauty, sexual well-being, household, and other non-prescription products and prescription medications through our web store located at www.drugstore.com. We also offer prestige beauty products through our web store located at www.beauty.com (which is also accessible through the drugstore.com website); contact lenses through our wholly owned subsidiary Vision Direct Inc. (Vision Direct), through web stores located at www.visiondirect.com, www.lensmart.com, www.lensworld.com, and www.lensquest.com (which are also accessible through the drugstore.com website); and customized nutritional supplement programs through our wholly owned subsidiary, Custom Nutrition Services, Inc. (CNS). Our products are also available toll-free by telephone at 1-800-DRUGSTORE and 1-800-VISIONDIRECT. On September 3, 2008, we entered into an amended and restated main agreement with Rite Aid Corporation and certain of its affiliates (Rite Aid) whereby we transferred to Rite Aid the rights to our local pick-up pharmacy business, which includes prescription refills sold online through the drugstore.com web store or the Rite Aid online store and picked up by customers at Rite Aid stores. As a result of this agreement, our local pick-up pharmacy segment is reported as discontinued operations in the consolidated financial statements for all periods presented. Accordingly, we now manage our business in three segments: over-the-counter (OTC), vision, and mail-order pharmacy. See Note 2 for additional information.

Principles of Consolidation and Basis of Presentation

The accompanying consolidated financial statements include those of drugstore.com, inc. and our subsidiaries. All material intercompany transactions and balances have been eliminated.

We operate using a 52/53-week retail calendar year with each of the fiscal quarters in a 52-week year representing a 13-week period. Fiscal years 2008, 2007, and 2006 were 52-week years.

Estimates and Assumptions

The preparation of financial statements in conformity with U.S. generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the amounts of assets and liabilities, revenues and expenses, and disclosure of contingent assets and liabilities at the date of the financial statements. These estimates include, but are not limited to, revenue recognition, inventories, goodwill and intangible assets, stock-based compensation, deferred taxes, and commitments and contingencies. Actual results could differ from our estimates, and these differences could be material.

Cash Equivalents

We consider all highly liquid investments with a maturity of three months or less from the date of purchase to be cash equivalents. Cash equivalents include money market funds and commercial paper.

Marketable Securities

Management determines the appropriate classification of marketable securities at the time of purchase and reevaluates such designation as of each balance sheet date. The evaluation includes our view that our investments in debt securities are available to support current operations and therefore classified as a current asset. At December 28, 2008 and December 30, 2007, marketable securities, which are considered available-for-sale,

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consisted primarily of government bonds, corporate notes, and commercial paper. Marketable securities are carried at fair value. Net unrealized holding gains were $133,000 at December 28, 2008 and $34,000 at December 30, 2007. Cost of securities sold is determined using the specific identification method.

We regularly monitor and evaluate the realizable value of our marketable securities. When assessing marketable securities for other-than-temporary declines in value, we consider such factors as, among other things, how significant the decline in value is as a percentage of the original cost, how long the market value of the investment has been less than its original cost, the performance of the issuer’s stock price in relation to the stock price of its competitors within the industry and the market in general, analyst recommendations, any news that has been released specific to the issuer, and the outlook for the overall industry in which the issuer operates. If events and circumstances indicate that a decline in the value of these assets has occurred and is other than temporary, we record a charge against net earnings. No such charges have been recorded in fiscal years 2008, 2007, and 2006.

Fair Value of Financial Instruments

We adopted Statement of Financial Position No. 157, Fair Value Measurements (SFAS 157) on December 31, 2007, the first day of our fiscal year 2008. SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). The standard outlines a valuation framework and creates a fair value hierarchy in order to increase consistency and comparability of fair value measurements and the related disclosures. Under GAAP, certain assets and liabilities must be measured at fair value, and SFAS 157 details the disclosures that are required for measured fair value (see note 4). We have certain financial assets including money market funds and marketable securities that are measured at the new fair value standard. We currently do not have non-financial assets and non-financial liabilities that are required to be measured at fair value on a recurring basis. Our financial assets and liabilities, subject to SFAS 157, are measured using inputs from the three levels of the fair value hierarchy. The three levels are as follows:

Level 1	Inputs are unadjusted quoted prices in active markets for identical assets or liabilities that we have the ability to access at the measurement date.
Level 2	Inputs include unadjusted quoted prices in active markets for similar assets or liabilities, or unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.
Level 3	Unobservable inputs for the asset or liability that reflect our assumptions that market participants would use in pricing the asset or liability.

The carrying value approximates the fair value for all financial instruments that are not measured at fair value on the balance sheet, including accounts receivable and debt, due to the short-maturities of the instruments.

Concentration of Credit Risk

Financial instruments, which potentially subject us to concentrations of credit risk, consist principally of our holdings of cash, cash equivalents, marketable securities, and accounts receivable. Our credit risk is managed by investing our cash equivalents and marketable securities in high-quality money market instruments and securities of the U.S. government agencies, and high-quality corporate issuers. Our credit risk is managed through monitoring the stability of the United States-based financial institutions we use and the diversification of our financial resources by limiting the investment in any one issuer of not more than 10% of the total portfolio at the time of purchase, except for investments in U.S. treasuries and agencies and investment advisors’ money market funds.

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Sales subject to reimbursements collected from insurance companies, pharmacy benefit managers (PBMs), and managed care organizations through our relationship with Rite Aid currently represent 26% of our mail-order pharmacy sales.

Accounts Receivable

Accounts receivable consists primarily of the net amounts to be collected from third parties, including amounts collectible related to credit card purchases, vendor volume purchase and rebate allowances, amounts collectible from advertising agreements, amounts due from Rite Aid for co-payment and insurance reimbursement payments collected on our behalf, OTC fulfillment fees related to our agreement with Weil, and product revenue generated through our merchant agreement with Amazon.com, Inc. (Amazon.com). Accounts receivable are recorded net of allowances for doubtful accounts, which were $16,000 as of December 28, 2008 and $41,000 as of December 30, 2007. We determine our allowance for doubtful accounts by considering a number of factors, including the length of time receivables are past due, previous loss history, our ability to offset our obligations, and the customer’s ability to pay its obligation. We write off accounts receivable when they become uncollectible, and any payments subsequently received are applied to the allowance for doubtful accounts.

Inventories

Inventories consist of finished goods and are stated at the lower of cost (using the weighted average cost method) or the current estimated market value and adjusted for shrinkage, slow moving, damaged, and expired inventory. We currently purchase our non-pharmaceutical inventory directly from manufacturers and distributors. Through our agreement with Rite Aid, have the right to purchase its pharmaceutical inventory and Rite Aid private label over-the counter products through Rite Aid. As a result of this relationship, Rite Aid remains one of our largest suppliers.

Fixed Assets

Fixed assets are stated at cost less accumulated depreciation and amortization, which includes the depreciation of assets recorded under capital leases. Depreciation and amortization is determined using the straight-line method over the estimated useful lives of the related assets, which range from two to ten years. Fixed assets purchased under capital leases and leasehold improvements are depreciated over the shorter of the lease term or the estimated useful life. Repairs and maintenance costs are expensed as incurred.

Included in fixed assets is the cost of internally developed software and website development, including software used to upgrade and enhance our websites. We expense all costs related to the internally developed software other than those incurred during the application development stage. Costs incurred during the application development stage are capitalized and amortized over the estimated useful life of the software, generally three years. Internal labor costs, including benefit costs, and third-party consulting costs totaling $12.0 million, $10.8 million, and $3.5 million were capitalized during the fiscal years ended December 28, 2008, December 30, 2007, and December 31, 2006, respectively.

Leases

We categorize leases at their inception as either operating or capital leases depending on certain defined criteria. We recognize operating lease costs on a straight-line basis without regard to deferred payment terms and lease incentives are treated as a reduction of our costs over the term of the agreement.

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Other Intangible Assets

Other intangible assets consist of assets acquired in connection with agreements between drugstore.com and General Nutrition Corporation (GNC). We also acquired certain other intangible assets in connection with the purchase of Beauty.com, Inc. (Beauty.com), CNS, and Vision Direct, including trade names, domain names, and customer lists. In 2007, we acquired for $456,000 certain trademarks and intangibles associated with our private label de~luxe^™ brand of natural, spa quality personal care products. All definite-lived intangible assets are being amortized over their expected useful lives, which range from two to ten years.

Goodwill

We test for impairment of goodwill during the fourth quarter of each year and whenever indicators of impairment occur. The first phase of the test screens for impairment, while the second phase of the test (if necessary) measures the amount of impairment. The first phase is performed by comparing the implied fair value of the applicable reporting unit to its carrying value. Fair value is determined using either a discounted cash flow methodology or methodology based on comparable market prices. The second step of the goodwill impairment test compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to the excess.

During fiscal 2008, we estimated the fair value of our reporting units by preparing a discounted cash flow analysis using forward looking projections of our estimated future operating results. Based on the results of the discounted cash flow analysis, we concluded that the fair value exceeds the carrying value, and therefore goodwill is not impaired. We also considered as an indicator of market value the market value of our common stock during the fourth quarter.

The significant assumptions used in our discounted cash flow analysis included: projected operating results, the discount rate used to present value future cash flows, and capital expenditures. Projected operating results assumptions include sales growth assumptions which are based on historical trends, and to a lesser extent, future sales growth from new strategic partnerships. Also included in projected operating results are gross margin and operating cost growth assumptions which are based on historical relationship of those measures compared to sales. Our discount rate is a “market participant” weighted average cost of capital (WACC) of 16%. Our capital expenditure assumptions are based on our planned capital expenditures for existing and new projects. Sensitivity tests were performed on our significant assumptions and determined that a reasonable, negative change in assumptions would not impact our conclusions.

During fiscal years 2007 and 2006, we also performed our annual goodwill impairment review and determined that the fair value of each of our reporting units was greater than the carrying value and, accordingly, no impairment charges were recorded.

Long-Lived Assets

We review the carrying values of our amortized long-lived assets, including definite-lived intangible assets, whenever an indicator of impairment exists. When facts and circumstances indicate that the carrying values of long-lived assets may be impaired, we perform an evaluation of recoverability. The determination of whether impairment exists is based on any excess of the carrying value over the expected future cash flows, as estimated through undiscounted cash flows, excluding interest charges. Any resulting impairment charge would be measured based on the difference between the carrying value of the asset and its fair value, as estimated through expected future discounted cash flows, discounted at a rate of return for an alternate investment.

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We review our indefinite-lived intangible assets, other than goodwill, for impairment annually during the fourth quarter or when an indicator of impairment exists. We compare the carrying value of the asset to its estimated fair value and record an impairment charge when the carrying value of the asset exceeds the estimated fair value. Based upon our review, no impairment was recorded in fiscal 2008, 2007, or 2006.

Net Sales

We recognize revenues in accordance with SEC Staff Accounting Bulletin No. 104, Revenue Recognition. We recognize revenue from product sales or services rendered (including advertising revenues), net of sales tax, when the following revenue recognition criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) the selling price or fee earned is fixed or determinable; and (4) collection of the resulting receivable is reasonably assured.

OTC¸ Vision, and Mail-Order. We record revenues from sales of OTC, vision, and mail-order pharmacy when the products are shipped and title passes to customers, net of promotional discounts, cancellations, rebates, and returns allowances. We generally require payment by credit card at the point of sale. We estimate return allowances, which reduce product sales by our estimate of expected product returns, based on our historical experience. Historically, product returns have not been significant and have not differed significantly from our estimates.

From time to time, we provide incentive offers to our customers to encourage purchases. Such offers include discounts on specific current purchases, or future rebates based on a percentage of the current purchase, as well as other offers. We treat discounts, when our customers accept them, as a reduction in the sales price of the related transaction and we present them as a net amount in net sales. We treat rebates as a reduction in the sales price based on estimated redemption rates. We estimate redemption rates using our historical experience for similar offers. Historically, our redemption rates have not differed materially from our estimates, which we adjust quarterly.

Prescription Sales. For insured prescriptions in our mail-order segment, the co-payment and the insurance reimbursement (which together make up the amount due to drugstore.com) constitute the full value of the prescription drug sale, and we receive this entire amount as cash. We therefore recognize the entire amount as revenue when we ship the order to the customer.

We also evaluate the criteria of Emerging Issues Task Force Issue No. 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent, or EITF 99-19. Generally, when we are the primary party obligated in a transaction, are subject to inventory risk, have latitude in establishing prices and selecting suppliers, or have several but not all of these indicators, we record revenue on a gross basis. If we are not primarily obligated and amounts earned are determined using a fixed percentage, a fixed-payment schedule, or a combination of the two, we record revenue on a net basis.

Consignment and Drop-ship Arrangements. We record revenues generated by consignment arrangements with GNC and Rite Aid in our OTC segment on a net basis because we do not take title to the inventory and do not establish pricing. We record revenues generated from our drop-ship arrangements with vendors in our OTC segment on a gross basis when we are the primary party obligated in a transaction, are subject to inventory risk, have latitude in establishing prices and selecting suppliers, or have several but not all of these indicators.

Strategic Partnerships. We record revenues generated from the Amazon.com Marketplace in our OTC segment on a gross basis, because we act as a principal, based on the fact that we are subject to inventory risk, have latitude in establishing prices and selecting suppliers. We record revenues generated by the Weil agreement

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in our OTC segment on a net basis, because we act as an agent, based on the fact that we earn a fixed dollar amount per customer transaction regardless of the amount billed to the customer, and we do not bear general inventory risk associated with these sales. We record revenues generated from the Rite Aid online store in our OTC segment on a gross basis, because we act as a principal, based on the fact that we are subject to inventory and credit risk, have latitude in establishing prices and selecting suppliers. Rite Aid earns a percentage of the contribution margin, defined as net sales, less direct costs of these sales and the incremental cost of fulfilling, processing and delivering the order, from the Rite Aid online store, which we record in marketing and sales expense in the statements of operations.

We also evaluate the criteria of Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple Deliverables, or EITF 00-21, when we enter into arrangements with multiple deliverables. EITF 00-21 establishes three criteria that must be met in order for the deliverables in the arrangement to be treated as separate units of accounting; (1) the delivered item has value on a stand-alone basis; (2) there is objective and reliable evidence of the fair value of the undelivered item; and (3) delivery or performance of the undelivered item is considered probable and substantially in the control of the vendor. When the separation criteria are not met, the delivered item is accounted for as a combined unit of accounting with the undelivered item. Therefore, revenue for the delivered and undelivered items are recognized over the service period of the last delivered item or if it is not a service, when the last item is delivered.

Cost of Sales

Cost of sales consists primarily of the cost of products sold to our customers, including allowances for shrinkage and damaged, slow-moving, and expired inventory, outbound and inbound shipping costs, and expenses related to promotional inventory included in shipments to customers. Payments that we receive from vendors in connection with volume purchase or rebate allowances and payment discount terms are netted against cost of sales.

Shipping Activities

Our revenues from shipping charges to customers are included in net sales and were $14.8 million, $15.4 million, and $13.6 million for the years ended December 28, 2008, December 30, 2007, and December 31, 2006. Outbound shipping costs are included in cost of sales and were $26.8 million, $24.8 million, and $21.9 million for the years ended December 28, 2008, December 30, 2007, and December 31, 2006. The net cost to us of shipping activities was $12.0 million, $9.4 million, and $8.3 million for the years ended December 28, 2008, December 30, 2007, and December 31, 2006.

Fulfillment and Order Processing

Fulfillment and order processing expenses include payroll and related expenses for personnel engaged in purchasing, fulfillment, distribution, and customer care activities (including warehouse personnel and pharmacists engaged in prescription verification activities), distribution center equipment and packaging supplies, credit card processing fees, drop-ship processing fees, and bad debt expenses. These expenses also include rent and depreciation related to equipment and fixtures in our distribution center and call center facilities.

Marketing and Sales

Marketing and sales expenses include advertising expenses, promotional expenditures, web analytical tools, web design, and payroll and related expenses for personnel engaged in marketing and merchandising activities.

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Advertising costs are expensed as incurred. Costs associated with our brand advertising and personalization initiatives, which concluded in the first quarter of 2006, public relations, advertising, and trade shows are expensed when the related services are rendered. Advertising expense for the years ended December 28, 2008, December 30, 2007, and December 31, 2006 was $23.2 million, $20.7 million, and $18.7 million, respectively.

Technology and Content

Technology and content expenses consist primarily of payroll and related expenses for personnel engaged in developing, maintaining, and making routine upgrades and enhancements to our websites. Technology and content expenses also include Internet access and hosting charges, depreciation on hardware and IT structures, utilities, and website content and design expenses.

Technology and content costs are expensed as incurred, except for certain costs relating to the development of internal-use software and website development, including upgrades and enhancements to our websites, which are capitalized and depreciated over their estimated useful life.

General and Administrative

General and administrative expenses consist of payroll and related expenses for executive and administrative personnel, corporate facility expenses, professional service expenses, and other general corporate expenses.

Interest Income and Expense

Interest income consists of earnings on our cash, cash equivalents, and marketable securities, and interest expense consists primarily of interest associated with capital leases and debt obligations. Interest income for the years ended December 28, 2008, December 30, 2007, and December 31, 2006 totaled $1.1 million, $2.1 million, and $2.1 million, respectively. Interest expense was $0.5 million, $0.4 million, and $0.4 million for the years ended December 28, 2008, December 30, 2007, and December 31, 2006, respectively.

Accumulated Other Comprehensive Income/Loss

Accumulated other comprehensive income/loss consists of the accumulated net unrealized gains and losses on available-for-sale securities (see note 4) and cumulative translation adjustments from the translation of assets and liabilities of our Canadian subsidiary into U.S. dollars. Our currency translation adjustment included in accumulated other comprehensive income/loss was an unrealized loss of $69,000 in 2008 and an unrealized gain of $6,000 in 2007.

Income Taxes

We account for income taxes under the liability method. Under the liability method, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that are expected to be in effect when the differences are expected to be recovered. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amounts expected to be realized.

Effective January 1, 2007, we adopted the provisions of Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109 (FIN 48). FIN 48 contains a two-step approach to recognizing and measuring uncertain tax positions (tax

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contingencies) accounted for in accordance with SFAS No. 109. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments and which may not accurately forecast actual outcomes. We did not have any unrecognized tax benefits before or after the adoption of FIN 48. Our policy is to recognize interest and penalties related to the underpayment of income taxes as a component of income tax expense. To date, we have not incurred charges for interest or penalties in relation to the underpayment of income taxes. The tax years 1998 through the present remain open to examination by the major taxing jurisdictions to which we are subject.

Stock-Based Compensation

We account for stock-based compensation under the provisions of FASB Statement No. 123 (revised 2004), Share-Based Payment (FAS 123(R)), which requires measurement of compensation cost for all stock-based awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The fair value of stock options is based on the estimated grant date fair value method using the Black-Scholes valuation model. The fair value of restricted stock is determined based on the number of shares granted and the quoted price of our common stock. Such value is recognized as expense over the service period, net of estimated forfeitures, using the straight-line method. The estimation of stock awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results and future estimates may differ substantially from our current estimates.

Net Loss per Share

Net loss per share is computed using the weighted average number of shares of common stock outstanding. Shares associated with stock options, warrants, and our employee stock purchase plan are not included in the calculation of diluted net loss per share as their effects are antidilutive. The following shares were excluded from the computation of diluted net loss per share as their effect was antidilutive. If we had reported net income, the calculation of diluted net loss per share would have included the dilutive effect of these common stock equivalents using the treasury stock method.

	December 28, 2008	December 30, 2007	December 31, 2006
Stock options	16,706,547	16,742,358	18,995,824
Warrants	400,000	865,000	615,000
	17,106,547	17,607,358	19,610,824

We granted shares of restricted stock and stock options totaling 3,451,700 on March 5, 2009, pending stockholder approval of the 2008 Equity Plan. See note 11.

New Accounting Pronouncements

In May 2008, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 162, Hierarchy of Generally Accepted Accounting Principles (SFAS 162). This statement is intended to improve financial reporting by identifying a consistent framework, or hierarchy, for selecting

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accounting principles to be used in preparing financial statements of non-governmental entities that are presented in conformity with GAAP. This statement will be effective 60 days following the U.S. Securities and Exchange Commission’s approval of the Public Company Accounting Oversight Board amendment to AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles. We are currently evaluating the potential impact, if any, of the adoption of SFAS 162 on our consolidated financial statements.

In April 2008, the FASB issued FASB Staff Position (FSP) No. SFAS 142-3, Determination of the Useful Life of Intangible Assets (FSP SFAS 142-3). FSP SFAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, Goodwill and Other Intangible (SFAS 142). The intent of FSP SFAS 142-3 is to improve the consistency between the useful life of a recognized intangible asset under SFAS 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141R (revised 2007), Business Combinations (SFAS 141R) and other applicable accounting literature. FSP SFAS 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008. Early adoption is prohibited. We do not anticipate that the adoption of FSP No. 142-3 will have any material impact on our consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141 (R), Business Combinations and SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements. SFAS No. 141 (R) requires an acquirer to measure the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree at their fair values on the acquisition date, with goodwill being the excess value over the net identifiable assets acquired. SFAS No. 160 clarifies that a noncontrolling interest in a subsidiary should be reported as equity in the consolidated financial statements. The calculation of earnings per share will continue to be based on income amounts attributable to the parent. SFAS No. 141 (R) and SFAS No. 160 are effective for financial statements issued for fiscal years beginning after December 15, 2008. Early adoption is prohibited. We do not anticipate that the adoption of SFAS No. 141 (R) or SFAS No. 160 will currently have any material impact on our consolidated financial statements but will have an impact on any future business combinations consummated beginning in 2009.

In June 2008, the FASB ratified the consensus reached on Emerging Issues Task Force (EITF) Issue No. 07-05, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock (EITF 07-05). EITF 07-05 clarifies the determination of whether an instrument (or an embedded feature) is indexed to an entity’s own stock, which would qualify as a scope exception under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities. EITF 07-05 is effective for financial statements issued for fiscal years beginning after December 15, 2008 (our fiscal year 2009). Early adoption for an existing instrument is not permitted. Upon the adoption of EITF 07-05, 200,000 outstanding warrants to purchase common stock will be reclassified from equity to a liability and adjusted to fair value at each reporting period. We do not anticipate that the adoption of EITF 07-05 will have a material impact on our consolidated financial statements however future changes in our stock price could result in a material impact in future periods.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value under GAAP, and expands disclosures about fair value measurements. SFAS 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and states that a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. For financial assets and liabilities, SFAS 157 was effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. See Note 4 for further discussion. In February 2008, the FASB issued FASB Staff Position No. FAS 157-2,

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Effective Date of FASB Statement No. 157 (SFAS 157-2), which amends SFAS 157 by delaying its effective date by one year for non-financial assets and non-financial liabilities, except for items that are recognized or disclosed as fair value in the financial statements on a recurring basis. Therefore, beginning on the first day of fiscal year 2009, this standard applies prospectively to fair value measurements of financial instruments and recurring fair value measurements of non-financial assets and non-financial liabilities. Beginning on the first day of fiscal year 2009, the standard will apply to all other fair value measurements. We do not anticipate that the adoption of SFAS 157-2 will have a material impact on our consolidated financial statements.

2. Discontinued Operations

On September 3, 2008, we entered into an amended and restated main agreement with Rite Aid whereby we transferred to Rite Aid the rights to our local pick-up pharmacy business (LPU), which includes prescription refills sold online through the drugstore.com web store or the Rite Aid online store and picked up by customers at Rite Aid stores, in exchange for $9.9 million, paid in ten monthly installments beginning in September 2008. We recorded the purchase price as a deferred gain that we are recognizing over the ten-month contractual payment period ending in June 2009. Additionally, Rite Aid will pay drugstore.com ongoing marketing service fees for the continued marketing of Rite Aid’s LPU offering on the drugstore.com site during the term of the agreement, which continues for two years unless extended for another year by either party. The marketing service fees are considered indirect cash inflows of our discontinued LPU segment as we anticipate the fees earned will not be a significant source of ongoing revenue in the future.

In conjunction with the amended and restated main agreement, we recognized a net gain of $2.3 million, which consisted of a $4.0 million gain recognized from the sale of the LPU business, a $276,000 gain recognized from the sale of inventory, partially offset by the accelerated amortization of prepaid marketing costs totaling $1.9 million under our previous agreement upon the discontinuation of the LPU business. The gain from the sale of the discontinued operations was $9.9 million of which $4.0 million was recognized in fiscal 2008 and $5.9 million will be recognized in fiscal 2009 as the payments become due. We have classified the results of operations of our LPU segment as discontinued operations in the accompanying consolidated statements of operations for all periods presented.

The following table summarizes the results of operations of our LPU segment that we have classified as discontinued operations.

	For the year ended
	December 28, 2008		December 30, 2007		December 31, 2006
	(in thousands)
Net sales	$	80,943	$	106,392	$	100,654
Cost of sales		70,383		93,611		89,654
Fulfillment and order processing		3,285		4,383		4,128
Marketing and sales		1,527		2,290		2,290
Income from discontinued operations		5,748		6,108		4,582
Net gain from sale of discontinued operations		2,332		—		—
Gain from discontinued operations (taxes $0, $0, and $0)	$	8,080	$	6,108	$	4,582

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We have classified the assets and liabilities of our LPU segment as net assets and liabilities from discontinued operations in the accompanying consolidated balance sheets for all periods presented.

	December 28, 2008		December 30, 2007
	(in thousands)
Accounts receivable	$	5,954	$	27,064
Inventories		—		264
Prepaid marketing expenses		—		2,290
Non-current prepaid marketing expenses		—		1,145
Assets of discontinued operations	$	5,954	$	30,763
Accounts payable	$	—	$	24,968
Deferred gain on discontinued operations		5,946		—
Liabilities of discontinued operations	$	5,946	$	24,968
Net assets of discontinued operations	$	8	$	5,795

3. Strategic Agreements

Agreements with Rite Aid

In June 1999, we entered into a ten-year strategic relationship with Rite Aid. On September 3, 2008, we amended and restated both the main agreement (see note 2) and the pharmacy supply and services agreement dated June 17, 1999 between Rite Aid and drugstore.com. Through our agreements with Rite Aid, we have access to Rite Aid customers through the RiteAid.com website and the Rite Aid online store, which is powered by the drugstore.com website.

Under the amended and restated pharmacy and private label supply and services agreement, Rite Aid has granted drugstore.com, during the two-year term of the agreement, a nonexclusive, fully paid license to the Rite Aid information and pharmacy systems that are integrated with our systems, subject to third-party rights to such technology. Through this technology integration, Rite Aid will continue to adjudicate and collect insurance reimbursement payments for prescription medications in our mail-order pharmacy segment on behalf of drugstore.com. In addition, we will continue to have the right to purchase pharmaceutical inventory and Rite Aid private label over-the counter products through Rite Aid. As a result of this continued relationship, Rite Aid remains one of our largest suppliers, and we will maintain our access to many of Rite Aid’s relationships with insurance companies and PBMs, allowing us to continue to facilitate insurance coverage to those customers.

Also on September 3, 2008, we entered into a two year web store and fulfillment agreement with Rite Aid whereby drugstore.com will provide site design, development, hosting, customer service, and fulfillment for the Rite Aid online store. In December 2008, we launched the Rite Aid online store. Under the terms of this agreement, we retain the gross revenues collected from the Rite Aid online store, and Rite Aid earns a percentage of the contribution margin generated by the Rite Aid online store. We record the amount paid to Rite Aid as a marketing expense in our consolidated statements of operations.

Agreement with GNC

We have a 10-year agreement with GNC under which we are an online provider of GNC-branded products. We had the exclusive right to sell GNC’s wellness products over the Internet until July 2005, at which time our exclusivity provisions terminated. For the remainder of the agreement, which ends in June 2009, we have the

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nonexclusive right to sell these products. The agreement automatically extends for successive one year periods until such time notice is given by either party to terminate. As part of this relationship, we created the GNC Store within the drugstore.com website, which is dedicated to selling GNC products on a consignment basis. We retain a percentage of the gross revenues that we collect from sales of GNC products and recognize only the net amount we retain as revenues. We have also agreed with GNC to co-promote each other’s products and services in both traditional and online marketing efforts, including GNC’s placement of a link to our website on the GNC website.

A portion of the non-cash consideration relating to the agreements with GNC has been allocated to vendor agreements and classified within other intangible assets. The assets are being amortized on a straight-line basis over their contractual life of 10 years.

Agreements with Amazon.com

In September 2007, we entered into a three-year merchant agreement with Amazon.com, a related party, to sell prestige beauty products through the Beauty.com marketplace on the Amazon.com website. We ship the Amazon.com orders from our distribution facility in exchange for an agreed-upon product price less a referral fee. Product revenue generated by the merchant agreement totaled $1.3 million in 2008 and $124,000 in 2007, and referral fees paid totaled $221,000 in 2008 and $20,000 in 2007. As of December 28, 2008 and December 30, 2007, amounts due from Amazon.com totaled $49,000 and $21,000, respectively.

Agreement with Weil Lifestyle

In November 2008, we entered into an amended and restated fulfillment agreement with Weil whereby we provide fulfillment and customer service operations in exchange for an agreed-upon fulfillment fee through December 31, 2011. This agreement replaces our previous three-year fulfillment agreement with Weil entered into on December 31, 2005. The revenue generated by our agreement with Weil totaled $1.6 million in 2008, $1.7 million in 2007, and $2.0 million in 2006.

4. Cash, Cash Equivalents and Marketable Securities

Cash, cash equivalents, and marketable securities consist of the following:

	December 28, 2008
	Amortized Cost		Gross Unrealized Holding Gains		Gross Unrealized Holding Losses		Fair Value
	(in thousands)
Cash and money market funds	$	21,601	$	—	$	—	$	21,601
Commercial paper		3,595		1		—		3,596
Cash and cash equivalents		25,196		1		—		25,197
U.S. government agency obligations		9,462		118		—		9,580
Corporate notes and bonds		2,505		12		—		2,517
Commercial paper		898		2		—		900
Marketable securities		12,865		132		—		12,997
Total cash, cash equivalents and marketable securities	$	38,061	$	133	$	—	$	38,194

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	December 30, 2007
	Amortized Cost		Gross Unrealized Holding Gains		Gross Unrealized Holding Losses		Fair Value
	(in thousands)
Cash and money market funds	$	17,675	$	—	$	—	$	17,675
Commercial paper		897		—		—		897
Cash and cash equivalents		18,572		—		—		18,572
U.S. government agency obligations		10,466		7		—		10,473
Corporate notes and bonds		4,871		20		—		4,891
Commercial paper		1,791		—		—		1,791
Private placement bonds		515		7		—		522
Marketable securities		17,643		34		—		17,677
Total cash, cash equivalents and marketable securities	$	36,215	$	34	$	—	$	36,249

The following table summarizes contractual maturities of our commercial paper and marketable securities as of December 28, 2008 (in thousands):

	Amortized Cost		Fair Value
Due within one year	$	13,651	$	13,712
Due after one year through three years		2,809		2,881
Total	$	16,460	$	16,593

The following table summarizes, by major security type, our assets that are measured at fair value on a recurring basis and are categorized using the fair value hierarchy (in thousands):

	December 28, 2008
	Cash		Level 1 Estimated Fair Value		Level 2 Estimated Fair Value		Level 3 Estimated Fair Value		Total Estimated Fair Value
	(in thousands)
Cash	$	18,807	$	—	$	—	$	—	$	18,807
Money market funds (1)		—		2,794		—		—		2,794
Commercial paper (2)		—		—		4,496		—		4,496
U.S. government agency obligations (3)		—		—		9,580		—		9,580
Corporate notes and bonds (3)		—		—		2,517		—		2,517
	$	18,807	$	2,794	$	16,593	$	—	$	38,194

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	December 30, 2007
	Cash			Level 1 Estimated Fair Value		Level 2 Estimated Fair Value		Level 3 Estimated Fair Value		Total Estimated Fair Value
	(in thousands)
Cash	$	(25	)	$	—	$	—	$	—	$	(25	)
Money market funds (1)		—			17,700		—		—		17,700
Commercial paper (2)		—			—		2,688		—		2,688
U.S. government agency obligations (3)		—			—		10,473		—		10,473
Private placement bonds (3)		—			—		522		—		522
Corporate notes and bonds (3)		—			—		4,891		—		4,891
	$	(25	)	$	17,700	$	18,574	$	—	$	36,249

(1) Included in cash and cash equivalents in the consolidated balance sheets. We determined fair values based on quoted market prices.

(2) Included in cash and cash equivalents in the consolidated balance sheets if the investment has a maturity of three months or less from the date of purchase or included in marketable securities if the investment has a maturity in excess of three months from the date of purchase. We determined fair values based on observable market prices in less active markets or quoted market prices for similar instruments.

(3) Included in marketable securities in the consolidated balance sheets. We determined fair value based on observable market prices in less active markets or quoted market prices for similar instruments.

5. Fixed Assets

Fixed assets consist of the following:

	December 28, 2008			December 30, 2007
	(in thousands)
Computers and equipment	$	26,421		$	24,838
Purchased and internally developed software		37,576			23,994
Furniture and fixtures		2,638			3,127
Leased assets		6,022			7,187
Leasehold improvements		10,967			10,898
		83,624			70,044
Less accumulated depreciation and amortization		(58,881	)		(51,211	)
		24,743			18,833
Construction in progress		3,563			6,668
Total	$	28,306		$	25,501

Accumulated amortization on leased assets was $5.0 million and $5.4 million as of December 28, 2008, and December 30, 2007. Amortization is included in depreciation expense.

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6. Other Intangible Assets and Goodwill

Intangible Assets

The other intangible assets balances as of December 28, 2008 were as follows (in thousands):

	Weighted Average Years Useful Life	Gross Carrying Amount (1)		Acquisitions		Accumulated Amortization (1)			Net Balance
Vision Direct trade name	indefinite	$	2,700	$	—	$	—		$	2,700
GNC vendor agreement	10		12,265		—		(11,893	)		372
Truescents trademark	indefinite		252		—		—			252
Technology license, domain names and other	9		709		—		(302	)		407
Total other intangible assets	9.9	$	15,926	$	—	$	(12,195	)	$	3,731

(1) During 2008, we wrote-off $8.3 million of fully amortized intangible assets with a net book value of $0.

The other intangible assets balances as of December 30, 2007 were as follows (in thousands):

	Weighted Average Years Useful Life	Gross Carrying Amount		Acquisitions (2)		Accumulated Amortization			Net Balance
Vision Direct trade name	indefinite	$	2,700	$	—	$	—		$	2,700
Vision Direct customer base	3		1,931		—		(1,931	)		—
Vision Direct vendor agreement	2		1,434		—		(1,434	)		—
Vision Direct covenant of non-compete	2		575		—		(575	)		—
GNC vendor agreement	10		12,265		—		(11,149	)		1,116
CNS contract and technology assets	4		3,330		—		(3,312	)		18
Truescents trademark	indefinite		—		252		—			252
Technology license, domain names and other	6		1,511		204		(1,203	)		512
Total other intangible assets	7	$	23,746	$	456	$	(19,604	)	$	4,598

(2) During 2007, we acquired for $456,000 certain trademarks and intangibles associated with our new, private label de~luxe^™ brand of natural, spa quality personal care products.

The following table summarizes our estimated amortization expense for each of the next five fiscal years (in thousands):

Fiscal year
2009	$	451
2010		80
2011		80
2012		80
2013		67
Total	$	758

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Goodwill

Goodwill in our OTC segment includes $2.7 million related to the acquisition of CNS in 2003 and $5.7 million related to our acquisition of Beauty.com in 2000. Goodwill in our vision segment includes $23.8 million related to the acquisition of Vision Direct in 2003. There were no changes to goodwill in fiscal years 2008 or 2007.

7. Long-Term Obligations

Line of Credit and Term Loans

In December 2004, we entered into an amended and restated loan and security agreement with a bank. In January 2005, we borrowed $1.0 million on the line of credit and in December 2005, we converted the $1.0 million line of credit into a term loan. The term loan totaled $361,000 as of December 30, 2007 and was payable in 36 monthly installments of principal and interest at a rate of prime rate plus 0.50%. In addition, the agreement included a $2.0 million term loan for capital equipment expenditures that accrued interest on the outstanding principal balance at a rate of prime rate plus 0.50%. This term loan was payable in 36 equal monthly installments of principal, plus accrued interest, beginning on February 1, 2005 and ending on January 1, 2008. The balance outstanding under this term loan was $55,000 as December 30, 2007.

In April 2007, we entered into an amended and restated loan and security agreement with our existing bank. The agreement included a revolving line of credit allowing for borrowings of up to $10.0 million, which accrue interest at the prime rate. The revolving line of credit matured in March 2008. The agreement allowed for the conversion of up to $2.5 million of the outstanding balance into a term loan within 60 days of maturity. For the year ended December 30, 2007, borrowings under the existing line of credit totaled $4.0 million, of which $1.0 million was converted into a term loan in April 2007, $2.5 million was repaid and $1.5 million remained outstanding as of December 30, 2007 and was payable in 36 monthly installments of principal and interest at a rate of prime rate plus 0.50%.

In March 2008, we entered into an amended and restated loan and security agreement with our existing bank. This agreement includes a revolving line of credit allowing for borrowings of up to $10.0 million, which accrue interest at the prime rate. The revolving line of credit matured in March 2009. The agreement allows for the conversion of up to $5.0 million of the outstanding balance into a term loan within 60 days of maturity. In March 2008, borrowings under the existing line of credit totaling $5.0 million and existing term loans totaling $972,222 were converted into one term loan totaling approximately $6.0 million under the amended and restated loan and security agreement. The term loan is payable in 36 monthly installments and accrues interest at the prime rate plus 0.50% (3.75% at December 28, 2008). The balance outstanding under the term loan totaled $5.5 million as of December 28, 2008, and there was no balance outstanding under the line of credit as of December 28, 2008. Our equipment, inventory, accounts receivable, cash, investments, and intangible assets collateralize the borrowings under the agreement. The agreement contains certain financial and non-financial covenants with which we were in compliance at December 28, 2008.

In March 2009, we entered into a loan and security agreement with our existing bank. This agreement includes a revolving two-year line of credit allowing for borrowings up to $25.0 million, which accrue interest at the prime rate, for general corporate purposes, including short-term working capital needs, and to finance certain potential acquisitions, should we elect to pursue any in the future. The agreement allows for the conversion of up to $15.0 million of the outstanding balance into a term loan, payable in 36 monthly installments of principal and interest at a rate equal to the greater of (a) the prime rate plus 0.50% or (b) 4.50%. Advances available under the revolving line of credit are limited, based on eligible inventory, accounts receivable, and cash and investment balances, and balances outstanding under our existing term loan. As of March 9, 2009, approximately $4.0 million in borrowings under our previous facility were considered outstanding under this facility. Accordingly,

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the available borrowings under the line of credit were approximately $21.0 million. The agreement contains certain covenants that are customary in transactions of this nature, including a prohibition on other debt and liens, requirements regarding the payment of taxes, and certain restrictions on mergers and acquisitions, investments, and transactions with our affiliates, as well as certain financial covenants related to our cash and cash equivalents and our free cash flow. The agreement identifies certain events of default that are customary for transactions of this nature and subject to materiality provisions and grace periods where appropriate, including failure to pay any principal or interest under this facility or other instruments when due, violations of any covenants, a material cross-default to our other debt, or a change of control.

Capital Leases

In July 2006, we entered into an agreement to finance equipment in our distribution center totaling $1.9 million under a non-cancelable capital lease. The lease is payable in 36 monthly installments of approximately $60,000 beginning January 2007 and ending December 2009, and accrues interest at a rate of 8%. As of December 28, 2008 and December 30, 2007, the amount due under the agreement was $690,000 and $1.3 million, respectively.

We also lease computer equipment under non-cancelable capital leases. Capital lease obligations bear interest at rates ranging from 7% to 8% and mature 21 to 24 months from the date of funding. We secured additional funds of $524,000 during 2008 and $469,000 during 2007, through capital lease financing agreements, through which we financed certain computer equipment and software for periods of two and three years. We are in compliance with all covenants required by these agreements. These amounts are included in the table below within the category of capital leases.

Maturities of long-term obligations at December 28, 2008 are as follows:

Fiscal Year	Term Loan			Capital Leases			Total
2009	$	1,991		$	1,052		$	3,043
2010		1,991			74			2,065
2011		498			—			498
Total minimum payments		4,480			1,126			5,606
Less amounts representing interest		—			(41	)		(41	)
Present value of minimum payments		4,480			1,085			5,565
Less current portion of long-term obligations		(1,991	)		(1,007	)		(2,998	)
Non-current portion of long-term obligations	$	2,489		$	78		$	2,567

8. Commitments and Contingencies

Operating Leases

We lease office, distribution center, and call center facilities under non-cancelable operating leases, which include fixed rental payments ending between 2009 and 2013. We have the option to extend some of these leases for one or two additional terms of five years. In addition, we lease various office and IT equipment under operating leases. Total rent expense under operating leases was $3.7 million in 2008, $3.4 million in 2007, and $3.0 million in 2006.

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In August 2004, we entered into an operating lease for approximately 53,000 square feet for our corporate headquarters. The lease expires on July 31, 2013, with two separate five-year renewal options that, if exercised, would extend the lease expiration to July 2023. In connection with the lease, we received landlord-provided incentives of approximately $2.3 million in the form of tenant improvements, which have been recorded as additions to fixed assets and other current and long-term liabilities and are being amortized over the term of the lease. As of December 28, 2008 and December 30, 2007, our long-term deferred rent liability totaled $1.0 million and $1.3 million, respectively, and our current deferred rent liability totaled $0.3 million.

In connection with the lease arrangements for our corporate headquarters, we are required to provide a standby letter of credit to our landlord as a security deposit, which will be renewed annually until the end of the lease term. The standby letter of credit is funded under our revolving line of credit and is not required to be secured with cash.

Future minimum commitments at December 28, 2008 are as follows:

Fiscal Year	Operating Leases
2009	$	3,042
2010		3,028
2011		1,565
2012		1,487
2013		876
Thereafter		—
Total minimum payments	$	9,998

Legal Proceedings

1-800 Contacts Litigation. On February 26, 2008, 1-800 Contacts, Inc. (1-800 Contacts) filed an action in the U.S. District Court for the District of Utah, Central Division against us and our subsidiary Vision Direct alleging direct and contributory trademark infringement and dilution under federal and state law, unfair competition, intentional interference with economic relations, and unjust enrichment. One day later, on February 27, 2008, 1-800 Contacts filed a separate action in the U.S. District Court for the Southern District of New York against Vision Direct alleging breach of a 2004 settlement agreement between Vision Direct and 1-800 Contacts. In both actions, 1-800 Contacts seeks monetary damages as well as injunctive relief. In the Utah action, we filed a motion to dismiss for improper venue or, in the alternative, to transfer the case to the U.S. District Court for the Southern District of New York. By Order dated August 11, 2008, the Utah District Court dismissed the Utah action for improper venue. On September 11, 2008, 1-800 Contacts filed with the Utah District Court a notice of appeal to the U.S. Court of Appeals for the Tenth Circuit. 1-800 Contacts subsequently agreed to discontinue the appeal. Pursuant to a stipulation of the parties, the Tenth Circuit appeal was dismissed with prejudice on February 2, 2009. In the New York action, we filed an answer denying that 1-800 Contacts is entitled to the relief requested and counterclaims asserting, among other things, that 1-800 Contacts’ pursuit of the Utah action constitutes a violation of the settlement agreement’s forum selection clause. 1-800 Contacts filed a Motion to Dismiss our counterclaims, which motion is now fully briefed. In open court on July 22, 2008, the District Court for the Southern District of New York stated that it would take no action on 1-800 Contacts’ motion in the New York action until our motion in the Utah action had been decided and the parties’ had informed the Court of the outcome. The parties have since agreed to mediate the dispute. In the event that a settlement is not reached in mediation, discovery will commence in the New York action. We believe 1-800 Contacts’ claims are without merit and intend to defend against them vigorously.

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Due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of these matters. We are unable to estimate the potential damages that might be awarded if we were found liable. Because our liability, if any, cannot be reasonably estimated, no amounts have been accrued for these matters. An adverse outcome in these matters could have a material adverse effect on our financial position and results of operations.

State Sales Tax Claims. In early 2002, we received an arbitrary assessment notice from the state of New Jersey for past sales tax due from fiscal years 2000 and 2001, based on its best estimate of sales revenue numbers during those periods. In December 2002, we received a revised assessment from the state of New Jersey for 2000 and 2001 in the aggregate amount of $221,626 in tax, plus penalties in the amount of $11,081 and interest that continues to accrue. In March 2003, we filed an appeal of the revised assessment with the Tax Court of New Jersey, based on the fact that the state of New Jersey is pursuing its claim specifically against one of our consolidated subsidiaries that is not a retailing entity in that state. On February 19, 2008, we were informed of the decision by the Tax Court of New Jersey against us in the case of drugstore.com, inc. vs. Director, Division of Taxation (the NJ Tax Case). We did not believe that it was required to collect sales taxes on sales made to customers in New Jersey based on applicable law. In its decision, the Tax Court of New Jersey ruled otherwise. Prior to this ruling we had not collected sales tax in New Jersey. The Tax Court’s Opinion is currently being appealed at the Superior Court of New Jersey, Appellate Division. Briefing was completed in November of 2008; oral argument for the Appeal has not yet been scheduled. Effective March 2008, we began collecting and remitting sales tax on taxable New Jersey sales. Given the decision, we believe that it is probable that we have incurred a liability of $2.5 million for estimated taxes and interest. Accordingly, we recorded an expense in general and administrative expenses in the consolidated statement of operations during the year ended December 30, 2007. The liability is an estimate of the New Jersey tax obligation for the 2000 and 2001 assessment that gave rise to the NJ Tax Case, as well as for all subsequent years through 2007. During 2008, we have recorded an additional $380,000 of estimated uncollected taxes related to 2008 and interest.

Class Action Laddering Litigation. A Consolidated Amended Complaint, which is now the operative complaint, was filed on April 19, 2002 in the United States District Court for the Southern District of New York (the Court). It names drugstore.com as a defendant, along with the underwriters and certain of our present and former officers and directors (the Individual Defendants), in connection with our July 27, 1999 initial public offering and March 15, 2000 secondary offering (together, the Offerings). The suit purports to be a class action filed on behalf of purchasers of our common stock during the period July 28, 1999 to December 6, 2000.

In general, the complaint alleges that the prospectuses through which we conducted the Offerings were materially false and misleading because they failed to disclose, among other things, that (i) the underwriters of the Offerings allegedly had solicited and received excessive and undisclosed commissions from certain investors in exchange for which the underwriters allocated to those investors material portions of the restricted number of shares issued in connection with the Offerings and (ii) the underwriters allegedly entered into agreements with customers whereby the underwriters agreed to allocate drugstore.com shares to customers in the Offerings in exchange for which customers agreed to purchase additional drugstore.com shares in the after-market at predetermined prices. The complaint asserts violations of various sections of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended. The action seeks damages in an unspecified amount and other relief. The action is being coordinated with approximately 300 other nearly identical actions filed against other companies or their present and former officers and directors.

On October 9, 2002, the Court dismissed the Individual Defendants from the case without prejudice. On December 5, 2006, the Second Circuit vacated a decision by the district court granting class certification in six of the coordinated cases, which are intended to serve as test, or “focus,” cases. The plaintiffs selected these six cases, which do not include us. On April 6, 2007, the Second Circuit denied a petition for rehearing filed by plaintiffs, but noted that plaintiffs could ask the district court to certify more narrow classes than those that were rejected.

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On August 14, 2007, the plaintiffs filed amended complaints in the six focus cases. The six focus case issuers and the underwriters named as defendants in the focus cases filed motions to dismiss the amended complaints against them on November 14, 2007. On September 27, 2007, the plaintiffs filed a motion for class certification in the six focus cases. On March 26, 2008, the District Court dismissed the Securities Act claims of those members of the putative classes in the focus cases who sold their securities for a price in excess of the initial offering price and those who purchased outside the previously certified class period. With respect to all other claims, the motions to dismiss were denied. On October 10, 2008, at the request of Plaintiffs, Plaintiffs’ motion for class certification was withdrawn, without prejudice.

The parties in the approximately 300 coordinated class actions, including drugstore.com, the underwriter defendants in the drugstore.com class action, and the plaintiffs in the drugstore.com class action, have reached an agreement in principle under which the insurers for the issuer defendants in the coordinated cases will make the settlement payment on behalf of the issuers, including drugstore.com. The settlement is subject to approval by the parties, termination by the parties under certain circumstances, and Court approval. There is no assurance that the settlement will be concluded or that the Court will approve the settlement.

Due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of this matter. We are unable to estimate the potential damages that might be awarded if the settlement is not concluded or approved and we were found liable, there arose a material limitation with respect to our insurance coverage, or the amount awarded were to exceed our insurance coverage. Because our liability, if any, cannot be reasonably estimated, no amounts have been accrued for this matter. An adverse outcome in this matter could have a material adverse effect on our financial position and results of operations.

Other. From time to time, we are subject to other legal proceedings and claims in the ordinary course of business. We are not currently aware of any such legal proceedings or claims that we believe will have, individually or in the aggregate, a material adverse effect on our business prospects, financial condition, or operating results, other than those listed above.

9. Income Taxes

No tax benefit or expense was recorded in 2008, 2007, or 2006 due to our ongoing operating losses. In addition, no tax benefit or expense related to discontinued operations has been recorded due to the continuing and historical tax losses related to the LPU business. Our deferred tax assets consist primarily of net operating loss carry-forwards and amortization and impairment of intangible assets. We have provided a valuation allowance for our deferred tax assets to an amount expected to be realized. The increase in the valuation allowance on the deferred tax assets was $4.0 million in 2008 and $12.6 million in 2007.

At December 28, 2008 and December 30, 2007, we had approximately $567.2 million and $555.9 million, respectively, of net operating loss carry-forwards that will expire beginning in 2018. Internal Revenue Code Section 382 imposes limitations on our ability to utilize net operating losses if we experience an ownership change. An ownership change may result from transactions increasing the ownership of certain stockholders in the stock of a corporation by more than 50 percentage points over a three-year period. The value of the stock at the time of an ownership change is multiplied by the applicable long-term tax exempt interest rate to calculate the annual limitation. Any unused annual limitation may be carried over to later years. As of December 28, 2008, there were no significant limitations on the use of our existing net operating loss under Internal Revenue Code Section 382.

Approximately $8.6 million of our net operating loss carry-forwards are acquired operating loss carry-forwards. To the extent that we realize these acquired operating loss carry-forwards, the resulting tax benefits

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would reduce any remaining goodwill related to the acquisition. Approximately $9.7 million of our net loss carry-forwards are related to tax-deductible stock-based compensation in excess of amounts recognized for financial reporting purposes. To the extent that net operating loss carry-forwards, if realized, relate to stock-based compensation, the resulting tax benefits will be recorded to stockholders’ equity, rather than to results of operations.

Deferred income tax balances reflect the effects of temporary differences between the carrying amount of assets and liabilities and their tax bases and are stated at the enacted tax rates expected to be in effect when taxes are actually paid or recovered. Significant components of our deferred tax assets and liabilities are as follows:

	December 28, 2008			December 30, 2007
	(in thousands)
Deferred tax assets:
Net operating loss carry-forward (federal)	$	198,529		$	194,559
Net operating loss carry-forward (state)		10,730			9,479
Depreciation, amortization and impairment of intangible assets		32,006			37,438
Tax credit carry-forwards		1,323			1,344
Stock compensation		8,799			6,204
Other temporary differences		3,027			1,357
Total gross deferred tax assets		254,414			250,381
Less valuation allowance		(254,414	)		(250,381	)
Net deferred tax assets, net of valuation allowance		—			—
Deferred tax liabilities:
Indefinite-lived intangible asset		(953	)		(947	)
Net deferred tax liability	$	(953	)	$	(947	)

A reconciliation of income taxes from continuing operations computed at the statutory rate to the income tax amount recorded is as follows:

	December 28, 2008			December 30, 2007			December 31, 2006
Income tax benefit at statutory rate	$	2,899		$	4,028		$	4,428
State taxes, net of federal impact		2,093			1,427			214
State net operating loss expiration		(597	)		—			—
Tax credits		(24	)		123			1,118
Other permanent differences		(166	)		(67	)		(476	)
Impact of rate change—State		(172	)		4,756			—
Impact of rate change—Federal		—			2,369			(2,614	)
Increase in valuation allowance		(4,033	)		(12,636	)		(2,670	)
Total income tax benefit	$	—		$	—		$	—

10. Stockholders’ Equity

Outstanding Warrants

In June 2008, we issued a fully vested warrant to purchase 50,000 shares of our common stock at $2.53 per share, expiring in June 2018, in conjunction with a consulting agreement. The fair value of the warrant, determined using the Black-Scholes option pricing model, was $69,000 and was recorded in general and administrative expenses in the consolidated statements of operation.

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In March 2008, we issued two fully vested warrants to purchase 50,000 shares (in total, 100,000 shares) of our common stock at $2.53 per share, expiring in March 2018, in conjunction with a consulting agreement. The fair value of the warrants, determined using the Black-Scholes option pricing model, totaled $163,000 and was recorded in general and administrative expenses in the consolidated statements of operations.

In June 2007, we issued to certain of our financial advisors a fully vested warrant to purchase 200,000 shares of our common stock at $2.50 per share, which expires in June 2017. The fair value of the warrant, determined using the Black-Scholes option pricing model, totaled $408,000 and is included in general and administrative expenses. In July 2007, we issued a fully vested warrant to purchase 50,000 shares of our common stock at $2.53 per share, expiring in July 2017, in conjunction with a consulting agreement. The fair value of the warrant, determined using the Black-Scholes option pricing model, totaled $121,000 and is included in general and administrative expenses.

On February 14, 2005, in connection with the performance of executive recruiting services, we issued to Heidrick & Struggles, Inc. a warrant to purchase 115,000 shares of our common stock at $2.36 per share, with an expiration date in February 2008. In November 2006, Heidrick & Struggles transferred ownership of this warrant to Lehman Brothers, Inc. In February 2008, the warrant was exercised and 115,000 shares of our common stock were issued in exchange for $271,400.

In June 2000, in connection with a five-year strategic agreement with CIGNA HealthCare Companies (CIGNA), we issued Tel-Drug, Inc., a subsidiary of CIGNA, a warrant to purchase 500,000 shares of our common stock at $7.76 per share. In December 2003, Tel-Drug transferred ownership of this warrant to Highbridge International LLC. The warrant expired unexercised in December 2008.

Common Stock Reserved for Future Issuance

The following table represents the number of shares of common stock reserved for future issuance as of December 28, 2008:

Stock option plan (1)	16,706,547
Employee stock purchase plan	2,109,152
Warrants to purchase common stock	400,000
	19,215,699

(1) Excludes 4,548,300 shares available for grant under the 2008 Equity Plan. See note 11.

11. Employee Benefit Plans

Defined Contribution Plan

We have adopted a defined contribution retirement plan under Section 401(k) of the Internal Revenue Code, which covers substantially all of our employees (401(k) Plan). Eligible employees may contribute amounts to the 401(k) Plan via payroll withholding, subject to certain limitations. Under the 401(k) Plan, employees may elect to reduce their current compensation by up to the statutorily prescribed annual limit and to have the amount of such reduction contributed to the 401(k) Plan. The 401(k) Plan permits us but does not require us to make additional matching contributions to the 401(k) Plan on behalf of all participants in the 401(k) Plan. Beginning in 2008, we began matching 25% of the employee contributions up to $1,000. We made matching contributions under our 401(k) Plan totaling $180,000 in 2008 and no matching contributions in 2007 and 2006.

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Stock-Based Benefit Plans

1998 Stock Plan—Under the terms of our 1998 Stock Plan, as amended (1998 Stock Plan), our board of directors could grant incentive and nonqualified stock options to employees, officers, directors, agents, consultants, and independent contractors of drugstore.com. Options under this plan generally vest over four years, as follows: 20% of the shares vest after six months, and the remaining 80% vest quarterly over the subsequent 42 months. Option grants generally had exercise prices equal to the fair market value of the common stock on the date of grant and expire ten years from the date of grant. The 1998 Stock Plan expired in June 2008 and was replaced with the 2008 Equity Incentive Plan (2008 Equity Plan) and no further awards have been or will be granted under the 1998 Stock Plan. The 1998 Stock Plan, however, will continue to govern awards previously granted under that plan and any outstanding options will continue to vest and will remain outstanding until they are exercised, are forfeited, or expire.

2008 Equity Incentive Plan—In June 2008 at our annual meeting of stockholders, our stockholders approved the 2008 Equity Plan, which replaced our 1998 Stock Plan. However, due to a technical error in determining the stockholders entitled to vote on the approval of the 2008 Equity Plan, on March 5, 2009, we held a special meeting of stockholders where our stockholders approved the 2008 Equity Plan. The 2008 Equity Plan had not been changed since the original stockholder approval, and all terms and conditions of the 2008 Equity Plan were identical to those that the stockholders approved in June 2008. During 2008, subsequent to the June 2008 approval but prior to the March 5, 2009 approval of the 2008 Equity Plan, we granted 2,927,000 shares of restricted stock and 524,700 options to purchase common stock to employees under the 2008 Equity Plan. In accordance with FAS 123(R), however, a grant date cannot occur before all necessary approvals have been obtained, including stockholder approval of a stock-based compensation plan. Accordingly, the restricted stock awards and options to purchase common stock granted under the 2008 Equity Plan prior to March 5, 2009 are not considered valid grants as of December 28, 2008, and are therefore excluded from the stock option activity presented below.

Under the terms of the 2008 Equity Plan, our board of directors may grant stock options, stock appreciation rights, restricted stock, restricted stock units, performance shares and performance units, and other stock or cash awards to employees, directors, and consultants who provide services to drugstore.com. The board of directors has reserved 8,000,000 shares of our common stock for issuance under the 2008 Equity Plan, as well as up to 15,000,000 shares from stock options or similar awards granted under the 1998 Stock Plan that expire or otherwise terminate without having been exercised in full and shares issued pursuant to awards granted under the 1998 Stock Plan that are forfeited or that we repurchase. The shares may be authorized, but unissued, or reacquired common stock.

Under the 2008 Equity Plan, options generally vest over four years, as follows: 20% of the shares vest after six months, and the remaining 80% vest quarterly over the subsequent 42 months. The exercise price of options granted under the 2008 Equity Plan must be at least equal to the fair market value of our common stock on the date of grant. In addition, the exercise price of an incentive stock option granted to any participant who owns more than 10% of the total voting power of all classes of our outstanding stock must be at least 110% of the fair market value of the common stock on the grant date. The term of an option may not exceed ten years, except that, with respect to any participant who owns 10% of the voting power of all classes of our outstanding capital stock, the term of an incentive stock option may not exceed five years.

Under the 2008 Equity Plan, stock appreciation rights, which are the rights to receive the appreciation in fair market value of common stock between the exercise date and the date of grant, become exercisable at the times and on the terms established by the plan administrator. The plan administrator has complete discretion to

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determine the terms and conditions of stock appreciation rights granted under the 2008 Equity Plan; provided, however, that the exercise price may not be less than 100% of the fair market value of a share on the date of grant. The term of a stock appreciation right may not exceed ten years. Under the 2008 Equity Plan, the plan administrator may issue awards of restricted stock, restricted stock units, and performance units and performance shares at its sole discretion. Restricted stock awards generally vest every six-months over a period of four years.

1999 Employee Stock Purchase Plan—Under the terms of our 1999 Employee Stock Purchase Plan, as amended (1999 ESPP), eligible employees may purchase common stock for a purchase price equal to 85% of the fair market value of our common stock on the first or last day, whichever is less, of the applicable six-month purchase period, which periods end in January and July of each year. For the years ended December 28, 2008, December 30, 2007, and December 31, 2006 employees purchased 92,047, 92,585, and 102,283, shares, respectively, of our common stock under the 1999 Employee Stock Purchase Plan in exchange for $189,000, $224,000, and $266,000. As of December 28, 2008, there were 2,109,152 shares reserved for future issuance under the 1999 Employee Stock Purchase Plan, which expires in 2009.

Determining Fair Value

We calculate the fair value of our stock options granted to employees using the Black-Scholes option pricing model using the single option award approach. This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. The following weighted-average assumptions were used in arriving at the fair value of each option grant:

	Employee Stock Options
	Year ended December 28, 2008			Year ended December 30, 2007			Year ended December 31, 2006
Expected volatility		65	%		74	%		77	%
Expected term (in years)		4.3			5.8			6.0
Risk-free interest rate		2.5	%		4.4	%		4.5	%
Expected dividend		0	%		0	%		0	%
Weighted-average fair value	$	1.40		$	1.89		$	2.31

Volatility

Our computation of expected volatility is based on our historical volatility, adjusted for changes in capital structure and corporate changes, information available that may indicate future volatility, and observable mean reversion tendencies of historical volatility.

Expected Term

Our expected term estimates are based on a comprehensive weighted average life (WAL) analysis. The WAL analysis provides a historical based platform for use in developing expected term estimates for the future based on the historically observed time periods from grant date through post-vesting activities, such as exercise and cancellation. The historical grant data is segregated into pre-vesting forfeitures, post-vesting forfeitures, outstanding and unvested grants, and outstanding and vested grants and then data is included or excluded in the WAL depending on the applicable contractual or vesting provisions, differences in other option terms and insufficient elapsed time from grant date or from vesting dates. We also analyze by homogenous group, which

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includes employees, executives, our chief executive officer, board members, and other non-employees, the weighted average time from grant date to post-vesting activity. For those grants still outstanding, we developed a reasonable assumption regarding the expected time of settlement. This analysis resulted in an expected term ranging from 4.2 years to 6.3 years, depending on the homogenous group. Our expected term in 2006 and during the first nine months of 2007 was calculated using the simplified method outlined by SEC Staff Accounting Bulletin No. 107, Share-Based Payment (SAB 107). Under this method, our expected term was equal to the sum of the weighted average vesting term plus the original contractual term divided by two, which resulted in a six-year expected term.

Risk-Free Interest Rate and Dividend Yield

We base the risk-free interest rate on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term. Where the expected term of our stock-based awards do not correspond with the terms for which interest rates are quoted, we average the periods to determine the rate from the available term maturities. A dividend yield of 0% was considered appropriate as we have not issued and do not anticipate issuing any dividends in the near future.

Forfeitures

When estimating forfeitures, we considered historical voluntary termination behavior, in addition to analyzing actual option forfeitures. In conjunction with this analysis, we identified distinct subgroups: employees, executives, our chief executive officer, board members, and other non-employees. Through the third quarter of 2006, an estimated forfeiture rate of approximately 30% was applied to employees and executive subgroups based on the weighted average termination behavior of those subgroups. In the fourth quarter of 2006, we reviewed our forfeiture rate analysis, which resulted in an increase in our forfeiture rate to 35%. We recorded the revised forfeiture rate as a change in estimate, resulting in a reduction of stock-based compensation in 2006 totaling approximately $185,000. In 2008 and 2007, we determined that our forfeiture rate of 35% was still applicable. A forfeiture rate of 0% is applied to our chief executive officer, board members, and non-employees.

Stock Option Activity

The following table summarizes our stock option activity:

	Outstanding Options				Weighted- Average Remaining Contractual Term	Aggregate Intrinsic Value (in thousands)
	Number of Shares		Weighted- Average Exercise Price per Share
Outstanding at December 30, 2007	16,742,358		$	3.48
Options granted	3,156,904		$	2.81
Options exercised	(43,345	)	$	1.50
Options expired	(1,708,362	)	$	4.49
Options forfeited	(1,441,008	)	$	3.07
Outstanding at December 28, 2008	16,706,547		$	3.29
Vested and expected to vest at December 28, 2008	13,554,085		$	3.36	6.57	$	57
Exercisable at December 28, 2008	12,045,449		$	3.42	6.34	$	57

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The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the market price of our common stock for the 54,000 shares subject to options that were in-the-money at December 28, 2008 (i.e., with an exercise price of $1.15 or less). The aggregate intrinsic value of options exercised was $32,000, $1.4 million and $2.0 million during the years ended December 28, 2008, December 30, 2007, and December 31, 2006.

As of December 28, 2008, the total compensation cost related to unvested options granted to employees under our 1998 Stock Plan totaled $4.8 million, net of estimated forfeitures of approximately $8.0 million. This cost will be amortized on a straight-line basis over a weighted-average period of 2.3 years and will be adjusted for subsequent changes in estimated forfeitures.

Certain stock options were modified for terminated employees and in conjunction with a share tender offer in December 2008, which resulted in a stock compensation charge of $285,000 in 2008, $117,000 in 2007, and $329,000 in 2006.

Stock Compensation Expense

The following table summarizes stock-based compensation by operating function recorded in the Statements of Operations:

	Year ended December 28, 2008		Year ended December 30, 2007		Year ended December 31, 2006
	(in thousands)
Fulfillment and order processing	$	576	$	784	$	835
Marketing and sales		1,619		1,381		1,058
Technology and content		1,265		1,224		1,071
General and administrative		4,104		5,412		3,757
Total	$	7,564	$	8,801	$	6,721

12. Segment Information

We have three reporting segments: over-the-counter (OTC), vision, and mail-order pharmacy. The OTC segment is comprised of the sales and related costs of selling all non-prescription health, beauty, personal care, household, and other products. Our vision segment is comprised of sales and the related costs of selling contact lenses and other contact lens supplies through Vision Direct. The mail-order pharmacy segment is comprised of sales and the related costs of selling prescription drugs and supplies through the drugstore.com web store for mail-order delivery. On September 3, 2008, we entered into an amended and restated main agreement with Rite Aid whereby we transferred to Rite Aid the rights to our LPU business, which includes prescription refills sold online through the drugstore.com web store or the Rite Aid online store and picked up by customers at Rite Aid stores. As a result of this agreement, we have excluded our LPU segment from the following segment information and reported it as discontinued operations in the consolidated financial statements for all periods presented. We operate and evaluate our business segments based on contribution margin results. We define contribution margin as net sales attributable to a segment, less the direct cost of these sales and the incremental (variable) costs of fulfilling, processing, and delivering the order (labor, packaging supplies, credit card fees, and royalty costs that are variable based on sales volume).

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The information presented below for these segments is information used by our chief operating decision makers in evaluating operating performance.

	Fiscal Year 2008		Fiscal Year 2007		Fiscal Year 2006
	(in thousands)
OTC:
Net sales	$	260,794	$	234,282	$	197,964
Cost of sales		180,252		164,469		139,674
Variable order costs (a)		23,499		22,259		18,650
Contribution margin (b)	$	57,043	$	47,554	$	39,640
Vision:
Net sales	$	61,420	$	54,906	$	49,780
Cost of sales		47,279		41,904		38,682
Variable order costs (a)		2,899		2,708		2,478
Contribution margin (b)	$	11,242	$	10,294	$	8,620
Mail-Order Pharmacy:
Net sales	$	44,365	$	50,143	$	67,379
Cost of sales		36,166		41,935		58,026
Variable order costs (a)		3,447		3,967		5,501
Contribution margin (b)	$	4,752	$	4,241	$	3,852
Consolidated:
Net sales (c)	$	366,579	$	339,331	$	315,123
Cost of sales		263,697		248,308		236,382
Variable order costs (a)		29,845		28,934		26,629
Contribution margin (b)	$	73,037	$	62,089	$	52,112

(a) These amounts include all variable costs of fulfillment and order processing, including labor, packaging supplies, and credit card fees, and royalty costs that are variable based on sales volume. These amounts exclude depreciation, fixed overhead costs, and stock-based compensation.

(b) Contribution margin represents a measure of how well each segment is contributing to our operating goals. It is calculated as net sales less the direct cost of these sales and the incremental (variable) fulfillment and order processing costs of delivering orders to our customers and royalty costs.

(c) Net sales in 2008, 2007, and 2006 were comprised of 99% of sales in the United States of America and 1% of sales internationally.

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Consolidated contribution margin for reportable segments	$	73,037		$	62,089		$	52,112
Less:
Fixed fulfillment and order processing (d)		13,623			10,988			10,404
Marketing and sales (e)		33,500			29,975			27,383
Technology and content		23,011			18,258			16,190
General and administrative		19,034			20,928			15,413
Amortization of intangible assets		867			1,234			2,060
Operating loss	$	(16,998	)	$	(19,294	)	$	(19,338	)

(d) These amounts include all fixed costs of fulfillment and order processing that are not discernable by business segment.

(e) These amounts exclude royalty expenses of $91,000 in 2008, $105,000 in 2007, and $62,000 in 2006 that are included in variable costs.

The following table presents assets by segment and geographic asset information:

	December 28, 2008		December 30, 2007
	(in thousands)
Total Assets:
OTC	$	49,085	$	49,931
Vision		32,507		31,949
Mail-Order Pharmacy		2,773		5,436
Discontinued operations		5,954		30,763
Corporate		62,230		57,329
Consolidated	$	152,549	$	175,408
Property and Equipment, Net:
United States of America	$	28,222	$	25,417
Canada		84		84
	$	28,306	$	25,501

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13. Quarterly Results of Operations (unaudited)

The following tables contain selected unaudited consolidated statement of operations information for each quarter of fiscal years 2008 and 2007. We believe that the following information reflects all normal recurring adjustments necessary for a fair presentation of the information for the periods presented. The operating results for any quarter are not necessarily indicative of results for any future period.

	Fiscal Year Ended December 28, 2008												Fiscal Year Ended December 30, 2007
	First Quarter			Second Quarter			Third Quarter			Fourth Quarter			First Quarter			Second Quarter			Third Quarter			Fourth Quarter
	($ in thousands, except per share data)
Net sales	$	92,568		$	92,248		$	87,823		$	93,940		$	83,292		$	83,773		$	80,959		$	91,307
Cost of sales		67,183			66,679			62,708			67,127			61,460			61,751			59,333			65,764
Loss from continued operations		(4,492	)		(4,371	)		(4,722	)		(2,782	)		(4,989	)		(4,414	)		(3,984	)		(4,232	)
Gain from discontinued operations		1,807			2,099			1,103			3,071			1,211			1,399			1,610			1,888
Net income (loss)		(2,685	)		(2,272	)		(3,619	)		289			(3,778	)		(3,015	)		(2,374	)		(2,344	)
Basic and diluted:
Loss from continuing operations per share (1)	$	(0.05	)	$	(0.05	)	$	(0.05	)	$	(0.03	)	$	(0.05	)	$	(0.05	)	$	(0.04	)	$	(0.04	)
Gain from discontinued operations per share (1)	$	0.02		$	0.02		$	0.01		$	0.03		$	0.01		$	0.01		$	0.02		$	0.02
Net income (loss) per share (1)	$	(0.03	)	$	(0.02	)	$	(0.04	)	$	0.00		$	(0.04	)	$	(0.03	)	$	(0.02	)	$	(0.02	)
Weighted average shares used in computation of:
Basic net income (loss) per share		96,392,737			96,478,573			96,515,737			96,540,101			94,500,129			95,006,512			95,664,011			96,229,531
Diluted net income (loss) per share (2)		96,392,737			96,478,573			96,515,737			96,643,524			94,500,129			95,006,512			95,664,011			96,229,531

(1) Loss from continuing operations per share, gain from discontinued operations per share, and net income (loss) per share is computed independently for each of the quarters presented. Therefore, the sum of the quarterly net loss per share may not equal the annual net loss per share and the sum of the loss from continuing operations per share and the gain from discontinued operations per share may not equal the net income (loss) per share.

(2) The calculation of fourth quarter 2008 weighted average shares includes 103,423 shares of dilutive stock options.

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SCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS

(in thousands)

Description	Balance at beginning of fiscal period		Charges to revenue, costs and expenses		Deductions			Balance at end of fiscal period
Year Ended December 28, 2008
Allowance for doubtful accounts	$	41	$	183	$	208	(a)	$	16
Allowance for sales returns		493		3,633		3,806	(b)		320
Reserve for inventory valuation		412		356		(13	)(c)		781
Year Ended December 30, 2007
Allowance for doubtful accounts	$	38	$	85	$	82	(a)	$	41
Allowance for sales returns		339		3,491		3,337	(b)		493
Reserve for inventory valuation		509		732		829	(c)		412
Year Ended December 31, 2006
Allowance for doubtful accounts	$	101	$	159	$	222	(a)	$	38
Allowance for sales returns		369		2,742		2,772	(b)		339
Reserve for inventory valuation		592		418		501	(c)		509

(a) Deductions consist of write-offs of uncollectible accounts, net of recoveries.

(b) Deductions consist of sales credits to customers for product returns.

(c) Deductions consist of write-off of obsolete inventory and inventory shrinkage.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 13, 2009.

DRUGSTORE.COM, INC.
By:	/s/    DAWN G. LEPORE
	Dawn G. Lepore President, Chief Executive Officer and Chairman of the Board

POWER OF ATTORNEY

Each person whose individual signature appears below hereby authorizes and appoints Dawn G. Lepore and Robert P. Potter, and each of them, with full power of substitution and resubstitution and full power to act without the other, as his or her true and lawful attorney-in-fact and agent to act in his or her name, place and stead and to execute in the name and on behalf of each person, individually and in each capacity stated below, and to file, any and all amendments to this report, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto such attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing, ratifying and confirming all that said attorneys-in-fact and agents or any of them or their or his or her substitute or substitutes may lawfully do or cause to be done by virtue thereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities indicated as of March 13, 2009.

Signature	Title
/s/    DAWN G. LEPORE         Dawn G. Lepore	President, Chief Executive Officer and Chairman of the Board (Principal Executive Officer)
/s/    ROBERT P. POTTER         Robert P. Potter	Vice President, Chief Accounting Officer (Principal Financial and Accounting Officer)
/s/    RICHARD W. BENNET III         Richard W. Bennet III	Director
/s/    GEOFFREY R. ENTRESS         Geoffrey R. Entress	Director
/s/    JEFFREY M. KILLEEN         Jeffrey M. Killeen	Director
/s/    WILLIAM D. SAVOY         William D. Savoy	Director
/s/    GREGORY S. STANGER         Gregory S. Stanger	Director

92

EX-10.16

Exhibit 10.16

FIRST AMENDMENT TO LEASE

THIS FIRST AMENDMENT (“Amendment”) is made effective as of August 1, 2008, by and between Sam-Cher Holdings, Inc. (“Lessor”) and Vision Direct Inc., successor to International Vision Direct, Inc. and International Vision Direct Corp. (“Lessee”) to the Standard Industrial Lease dated May 2, 2003 by and between the parties (the “Lease”). Capitalized terms used but not defined herein have the meanings ascribed to them in the Lease.

WHEREAS, Lessee provided timely written notice to Lessor of its intent not to renew the Lease on the expiration of the current term on its current terms and conditions and the parties agreed at that time to amend certain of the terms and conditions of the Lease;

WHEREAS, the parties now desire to extend the term of the Lease and otherwise modify the Lease as set forth herein;

NOW, THEREFORE, the parties hereto, in consideration of the mutual promises and covenants contained herein and in the Lease and for other good and valuable consideration receipt and sufficiency of which is hereby acknowledged, and intending to be legally bound hereby, agree as follows:

1. Section 3 of the Lease is hereby amended and restated in its entirety as follows:

“3. Term.

3.1. Term. The term of this Lease will be on a month-to-month basis, commencing on August 1, 2008.

3.2. Termination. The Lessee will each have the right to terminate the Lease on sixty (60) days’ written notice to the other party.”

2. Section 4.1 of the Lease is hereby amended and restated in its entirety as follows:

“4.1 Base Rent. Lessee will pay Lessor, as Base Rent for the Premises, without any offset or deduction, except as may be otherwise expressly provided in this Lease, on the First day of each month of the term hereof, monthly payments in advance of $9,240.00.”

3. Section 9.4(a) is hereby amended to delete the phrases “Subject to paragraph 9.4(b),” and “during the last six months of”.

4. Section 9.4(b) is hereby deleted in its entirety.

5. Section 15 is hereby deleted in its entirety.

6. Section 39 is hereby deleted in its entirety.

7. Section 49 is hereby deleted in its entirety.

8. Except as expressly modified herein, the terms and conditions of the Lease will remain unchanged and in full force and effect.

IN WITNESS WHEREOF, the parties have entered into this Amendment as of this 9th day of May, 2008.

VISION DIRECT INC.	SAM-CHER HOLDINGS, INC.
By:	By:
Name:	Name:
Title:	Title:

EX-10.17

Exhibit 10.17

INDUSTRIAL BUILDING LEASE

between

US INDUSTRIAL REIT II

A Texas real estate investment trust

as Landlord

and

DS DISTRIBUTION, INC.

A Delaware corporation

as Tenant

June 20, 2007

ARTICLE I	BASIC LEASE PROVISIONS	1
1.1	Premises	1
1.2	Building	1
1.3	Land	1
1.4	Property	1
1.5	Project	1
1.6	Rentable Square Feet (Foot) or Rentable Area	1
1.7	Term	1
1.8	Commencement Date	1
1.9	Expiration Date	1
1.10	Lease Year	1
1.11	Calendar Year	1
1.12	Basic Rent	1
1.13	Security Deposit	1
1.14	Interest Rate	1
1.15	Tenant’s Proportionate Share	1
1.16	Broker(s)	1
1.17	Guarantor(s)	1
1.18	Landlord’s Notice Address	1
1.19	Tenant’s Notice Address	2
1.20	Agents	2
1.21	Common Area	2
ARTICLE II.	PREMISES AND TERM	2
2.1	Premises	2
2.2	Commencement Date	2
2.3	Early Possession	2
ARTICLE III	BASE RENT AND GENERAL RENTAL PAYMENT PROVISIONS	2
3.1	Types of Rental Payments	2
3.2	Covenants Concerning Rental Payments	2
3.3	Net Lease	2
3.4	Security Deposit	2
ARTICLE IV	ADDITIONAL RENT	3
4.1	Additional Rent	3
4.2	Definitions	3
4.3	Expense Adjustment	3
4.4	Tenant’s Right to Audit	3
4.5	Sales or Excise Taxes	4
ARTICLE V	USE	4
5.1	Use of Premises	4
5.2	Operation of Tenant’s Business	4
5.3	Use of Common Areas	4
ARTICLE VI	CONDITION AND DELIVERY OF PREMISES	4
ARTICLE VII	SUBORDINATION; NOTICE TO SUPERIOR LESSORS AND MORTGAGEES	4
ARTICLE VIII	QUIET ENJOYMENT	4
ARTICLE IX	ASSIGNMENT, SUBLETTING AND MORTGAGING	5
9.1	Landlord’s Consent	5
9.2	Landlord’s Option to Recapture Premises	5
9.3	Distribution of Net Profits	5
9.4	Transfers to Related Entities	5
ARTICLE X	COMPLIANCE WITH LAWS	6
10.1	General Compliance	6
10.2	ADA Compliance	6
10.3	ISRA Compliance	6
ARTICLE XI	INSURANCE	7
11.1	Certain Insurance Risks	7
11.2	Tenant’s Insurance	7
11.3	Forms of the Policies	7
11.4	Waiver of Subrogation	8
11.5	Adequacy of Coverage	8
ARTICLE XII	ALTERATIONS	8
12.1	Procedural Requirements	8
12.2	Performance of Alterations	8
12.3	Lien Prohibition	8
ARTICLE XIII	LANDLORD’S AND TENANT’S PROPERTY	8
13.1	Landlord’s Property	8
13.2	Tenant’s Property	9
13.3	Removal of Tenant’s Property	9
ARTICLE XIV	REPAIRS AND MAINTENANCE	9
14.1	Tenant Repairs and Maintenance	9
14.2	Landlord Repairs	9
14.3	Tenant Equipment	9
ARTICLE XV	UTILITIES	9
15.1	Purchasing Utilities	9
15.2	Use of Electrical Energy by Tenant	9
ARTICLE XVI	INVOLUNTARY CESSATION OF SERVICES	9
ARTICLE XVII	LANDLORD’S RIGHTS	10
ARTICLE XVIII	NON-LIABILITY AND INDEMNIFICATION	10

18.1	Indemnification	10
18.2	Waiver and Release	10
18.3	Survival	10
ARTICLE XIX	DAMAGE OR DESTRUCTION	10
19.1	Damage to the Premises	10
19.2	Condemnation	10
ARTICLE XX	SURRENDER AND HOLDOVER	11
ARTICLE XXI	DEFAULT OF TENANT	11
21.1	Events of Default	11
21.2	Landlord’s Remedies	12
21.3	Mitigation of Damages	12
21.4	No Waiver	12
21.5	Late Payment	12
21.6	Waiver of Redemption	12
21.7	Landlord’s Lien	13
ARTICLE XXII	BROKER	13
ARTICLE XXIII	ESTOPPEL CERTIFICATES	13
ARTICLE XXVI	ENVIRONMENTAL	13
24.1	Hazardous Material	13
24.2	Definition	13
24.3	Tenant’s Liability	13
24.4	Landlord’s Liability	13
ARTICLE XXV	SIGNAGE	14
ARTICLE XXVI	MISCELLANEOUS	14
26.1	Merger	14
26.2	Notices	14
26.3	Non-Waiver	14
26.4	Parties Bound	14
26.5	Recordation of Lease	14
26.6	Survival of Obligations	14
26.7	Prorations	14
26.8	Governing Law; Construction	14
26.9	Time	15
26.10	Authority of Tenant	15
26.11	Security	15
26.12	Financial Reports	15
26.13	Rules and Regulations	15
26.14	Force Majeure	15
26.15	Waiver of Jury Trial	15
26.16	Attorneys’ Fees	15
26.18	Landlord’s Fees	15
26.19	Light, Air or View Rights	15
26.20	Counterparts	15
26.21	Nondisclosure of Lease Terms	16
26.22	Joint and Several Obligations	16
26.23	Notice of Lease Term Dates	16
26.24	Anti-Terrorism	16
CORPORATE GUARANTY - FORM

EXHIBIT A-1	DESCRIPTION OF PREMISES
EXHIBIT A-2	LEGAL DESCRIPTION OF LAND
EXHIBIT B-1	LANDLORD FORM OF WORK AGREEMENT
EXHIBIT B-2	TENANT FORM OF WORK AGREEMENT
EXHIBIT C	SECRETARY’S CERTIFICATE
EXHIBIT D	RULES AND REGULATIONS
EXHIBIT E	NOTICE OF LEASE TERM DATES
EXHIBIT F	GUARANTY

INDUSTRIAL BUILDING LEASE

THIS LEASE (the “Lease”), dated the 20th day of June, 2007 (“Date of Lease”) is entered into by and between DS DISTRIBUTION, INC., a Delaware corporation (“Tenant”) and US Industrial REIT II, a Texas real estate investment trust (“Landlord”).

I BASIC LEASE PROVISIONS

1.1 Premises. Approximately 85,080 Rentable Square Feet of space known as Suite 300 as outlined on Exhibit A-1 attached hereto and made a part hereof and located at the Building.

1.2 Building. The building containing approximately 385,884 Rentable Square Feet and located at 1130 Commerce Boulevard, Logan Township, New Jersey.

1.3 Land. The piece or parcel of land which comprises the Building, as more particularly described on Exhibit A-2 attached hereto and made a part hereof, and all rights, easements and appurtenances thereunto belonging or pertaining.

1.4 Property. The Building and the Land.

1.5 Project. The development known as LogistiCenter at Logan, consisting of the real property and all improvements built thereon, containing approximately 385,884 Rentable Square Feet.

1.6 Rentable Square Feet (Foot) or Rentable Area. The rentable area within the Premises, Building or Project deemed to be the amounts set forth in this Article I. Landlord and Tenant stipulate and agree that the Rentable Square Feet of the Premises, Building and Project are correct and shall not be remeasured.

1.7 Term. Forty-three (43) months, beginning on the Commencement Date and expiring on the Expiration Date, subject to adjustment as specified in Article II.

1.8 Commencement Date. August 1, 2007, subject to adjustment as specified in Article II (sometimes referred to herein as the “CD”).

1.9 Expiration Date. February 28, 2011.

1.10 Lease Year. Each consecutive 12 month period elapsing after: (i) the Commencement Date if the Commencement Date occurs on the first day of a month; or (ii) the first day of the month following the Commencement Date if the Commencement Date does not occur on the first day of a month. Notwithstanding the foregoing, the first Lease Year shall include the additional days, if any, between the Commencement Date and the first day of the month following the Commencement Date, in the event the Commencement Date does not occur on the first day of a month.

1.11 Calendar Year. For the purpose of this Lease, Calendar Year shall be a period of 12 months commencing on each January 1 during the Term, except that the first Calendar Year shall be that period from and including the Commencement Date through December 31 of that same year, and the last Calendar Year shall be that period from and including the last January 1 of the Term through the earlier of the Expiration Date or date of Lease termination.

1.12 Basic Rent. The amount set forth in the following schedule, subject to adjustment as specified in Article IV.

Month(s)	Approximate Annual Rent (RSF)			Monthly Basic Rent			Annual Basic Rent
CD-7/31/08	$	4.25	*	$	30,132.50	*	$	361,590.00	**
8/1/08-7/31/09	$	4.36		$	30,912.40		$	370,948.80
8/1/09-7/31/10	$	4.47		$	31,692.30		$	380,307.60
8/1/10-2/28/11	$	4.58		$	32,472.20		$	389,666.40	**

* Provided that no Event of Default (as defined in Section 21 of the Lease) occurs under the Lease, the Basic Rent shall be abated for the first ninety (90) days following the Commencement Date (“Abatement Period”). All of the terms and conditions of the Lease shall remain in full force and effect during the foregoing Abatement Period, including the obligation to pay Additional Rent, if any. If any Event of Default occurs under the Lease, the Basic Rent abatement provided for herein shall immediately terminate

** Annualized amount

1.13 Security Deposit. $     N/A             

1.14 Interest Rate. The per annum interest rate listed as the base rate on corporate loans at large U.S. money center commercial banks as published from time to time under “Money Rates” in the Wall Street Journal plus 3%, but in no event greater than the maximum rate permitted by law. In the event the Wall Street Journal ceases to publish such rates, Landlord shall choose, at Landlord’s reasonable discretion, a similarly published rate.

1.15 Tenant’s Proportionate Share. Tenant’s Proportionate Share of the Building is 22.04 % (determined by dividing the Rentable Square Feet of the Premises by the Rentable Square Feet of the Building and multiplying the resulting quotient by one hundred and rounding to the second decimal place).

1.16	Broker(s).	Landlord’s	Tenant’s
		David Ricci	William A. R. Goodwin
		The Flynn Company	CB Richard Ellis
		1621 Wood Street	1800 JFK Blvd., 10th Floor
		Philadelphia, PA 19103	Philadelphia, PA 19103
1.17	Guarantor(s).	Drugstore.com, Inc., a Delaware corporation
1.18	Landlord’s Notice	9830 Colonnade Boulevard, Suite 600
	Address.	San Antonio, Texas 78230-2239
		Attention: VP Real Estate Counsel
		Attention: VP Portfolio Management

1

	With copies at the same time to.	US INDUSTRIAL REIT II
1.19	Tenant’s	411 108th Avenue NE, Suite 1400
	Notice Address.	Bellevue, WA 98004
		Attention: Nathan Garnett, Associate General Counsel

1.20 Agents. Officers, partners, directors, employees, agents, licensees, contractors, customers and invitees; to the extent customers and invitees are under the principal’s control or direction.

1.21 Common Area. All areas from time to time designated by Landlord for the general and nonexclusive common use or benefit of Tenant, other tenants of the Property, and Landlord, including, without limitation, roadways, entrances and exits, loading areas, landscaped areas, open areas, park areas, service drives, walkways, common trash areas, vending or mail areas, common pipes, conduits, wires and appurtenant equipment within the Building, maintenance and utility rooms and closets, exterior lighting, exterior utility lines, and parking facilities.

II. PREMISES AND TERM

2.1 Premises. Landlord hereby leases the Premises to Tenant, and Tenant hereby leases the Premises from Landlord, upon and subject to the terms, covenants, provisions and conditions of this Lease.

2.2 Commencement Date. The Term shall commence on the Commencement Date and expire at midnight on the Expiration Date. Notwithstanding the foregoing, if Landlord is obligated to construct any improvements within the Premises then such construction shall be governed by the terms of the Work Agreement attached hereto as Exhibit B-1 and the date set forth as the Commencement Date in Section 1.8 shall instead be defined as the “Target Commencement Date” by which date Landlord will use reasonable efforts to Substantially Complete (as defined in Exhibit B-1) the Landlord Work (as defined in Exhibit B-1), and the actual Commencement Date shall be the date of Substantial Completion. In such event, the term length shall be adjusted so that the Expiratioin Date remains February 28, 2011. Presently, the anticipated Commencement Date is August 1, 2007 (the “Anticipated Commencement Date”). In the event the Landlord has been unable to Substantially Complete the Premises within ninety (90) days after the Anticipated Commencement Date through no delays on the part of Tenant, but subject to force majeure, Tenant shall have the right to terminate this Lease upon notice to Landlord, whereupon neither party shall have any further obligation to the other hereunder.

2.3 Early Possession. If Tenant takes possession of the Premises before the Commencement Date for the purposes of commencing business operations therein , such possession shall be subject to the terms and conditions of this Lease and Tenant shall pay Rent (as defined in Article III) to Landlord for each day of possession before the Commencement Date. However, except for the cost of services requested by Tenant, Tenant shall not be required to pay Rent for any days of possession before the Commencement Date during which Tenant is in possession of the Premises for the sole purpose of: (i) performing improvements in accordance with the terms of the Work Agreement attached hereto as Exhibit B-2; or (ii) installing furniture, equipment or other personal property with the prior written approval of Landlord.

III BASIC RENT AND SECURITY DEPOSIT

3.1 Types of Rental Payments. “Rent” shall be and consist of (a) Basic Rent payable in monthly installments as set forth in Section 1.12, in advance, on the first day of each and every calendar month during the Term of this Lease; and (b) Additional Rent as defined in Section 4.1. Rent shall be paid electronically via automatic debit, ACH credit or wire transfer to such account as Landlord designates in writing to Tenant. Landlord may, in its sole discretion, designate an address for payment in lawful U.S. Dollars. The installment of the Basic Rent and Additional Rent payable for the first full calendar month of the Term shall be due and payable at the time of execution and delivery of this Lease. Notwithstanding anything contained herein to the contrary, the first month’s Basic Rent shall be applied to the fourth (4^th) month of the Term in order to recognize the rent abatement as set forth in the Basic Lease Provisions.

3.2 Covenants Concerning Rental Payments. Tenant shall pay the Basic Rent and the Additional Rent promptly when due, without notice or demand therefor, and without any abatement, deduction or setoff for any reason whatsoever, except as may be expressly provided in this Lease. No payment by Tenant, or receipt or acceptance by Landlord, of a lesser amount than the correct Basic Rent and/or Additional Rent shall be deemed to be other than a payment on account, nor shall any endorsement or statement on any check or letter accompanying any payment be deemed an accord or satisfaction, and Landlord may accept such payment without prejudice to its right to recover the balance due or to pursue any other remedy in this Lease or at law. In addition, any such late Rent payment shall bear interest from the date such Rent became due and payable to the date of payment thereof by Tenant at the Interest Rate. Such interest shall be due and payable within five (5) days after written demand from Landlord.

3.3 Net Lease. It is intended that the Rent provided for in this Lease shall be an absolutely net return to Landlord for the Term of this Lease and any renewals or extensions thereof, free of any and all expenses or charges with respect to the Premises except for those obligations of Landlord expressly set forth herein.

3.4 Security Deposit. Contemporaneously with the execution of this Lease, Tenant shall pay to Landlord a security deposit of in the amount set forth in Section 1.13, in immediately available funds, which shall be held by Landlord without liability for interest and as security for the performance by Tenant of its obligations under this Lease. The Security Deposit is not advance payment of Basic Rent or Additional Rent or a measure or limit of Landlord’s damages upon an Event of Default (as such term is defined in Section 21.1 of this Lease). Landlord shall be entitled to commingle the Security Deposit with Landlord’s other funds. Landlord may, from time to time and without prejudice to any other remedy, use all or part of the Security Deposit to perform any obligation which Tenant was obligated, but failed, to perform hereunder. Tenant waives the provisions of any law, now or hereafter enforced, which provide that Landlord may claim from a security deposit only those sums reasonably necessary to remedy defaults in the payment of rent, to repair damage caused by Tenant or to clean the Premises, it being agreed that Landlord may, in addition, claim those sums reasonably necessary to compensate Landlord for any other loss or damage caused by the acts or omissions of Tenant or anyone acting by, through or under Tenant. Following any such application of the Security Deposit , Tenant shall pay to Landlord within ten (10) days after demand the amount so applied in order to restore the Security Deposit to its original amount. Within thirty (30) days after the Term ends, provided Tenant has performed all of its obligations hereunder, Landlord shall return to Tenant the balance of the Security Deposit not applied to satisfy Tenant’s obligations. If Landlord transfers its interest in the Premises, then Landlord may assign the Security Deposit to the transferee and Landlord thereafter shall have no further liability for the return of the Security Deposit.

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IV. ADDITIONAL RENT

4.1 Additional Rent. In addition to paying the monthly Basic Rent, Tenant shall pay as “Additional Rent” the amounts determined pursuant to this Article IV and all other amounts payable by Tenant under this Lease. Without limitation on the other obligations of Tenant which shall survive the expiration or earlier termination of this Lease, the obligations of Tenant to pay the Rent incurred during the Term of this Lease shall survive the expiration or earlier termination of this Lease. For any partial Calendar Year, Tenant shall be obligated to pay only a pro rata share of the Additional Rent, equal to Additional Rent for such entire Calendar Year divided by 360, such quotient multiplied by the number of days of the Term falling within such Calendar Year.

4.2 Definitions. As used herein, the following terms shall have the following meanings:

(a) “Basic Costs” shall mean all expenses, costs and disbursements which Landlord shall pay or become obligated to pay because of, or in connection with, the normal commercial operation, maintenance and repair of the Building, including but not limited to (i) wages, salaries and fees of all personnel directly engaged in operating, maintaining or securing the Building, including taxes, insurance and benefits relating thereto; (ii) a management fee payable to Landlord or the company or companies managing the Building, not to exceed what is customary and reasonable in the Logan Township, New Jersey area; (iii) all supplies, tools, equipment and materials used directly in the operation and maintenance of the Building, including any lease payments therefor; (iv) cost of reasonable repairs and general maintenance, including but not limited to the parking lot, roof repairs and landscaping (excluding repairs and general maintenance paid by proceeds of insurance or by Tenant or other parties, and alterations attributable solely to specific tenants of the Building); (v) reasonable legal expenses and accounting expenses incurred with respect to the Building; (vi) Taxes; (vii) cost of all maintenance and service agreements for the Building, and any equipment related thereto, including window cleaning and snow removal; (viii) premiums and deductibles paid for insurance relating to the Building, including, without limitation, fire and extended coverage, boiler, earthquake, windstorm, rental loss, and commercial general liability insurance; and (ix) capital improvements, except that Basic Costs for capital improvements shall be limited to (A) the cost during the Term of this Lease of any capital improvement which is reasonably intended to reduce any component cost included within Basic Costs as reasonably amortized by Landlord with interest on the unamortized amount at the Interest Rate , and (B) the cost of any capital improvements which are necessary to keep the Building or any part thereof in compliance with all governmental rules and regulations applicable thereto, provided the Project’s use remains an office and industrial complex, from time to time as reasonably amortized by Landlord with interest on the unamortized amount at the Interest Rate. Any capital improvement costs which are included in the term “Basic Costs” shall only be included to the extent any such costs are attributable, on a straight-line amortization (based on the life of the improvement for federal tax purposes), to the remaining portion of the Term of this Lease and any renewal or extension thereof.

(b) Exclusions from Basic Costs. The following items are specifically excluded from the definition of Basic Costs: (i) interest (except as otherwise allowed herein); (ii) depreciation; (iii) penalties and fines; (iv) marketing expenses and commissions; (v) costs of services or labor provided solely and directly to specific tenants at the Building, including, but not limited to tenant improvement costs; (vi) organizational expenses associated with the creation and operation of the entity which constitutes Landlord; (vii) general or special assessments levied against the owner of the Building for public improvements which are not currently due; (viii) capital improvements except as set forth in subparagraph (a) above; and (ix) leasing commissions.

(c) “Taxes” shall be defined as (i) all real property taxes and assessments levied by any public authority against the Property; (ii) all personal property taxes levied by any public authority on personal property of Landlord used in the management, operation, maintenance and repair of the Building, (iii) all taxes, assessments and reassessments of every kind and nature whatsoever levied or assessed in lieu of or in substitution for existing or additional real or personal property taxes and assessments on the Building, or (iv) amounts necessary to be expended because of governmental orders, whether general or special, ordinary or extraordinary, unforeseen as well as foreseen, of any kind and nature for public improvements, services, benefits or any other purposes which are assessed, levied, confirmed, imposed or become a lien upon the Premises or Building or become payable during the Term. Further, for the purposes of this Article IV, Taxes shall include the reasonable expenses (including, without limitation, attorneys’ fees) incurred by Landlord in challenging or obtaining or attempting to obtain a reduction of such Taxes, regardless of the outcome of such challenge, and any costs incurred by Landlord for compliance, review and appeal of tax liabilities. Notwithstanding the foregoing, Landlord shall have no obligation to challenge Taxes. If as a result of any such challenge, a tax refund is made to Landlord, then provided no monetary Event of Default exists under this Lease, the amount of such refund less the expenses of the challenge shall be deducted from Taxes due in the Calendar Year such refund is received. In the case of any Taxes which may be evidenced by improvement or other bonds or which may be paid in annual or other periodic installments, Landlord shall elect to cause such bonds to be issued or cause such assessment to be paid in installments over the maximum period permitted by law. Nothing contained in this Lease shall require Tenant to pay any franchise, gift, estate, inheritance or succession transfer tax of Landlord, or any income, profits or revenue tax or charge, upon the net income of Landlord from all sources

4.3 Expense Adjustment. Commencing on the Commencement Date and continuing throughout the remainder of the Term, Tenant shall pay to Landlord as Additional Rent, on the first day of each calendar month, an amount equal to one-twelfth (1/12) of Tenant’s Proportionate Share of the total amount of the Basic Costs incurred with respect to each Calendar Year in the Term of this Lease (the total amount paid by the Tenant in each Calendar Year being referred to herein as the “Expense Adjustment Amount”). The Expense Adjustment Amount for each Calendar Year shall be estimated from time to time by Landlord and communicated by written notice to Tenant not more frequently than quarterly. Landlord shall cause to be kept books and records showing Basic Costs in accordance with an appropriate system of accounts and account practices consistently maintained. Within one hundred and twenty (120) days following the close of each Calendar Year, Landlord shall cause the amount of the Expense Adjustment Amount which should have been paid by Tenant for such Calendar Year (the “Final Expense Amount”) to be computed on the basis of the actual Basic Costs for each Calendar Year, and Landlord shall deliver to Tenant a statement of such Final Expense Amount. If the Final Expense Amount exceeds the Expense Adjustment Amount, Tenant shall pay such deficiency within thirty (30) days after receipt of such statement. If the Expense Adjustment Amount exceeds the Final Expense Amount, then at Landlord’s option such excess shall be either credited against payments of Additional Rent next due or refunded by Landlord, provided no Tenant Event of Default exists hereunder. Delay in computation of the Final Expense Amount or any Expense Adjustment Amount shall not be deemed a default hereunder or a waiver of Landlord’s right to collect the Final Expense Amount or Expense Adjustment Amount, as the case may be.

4.4 Tenant’s Right to Audit. Tenant shall have a right, at Tenant’s sole cost and expense, to audit Landlord’s Final Expense Amount upon the following terms and conditions. Tenant shall notify Landlord in writing that it is exercising its right to audit within 90 days following delivery of the Final Expense Amount, indicating in such notice with reasonable specificity those cost components of the Final Expense Amount to be subject to audit. The audit shall take place at Landlord’s regional offices or, at Landlord’s option, the Building, at a time mutually convenient to Landlord and Tenant (but not later than 60 days after receipt of Tenant’s notice to audit). Except as Landlord may consent in writing, the audit shall be completed within 10 days after commencement. No copying of Landlord’s books or records will be allowed. The audit may be accomplished by either Tenant’s own employees with accounting experience reasonably sufficient to conduct such review, or a nationally or regionally recognized public accounting firm mutually acceptable to Landlord and Tenant that is engaged on either a fixed price or hourly basis. Under no circumstances shall Landlord be required to consent to an accounting firm that is also a tenant

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of Landlord (or any Landlord affiliate) in the Building or any building in the city or metropolitan area in which the Building is located. The records reviewed by Tenant shall be treated as confidential and prior to commencing the audit, Tenant and any other person which may perform such audit for Tenant, shall execute a Confidentiality Agreement in a form reasonably acceptable to Landlord. A copy of the results of the audit shall be delivered to Landlord within 30 days after the completion of the audit. If Landlord and Tenant determine that the Final Expense Amount for the Calendar Year is less than reported, Landlord shall give Tenant a credit in the amount of the overpayment toward Tenant’s next monthly payment of Basic Costs, or, in the event the Lease has expired or terminated and no monetary Event of Default exists, Landlord shall pay Tenant the total amount of such overpayment within 30 days. If Landlord and Tenant determine that the Final Expense Amount for the Calendar Year is more than reported, Tenant shall pay Landlord the amount of any underpayment within 30 days. Failure by Tenant to timely request an audit, or to timely deliver to Landlord the results of the audit, or to follow any of the procedures set forth in this Section 4.4 is deemed a waiver of the applicable audit right and any right to contest the Final Expense Amount for the applicable Calendar Year and is deemed acceptance of the Final Expense Amount for the applicable Calendar Year. Any audit review by Tenant shall not postpone or alter the liability and obligation of Tenant to pay any Rent due under the terms of the Lease. Tenant shall not be entitled to conduct such an audit if any monetary Event of Default exists under this Lease. No subtenant shall have any right to conduct an audit except for a permitted assignee or sublessee under Article IX of the Lease occupying the entire Premises and no assignee or sublessee shall conduct an audit for any period during which such assignee or sublessee was not in possession of the Premises or for any period in which Tenant has conducted an audit.

4.5 Sales or Excise Taxes. Tenant shall pay to Landlord, as Additional Rent, concurrently with payment of Basic Rent all taxes, including, but not limited to any and all sales, rent or excise taxes (but specifically excluding income taxes calculated upon the net income of Landlord) on Basic Rent, Additional Rent or other amounts otherwise benefiting Landlord, as levied or assessed by any governmental or political body or subdivision thereof against Landlord on account of such Basic Rent, Additional Rent or other amounts otherwise benefiting Landlord, or any portion thereof.

V. USE

5.1 Use of Premises. In accordance with the terms, covenants and conditions set forth in this Lease, and applicable governmental regulations, restrictions and permitting (without the necessity of obtaining any zoning changes, conditional use permits or other special use permits), solely for warehouse and general business office purposes and uses incidental thereto, but for no other purpose.

5.2 Operation of Tenant’s Business. If any governmental license or permit, other than a Certificate of Occupancy (if any is issued or required), shall be required for the proper and lawful conduct of Tenant’s business in the Premises or any part thereof, Tenant shall first provide Landlord with prior written notice and obtain Landlord’s consent thereto. Thereafter, at its expense, Tenant shall procure such license prior to the first day of the Term, and thereafter maintain and renew such license or permit. Tenant shall, at all times, comply with the terms and conditions of each such license or permit. Tenant shall not, at any time, use or occupy, or suffer or permit anyone to use or occupy, the Premises, or do or permit anything to be done in the Premises, in any manner which may (a) violate any Certificate of Occupancy for the Premises or for the Building; (b) cause, or be liable to cause injury to the Building or any equipment, facilities or systems therein; (c) constitute a violation of the laws and requirements of any public authority or the requirements of insurance bodies; (d) impair or tend to impair the character, reputation or appearance of the Project or the Building; (e) impair or tend to impair the proper and economic maintenance, operation, and repair of the Property and the Building and/or its equipment, facilities or systems; and (f) annoy or inconvenience other tenants or users of the Building and the Project, if any. Tenant shall take all substantial or non substantial actions necessary to comply with all applicable statutes, ordinances, rules, regulations, orders and requirements regulating the use by Tenant of the Premises, including without limitation, the Occupational Safety and Health Act, and regulating Hazardous Materials (as such term is herein defined in Section 10.32). If the nature of Tenant’s use or occupancy of the Premises causes any increase in Landlord’s insurance premiums over and above those chargeable for the least hazardous type of occupancy legally permitted in the Premises, the Landlord will promptly give written notice of such increase to Tenant (which such notice shall include supporting documents evidencing such premium increase) and if Tenant fails to limit its use so as to negate such premium increase, Tenant will thereafter pay the resulting increase within ten (10) days after receipt of a statement from Landlord setting forth the amount thereof.

5.3 Use of Common Areas. Tenant and its employees and visitors shall have the non-exclusive right to use any Common Areas of the Property as constituted from time to time, subject to such reasonable rules and regulations governing the use as Landlord from time to time may prescribe.

VI. CONDITION AND DELIVERY OF PREMISES

Tenant hereby covenants and agrees that Tenant is familiar with the condition of the Property and the Premises and that Tenant is accepting the Premises on an “AS-IS,” “WHERE-IS” basis, and that Landlord is making absolutely no repairs, replacements or improvements of any kind or nature to the Premises or the Property in connection with, or in consideration of, this Lease, except for Landlord Work”, as set forth on Exhibit B-1. Landlord agrees to enforce, upon Tenant’s request, all manufacturer’s or contractor’s warranties given in connection with Landlord Work.

VII. SUBORDINATION; NOTICE TO SUPERIOR LESSORS AND MORTGAGEES; ATTORNMENT

This Lease is subject and subordinate to all ground or underlying leases and to any mortgage, deed of trust, security interest, or title retention interest affecting the Land, Building, Property or Project (the “Mortgage”) and to all renewals, modifications, consolidations, replacements and extensions thereof. This subordination shall be self-operative; however, in confirmation thereof, Tenant shall, within 10 days of receipt thereof, execute any instrument that Landlord or any holder of any note or obligation secured by a Mortgage (the “Mortgagee”) may request confirming such subordination. Notwithstanding the foregoing, before any foreclosure sale under a Mortgage, the Mortgagee shall have the right to subordinate the Mortgage to this Lease, and, in the event of a foreclosure, this Lease may continue in full force and effect and Tenant shall attorn to and recognize as its landlord the purchaser of Landlord’s interest under this Lease. Tenant shall, upon the request of a Mortgagee or purchaser at foreclosure, execute, acknowledge and deliver any instrument that has for its purpose and effect the subordination of the lien of any Mortgage to this Lease or Tenant’s attornment to such Purchaser. Landlord shall use commercially reasonable efforts to obtain a Subordination Nondisturbance Agreement on behalf of Tenant

VIII. QUIET ENJOYMENT

So long as Tenant pays all of the Rent and performs all of its other obligations hereunder, Tenant shall peaceably and quietly have, hold and enjoy the Premises without hindrance, ejection or molestation by Landlord, or any other person lawfully claiming through or under Landlord, subject, nevertheless, to the provisions of this Lease and to those of a Mortgage and to all laws, ordinances, orders, rules and regulations of any governmental authority. Landlord shall not be responsible for the acts or omissions of any other persons or third party that may interfere with Tenant’s use and enjoyment of the Premises.

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IX. ASSIGNMENT, SUBLETTING AND MORTGAGING

9.1 Landlord’s Consent.

(a) Tenant shall not assign, transfer, mortgage or otherwise encumber this Lease or sublet or rent (or permit a third party to occupy or use) the Premises, or any part thereof, nor shall any assignment or transfer of this Lease or the right of occupancy hereunder be effected by operation of law or otherwise, without the prior written consent of Landlord, such consent not to be unreasonably withheld. A transfer at any one time or from time to time of a majority interest in Tenant (whether stock, partnership interest or other form of ownership or control) shall be deemed to be an assignment of this Lease, unless at the time of such transfer Tenant is an entity whose outstanding stock is listed on a recognized security exchange. Within 30 days following Landlord’s receipt of Tenant’s request for Landlord’s consent to a proposed assignment, sublease, or other encumbrance, together with all information required to be delivered by Tenant pursuant to the provisions of this Section 9.1, Landlord shall: (i) consent to such proposed transaction; (ii) refuse such consent; or (iii) elect to terminate this Lease in the event of an assignment, or in the case of a sublease, terminate this Lease as to the portion of the Premises proposed to be sublet in accordance with the provisions of Section 9.2. Any assignment, sublease or other encumbrance without Landlord’s written consent shall be voidable by Landlord and, at Landlord’s election, constitute an Event of Default hereunder. Without limiting other instances in which Landlord may reasonably withhold consent to an assignment or sublease, Landlord and Tenant acknowledge that Landlord may withhold consent (a) if an Event of Default exists under this Lease or if an Event of Default would exist but for the pendency of any cure periods provided under Section 21.1; or (b) if the proposed assignee or sublessee is: a governmental entity; a person or entity with whom Landlord has negotiated for space in the Project during the prior 6 months; a present tenant in the Project; a person or entity whose tenancy in the Project would violate any exclusivity arrangement which Landlord has with any other tenant; a person or entity of a character or reputation or engaged in a business which is not consistent with the quality of the Project; or not a party of reasonable financial worth and/or financial stability in light of the responsibilities involved under this Lease on the date consent is requested. If Tenant requests Landlord’s consent to a specific assignment or subletting, Tenant will submit in writing to Landlord: (1) the name and address of the proposed assignee or subtenant; (2) a counterpart of the proposed agreement of assignment or sublease; (3) reasonably satisfactory information as to the nature and character of the business of the proposed assignee or subtenant, and as to the nature of its proposed use of the space; (4) banking, financial or other credit information reasonably sufficient to enable Landlord to determine the financial responsibility and character of the proposed assignee or subtenant; (5) executed estoppel certificates from Tenant containing such information as provided in Article XXIV; and (6) any other information reasonably requested by Landlord.

(b) Notwithstanding that the prior express written permission of Landlord to any of the aforesaid transactions may have been obtained, the following shall apply:

(i) In the event of an assignment, contemporaneously with the granting of Landlord’s aforesaid consent, Tenant shall cause the assignee to expressly assume in writing and agree to perform all of the covenants, duties, and obligations of Tenant hereunder and such assignee shall be jointly and severally liable therefore along with Tenant.

(ii) All terms and provisions of the Lease shall continue to apply after any such transaction.

(iii) In any case where Landlord consents to an assignment, transfer, encumbrance or subletting, the undersigned Tenant and any guarantor shall nevertheless remain directly and primarily liable for the performance of all of the covenants, duties, and obligations of Tenant hereunder (including, without limitation, the obligation to pay all Rent and other sums herein provided to be paid), and Landlord shall be permitted to enforce the provisions of this instrument against the undersigned Tenant, any guarantor and/or any assignee without demand upon or proceeding in any way against any other person. Neither the consent by Landlord to any assignment, transfer, encumbrance or subletting nor the collection or acceptance by Landlord of rent from any assignee, subtenant or occupant shall be construed as a waiver or release of the initial Tenant or any guarantor from the terms and conditions of this Lease or relieve Tenant or any subtenant, assignee or other party from obtaining the consent in writing of Landlord to any further assignment, transfer, encumbrance or subletting.

(iv) Tenant hereby assigns to Landlord the rent and other sums due from any subtenant, assignee or other occupant of the Premises and hereby authorizes and directs each such subtenant, assignee or other occupant to pay such rent or other sums directly to Landlord; provided however, that until the occurrence of an Event of Default, Tenant shall have the license to continue collecting such rent and other sums. Notwithstanding the foregoing, in the event that the rent due and payable by a sublessee under any such permitted sublease (or a combination of the rent payable under such sublease plus any bonus or other consideration therefor or incident thereto) exceeds the hereinabove provided Rent payable under this Lease, or if with respect to a permitted assignment, permitted license, or other transfer by Tenant permitted by Landlord, the consideration payable to Tenant by the assignee, licensee, or other transferee exceeds the Rent payable under this Lease, then Tenant shall be bound and obligated to pay Landlord such excess rent and other excess consideration in accordance with Section 9.3 within 10 days following receipt thereof by Tenant from such sublessee, assignee, licensee, or other transferee, as the case may be.

(v) Tenant shall pay Landlord a fee in an amount not to exceed $1,000.00 to reimburse Landlord for all its expenses under this Article IX for each proposed transaction, including, without limitation, reasonable attorneys’ fees.

9.2 Landlord’s Option to Recapture Premises. If Tenant proposes to assign this Lease, Landlord may, at its option, upon written notice to Tenant given within 30 days after its receipt of Tenant’s notice of proposed assignment, together with all other necessary information, elect to recapture the Premises and terminate this Lease. If Tenant proposes to sublease all or part of the Premises for a greater amount of Basic Rent than that being charged hereunder, Landlord may, at its option upon written notice to Tenant given within 30 days after its receipt of Tenant’s notice of proposed subletting, together with all other necessary information, elect to recapture such portion of the Premises as Tenant proposes to sublease and upon such election by Landlord, this Lease shall terminate as to the portion of the Premises recaptured. If a portion of the Premises is recaptured, the Rent payable under this Lease shall be proportionately reduced based on the square footage of the Rentable Square Feet retained by Tenant and the square footage of the Rentable Square Feet leased by Tenant immediately prior to such recapture and termination, and Landlord and Tenant shall thereupon execute an amendment to this Lease in accordance therewith. Landlord may thereafter, without limitation, lease the recaptured portion of the Premises to the proposed assignee or subtenant without liability to Tenant. Upon any such termination, Landlord and Tenant shall have no further obligations or liabilities to each other under this Lease with respect to the recaptured portion of the Premises, except with respect to obligations or liabilities which accrue or have accrued hereunder as of the date of such termination (in the same manner as if the date of such termination were the date originally fixed for the expiration of the Term). Notwithstanding anything contained herein to the contrary, Landlord’s shall not have the option to recapture the Premises in the event Tenant proposes to sublease all or part of the Premises for an amount equal to or less than the amount of Basic Rent being charged hereunder or in the event of an assignment or sublease to a Related Entity.

9.3 Distribution of Net Profits. In the event that Tenant assigns this Lease or sublets all or any portion of the Premises during the Term to any entity, Landlord shall receive 75% of any “Net Profits” (as hereinafter defined) and Tenant shall receive 25% of any Net Profits received by Tenant from any such assignment or subletting. The term “Net Profits” as used herein shall mean such portion of the Rent payable by such assignee or subtenant in excess of the Rent payable by Tenant under this Lease (or pro rata portion thereof in the event of a subletting) for the corresponding period, after deducting from such excess Rent all of Tenant’s documented reasonable third party costs associated with such assignment or subletting, including, without limitation, broker commissions, attorney fees and any costs incurred by Tenant to prepare or alter the Premises, or portion thereof, for the assignee or sublessee.

9.4 Transfers to Related Entities. Notwithstanding anything in this Article IX to the contrary, provided no Event of Default exists under this Lease or would exist but for the pendency of any cure periods provided for under Section 21.1, Tenant may, without Landlord’s consent, but after providing written notice to Landlord and subject to the provisions of Section 9.1(b)(i-iii) , assign this Lease or

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sublet all or any portion of the Premises to any Related Entity (as hereinafter defined) provided that (i) such Related Entity is not a governmental entity or agency; (ii) such Related Entity’s use of the Premises would not cause Landlord to be in violation of any exclusivity agreement within the Project; and (iii) the net worth (computed in accordance with generally accepted accounting principles exclusive of goodwill) of the Guarantor is greater than or equal to the greater of (a) the net worth of Guarantor as of the Date of Lease; or (b) the net worth of the Guarantor immediately prior to such transfer, and proof satisfactory to Landlord that such net worth standards have been met shall have been delivered to Landlord at least 10 days prior to the effective date of any such transaction. “Related Entity” shall be defined as (a) any parent company, subsidiary, affiliate or related corporate entity of Tenant that controls, is controlled by, or is under common control with Tenant, or (b) an entity (i) resulting from the merger or consolidation of Tenant with or into such other entity or (ii) purchasing all or substantially all of the assets of Tenant.

X. COMPLIANCE WITH LAWS

10.1 General Compliance. Tenant shall give prompt notice to Landlord of any notice it receives of the violation of any law or requirement of any governmental or administrative authority with respect to the Premises or the use or occupation thereof. Tenant shall, at Tenant’s expense, comply with all laws and requirements of any governmental or administrative authorities which shall impose any violation, order or duty on Landlord or Tenant arising from (a) Tenant’s particular use of the Premises; (b) the manner or conduct of Tenant’s business or operation of its installations, equipment or other property therein; (c) any cause or condition created by or caused by Tenant; (d) breach of any of Tenant’s obligations under this Lease, whether or not such compliance requires work which is structural or non-structural, ordinary or extraordinary, foreseen or unforeseen; and Tenant shall pay all the costs, expenses, fines, penalties and damages which may be imposed upon Landlord by reason or arising out of Tenant’s failure to fully and promptly comply with and observe the provisions of this Article X. Nothing in this Article X shall make Tenant responsible for any structural repairs or improvements that are not specifically necessitated by the causes set forth in Clauses (a), (b), (c) or (d) of the immediately preceding sentence.

10.2 ADA Compliance. Notwithstanding any other statement in this Lease, the following provisions shall govern the parties’ compliance with the Americans With Disabilities Act of 1990, as amended from time to time, Public Law 101-336; 42 U.S.C. §§12101, et seq. (the foregoing, together with any similar state statute governing access for the disabled or handicapped collectively referred to as the “ADA”):

(a) To the extent governmentally required as of the Commencement Date of this Lease, Landlord shall be responsible for the cost of compliance with Title III of the ADA, and such cost shall not be included as a Basic Cost of the Property, with respect to any repairs, replacements or alterations to the Common Areas of the Project. To the extent governmentally required subsequent to the Commencement Date of this Lease as a result of an amendment to Title III of the ADA or any regulation thereunder enacted subsequent to the Commencement Date of this Lease, Landlord shall be responsible for compliance with Title III of the ADA with respect to any repairs, replacements or alterations to the Common Area of the Property, and such expense shall be included as a Basic Costs of the Property. Landlord shall indemnify, defend and hold harmless Tenant and its Agents from all fines, suits, procedures, penalties, claims, liability, losses, expenses and actions of every kind, and all costs associated therewith (including, without limitation, reasonable attorneys’ and consultants’ fees) arising out of or in any way connected with Landlord’s failure to comply with Title III of the ADA as required above.

(b) To the extent governmentally required, Tenant shall be responsible for compliance, at its expense, with Titles I and III of the ADA with respect to the Premises. Tenant shall indemnify, defend and hold harmless Landlord and its Agents from all fines, suits, procedures, penalties, claims, liability, losses, expenses and actions of every kind, and all costs associated therewith (including, without limitation, reasonable attorneys’ and consultants’ fees) arising out of or in any way connected with Tenant’s failure to comply with Titles I and III of the ADA as required above.

10.3 ISRA Compliance.

(a) Tenant shall, at Tenant’s sole cost and expense, comply with the Industrial Site Recovery Act (N.J.S.A. 13:1k-6 et seq.), the regulations promulgated thereunder and any amending and successor legislation and regulations (collectively, “ISRA”). Tenant shall, at Tenant’s sole cost and expense, make all submissions to, provide all information to, and comply with all requirements of, the Industrial Site Evaluation Element or its successor (the “Element”) of the New Jersey Department of Environmental Protection or its successor (the “NJDEP”). Tenant’s obligations under Section 10.3 of this Lease shall arise if there is a closing of operations, a transfer of ownership or operations, or a change in ownership at or affecting the Premises pursuant to ISRA, whether triggered by Landlord or Tenant. Provided this Lease is not previously canceled or terminated by either party to this Lease or by operation of law, Tenant shall commence its submission to the Element in anticipation of the end of the Term no later than one year prior to the Expiration Date.

(b) For purposes of Section 10.3 of this Lease, “Environmental Documents” means, collectively, all environmental documentation concerning the Premises or its environs in the possession or under the control of Tenant, including, without limitation, all sampling plans, clean-up plans, preliminary assessment plans and reports, site investigation plans and reports, remedial investigation plans and reports, remedial action plans and reports or the equivalent, sampling results, sampling result reports, data, diagrams, charts, maps, analyses, conclusions, quality assurance/quality control documentation, correspondence to or from the Element or any other municipal, county, state or federal governmental authority, submissions to the Element or any other municipal, county, state or federal governmental authority and directives, orders, approvals and disapprovals issued by the Element or any other municipal, county, state or federal governmental authority. During the Term and thereafter promptly after receipt by Tenant or Tenant’s representatives, Tenant shall deliver to Landlord all Environmental Documents concerning or generated by or on behalf of Tenant, whether currently or hereafter existing.

(c) At no expense to Landlord, Tenant shall promptly provide all information requested by Landlord or NJDEP for preparation of a non-applicability affidavit, de minimus quantity exemption application, limited conveyance application or other submission and shall promptly sign such affidavits and submissions when requested by Landlord or NJDEP.

(d) Tenant shall notify Landlord in advance of all meetings scheduled between Tenant or Tenant’s representatives and NJDEP or any other environmental authority, and Landlord and Landlord’s representatives shall have the right, without the obligation, to attend and participate in all such meetings.

(e) Should Tenant’s operations at the Premises be outside of those industrial operations covered by ISRA, Tenant shall, at Tenant’s sole cost and expense, obtain a letter of non-applicability or de minimus quantity exemption from the Element prior to the Expiration Date and shall promptly provide Tenant’s submission and the Element’s exemption letter to Landlord. Should Tenant obtain a letter of non-applicability or a de minimus quantity exemption from the Element, then Tenant shall, at Landlord’s option, hire a consultant satisfactory to Landlord to undertake sampling at the Premises sufficient to determine whether fill materials, hazardous or toxic substances, pollutants or wastes exist or have been spilled, discharged or placed in, on, under or about the Premises during the Term. Tenant’s sampling shall also establish the integrity of all underground storage tanks at the Premises, if any. Should the sampling reveal any spill, discharge or placing of fill materials, or of hazardous or toxic substances, pollutants or wastes, in, on, under or about the Premises, then, at Tenant’s expense, prior to the Expiration Date or any earlier termination of the Term, Tenant shall promptly remediate the Premises in accordance with the terms and conditions of Section 10.3 of this Lease to the satisfaction of Landlord and NJDEP.

(f) Should the Element or any other division of NJDEP or other governmental authority determine that a remedial action workplan be prepared and that remediation be undertaken because fill materials, hazardous or toxic substances, pollutants or wastes exist,

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or have been spilled, discharged or placed in, on, under or about the Premises during the Term, at Tenant’s sole cost and expense, Tenant shall promptly prepare and submit a remedial action workplan and establish a remediation funding source, which plan and funding source shall be satisfactory to Landlord, and shall promptly implement the approved remedial action workplan to the satisfaction of Landlord. In no event shall Tenant’s remedial action involve engineering or institutional controls, including, without limitation, capping, deed notice, declaration of restriction or other institutional control notice pursuant to P.L. 1993, c.139, and notwithstanding NJDEP’s requirements, Tenant’s remedial action shall meet the most stringent NJDEP remediation standards for soil, surface water and groundwater. Promptly upon completion of all required investigatory and remedial activities, Tenant shall restore the affected areas of the Premises from any damage or condition caused by the work, including, without limitation, pursuant to law, the closing of any wells installed at the Premises and obtain a No Further Action Letter/Covenant Not To Sue Letter from NJDEP.

(g) If Tenant fails to obtain any of the following from the Element (any or all of such items described in clauses (i) through (iv) being sometimes hereinafter referred to as an “ISRA Clearance”): (i) a non-applicability letter; (ii) a de minimus quantity exemption; (iii) an unconditional approval of Tenant’s negative declaration; or (iv) a No Further Action Letter/Covenant Not To Sue Letter with respect to Tenant’s remedial action workplan; or fails to remediate the Premises pursuant to Section 10.3 of this Lease prior to the Expiration Date or any earlier termination of the Term, then upon the expiration or earlier termination of the Term, Landlord shall have the option either to consider this Lease as having ended or to treat Tenant as a holdover tenant in possession of the Premises. If Landlord considers this Lease as having ended, then Tenant shall nevertheless be obligated to promptly obtain ISRA Clearance or fulfill the obligations set forth in Section 10.3 of this Lease, as the case may be. If Landlord treats Tenant as a holdover tenant in possession of the Premises, then Tenant shall monthly pay to Landlord double the monthly Base Rent and Additional Rent which Tenant would otherwise have paid, until such time as Tenant obtains ISRA Clearance or fulfills its obligations under Section 10.3 of this Lease, as the case may be, and during the holdover period all of the terms of this Lease shall remain in full force and effect.

(h) Notwithstanding anything to the contrary set forth elsewhere in this Lease, including, without limitation, Article V of this Lease, the uses Tenant shall be permitted to make of the Premises shall be limited to operations having the following North American Industry Classification System (“NAICS”) numbers as defined by the most recent edition of the U.S. NAICS Manual prepared by the Office of Management and Budget’s Economic Classification Policy Committee and printed by the National Technical Information Service: 424210 (definition:             ). Except if and to the extent Tenant obtains Landlord’s prior written consent thereto (which prior written consent of Landlord may be withheld by Landlord in Landlord’s sole and absolute discretion) and Landlord and Tenant execute and deliver such amendments to this Lease relating thereto as shall be deemed necessary, in form and substance and in all other respects by Landlord, in Landlord’s sole and absolute discretion, Tenant shall make no use of the Premises other than as prescribed by Article V and Section 10.3(h) of this Lease.

(i) Tenant’s obligations contained in Section 10.3 of this Lease shall survive the Expiration Date or any earlier termination of this Lease. Tenant’s failure to abide by the terms of Section 10.3 of this Lease shall be restrainable by injunction.

XI. INSURANCE

11.1 Certain Insurance Risks. Tenant will not do or permit to be done any act or thing upon the Premises, the Property or the Project which would: (i) jeopardize or be in conflict with fire insurance policies covering the Project, and fixtures and property in the Property; or (ii) increase the rate of fire insurance applicable to the Project to an amount higher than it otherwise would be for general business office and warehouse use of the Project; or (iii) subject Landlord to any liability or responsibility for injury to any person or persons or to property by reason of any business or operation being conducted upon the Property.

11.2 Landlord’s Insurance. At all times during the Term, Landlord will carry and maintain:

(a) Property insurance coverage at least equal to ISO Special Form causes of loss with respect to the Building, its equipment and common area furnishings, and leasehold improvements in the Premises to the extent of any initial build out of the Premises by the Landlord;

(b) Bodily injury and property damage insurance; and

(c) Such other insurance as Landlord reasonably determines from time to time.

The insurance coverages and amounts in this Section 11.2 will be determined by Landlord in an exercise of its reasonable discretion.

11.3 Tenant’s Insurance. At all times during the Term, Tenant will carry and maintain, at Tenant’s expense, the following insurance, in the amounts specified below or such other amounts as Landlord may from time to time reasonably request, with insurance companies and on forms satisfactory to Landlord:

(a) Bodily injury and property damage liability insurance, with a combined single occurrence limit of not less than $1,000,000. All such insurance will be on an occurrence commercial general liability ISO standard or equivalent form including contractual liability coverage and personal liability insurance, on a claims made basis, of not less than $1,000,000. Such insurance shall include waiver of subrogation rights in favor of Landlord and Landlord’s management company;

(b) Insurance covering all of Tenant’s furniture and fixtures, machinery, equipment, stock and any other personal property owned and used in Tenant’s business and found in, on or about the Property, and any leasehold improvements to the Premises in excess of any initial build-out of the Premises by the Landlord, in an amount not less than the full replacement cost. Property forms will provide coverage on an open perils basis insuring against “all risks of direct physical loss” excluding earthquake and flood. All policy proceeds will be used for the repair or replacement of the property damaged or destroyed, however, if this Lease ceases under the provisions of Article XIX, Tenant will be entitled to any proceeds resulting from damage to Tenant’s furniture and fixtures, machinery and equipment, stock and any other personal property;

(c) Worker’s compensation insurance insuring against and satisfying Tenant’s obligations and liabilities under the worker’s compensation laws of the state in which the Premises are located, including employer’s liability insurance in the limit of $1,000,000 aggregate;

(d) If Tenant operates owned or leased vehicles on the Property, commercial automobile liability will be carried at a limit of liability not less than $1,000,000 combined bodily injury and property damage;

(e) Umbrella liability insurance in excess of the underlying coverage listed in paragraphs (a), (c) and (d) above, with limits of not less than $2,000,000 per occurrence/$2,000,000 aggregate;

(f) Loss of income and extra expense insurance and contingent business income insurance in amounts as will reimburse Tenant for direct or indirect loss of earning attributable to all perils insured against under the ISO Causes of Loss-Special Form Coverage excluding earthquake and flood. Such insurance shall provide for an extended period of indemnity to be not less than one hundred and eighty (180) days; and

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(g) All insurance required under this Article XI shall be issued by such good and reputable insurance companies qualified to do and doing business in the state in which the Premises are located and having a rating not less than A:VIII as rated in the most current copy of Best’s Insurance Report in the form customary to this locality.

11.4 Forms of the Policies. Landlord, Landlord’s management company and such other parties as Landlord shall designate to Tenant who have an insurable interest in the Premises or Property shall be (i) named as additional insured with respect to the coverages provided for under Section 11.3 (a), (c), (d) and (e) (other than Worker’s Compensation), and (ii) as loss payees as their interest may appear with respect to the coverage provided under Section 11.3 (b). Certificates of insurance together with copies of the policies and any endorsements naming Landlord, Landlord’s management company, and any others specified by Landlord as additional insureds or loss payee (as the case may be) will be delivered to Landlord prior to Tenant’s occupancy of the Premises and from time to time at least thirty (30) days prior to the expiration of the term or reduction in coverage of each such policy. Each certificate of insurance required hereunder will specifically provide that at least thirty (30) days prior written notice of cancellation will be given to Landlord and Landlord’s Mortgagee. All policies required to be maintained by Tenant will be written as primary policies, not contributing with and not supplemental to the coverage that Landlord may carry. Commercial general liability insurance required to be maintained by Tenant by this Article XI will not be subject to a deductible of more than $1,000. In the event Tenant fails to purchase and maintain any of the insurance required hereunder, Landlord reserves the right, but not the obligation, to purchase such insurance on behalf of Tenant, and at Tenant’s expense, with any expenses incurred by Landlord in connection therewith being reimbursed to Landlord by Tenant within thirty (30) days of written demand thereof.

11.5 Waiver of Subrogation. Landlord and Tenant each waive and shall cause their respective insurance carriers to waive any and all rights to recover against the other or against the Agents of such other party for any loss or damage to such waiving party (including deductible amounts) arising from any cause covered by any property insurance required to be carried by such party pursuant to this Article XI or any other property insurance actually carried by such party to the extent of the limits of such policy. Tenant agrees to cause all other occupants of the Premises claiming by, under or through Tenant, to execute and deliver to Landlord and Landlord’s management company such a waiver of claims and to obtain such waiver of subrogation rights endorsements

11.6 Adequacy of Coverage. Landlord and its Agents make no representation that the limits of liability specified to be carried by Tenant pursuant to this Article XI are adequate to protect Tenant. If Tenant believes that any of such insurance coverage is inadequate, Tenant will obtain such additional insurance coverage as Tenant deems adequate, at Tenant’s sole expense. Furthermore, in no way does the insurance required herein limit the liability of Tenant assumed elsewhere in the Lease.

XII. ALTERATIONS

12.1 Procedural Requirements. Tenant may, from time to time, at its expense, make such alterations, additions, or improvements (hereinafter collectively referred to as “Alterations”) in and to the Premises, excluding any initial leasehold improvements which shall be governed by the provisions of Exhibit B, as Tenant may reasonably consider necessary for the conduct of its business in the Premises; provided, however, that the written consent of the Landlord is first obtained. Landlord’s consent shall not be unreasonably withheld to Alterations, provided that: (a) the exterior of the Building shall not be affected; (b) the Alterations are non-structural and the structural integrity of the Building shall not be affected; (c) the Alterations are to the interior of the Premises and no part of the Building (including the roof) outside of the Premises shall be affected; (d) the proper functioning of the mechanical, electrical, sanitary and other service systems of the Building shall not be affected and the usage of such systems by Tenant shall not be increased; (e) Tenant shall have appropriate insurance coverage reasonably satisfactory to Landlord regarding the Alterations; (f) the Alterations do not require the issuance of a building permit and (g) before proceeding with any Alterations, Tenant shall submit to Landlord for Landlord’s approval, plans and specifications for the work to be done and Tenant shall not proceed with such work until Tenant has received said approval (which Landlord shall either give or deny within thirty (30) days of receipt of Tenant’s plans and specifications). Tenant shall obtain and deliver to Landlord (if so requested) either (i) a performance bond and a labor and materials payment bond (issued by a corporate surety licensed to do business in the state in which the Project is located) each in an amount equal to one hundred twenty-five percent (125%) of the estimated cost of the Alterations and in form satisfactory to Landlord, or (ii) such other security as shall be reasonably satisfactory to Landlord.

12.2 Performance of Alterations. Tenant, at its expense, shall obtain all necessary governmental permits and certificates for the commencement and prosecution of Alterations and for the final approval thereof upon completion, and shall cause the Alterations to be performed in compliance therewith and in compliance with all applicable laws and requirements of public authorities, including without limitation, Titles I and III of the ADA, the OSHA General Industry Standard (29 C.F.R. Section 1910.1001, et seq.) and the OSHA Construction Standard (29 C.F.R. Section 1926.1001, et seq.), all entities holding Mortgages on the Building and with Landlord’s rules and regulations or any other restrictions Landlord may impose on the Alterations. Tenant shall not commence any Alterations without having first demonstrated, to Landlord’s satisfaction, that all such permits and certificates have been obtained. The Alterations shall be diligently performed in a good and workmanlike manner, using new materials and equipment at least equal in quality and class to the standards for the Building established by Landlord. Alterations shall be performed by contractors first approved by Landlord, and Tenant’s Agents shall work in harmony, and not interfere with, Landlord and its Agents or with any other tenants or occupants of the Building. Tenant shall, and hereby does, indemnify, defend, and hold Landlord harmless from any and all claims, damages or losses, of any nature (including reasonable fees of attorneys of Landlord’s choosing), suffered by Landlord, whether directly or indirectly, as a result of, or due to, or arising from, the performance of any Alterations by, or on behalf of, Tenant. Alterations shall be performed in such manner so as to not unreasonably interfere with or delay and so as not to impose any additional expense upon Landlord in the construction, maintenance, repair or operation of the Building; and if any such expense is incurred by Landlord, Tenant shall pay the same upon demand. Tenant acknowledges that if any Alterations commenced or performed in violation of any provision of this Article XII shall cause Landlord irreparable injury, Landlord shall have the right to enjoin any such violations by injunction or other equitable relief.

12.3 Lien Prohibition. Tenant shall not permit any mechanics’ or materialmens’ liens to attach to the Premises, the Property, the Project, Tenant’s leasehold estate or any of them. Tenant shall and hereby does defend, indemnify, and hold Landlord harmless from and against any and all mechanics’ and other liens and encumbrances filed in connection with Alterations or any other work, labor, services, or materials done for or supplied to Tenant, or any person claiming through or under Tenant, including, without limitation, security interests in any materials, fixtures or articles installed in and constituting a part of the Premises and against all costs, expenses, and liabilities (including reasonable fees of attorneys of Landlord’s choosing) incurred in connection with any such lien or encumbrance or any action or proceeding brought thereon. Tenant, at its expense, shall procure the satisfaction or discharge of record of all such liens and encumbrances within ten (10) days after the filing thereof. In the event Tenant has not so performed, Landlord may, at its option, pay and discharge such liens and Tenant shall be responsible to reimburse Landlord for all costs and expenses incurred in connection therewith, together with interest thereon at the Interest Rate set forth in Section 1.14 above, which expenses shall include reasonable fees of attorneys of Landlord’s choosing, and any costs in posting bond to effect discharge or release of the lien as an encumbrance against the Premises, the Property, the Project, Tenant’s leasehold estate or any of them.

XIII. LANDLORD’S AND TENANT’S PROPERTY

13.1 Landlord’s Property. All fixtures, machinery, equipment, improvements and appurtenances to, or built into, the Premises after the Commencement Date, whether or not placed there by, or at the expense of, Tenant shall be and remain a part of the Premises; shall be deemed the property of Landlord (the “Landlord’s Property”), without compensation or credit to Tenant; and shall not be removed by Tenant unless Landlord requests their removal, in which event Tenant shall, on or before the Expiration Date or earlier termination of this

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Lease, remove the designated items, repair any damage to the Premises or Building resulting from such removal, and restore the Premises to the condition existing as of the Commencement Date. Removal of any initial leasehold improvements to the Premises shall be governed by the provisions of Exhibit B. Further, any personal property in the Premises on the Commencement Date, unless installed and paid for by Tenant, shall be and shall remain the property of the Landlord and shall not be removed by Tenant. Any flooring in the Premises during the Term shall be and remain the property of Landlord and shall not be removed or replaced without the prior written consent and approval by Landlord.

13.2 Tenant’s Property. All movable business and trade fixtures, machinery and equipment, communications equipment and office equipment, whether or not attached to, or built into, the Premises, which are installed in the Premises by, or for the account of, Tenant without expense to Landlord and which can be removed without structural damage to the Building, and all furniture, furnishings and other articles of movable personal property owned by Tenant and located in the Premises shall be and shall remain the property of Tenant (the “Tenant’s Property”) and may be removed by Tenant at any time during the Term, provided no Tenant Event of default exists hereunder. In the event Tenant’s Property is so removed, Tenant shall repair or pay the cost of repairing any damage to the Premises or to the Building resulting from the installation and/or removal thereof and restore the Premises to the condition existing as of the Commencement Date.

13.3 Removal of Tenant’s Property. At or before the Expiration Date, or the date of any earlier termination hereof, Tenant, at its expense, shall remove from the Premises all of Tenant’s Property, and Tenant shall repair any damage to the Premises or the Building resulting from any installation and/or removal of Tenant’s Property and restore the Premises to the condition existing as of the Commencement Date, reasonable wear and tear excepted. Any items of Tenant’s Property which shall remain in the Premises after the Expiration Date, or following an earlier termination date, may, at the option of Landlord, be deemed to have been abandoned, and in such case, such items may be retained by Landlord as its property or be disposed of by Landlord, without accountability, in such manner as Landlord shall determine, at Tenant’s expense. Notwithstanding the foregoing, if a Tenant Event of Default exists under the terms of this Lease, Tenant shall only remove Tenant’s property from the Premises upon the express, written direction of Landlord.

XIV. REPAIRS AND MAINTENANCE

14.1 Tenant Repairs and Maintenance. Except with respect to Landlord’s obligations set forth in Section 14.2 below, Tenant, at its sole cost and expense, throughout the Term of this Lease, shall take good care of the Premises, and shall keep the same in good, first class order, condition and repair, and shall make and perform all routine maintenance thereof, including janitorial maintenance, and all necessary repairs, ordinary and extraordinary, foreseen and unforseen, of every nature, kind and description. As used herein, “repairs” shall include all necessary replacements, restorations, renewals, alterations, additions and betterments to the Premises. All repairs made by Tenant shall be at least the quality and cost of the original work and shall be made by Tenant in accordance with all laws, ordinances and regulations whether heretofore and hereafter enacted. The necessity for or adequacy of maintenance and repairs shall be measured by the standards which are appropriate for improvements of similar construction and class, provided that Tenant shall in any event make all repairs necessary to avoid any damage or injury to the improvements. Throughout the Term of this Lease, Tenant will maintain (a) a maintenance contract for servicing of the HVAC system with a servicer reasonably acceptable to Landlord, and (b) maintenance logs on site and will cause the personnel engaged in the maintenance of the Premises to make timely and detailed entries in those logs so that the logs at all times accurately reflect the maintenance activity performed with respect to the Premises and its Building systems. Landlord’s representatives may inspect and copy those logs at any reasonable time after reasonable notice has been given to Tenant. Landlord will have the right to cause the maintenance of the Premises to be reviewed and the Premises inspected annually (or more frequently if Landlord determines that it is prudent to do so) by a qualified engineer or property manager consultant of Landlord’s choosing, to determine whether Tenant is maintaining the Premises in accordance with this Section 14.1 and, if it is determined that Tenant has not maintained the Premises as herein required, Tenant will reimburse Landlord for the cost of repairing the Premises and for the fees and expenses of such engineer or consultant within thirty (30) days after Landlord’s demand. Tenant will cooperate with the engineer or consultant in its performance of such review and inspection. Except with respect to the maintenance contract for the servicing of the HVAC system, Tenant may fulfill it maintenance and repair obligations under this Section 14.1 at its option either through the use of its employees or through the use of Agents . Notwithstanding the above, Landlord may enter into a master service agreement for HVAC maintenance with respect to the Property and Tenant shall pay its Proportionate Share of such cost in accordance with the provisions of Article IV.

14.2 Landlord Repairs. Landlord shall keep in good repair, (i) the structural portions of the foundation and exterior walls (exclusive of all glass and all exterior doors) of the Building; (ii) the roof of the Building; and (iii) the outside Common Areas of the Property, including the parking lots, landscaping and underground utility and sewer pipes outside the exterior walls of the Building, if any. All such repairs shall be at Landlord’s sole cost and expense, except that the cost of such items shall be a Basic Cost to the extent permitted by the provisions of Article IV. Notwithstanding the foregoing, the cost of repairs referenced in this Section 14.2 rendered necessary by the negligence or willful misconduct of Tenant or Tenant’s Agents or as a result of Tenant’s failure to use the Premises in accordance with the terms of Article V of this Lease, shall be reimbursed by Tenant to Landlord within thirty (30) days of Landlord’s written demand. Tenant hereby waives any right to make repairs and deduct the expenses of such repairs from the Basic Rent or Additional Rent due under the Lease.

14.3 Tenant Equipment. Tenant shall not place a load upon any floor of the Premises which exceeds either the load per square foot which such floor was designed to carry or which is allowed by law. Business machines and mechanical equipment belonging to Tenant which cause noise or vibrations that may be transmitted to the structure of the Building or to the Premises to such a degree as to be objectionable to Landlord shall, at the Tenant’s expense, be placed and maintained by Tenant in settings of cork, rubber or spring-type vibration eliminators sufficient to eliminate such noise or vibration.

XV. UTILITIES

15.1 Purchasing Utilities. Tenant shall purchase all utility services including, but not limited to, fuel, water, sewerage and electricity, from the utility or municipality providing such service, shall provide for cleaning and extermination services, and shall pay for such services when payments therefor are due. Tenant shall be solely responsible for the repair and maintenance of any meters necessary in connection with such services.

15.2 Use of Electrical Energy by Tenant. Tenant’s use of electrical energy in the Premises shall not, at any time, exceed the capacity of (i) any of the electrical conductors and equipment in or otherwise serving the Premises; or (ii) the Building’s HVAC system. In order to insure that such capacity is not exceeded and to avert possible adverse effects upon the Building’s electric service, Tenant shall not, without Landlord’s prior written consent in each instance, make any material alteration or addition to the electrical system of the Premises existing as of the Commencement Date.

XVI. INVOLUNTARY CESSATION OF SERVICES

Landlord reserves the right, without any liability to Tenant and without affecting Tenant’s covenants and obligations hereunder, to stop service of the heating, air conditioning, electric, sanitary, elevator, or other Building systems serving the Premises, or to stop any other services required by Landlord under this Lease, whenever and for so long as may be necessary, by reason of (i) accidents, emergencies, strikes, or the making of repairs or changes which Landlord in good faith deems necessary, or (ii) any other cause beyond Landlord’s reasonable control. Further, it is also understood and agreed that Landlord shall have no liability or responsibility for a cessation of services

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to the Premises or in the Building which occurs as a result of causes beyond Landlord’s control. No such interruption of service shall be deemed an eviction or disturbance of Tenant’s use and possession of the Premises or any part thereof, or render Landlord liable to Tenant for damages, or relieve Tenant from performance of Tenant’s obligations under this Lease including the obligation to pay Rent. Notwithstanding the foregoing, (i) if any interruption of utilities or services required to be provided by Landlord under this Lease shall continue for five (5) business days after written notice from Tenant to Landlord; and (ii) such interruption of utilities or services shall render any portion of the Premises unusable for the normal conduct of Tenant’s business and Tenant, in fact, ceases to use and occupy such portion of the Premises for the normal conduct of its business; and (iii) such interruption of utilities or services is due to the negligence or willful misconduct of Landlord; then all Rent payable hereunder with respect to such portion of the Premises rendered unusable for the normal conduct of Tenant’s business in which Tenant, in fact, ceases to use and occupy, shall be abated after the expiration of such five (5) business day period, in the event such utilities or services are not restored, and continue until such time that the utilities or services are restored.

XVII. LANDLORD’S RIGHTS OF ACCESS

Landlord and its Agents shall have the right to enter and/or pass through the Premises at any time or times upon reasonable notice (except in an emergency in which case no notice shall be required) (a) to examine the Premises and to show them to actual and prospective Mortgagees, or prospective purchasers or Mortgagees of the Building; and (b) to make such repairs, alterations, additions and improvements in or to the Premises and/or in or to the Building or its facilities and equipment as Landlord is required or desires to make; provided, however, that Landlord shall use reasonable efforts to avoid disturbing Tenant, Tenant’s employees and Tenant’s business operations. Landlord shall be allowed to take all materials into and upon the Premises that may be required in connection therewith, without any liability to Tenant and without any reduction of Tenant’s covenants and obligations hereunder. During the period of twelve (12) months prior to the Expiration Date (or at any time, if Tenant has vacated or abandoned the Premises), Landlord and its Agents may exhibit the Premises to prospective tenants.

XVIII. LIABILITY AND INDEMNIFICATION OF LANDLORD

18.1 Indemnification. Except to the extent caused by the gross negligence or willful misconduct of Landlord, Tenant will neither hold nor attempt to hold Landlord, its Agents or Mortgagee liable for, and Tenant will indemnify, hold harmless and defend (with counsel reasonably acceptable to Landlord) Landlord, its Agents and Mortgagee, from and against, any and all demands, claims, causes of action, fines, penalties, damages, liabilities, judgments, and expenses (including, without limitation, reasonable attorneys’ fees) incurred in connection with or arising from (i) the use or occupancy or manner of use or occupancy of the Premises by Tenant or its Agents; (ii) any activity, work or thing done, permitted or suffered by Tenant or its Agents in or about the Premises or the Project; (iii) any acts, omissions or negligence of Tenant or its Agents; (iv) any breach, violation or nonperformance by Tenant or its Agents of any term, covenant or provision of this Lease or any law, ordinance or governmental requirement of any kind; and (v) any injury or damage to the person, property or business of Tenant or its Agents.

18.2 Waiver and Release. Except to the extent caused by the gross negligence or willful misconduct of Landlord, Tenant covenants and agrees that Landlord, its Agents and Mortgagee will not at any time or to any extent whatsoever be liable, responsible or in any way accountable for any loss, injury, death or damage (including consequential damages) to persons, property or Tenant’s business occasioned by (i) any act or omission of Landlord or its Agents; (ii) any acts or omissions, including theft, of or by any other tenant, occupant or visitor of the Project; or (iii) any injury or damage to persons or property resulting from any casualty, explosion, falling plaster or other masonry or glass, steam, gas, electricity, water or rain which may leak from any part of the Building or any other portion of the Project or from the pipes, appliances or plumbing works therein or from the roof, street or subsurface or from any other place, or resulting from dampness. Tenant agrees to give prompt notice to Landlord upon the occurrence of any of the events set forth in this Section 18.2 or of defects in the Premises or the Building, or in the fixtures or equipment.

18.3 Survival. The covenants, agreements and indemnification obligations under this Article XVIII will survive the expiration or earlier termination of this Lease. Tenant’s covenants, agreements and indemnification obligations are not intended to and will not relieve any insurance carrier of its obligations under policies required to be carried by Tenant pursuant to the provisions of this Lease.

XIX. DAMAGE OR DESTRUCTION

19.1 Damage to the Premises. If the Premises or the Building shall be damaged by fire or other insured cause, Landlord shall within one hundred and eighty (180) days after such damage occurs (taking into account the time necessary to effect a satisfactory settlement with any insurance company involved) repair such damage at the expense of Landlord; provided, however, that Landlord’s obligation to repair such damage shall not exceed the proceeds of insurance available to Landlord (reduced by any proceeds retained pursuant to the rights of Mortgagee). Notwithstanding the foregoing, if the Premises or the Building are damaged by fire or other insured cause to such an extent that, in Landlord’s reasonable judgment, the damage cannot be substantially repaired within 180 days after the date of such damage, or if the Premises are substantially damaged during the last Lease Year, then: (i) Landlord may terminate this Lease as of the date of such damage by written notice to Tenant; or (ii) Tenant may terminate this Lease as of the date of such damage by written notice to Landlord within 10 days after (a) Landlord’s delivery of a notice that the repairs cannot be made within such 180-day period (Landlord shall use reasonable efforts to deliver to Tenant such notice within 60 days of the date of such damage or casualty); or (b) the date of damage, in the event the damage occurs during the last year of the Lease. Rent shall be apportioned and paid to the date of such damage.

During the period that Tenant is deprived of the use of the damaged portion of the Premises (but is able to conduct business from the rest of the Premises), Basic Rent and Tenant’s Proportionate Share shall be reduced by the ratio that the Rentable Square Footage of the Premises damaged bears to the total Rentable Square Footage of the Premises before such damage. All injury or damage to the Premises or the Building resulting from the gross negligence or willful misconduct of Tenant or its Agents shall be repaired by Landlord, at Tenant’s expense, and Rent shall not abate nor shall Tenant be entitled to terminate the Lease. Notwithstanding anything herein to the contrary, Landlord shall not be required to rebuild, replace, or repair any of the following: (i) specialized Tenant improvements as reasonably determined by Landlord; (ii) Alterations; or (iii) Tenant’s Property.

19.2 Condemnation. If any of the Premises, 20% or more of the Building or 30% or more of the Land shall be taken or condemned by any governmental or quasi-governmental authority for any public or quasi-public use or purpose (including, without limitation, sale under threat of such a taking), then the Term shall cease and terminate as of the date when title vests in such governmental or quasi-governmental authority, and Rent shall be prorated to the date when title vests in such governmental or quasi-governmental authority. If less than 20% of the Building (none of which is within the Premises) and less than 30% of the Land is taken or condemned by any governmental or quasi-governmental authority for any public or quasi-public use or purpose (including, without limitation, sale under threat of such a taking), this Lease shall continue in full force and effect. Tenant shall have no claim against Landlord (or otherwise) as a result of such taking, and Tenant hereby agrees to make no claim against the condemning authority for any portion of the amount that may be awarded as compensation or damages as a result of such taking; provided, however, that Tenant may, to the extent allowed by law, claim an award for moving expenses and for the taking of any of Tenant’s Property (other than its leasehold interest in the Premises) which does not, under the terms of this Lease, become the property of Landlord at the termination hereof, as long as such claim is separate and distinct from any claim of Landlord and does not diminish Landlord’s award. Tenant hereby assigns to Landlord any right and interest it may have in any award for its leasehold interest in the Premises.

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XX. SURRENDER AND HOLDOVER

On the Expiration Date, or upon any earlier termination of this Lease, or upon any re-entry by Landlord upon the Premises, Tenant shall quit and surrender the Premises to Landlord “broom-clean” and in good order, condition and repair, except for ordinary wear and tear and such damage or destruction as Landlord is required to repair or restore under this Lease, and Tenant shall remove all of the Tenant’s Property therefrom, except as otherwise expressly provided in this Lease. In the event that Tenant shall not immediately surrender the Premises to Landlord on the Expiration Date or earlier termination of this Lease, Tenant shall be deemed to be a tenant-at-will pursuant to the terms and provisions of this Lease, except the daily Basic Rent shall be one hundred and fifty (150%) percent of the daily Basic Rent during the first two (2) months following the Expiration Date and thereafter at twice the daily Basic Rent in effect on the Expiration Date or earlier termination of this Lease (computed on the basis of a thirty (30) day month) . Notwithstanding the foregoing, if Tenant shall hold over after the Expiration Date or earlier termination of this Lease, and Landlord shall desire to regain possession of the Premises, then Landlord may forthwith re-enter and take possession of the Premises by any legal process provided under applicable state law. If Landlord is unable to deliver possession of the Premises to a new tenant, or to perform improvements for a new tenant, as a result of Tenant’s holdover, Tenant shall be liable to Landlord for all damages, including, without limitation, special or consequential damages, that Landlord suffers from the holdover.

XXI. DEFAULT OF TENANT

21.1 Events of Default. Each of the following shall constitute an Event of Default: (i) Tenant fails to pay Rent within 3 days after notice from Landlord; provided that no such notice shall be required if at least two such notices shall have been given during the previous twelve (12) months; (ii) Tenant fails to observe or perform any other term, condition or covenant herein binding upon or obligating Tenant within 15 days after notice from Landlord; provided, however, that if Landlord reasonably determines that such failure cannot be cured within said 15-day period, then Landlord may in its reasonable discretion extend the period to cure the default for up to an additional 15 days provided Tenant has commenced to cure the default within the 15-day period and diligently pursues such cure to completion (notwithstanding the foregoing, if Landlord provides Tenant with notice of Tenant’s failure to observe or perform any term, condition or covenant under this Subsection (ii) on 2 or more occasions during any 12 month period, then Tenant’s subsequent violation shall, at Landlord’s option, be deemed an Event of Default immediately upon the occurrence of such failure, regardless of whether Landlord provides Tenant notice, or Tenant has commenced the cure of the same); (iii) Tenant abandons or vacates the Premises or fails to take occupancy of the Premises within 90 days after the Commencement Date; (iv) Tenant fails to execute and return a subordination agreement or estoppel within the time periods provided for in Article VII or Article XXIII; (v) Tenant or any Guarantor makes or consents to a general assignment for the benefit of creditors or a common law composition of creditors, or a receiver of the Premises for all or substantially all of Tenant’s or Guarantor’s assets is appointed, or Tenant or Guarantor hereafter files a voluntary petition in any bankruptcy or insolvency proceeding, or an involuntary petition in any bankruptcy or insolvency proceeding is filed against Tenant or Guarantor and is not discharged by Tenant or Guarantor within 60 days; or (vi) Tenant fails to immediately remedy or discontinue any hazardous conditions which Tenant has created or permitted in violation of law or of this Lease. Any notice periods provided for under this Section 21.1 shall run concurrently with any statutory notice periods and any notice given hereunder may be given simultaneously with or incorporated into any such statutory notice.

21.2 Landlord’s Remedies. Upon the occurrence of an Event of Default, Landlord, at its option, without further notice or demand to Tenant, may, in addition to all other rights and remedies provided in this Lease, at law or in equity, elect one or more of the following remedies:

(a) Terminate this Lease, or terminate Tenant’s right of possession to the Premises without terminating this Lease, and with or without reentering and repossessing the Premises. Upon any termination of this Lease, or upon any termination of Tenant’s right of possession without termination of this Lease, Tenant shall surrender possession and vacate the Premises immediately, and deliver possession thereof to Landlord. If Tenant fails to surrender possession and vacate the Premises, Landlord and its Agents shall have full and free license to enter into and upon the Premises with or without process of law for the purpose of repossessing the Premises, removing Tenant and removing, storing or disposing of any and all Alterations, signs, personal property, equipment and other property therefrom. Landlord may take these actions without (i) being deemed guilty of trespass, eviction or forcible entry or detainer, (ii) incurring any liability for any damage resulting therefrom, for which Tenant hereby waives any right to claim, (iii) terminating this Lease (unless Landlord intends to do so), (iv) releasing Tenant or any guarantor, in whole or in part, from any obligation under this Lease or any guaranty thereof, including, without limitation, the obligation to pay Rent or Damages (as defined herein) or (v) relinquishing any other right given to Landlord hereunder or by operation of law;

(b) Recover unpaid Rent (whether accruing prior to, on or after the date of termination of this Lease or Tenant’s right of possession and/or pursuant to the holdover provisions of Article XX, Rental Deficiency (as defined herein) and/or any Damages (as defined herein). “Rental Deficiency” is defined as a contractual measure of damages for Tenant’s non-payment of Rent measured by either the (i) “Actual Rental Deficiency”, which means the difference (never less than zero) between (A) the Basic Rent due for, and other Rent allocable under this Lease to, each calendar month beginning with the first month with respect to which Landlord receives rent from reletting the Premises and (B) the proceeds, if any, that Landlord actually collects from any substitute tenant for any part of the Premises in each corresponding month in which the Term and the term of the substitute tenant’s lease overlap; or (ii) “Market Rental Deficiency”, which is the present value (determined using a discount rate of seven percent [7%] per annum) of the difference (never less than zero) between (A) the total Rent which would have accrued to Landlord under this Lease for the remainder of the Term of this Lease (or such portion of the Term in which Landlord elects to recover this damage measure), if the terms of this Lease had been fully complied with by Tenant, and (B) the total fair market rental value of the Premises for the remainder of the Term of the Lease (or such portion of the Term in which Landlord elects to recover this damage measure). In determining the Market Rental Deficiency, the total fair market rental value will be the prevailing market rate for full service base rent for tenants of comparable quality for leases in buildings of comparable size, age, use location and quality in the marketplace in which the Project is located, taking into consideration the extent of the availability of space as large as the Premises in the marketplace. “Damages” shall mean all actual, incidental, and consequential damages, court costs, interest and attorneys’ fees arising from Tenant’s breach of the Lease, including, without limitation, (i) reletting costs, including, without limitation, the cost of restoring the Premises to the condition necessary to rent the Premises at the prevailing market rate, normal wear and tear excepted (including, without limitation, cleaning, decorating, repair and remodeling costs), brokerage fees, legal fees, advertising costs and the like); (ii) Landlord’s cost of recovering possession of the Premises; (iii) the cost of removing, storing and disposing of any of Tenant’s or other occupant’s property left on the Premises after reentry; (iv) any increase in insurance premiums caused by the vacancy of the Premises, (v) the amount of any unamortized improvements to the Premises in connection with this Lease paid for by Landlord, (vi) the amount of any unamortized brokerage commission paid by Landlord in connection with the leasing of the Premises to Tenant; (vii) costs incurred in connection with collecting any money owed by Tenant or a substitute tenant, (viii) any other sum of money or damages owed by Tenant to Landlord or incurred by Landlord as a result of or arising from, Tenant’s breach of the Lease or Landlord’s exercise of its rights and remedies for such breach, (ix) any contractual or liquidated type or measures of damages specified in this Lease and (x) any other type of measure of damages recoverable for any particular breach under applicable law statute, ordinance or governmental rule or regulation. Landlord may file suit to recover any sums falling due under the terms of this Section 21.2(b) from time to time, and no delivery to or recovery by Landlord of any portion due Landlord hereunder shall be any defense in any action to recover any amount not theretofore reduced to judgment in favor of Landlord. Nothing contained in this Lease shall limit or prejudice the right of Landlord to prove for and obtain in proceedings for bankruptcy or insolvency by reason of the termination of this Lease, an amount equal to the maximum allowed by any statute or rule of law in effect at the time when, and governing the proceedings in which, the damages are to be proved, whether or not the amount be greater, equal to, or less than the amount of the loss or damages referred to above.

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(c) If Landlord elects to terminate Tenant’s right to possession of the Premises without terminating this Lease, Tenant shall continue to be liable for all Rent and all other Damages, except to the extent otherwise provided under Section 21.3, and Landlord may (but shall not be obligated to) relet the Premises, or any part thereof, to a substitute tenant or tenants, for a period of time equal to or lesser or greater than the remainder of the Term of this Lease on whatever terms and conditions Landlord, at Landlord’s sole discretion, deems advisable. Notwithstanding any provision in this Section 21.2(c) to the contrary, Landlord may at (i) any time after reletting the Premises elect to exercise its rights under Section 21.2(b) for such previous breach; and (ii) upon the default of any substitute tenant or upon the expiration of the lease term of such substitute tenant before the expiration of the Term of this Lease, either relet to still another substitute tenant or exercise its rights under Section 21.2(b). For the purpose of such reletting Landlord is authorized to decorate or to make any repairs, changes, alterations or additions in or to the Premises that may be necessary.

(d) Take any lawful self-help or judicial action, to the extent permitted by New Jersey statute, including using a master or duplicate key or changing or picking the locks and security devices, without having any civil or criminal liability therefor to (i) reenter the Premises, repossess the Premises and exclude Tenant and other occupants from the Premises, and/or (ii) make such payment or do such act as Landlord determines is necessary (without obligation to do so) to cure the Event of Default or otherwise satisfy Tenant’s obligations under the terms of this Lease. Tenant agrees to reimburse Landlord on demand for any expenses which Landlord may incur in connection with the foregoing actions, which expenses shall bear interest until paid at the Interest Rate, and that Landlord shall not be liable for any damages resulting to Tenant from such actions.

(e) Withhold or suspend payment that this Lease would otherwise require Landlord to make.

(f) Recover, but only if Tenant fails to pay Basic Rent, and Landlord terminates this Lease or Tenant’s right of possession with more than twelve (12) months remaining in the Term, liquidated rental damages for the period after any such termination equal to twelve (12) times the monthly Rent in lieu of any other contractual or legal measure of damages for Tenant’s non-payment of Basic Rent, and the parties agree that this is a reasonable estimate of Landlord’s damages for such a breach given the uncertainty of future market rental rates and the duration of any vacancy.

(g) No right or remedy herein conferred upon or reserved to Landlord is intended to be exclusive of any other right or remedy, and each and every right and remedy shall be cumulative and in addition to any other right or remedy given hereunder or now or hereafter existing at law or in equity or by statute. In addition to other remedies provided in this Lease, Landlord shall be entitled, to the extent permitted by applicable law, to injunctive relief in case of the violation, or attempted or threatened violation, of any of the covenants, agreements, conditions or provisions of this Lease, or to a decree compelling performance of any of the covenants, agreements, conditions or provisions of this Lease, or to any other remedy allowed to Landlord at law or in equity.

21.3 Mitigation of Damages. Notwithstanding the foregoing, to the extent (but no further) Landlord is required by applicable law to mitigate damages, or is required by law to use efforts to do so, and such requirement cannot be lawfully and effectively waived, Tenant agrees that if Landlord markets the Premises in a manner substantially similar to the manner in which Landlord markets other space in the Building, then Landlord shall be deemed to have used commercially reasonable efforts to mitigate damages. Tenant shall continue to be liable for all Rent (whether accruing prior to, on or after the date of termination of this Lease or Tenant’s right of possession and/or pursuant to the holdover provisions of Article XX above) and Damages, except to the extent that Tenant receives any credit against unpaid Rent under Section 21.2(b) or pleads and proves by clear and convincing evidence that Landlord fails to exercise commercially reasonable efforts to mitigate damages to the extent required under this Section 21.3 and that Landlord’s failure caused an avoidable and quantifiable increase in Landlord’s damages for unpaid Rent. Without limitation to the foregoing, Landlord shall not be deemed to have failed to mitigate damages, or use efforts required by law to do so, because: (i) Landlord leases other space in the Building which is vacant prior to re-letting the Premises; (ii) Landlord refuses to relet the Premises to any Related Entity of Tenant, or any principal of Tenant, or any Related Entity of such principal; (iii) Landlord refuses to relet the Premises to any person or entity whose creditworthiness is not acceptable to Landlord in the exercise of its reasonable discretion; (iv) Landlord refuses to relet the Premises to any person or entity because the use proposed to be made of the Premises by such prospective tenant is not warehouse or general business office use of a type and nature consistent with that of the other tenants in the portions of the Building leased or held for lease for warehouse and general business office purposes as of the date Tenant defaults under this Lease (by way of illustration, but not limitation, manufacturing facilities, government offices, consular offices, doctor’s offices or medical or dental clinics or laboratories, or schools would not be uses consistent with that of other tenants in the Building), or such use would, in Landlord’s reasonable judgment, impose unreasonable or excessive demands upon the Building systems, equipment or facilities; (v) Landlord refuses to relet the Premises to any person or entity, or any affiliate of such person or entity, who has been engaged in litigation with Landlord or any of its affiliates; (vi) Landlord refuses to relet the Premises because the tenant or the terms and provisions of the proposed lease are not approved by the holders of any liens or security interests in the Building, or would cause Landlord to be in default of, or to be unable to perform any of its covenants or obligations under, any agreements between Landlord and any third party; (vii) Landlord refuses to relet the Premises because the proposed tenant is unwilling to execute and deliver Landlord’s standard lease form or such tenant requires improvements to the Premises to be paid at Landlord’s cost and expense; (viii) Landlord refuses to relet the Premises to a person or entity whose character or reputation, or the nature of such prospective tenant’s business, would not be acceptable to Landlord in its reasonable discretion; or (ix) Landlord refuses to expend any material sums of money to market the Premises in excess of the sums Landlord typically expends in connection with the marketing of other space in the Building.

21.4 No Waiver. If Landlord shall institute proceedings against Tenant and a compromise or settlement thereof shall be made, the same shall not constitute a waiver of any other covenant, condition or agreement herein contained, nor of any of Landlord’s rights hereunder. No waiver by Landlord of any breach shall operate as a waiver of such covenant, condition or agreement itself, or of any subsequent breach thereof. No payment of Rent by Tenant or acceptance of Rent by Landlord shall operate as a waiver of any breach or default by Tenant under this Lease. No payment by Tenant or receipt by Landlord of a lesser amount than the monthly installment of Rent herein stipulated shall be deemed to be other than a payment on account of the earliest unpaid Rent, nor shall any endorsement or statement on any check or communication accompanying a check for the payment of Rent be deemed an accord and satisfaction, and Landlord may accept such check or payment without prejudice to Landlord’s right to recover the balance of such Rent or to pursue any other remedy provided in this Lease. No act, omission, reletting or re-entry by Landlord, and no acceptance by Landlord of keys from Tenant, shall be considered an acceptance of a surrender of the Lease, shall be construed as an actual or constructive eviction of Tenant, or an election on the part of Landlord to terminate this Lease unless a written notice of such intention is given to Tenant by Landlord.

21.5 Late Payment. If Tenant fails to pay any Rent within 5 days after such Rent becomes due and payable, Tenant shall pay to Landlord a late charge of 10% of the amount of such overdue Rent. Such late charge shall be deemed Rent and shall due and payable within ten (10) days after written demand from Landlord. Tenant hereby acknowledges that late payment by Tenant to Landlord of Rent or other sums due hereunder will cause Landlord to incur costs not contemplated by this Lease, the exact amount of which is not readily ascertainable. Such costs include, but are not limited to, processing and accounting charges, and late charges which may be imposed upon Landlord by the terms of any mortgage or deed of trust covering the Premises and/or Property. Acceptance of such late charges by Landlord shall in no event constitute a waiver of Tenant’s default with respect to such overdue amounts, nor prevent Landlord from exercising any of the other rights and remedies granted hereunder.

21.6 Waiver of Redemption. Tenant hereby waives, for itself and all persons claiming by and under Tenant, all rights and privileges which it might have under any present or future law to redeem the Premises or to continue this Lease after being dispossessed or ejected from the Premises.

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21.7 Landlord’s Lien. To secure the payment of all Rent due and to become due hereunder and the faithful performance of all the other covenants of this Lease required by Tenant to be performed, Tenant hereby gives to Landlord an express contract lien on and security interest in all property, chattels, or merchandise which may be placed in the Premises and also upon all proceeds of any insurance which may accrue to Tenant by reason of damage to or destruction of any such property. All exemption laws are hereby waived by Tenant. This lien and security interest are given in addition to any Landlord’s statutory lien(s) and shall be cumulative thereto. Tenant authorizes Landlord to execute and file Uniform Commercial Code financing statements relating to the aforesaid security interest. If an Event of Default occurs, then Landlord will be entitled to exercise any or all rights and remedies under the Uniform Commercial Code, this Lease or by law and may sell any of the property described above at a public or private sale upon 10 days notice to Tenant, which notice Tenant stipulates is adequate and reasonable.

XXII. BROKER

Landlord recognizes Broker(s) as the sole broker(s) procuring this Lease and shall pay Broker(s) a commission therefor pursuant to a separate agreement between Broker(s) and Landlord. Landlord and Tenant each represents and warrants to the other that it has dealt with no broker, agent finder or other person other than Broker(s) relating to this Lease. Landlord shall indemnify and hold Tenant harmless, and Tenant shall indemnify and hold Landlord harmless, from and against any and all loss, costs, damages or expenses (including, without limitation, all attorneys fees and disbursements) by reason of any claim of liability to or from any broker or person arising from or out of any breach of the indemnitor’s representation and warranty.

XXIII. ESTOPPEL CERTIFICATES

Tenant agrees, at any time and from time to time, as requested by Landlord, to execute and deliver to Landlord (and to any existing or prospective mortgage lender, ground lessor, or purchaser designated by Landlord), within ten (10) days after the request therefor, a statement certifying that this Lease is unmodified and in full force and effect (or if there have been modifications, that the same is in full force and effect as modified and stating the modifications); certifying the dates to which the Rent has been paid; stating whether or not Landlord is in default in performance of any of its obligations under this Lease, and, if so, specifying each such default; and stating whether or not any event has occurred which, with the giving of notice or passage of time, or both, would constitute such a default, and, if so, specifying each such event. Any such statement delivered pursuant hereto shall be deemed a representation and warranty to be relied upon by Landlord and by others with whom such party may be dealing, regardless of independent investigation. Tenant also shall include in any such statements such other information concerning this Lease as Landlord may reasonably request including, but not limited to, the amount of Basic Rent and Additional Rent under this Lease, and whether Landlord has completed all improvements to the Premises required under this Lease,

XXIV. ENVIRONMENTAL

24.1 Hazardous Material. Tenant shall not cause or permit any Hazardous Material (as hereinafter defined) to be brought upon, kept or used in or about the Property and/or Premises by Tenant or its Agents, except for such Hazardous Material as is necessary for Tenant’s business. Any Hazardous Material permitted on the Property and/or Premises as provided herein, and all containers therefor, shall be used, kept, stored and disposed of in a manner that complies with all federal, state and local laws or regulations applicable to such Hazardous Material. Title to Hazardous Materials will remain and be stored or disposed of solely in Tenant’s name. Tenant shall not release, discharge, leak or emit or permit to be released, discharged, leaked or emitted, any material into the atmosphere, ground, ground water, surface water, storm or sanitary sewer system or any body of water, any Hazardous Material or any other material (as is reasonably determined by Landlord or any governmental authority) which may pollute or contaminate the same or may adversely affect (a) the health, welfare or safety of persons, or (b) the condition, use or enjoyment of the Property and/or Premises, or any other real or personal property. At the commencement of the Lease Term and each year thereafter during the Lease Term, Tenant shall disclose to Landlord the names and approximate amounts of all Hazardous Material that Tenant intends to store, use or dispose of on the Property and/or Premises during such year. In addition, at the commencement of each year during the Lease Term, beginning with the second such year, Tenant shall disclose to Landlord the names and amounts of all Hazardous Materials that were actually used, stored or disposed of on the Property and/or Premises if such materials were not previously identified to Landlord at the commencement of the previous year.

24.2 Definition. As used herein, “Hazardous Material” means (a) any “hazardous waste” as defined by the Resource Conservation and Recovery Act of 1976, as amended from time to time, and regulations promulgated thereunder (or any state counterpart to the foregoing statute); (b) any “hazardous substance” as defined by the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended from time to time, and regulations promulgated thereunder (or any state counterpart to the foregoing statute); (c) any oil, petroleum products and their by-products; (d) asbestos; (e) polychlorobiphenyls (“PCB”); and (f) any substance that is or becomes regulated by any federal, state or local governmental authority.

24.3 Tenant’s Liability. Tenant hereby agrees that it shall be fully liable for all costs and expense related to the use, storage and disposal of Hazardous Material kept on the Property and/or Premises by Tenants, its agents, employees and/or contractors, and Tenant shall give immediate notice to Landlord of any violation or potential violation of the provisions of Section 24.1 above. Tenant shall defend, indemnify and hold Landlord and its Agents harmless from and against any claims, demands, penalties, fines, liabilities, settlements, damages, costs or expenses (including without limitation, attorneys’ and consultants’ fees, court costs and litigation expense) of whatever kind or nature, known or unknown contingent or otherwise, arising out of or in any way related to (a) the presence, disposal, release or threatened release of any such Hazardous Material by Tenant, its agents, employees and/or contractors, that is on, from or affecting the soil, water, vegetation, buildings, personal property, persons, animals or otherwise located on or around the Premises; (b) any personal injury (including wrongful death), property damage (real or personal) arising out of or related to such Hazardous Material by Tenant, its agents, employees and/or contractors; (c) any lawsuit brought or threatened, settlement reached or government order relating to such Hazardous Material; (d) any violation of any laws applicable thereto by Tenant, its agents, employees and/or contractors; (e) a decrease in value of the Property and/or Premises, (f) damages caused by loss or restriction of rentable or usable space; and (g) damages caused by adverse impact on marketing of the space. Without limitation of the foregoing, if the Tenant causes or permits the presence of any Hazardous Materials on the Property and/or Premises which results in contamination, Tenant shall promptly, at its sole expense, take any and all necessary actions to return the Property and/or Premises to the condition existing prior to the presence of any such Hazardous Material on the Property and/or Premises. Tenant shall first obtain Landlord’s approval for any such remedial action. The provisions of this Section 24.3 shall be in addition to any other obligations and liabilities Tenant may have to Landlord at law or in equity and shall survive the transactions contemplated herein and shall survive the termination of this Lease.

24.4 Landlord’s Liability. Landlord shall indemnify, defend and hold harmless Tenant from and against any and all claims, damages, fines, judgments, penalties, costs, liabilities, losses and reasonable attorney’s fees to the extent caused by Landlord or its Agents and (i) arising out of or in connection with the existence of Hazardous Materials on the Property or Premises; or (ii) relating to any clean-up or remediation of the Property or Premises required under any applicable environmental laws. The obligations of Landlord under this Section 24.04 shall survive the Term of this Lease.

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XXV. SIGNAGE

Except as expressly provided for in this Article XXV, no sign, advertisement or notice shall be inscribed, painted, affixed, placed or otherwise displayed by Tenant on any part of the Property or the outside or the inside of the Building to the extent visible from the exterior of the Premises, Building or Property. Landlord shall provide, at Tenant’s expense; provided, however, Tenant shall have access to the Tenant Improvement Allowance (as defined in the Work Agreement) for payment of same, signage on the entry door to the Premises listing Tenant’s name and suite number in Building standard sign material and lettering. If any prohibited sign, advertisement or notice is nevertheless exhibited by Tenant, Landlord shall have the right to remove the same, and Tenant shall pay upon demand any and all expenses incurred by Landlord in such removal, together with interest thereon at the Interest Rate from the demand date.

XXVI. MISCELLANEOUS

26.1 Merger. Tenant expressly acknowledges and agrees that Landlord has not made and is not making, and Tenant, in executing and delivering this Lease, is not relying upon, any warranties, representations, promises, or statements, except to the extent that the same are expressly set forth in this Lease. All prior understandings and agreements between the parties are merged in this Lease (which includes the Exhibits attached hereto and made a part hereof), which alone fully and completely express the agreement of the parties. No agreement shall be effective to change, modify, waive, release, discharge, terminate or effect an abandonment of this Lease, in whole or in part, unless such agreement is in writing, and is signed by the party against whom enforcement of said change or modification is sought.

26.2 Notices. Any notice required to be given by either party pursuant to this Lease, shall be in writing and shall be deemed to have been properly given, rendered or made only if personally delivered, if sent by Federal Express or other comparable delivery service, or if sent by registered or certified mail, return receipt requested, postage prepaid, addressed to the other party at the addresses set forth below (or to such other address as Landlord or Tenant may designate to each other from time to time by written notice), and shall be deemed to have been received upon the earlier of receipt or, if mailed by certified mail, 3 days after such mailing:

If to Landlord:	US INDUSTRIAL REIT II
	c/o USAA Real Estate Company
	9830 Colonnade Blvd., Suite 600
	San Antonio, Texas 78230-2239
	Attention: VP - Portfolio Management
With a copy to:	USAA Real Estate Company
	9830 Colonnade Blvd., Suite 600.
	San Antonio, Texas 78230-2239
	Attention: VP - Real Estate Counsel
	The Flynn Company
	1621 Wood Street
	Philadelphia, PA 19103
	Attention: Property Manager
If to Tenant:	DS Distribution, Inc.
	411 108th Avenue NE, Suite 1400
	Bellevue, WA 98004
	Attention: Nathan Garnett, GC
With a copy to:	Pepper Hamilton, LLP
	Suite 400
	301 Carnegie Center
	Princeton, NJ 08543
	Attention: Andrea M. David, Esq.

26.3 Non-Waiver. The failure of either party to insist, in any one or more instances, upon the strict performance of any one or more of the obligations of this Lease, or to exercise any election herein contained, shall not be construed as a waiver or relinquishment for the future of the performance of such one or more obligations of this Lease or of the right to exercise such election, but the Lease shall continue and remain in full force and effect with respect to any subsequent breach, act or omission. The receipt by Landlord of Rent with knowledge of breach by Tenant of any obligation of this Lease shall not be deemed a waiver of such breach.

26.4 Parties Bound. Except as otherwise expressly provided for in this Lease, this Lease shall be binding upon, and inure to the benefit of, the successors and assignees of the parties hereto. However, the obligations of Landlord shall not be binding upon Landlord herein named with respect to any period subsequent to the conveyance and transfer of its entire interest in the Building, as owner thereof, and in the event of such conveyance and transfer, said obligations shall thereafter be binding upon each transferee, and Tenant waives all rights and causes of action Tenant may then have, as against the Landlord herein named. Submission of this instrument by Landlord to Tenant for examination shall not bind Landlord in any manner, and no lease, option, agreement to lease or other obligation of Landlord shall arise until the instrument is signed by, and delivered to, both Landlord and Tenant. Notwithstanding anything to the contrary in this Lease, the liability of Landlord hereunder and any recourse by Tenant against Landlord shall be limited solely and exclusively to an amount equal to the interest of Landlord in the Property, and neither Landlord, nor any of its constituent partners, shall have any personal liability therefor.

26.5 Recordation of Lease. Tenant shall not record or file this Lease in the public records of any county or state.

26.6 Survival of Obligations. Upon the Expiration Date or other termination of this Lease, neither party shall have any further obligation or liability to the other except as otherwise expressly provided in this Lease and except for such obligations as, by their nature or under the circumstances, can only be, or by the provisions of this Lease, may be, performed after such expiration or other termination; and, in any event, unless otherwise expressly provided in this Lease, any liability for any payment hereunder which shall have accrued to, or with respect to, any period ending at the time of expiration or other termination of this Lease shall survive the Expiration Date or other termination of this Lease.

26.7 Prorations. Any apportionments or prorations of Rent to be made under this Lease shall be computed on the basis of a year containing three hundred sixty (360) days, consisting of twelve (12) months of thirty (30) days each.

26.8 Governing Law; Construction. This Lease shall be governed by and construed in accordance with the laws of the state in which the Project is located. If any provision of this Lease or the application thereof to any person or circumstance shall, for any reason and to any extent, be invalid or unenforceable, the remainder of this Lease and the application of that provision to other persons or circumstances shall not be affected but rather shall be enforced to the extent permitted by law. The captions, headings and titles in this Lease are solely for

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convenience of reference and shall not affect its interpretation. This Lease shall be construed without regard to any presumption or other rule requiring construction against the party causing this Lease to be drafted. Each covenant, agreement, obligation, or other provision of this Lease on Tenant’s part to be performed, shall be deemed and construed as a separate and independent covenant of Tenant, not dependent on any other provision of this Lease. All terms and words used in this Lease, regardless of the number or gender in which they are used, shall be deemed to include any other number and any other gender as the context may require.

26.9 Time. Time is of the essence of this Lease and in the performance of all obligations hereunder. If the time for performance hereunder falls on a Saturday, Sunday or a day which is recognized as a holiday in the state in which the Project is located, then such time shall be deemed extended to the next day that is not a Saturday, Sunday or holiday in the state in which the Project is located.

26.10 Authority of Tenant.

(a) If Tenant signs as a corporation, the person executing this Lease on behalf of Tenant hereby represents and warrants that Tenant is a duly formed and validly existing corporation, in good standing, qualified to do business in the district in which the Project is located, that the corporation has full power and authority to enter into this Lease and that he or she is authorized to execute this Lease on behalf of the corporation. Tenant further agrees that it shall provide Landlord with a secretary’s certificate from the secretary of said corporation certifying as to the above in the form of EXHIBIT C attached hereto and made a part hereof.

(b) If Tenant signs as a partnership or limited liability company, the person executing this Lease on behalf of Tenant hereby represents and warrants that Tenant is a duly formed, validly existing partnership or limited liability company, as applicable, qualified to do business in the applicable state, that the partnership or limited liability company, as applicable, has full power and authority to enter into this Lease, and that he or she is authorized to execute this Lease on behalf of the partnership or limited liability company, as applicable. Tenant further agrees that it shall provide Landlord with an authorization from the partnership or limited liability company, as applicable, certifying as to the above in a form acceptable to Landlord.

26.11 Security. Landlord makes no representation or warranty regarding security at the Property, the Building or the Project. If Tenant requests security services and Landlord approves such services, Tenant shall pay the cost of all such security services.

26.12 Financial Reports. Prior to the execution of this Lease by Tenant and thereafter within 15 days after Landlord’s request, Tenant will furnish Tenant’s most recent audited financial statements (including any notes to them) to Landlord, or, if no such audited statements have been prepared, such other financial statements (and notes to them) as may have been prepared by an independent certified public accountant, or, failing those, Tenant’s internally prepared financial statements, certified by Tenant.

26.13 Rules and Regulations. Tenant and its Agents shall at all times abide by and observe the Rules and Regulations set forth in Exhibit D and any amendments thereto that may reasonably be promulgated from time to time by Landlord for the operation and maintenance of the Project and the Rules and Regulations shall be deemed to be covenants of the Lease to be performed and/or observed by Tenant. Nothing contained in this Lease shall be construed to impose upon Landlord any duty or obligation to enforce the Rules and Regulations, or the terms or provisions contained in any other lease, against any other tenant of the Project. Landlord shall not be liable to Tenant for any violation by any party of the Rules and Regulations or the terms of any other Project lease. If there is any inconsistency between this Lease (other than Exhibit D) and the then current Rules and Regulations, this Lease shall govern.

26.14 Force Majeure. The obligations of Tenant hereunder shall not be affected, impaired or excused, and Landlord shall have no liability whatsoever to Tenant, with respect to any act, event or circumstances arising out of (a) Landlord failing to fulfill, or delaying in fulfilling any of its obligations under this Lease by reason of fire; earthquake; explosion; flood; hurricane; the elements; acts of God or the public enemy; actions, restrictions, governmental authorities (permitting or inspection), governmental regulation of the sale of materials or supplies or the transportation thereof; war; invasion; insurrection; rebellion; riots; strikes or lockouts, inability to obtain necessary materials, goods, equipment, services, utilities or labor; or any other cause whether similar or dissimilar to the foregoing; or (b) any failure or defect in the supply, quantity or character of electricity, gas, steam or water furnished to the Premises, or by reason of any requirement, act or omission of any public utility or others serving the Property, beyond Landlord’s reasonable control. Tenant shall not hold Landlord liable for any latent defect in the Premises or the Building nor shall Landlord be liable for injury or damage to person or property caused by fire, or theft, or resulting from the operation of heating or air conditioning or lighting apparatus, or from falling plaster, or from steam, gas, electricity, water, rain, snow, ice, or dampness, which may leak or flow from any part of the Building, or from the pipes, appliances or plumbing work of the same. Tenant agrees that under no circumstances shall Landlord be liable to Tenant or any third party for any loss of, destruction of, damage to or shortage of any property; including, by way of illustration and not limitation, equipment, goods or merchandise, including Tenant’s Property placed on the Premises or suffered to be placed thereon by Tenant, it being the intention of the parties hereto that the risk of any and all such loss, destruction, damage or shortage shall be borne by Tenant.

26.15 Waiver of Jury Trial. Landlord and Tenant each waive trial by jury in connection with proceedings or counterclaims brought by either of the parties against the other with respect to any matter whatsoever arising out of or in any way connected with this Lease, the relationship of Landlord and Tenant hereunder or Tenant’s use or occupancy of the Premises.

26.16 Attorneys’ Fees. If either Landlord or Tenant commences or engages in any legal action or proceeding against the other party (including, without limitation, litigation or arbitration) arising out of or in connection with the Lease, the Premises, the Property or the Project (including, without limitation (a) the enforcement or interpretation of either party’s rights or obligations under this Lease (whether in contract, tort, or both) or (b) the declaration of any rights or obligations under this Lease), the prevailing party shall be entitled to recover from the losing party reasonable attorneys’ fees, together with any costs and expenses, incurred in any such action or proceeding, including any attorneys’ fees, costs, and expenses incurred on collection and on appeal.

26.17 Intentionally Deleted.

26.18 Landlord’s Fees. Whenever Tenant requests Landlord to take any action or give any consent required or permitted under this Lease, Tenant will reimburse Landlord for all of Landlord’s costs incurred in reviewing the proposed action or consent, including, without limitation, attorneys’, engineers’ or architects’ fees, not to exceed $1,000 per review, within 10 days after Landlord’s delivery to Tenant of a statement of such costs. Tenant will be obligated to make such reimbursement without regard to whether Landlord consents to any such proposed action.

26.19 Light, Air or View Rights. Any diminution or shutting off of light, air or view by any structure which may be erected on lands adjacent to or in the vicinity of the Building and Project shall not affect this Lease, abate any payment owed by Tenant hereunder or otherwise impose any liability on Landlord.

26.20 Counterparts. This Lease may be executed in one or more counterparts, each of which shall constitute an original and all of which shall be one and the same agreement.

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26.21 Nondisclosure of Lease Terms. Tenant acknowledges and agrees that the terms of this Lease are confidential and constitute proprietary information of Landlord. Disclosure of the terms could adversely affect the ability of Landlord to negotiate other leases and impair Landlord’s relationship with other tenants. Accordingly, Tenant agrees that it, and its Agents shall not intentionally or voluntarily disclose the terms and conditions of this Lease to any newspaper or other publication or any other tenant or apparent prospective tenant of the Building, the Premises or the Project, without the prior written consent of Landlord, provided, however, that Tenant may disclose the terms to prospective subtenants or assignees under this Lease.

26.22 Joint and Several Obligations. If more than one person or entity executes this Lease as Tenant, their execution of this Lease will constitute their covenant and agreement that: (i) each of them is jointly and severally liable for the keeping, observing and performing of all of the terms, covenants, conditions, provisions and agreements of this Lease to be kept, observed and performed by Tenant; and (ii) the term “Tenant” as used in this Lease means and includes each of them jointly and severally. The act of or notice from, or the signature of any one or more of them, with respect to the tenancy of this Lease, including, but not limited to the exercise of any options hereunder, will be binding upon each and all of the persons executing this Lease as Tenant with the same force and effect as if each and all of them had so acted.

26.23 Notice of Lease Term Dates. Within thirty (30) days after the Commencement Date, Landlord and Tenant shall execute the Notice of Lease Term Dates, the form of which is attached hereto as Exhibit E and made a part hereof.

26.24 Anti-Terrorism. Tenant represents and warrants to and covenants with Landlord that (i) neither Tenant nor any of its owners or affiliates currently are, or shall be at any time during the term hereof, in violation of any laws relating to terrorism or money laundering (collectively, the “Anti-Terrorism Laws”), including without limitation Executive Order No. 13224 on Terrorist Financing, effective September 24, 2001, and regulations of the U.S. Treasury Department’s Office of Foreign Assets Control (OFAC) related to Specially Designated Nationals and Blocked Persons (SDN’s OFAC Regulations), and/or the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (Public Law 107-56) (the “USA Patriot Act”); (ii) neither Tenant nor any of its owners, affiliates, investors, officers, directors, employees, vendors, subcontractors or agents is or shall be during the term hereof a “Prohibited Person” which is defined as follows: (1) a person or entity owned or controlled by, affiliated with, or acting for or on behalf of, any person or entity that is identified as an SDN on the then-most current list published by OFAC at its official website, http://www.treas.gov/offices/eotffc/ofac/sdn/t11sdn.pdf, or at any replacement website or other replacement official publication of such list, and (2) a person or entity who is identified as or affiliated with a person or entity designated as a terrorist, or associated with terrorism or money laundering pursuant to regulations promulgated in connection with the USA Patriot Act; and (iii) Tenant has taken appropriate steps to understand its legal obligations under the Anti-Terrorism Laws and has implemented appropriate procedures to assure its continued compliance with such laws. Tenant hereby agrees to defend, indemnify, and hold harmless Landlord, it officers, directors, agents and employees, from and against any and all claims, damages, losses, risks, liabilities and expenses (including attorney’s fees and costs) arising from or related to any breach of the foregoing representations, warranties and covenants. At any time and from time-to-time during the term, Tenant shall deliver to Landlord within ten (10) days after receipt of a written request therefor, a written certification or such other evidence reasonably acceptable to Landlord evidencing and confirming Tenant’s compliance with this paragraph.

IN WITNESS WHEREOF, Landlord and Tenant have duly executed this Lease as of the day and year first above written.

LANDLORD:	TENANT:
US INDUSTRIAL REIT II	DS DISTRIBUTION, INC.
a Texas real estate investment trust	a Delaware corporation
By:	By:
Name:	Name:
Title:	Title:

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EX-10.18

Exhibit 10.18

FIRST AMENDMENT TO INDUSTRIAL BUILDING LEASE

THIS FIRST AMENDMENT TO INDUSTRIAL BUILDING LEASE (the “Amendment”) is made this             day of             , 2007, between US INDUSTRIAL REIT II, a Texas real estate investment trust (hereinafter referred to as “Landlord”) and DS DISTRIBUTION, INC., a Delaware corporation (hereinafter referred to as “Tenant”).

W I T N E S S E T H:

WHEREAS, Landlord and Tenant entered into that certain Industrial Building Lease dated June 20, 2007 (the “Lease”) pursuant to which Landlord agreed to lease to Tenant and Tenant agreed to lease from Landlord, certain Premises containing 85,080 Rentable Square Feet known as Suite 300 in the building located at 1130 Commerce Boulevard, Logan Township, New Jersey (the “Building”); and

WHEREAS, the parties hereto desire to modify the Lease to reflect that the square footage of the Premises through July 31, 2008, shall be 69,015 Rentable Square Feet for the purposes of Basic Rent only as set forth herein (Tenant’s proportionate share shall remain 22.04%); and

WHEREAS, any capitalized terms not otherwise defined in this Amendment shall have the meanings ascribed to them in the Lease.

NOW, THEREFORE, in consideration of the mutual covenants and agreements hereinafter set forth, and for other good and valuable consideration, the mutual receipt and legal sufficiency of which are hereby acknowledged, Landlord and Tenant hereby agree as follows:

1. Basic Rent. Section 1.12 of the Lease is hereby deleted and the following rent schedule is substituted in lieu thereof:

“1.12 Basic Rent. The amount set forth in the following schedule, subject to adjustment as specified in Article IV.

Month(s)	Approximate Annual Rent (PSF)			Monthly Basic Rent			Annual Basic Rent
CD-7/31/08	$	4.25	*	$	24,442.81	*	$	293,313.72	**
8/1/08-7/31/09	$	4.36		$	30,912.40		$	370,948.80
8/1/09-7/31/10	$	4.47		$	31,692.30		$	380,307.60
8/1/10-2/28/11	$	4.58		$	32,472.20		$	389,666.40	**

* Provided that no Event of Default (as defined in Section 21 of the Lease) occurs under the Lease, the Basic Rent shall be abated for the first ninety (90) days following the Commencement Date (“Abatement Period”). All of the terms and conditions of the Lease shall remain in full force and effect during the foregoing Abatement Period, including the obligation to pay Additional Rent, if any. If any Event of Default occurs under the Lease, the Basic Rent abatement provided for herein shall immediately terminate.

** Annualized amount

2. Brokers. Tenant and Landlord each represent that it has not had any dealings with a real estate broker, finder or other person with respect to this Amendment in any manner, and that no commissions are due as a result of this Amendment. Each party shall indemnify the other party against all costs or liabilities for commissions or compensation claimed by any broker or agent claiming the same by, through, or under the indemnifying party.

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3. This Amendment shall not be effective or binding until such time as it has been executed and delivered by all parties hereto. This Amendment may be executed in counterparts, all of which shall constitute a single agreement.

4. Except as modified by this Amendment, the Lease and all terms, conditions, covenants and agreements thereof shall remain in full force and effect and are hereby in all respects ratified and confirmed. For the avoidance of doubt, Landlord reserves all of its rights and remedies under the Lease and no provision of the Lease shall be waived, except by an instrument in writing (referring specifically to the Lease) executed by the party against whom waiver is sought.

5. In the event of a conflict between this Amendment and any other provision of the Lease, this Amendment shall control.

SIGNATURES ON FOLLOWING PAGE

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LANDLORD:
US INDUSTRIAL REIT II,
a Texas real estate investment trust
By:
Name:	Lewis Friedland
Title:	President

TENANT:

DS DISTRIBUTION, INC.

a Delaware corporation

By:

Name:

Title:

EX-10.21

Exhibit 10.21

SUBLEASE

THIS SUBLEASE is entered into December 10, 2007 between drugstore.com, Inc., a Delaware corporation (“Subtenant”), and ROD ASHER AND ASSOCIATES, LTD., a Washington corporation (“Sublandlord”).

RECITALS

A. Sublandlord has leased from EOP-NORTHWEST PROPERTIES, L.L.C., a Delaware limited liability company, as predecessor in interest to W2007 SEATTLE OFFICE ONE BELLEVUE CENTER REALTY, LLC, a Delaware limited liability company (“Master Landlord”) certain premises described in the Office Lease Agreement dated March 3, 2004, between Master Landlord and Sublandlord. A copy of the referenced lease is attached as Exhibit A to this Sublease (the “Master Lease”).

B. The premises under the Master Lease are composed of approximately 3,206 rentable square feet of space (as re-measured in 2007, but as incorrectly identified in the Master Lease as 3,138 rentable square feet) on the twentieth (20th) floor, as depicted on the attached Exhibit B (the “Master Lease Premises”) in a building commonly called “One Bellevue Center” located at 411 108^th Avenue N.E., Bellevue, Washington, 98004 (the “Building”).

C. Subtenant desires to sublease from Sublandlord and Sublandlord desires to sublease to Subtenant a portion of the Master Lease Premises in the amount of 1,364 rentable square feet (the “Sublease Premises”) on the terms and conditions set forth in this Sublease (the “Sublease”). The Sublease Premises are that portion of the Master Lease Premises depicted on Exhibit B by cross-hatching.

D. Except as specifically set forth herein, all capitalized terms used in this Sublease shall have the meanings set forth in the Master Lease.

AGREEMENT

NOW, THEREFORE, in consideration of the rent payable hereunder, the mutual covenants contained herein, and other good and valuable consideration, the parties agree as follows:

1. AGREEMENT TO SUBLEASE. Subject to Master Landlord’s written consent to the terms of this Sublease (“Master Landlord’s Consent”), Sublandlord hereby subleases the Sublease Premises to Subtenant and Subtenant hereby subleases the Sublease Premises from Sublandlord on the terms and conditions set forth in this Sublease. The recitals set forth above are incorporated into this Sublease as part of the agreement by this reference.

2. TERM. The term of this Sublease shall be for a period of twelve (12) calendar months commencing on January 1, 2008 and ending on December 31, 2008, unless sooner terminated as provided herein or in the Master Lease (the “Term”).

2.1 Extension of Term. The Term may be extended at Subtenant’s election for the remaining seven (7) month term of the Master Lease, which term expires on July 31, 2009. If the Subtenant elects to extend the Term of this Sublease, then the extended Term shall end on July 30, 2009. Subtenant may elect to extend the Term by providing Sublandlord written notice of its exercise of the extension of the Term on or before November 1, 2008. If the Term is extended by Subtenant’s election, then all the terms of this Sublease continue in effect as written through the end of the extended Term.

3. RENT.

3.1 Rent. Subtenant covenants and agrees to pay rent to Sublandlord on a full service basis, with no other amounts due hereunder absent Subtenant’s default (i.e., “Gross Rent”) in monthly installments during the Term in the total amount of $2,728 per month (which is calculated at an annual rate of $24 per rentable square foot), on the first day of each calendar month during the Term commencing January 1, 2008. Gross Rent, together with any amounts payable under Section 3.2 below as Additional Rent, constitutes Subtenant’s entire obligation for rent of any kind under this Sublease, notwithstanding any incorporated provision of the Master Lease.

3.2 Additional Rent. While this Sublease is a fully serviced, gross rent sublease, during the Term Subtenant is responsible to pay and shall pay directly to the service providers when due all costs of telephone and data connections and service provided to the Sublease Premises (the “Additional Rent”). Gross Rent and Additional Rent are sometimes herein referred to collectively as “Rent.” Except for the Rent, Subtenant shall not be required to pay any amounts due under the Master Lease.

3.3 Payment Terms. Gross Rent is due and payable monthly in advance on or before the first (1st) day of each month during the Term. The first monthly installment of Gross Rent shall be paid upon the full execution of this Sublease and delivery to Subtenant of the fully signed Master Landlord’s consent to this Sublease. Additional Rent shall be paid when due under Subtenant’s contracts with its service providers. Should the first or last day of the Term be adjusted by agreement of the parties or otherwise not fall on the first or last day of a month, respectively, then Gross Rent shall be prorated for that fractional month based on a thirty (30) day month, and the appropriate amounts paid or refunded within thirty (30) days after the adjusted date. If, following the end of the Term, Subtenant has unpaid Rent obligations under this Sublease, such payment obligations shall continue regardless of the termination of the Sublease. Except as otherwise specifically provided in this Sublease, Subtenant shall pay all installments of Rent in lawful money without demand, and without abatement, offset or deduction.

3.4 Payment Address. All Gross Rent shall be paid to Sublandlord at such address as Sublandlord may designate in writing. Initially such payments shall be made to Rod Asher and Associates, Ltd., and sent to 411 108^th Ave. N.E. Suite 2050, Bellevue, Washington 98004, Attn: Rodney Blumenstein.

3.5 Failure to Pay. If any payment of Gross Rent, or any other sum payable hereunder by Subtenant to Sublandlord, shall not be paid on or before the fifth (5th) day following the due date for the same provided herein, such delinquent payment shall bear interest from the date due until the date paid at the lesser of (a) the maximum rate allowed by law, or (b) an annual interest rate of two percent (2%) over the prime rate quoted by Bank of America, N.T.

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& S.A. at its downtown Seattle, Washington branch during the period such interest accrues. Sublandlord agrees to give Subtenant notice of its failure to receive payment of Rent before the fifth (5^th) day following the due date for Rent; provided failure to provide such notice shall not affect the accrual of interest as provided in this Section.

3.6 Security Deposit. No security deposit is required from Subtenant.

4. EARLY ACCESS. At any time following full execution of this Sublease, Subtenant may enter the Sublease Premises by appointment for the purpose of evaluating the space and any potential modifications that may be necessary for its occupancy and to have its new telephone and data cabling and services installed. Subtenant may enter the Sublease Premises beginning at 8:00 a.m. local time on December 11, 2007 to install its furniture and equipment so that it may begin its operations in the Sublease Premises on January 2, 2008. Subtenant shall be fully responsible for all damage or claims that may occur resulting from Subtenant’s acts during such period before the first day of the Term.

5. USE. Subtenant agrees that the Sublease Premises shall be used only for the permitted uses set forth in the Master Lease, and for no other use whatsoever without the express consent of the Sublandlord and Master Landlord.

6. ACCEPTANCE OF THE SUBLEASE PREMISES. Possession of the Sublease Premises shall be delivered to Subtenant on the first day of the Term in broom clean condition with all furniture and equipment removed (other than any Sublandlord Personal Property as defined in Section 7), all in accordance with the terms of this Sublease. Subject to satisfactory completion of the work by Sublandlord described in Section 6.1 below to a standard accepted by the Master Landlord, Subtenant accepts the Sublease Premises, the Sublandlord’s Personal Property “AS IS” as of the first day of the Term, and subject also to damage by Subtenant, its employees, agents or invitees during any early access granted in this Sublease to allow the installation of furniture and equipment; provided Sublandlord represents and warrants that it has kept and maintained, and agrees to keep and maintain, the Sublease Premises and its attendant cabling and related electrical, telecommunications or data transmission systems in good condition with no deferral of maintenance, and as otherwise required of Sublandlord under the Master Lease prior to the first day of the Term. Except as otherwise provided herein, Sublandlord is not required to do any work in, or make any improvements to, the Sublease Premises to prepare the Sublease Premises for Subtenant’s occupancy other than to deliver the Sublease Premises in broom clean condition on the first day of the Term. Subtenant acknowledges and agrees that neither Sublandlord nor Master Landlord has undertaken any other obligation to make or agreed to make any alteration or improvements to the Sublease Premises for Subtenant’s use or occupancy thereof, except as otherwise set forth herein. If Subtenant desires to alter or improve the Sublease Premises in any way, Subtenant shall first obtain Master Landlord’s prior written consent to any such alteration or improvement, and any such alterations or improvements shall be made in accordance with the Master Lease.

6.1 Improvements to the Sublease Premises. Subtenant is expressly allowed to install telephone and data services for the Sublease Premises, a key pad security access system on the door leading to the Premises, and locks on doors inside the Sublease Premises for its use during the early access period provided in Section 4 above. Subtenant shall have the right to install telephone and data equipment in the telephone closet in the common

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hallway and have the closet locked with access restricted to Subtenant, Sublandlord and Master Landlord. Subtenant shall pay directly to its vendors all costs of installing such services and equipment, including but not limited to the costs of adding any electrical, telephone and data outlets, jacks, wiring or cabling, adding an electrical key-pad security system on the exterior public hall-way door leading into the Sublease Premises, and adding door lock mechanisms throughout the Sublease Premises, as needed. On or before the first day of the Term, Sublandlord agrees to make and pay for the improvements needed to demise Sublandlord’s retained portion of the Master Lease Premises from the Sublease Premises, as more fully depicted on Exhibit B hereto. Such work shall be as set forth in the bid for construction services attached hereto as Exhibit C which includes the construction of an interior demising wall across the internal corridor of the Master Lease Premises finished with paint the color of the remainder of the walls in the Sublease Premises. Such work shall comply with the requirements of the Master Lease. If additional work is required by the Master Landlord, then either party shall have the right to terminate this Sublease upon notice to the other within two (2) business days following notice of the requirement for any such additional work.

7. PERSONAL PROPERTY. Subtenant may use the furniture, fixtures, electrical wiring and telecommunications and data cabling located in the Sublease Premises on the first day of the Term, including without limitation the existing receptionist desk, and the telecommunications and data cable runs back to the riser room in the hallway immediately outside of the Sublease Premises (the “Sublandlord’s Personal Property”) at no additional cost during the Term. Sublandlord and Subtenant shall compile and initial a written inventory of the Sublandord’s Personal Property as of the first day of the Term, and shall note the condition of such Sublandlord’s Personal Property on that inventory. Subtenant may use Sublandlord’s Personal Property at its own risk, and is solely responsible for all other cabling and telecommunications, data, internet and networking services and costs it may require. Subtenant: (a) accepts Sublandlord’s Personal Property in its “as is” condition as of the first day of the Term (subject to the last sentence of this Section and as the same may be affected by reasonable wear and tear after the date hereof), without warranty (express or implied) of any kind, including, without limitation, merchantability or fitness for use or any particular purpose; (b) shall maintain and keep the Sublandlord’s Personal Property in reasonably good repair, wear and tear excepted, throughout the Term, and shall insure Sublandlord’s Personal Property against loss or damage by fire or other casualty (and all of the provisions of this Sublease, including the provisions of the Master Lease that are incorporated herein, applicable to insurance required to be carried by Subtenant shall be applicable to Sublandlord’s Personal Property); and (c) surrender Sublandlord’s Personal Property to Sublandlord upon the expiration or sooner termination of the Term in the same condition as at the first day of the Term, as the same may be affected by reasonable wear and tear after the date hereof.

8. PARKING. No parking is being provided by Sublandlord to Subtenant.

9. INCORPORATION OF TERMS OF THE MASTER LEASE.

9.1 Except as expressly amended hereby, this Sublease is subject and subordinate to all the terms and conditions of the Master Lease and the Master Landlord’s consent to this Sublease, to the extent the terms and conditions apply to the Sublease Premises. Consistent with item 5 of Exhibit E to the Master Lease, Sublandlord consents and covenants to obtain Master Landlord’s consent, as part of the consent to this Sublease, to Subtenant’s

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installation of locks on the doors to the offices in the Sublease Premises. Except for Sections 11.2 and 21 of the Master Lease which is hereby expressly excluded from this Sublease, and except to the extent directly inconsistent with the terms of this Sublease, all of the terms of the Master Lease are hereby incorporated into and made a part of this Sublease as if stated at length herein, and Subtenant accepts this Sublease subject to, and hereby agrees to be bound by, all of the terms, covenants, conditions and agreements contained in the Master Lease, as modified by this Sublease. The parties hereto agree that subject to the provisions of this Sublease, wherever the phrase “Premises,” or words of similar import appear in the Master Lease, the same shall be deemed to mean the Sublease Premises and wherever the words “Landlord” and “Tenant” appear in the Master Lease, the words shall be deemed to refer to Sublandlord and Subtenant, respectively, so that, subject to the provisions of this Sublease, Sublandlord shall have the rights, powers and obligations of Master Landlord under the Master Lease, and Subtenant shall have and does hereby agree to be bound by and accepts all of the rights, powers, duties and obligations of the Tenant under the Master Lease relating to the Sublease Premises during the Term; provided, however, that notwithstanding the foregoing: (a) in all provisions of the Master Lease (before modification by this Sublease) requiring the approval or consent of Master Landlord, Subtenant shall obtain the approval or consent of both Sublandlord and Master Landlord, neither of which shall be unreasonably withheld, conditioned or delayed; (b) in all the provisions of the Master Lease requiring Tenant to submit, exhibit to, supply or provide Master Landlord with evidence, certificates or any other matter or thing, Subtenant shall perform the same for both Sublandlord and Master Landlord; and (c) Sublandlord shall have no obligation to restore or rebuild any portion of the Sublease Premises after any destruction or taking by eminent domain.

9.2 Subtenant shall not commit, nor permit to be committed on the Sublease Premises, any act or omission which would violate any term or condition of the Master Lease or be a cause for termination of the Master Lease by Master Landlord. Subtenant shall indemnify and hold Sublandlord harmless from any loss or claim arising from such violation, which obligations shall survive the termination of this Sublease.

9.3 In the event of any conflict between the Sublease and the Master Lease, the terms of the Sublease shall control. Subject to the foregoing, Subtenant covenants and agrees that it shall not cause a breach of any of the terms, covenants, or conditions of the Master Lease that continues beyond any applicable grace, notice or cure period.

9.4 Sublandlord covenants and agrees not to modify, or cause or suffer to be modified, the Master Lease without the express prior written consent of Subtenant to each modification.

10. TIME FOR NOTICES. For the purpose of this Sublease only, and subject to the provisions of Section 9 of this Sublease, by signing this Sublease and providing its consent, respectively, Sublandlord and Master Landlord agree that whenever in the Master Lease a time is specified for the giving of any notice or the making of any demand by Tenant thereunder, such time is hereby changed by adding two (2) business days thereto, and wherever in the Master Lease a time is specified for the giving of any notice or the making of any demand by the Landlord thereunder, such time is hereby changed by adding two (2) business days thereto in order to allow time for such notices to pass to and from Subtenant. For the purpose of this Sublease only, wherever in the Master Lease a time is specified within which the Tenant must

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respond to any notice, request or demand previously given or made by Landlord thereunder, or to comply with an obligation on Tenant’s part thereunder, such time is hereby changed by subtracting two (2) business days therefrom to allow Sublandlord to have the notice from Subtenant in time to respond to the Master Landlord. For the purposes of this Sublease only, wherever in the Master Lease a time is specified within which Landlord thereunder must give notice or make a demand following an event, or within which Tenant must respond to any notice, request or demand previously given or made by Tenant thereunder, or to comply with any obligation on Master Landlord’s part thereunder, such time is hereby changed by adding two (2) business days thereto. It is the purpose and intent of this Section to provide Sublandlord with time within which to transmit to Master Landlord any notice or demands received from the Subtenant, and provide Subtenant time within which to act on any notice or demands received from Sublandlord or the Master Landlord.

11. SUBTENANT’S AND SUBLANDLORD’S REPRESENTATIONS.

11.1 Sublandlord represents and warrants that Exhibit A contains a true, correct and complete copy of the Master Lease. Subtenant expressly assumes all of the responsibilities and obligations of Sublandlord under the Master Lease as it pertains to the Sublease Premises, except as otherwise expressly provided in this Sublease. Sublandlord agrees that Subtenant shall be entitled to receive all services and repairs to be provided by Landlord under the Master Lease. Sublandlord agrees that Subtenant shall have direct access to Master Landlord to obtain such services and need only provide Sublandlord notice of its communications regarding such services as provided in this Sublease.

11.2 Sublandlord represents and warrants that if Subtenant timely pays the Gross Rent and performs the terms and provisions hereunder, Subtenant shall peaceably and quietly have, hold and enjoy the Sublease Premises during the Term, free of lawful claims by any party acting by or through Sublandlord, subject to all other provisions of this Sublease. Sublandlord acknowledges that the amount of rent due under the Master Lease is greater than the Gross Rent payable under this Sublease, and thus covenants and agrees with Subtenant to timely pay when due all rent under the Master Lease and perform all obligations of Tenant under the Master Lease not expressly assumed by Subtenant under this Sublease.

11.3 Sublandlord represents and warrants that the Master Lease is in full force and effect, that to Sublandlord’s knowledge no default (nor event which with the passage of time could constitute a default) exists under the Master Lease (and that Sublandlord shall make a reasonable effort to obtain the consent of Master Landlord for this Sublease as required by Section 11 of the Master Lease).

11.4 Sublandlord will use reasonable efforts to obtain a nondisturbance agreement favoring Subtenant in any subordination or attornment agreement described in Section 23 of the Master Lease.

12. RISK OF LOSS. During the Term, Subtenant shall be fully responsible for and shall assume all risk of loss of its personal property, furniture, fixtures, equipment and furnishings in the Sublease Premises and Sublandlord’s Personal Property.

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13. INSURANCE. Without limiting the generality of any provision of this Sublease, Subtenant shall comply with the insurance requirements imposed upon Sublandlord as Tenant under the Master Lease. Subtenant agrees to name the Sublandlord and Master Landlord as additional insureds on insurance policies required under the Master Lease and under which the Landlord is required to be named as an additional insured under the Master Lease, and hereby releases Sublandlord and waives subrogation to the same extent as Tenant is required to release and waive subrogation with respect to Landlord under the Master Lease, and Sublandlord agrees to do the same for Subtenant.

14. MAINTENANCE AND REPAIRS. Subtenant shall repair and maintain the Sublease Premises in as good condition and repair substantially as existed on the first day of the Term, reasonable wear and tear, condemnation and casualty excepted.

15. SURRENDER. Upon the expiration or other termination of the Term, Subtenant covenants and agrees to quit and surrender to Sublandlord the Sublease Premises, in accordance with the terms of the Master Lease; provided, however, that in no event shall Subtenant be obligated to repair or restore the Sublease Premises to a condition better than the condition in which the Sublease Premises existed as of the commencement of the Term, reasonable wear and tear, and damage by casualty excepted, nor shall Subtenant be obligated to remove alterations or improvements to the Sublease Premises made by or for the account of itself or Sublandlord.

16. TRANSFER. Subtenant shall be subject to the provisions of Section 11 of the Master Lease with respect to a proposed assignment or sub-sublease; provided that any such transfer that requires the consent of Master Landlord shall also require the consent of Sublandlord, which consent may be granted or not on the standard and procedure in Section 11 of the Master Lease. If Subtenant assigns or sublets as permitted by the Master Lease and this Section, then Subtenant shall nevertheless remain responsible for the faithful performance and observance of all of its covenants and obligations set forth in this Sublease.

17. DEFAULT. If Subtenant fails to perform any obligation under this Sublease, then Sublandlord shall have all rights and remedies allowed to Master Landlord under the Master Lease and at law. If Subtenant shall remain in default in the performance of any of its obligations under this Sublease following the expiration of any applicable grace, notice or cure period, Sublandlord without being under any obligation to do so and without thereby waiving such default, may upon prior written notice to the Subtenant, remedy such default for the account and at the expense of Subtenant. If Sublandlord fails to perform any obligation under this Sublease, then Subtenant shall have all rights and remedies allowed to Tenant under the Master Lease. If Sublandlord shall remain in default in the performance of any of its obligations under the Master Lease or this Sublease following the expiration of any applicable grace, notice or cure period, Subtenant without being under any obligation to do so and without thereby waiving such default, may upon prior written notice to the Sublandlord, remedy such default for the account and at the expense of Sublandlord. If Master Landlord is in default under the Master Lease and fails to cure such default within any applicable cure periods (provided Subtenant has provided notice of such default to the same extent as Sublandlord is required under the Master Lease and subject to the additional time periods for response set forth in Section 10 of this Sublease), then Subtenant shall have the same rights to terminate this Sublease (whether by contract, statute or common law) as Sublandlord would have to terminate the Master Lease based on such default, and shall have such other rights and remedies as provided to Tenant under the Master Lease or at

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law. If Sublandlord is prevented from performing any of its obligations under this Sublease by a breach by Master Landlord, then Sublandlord shall use reasonable efforts in diligently pursuing correction or cure by Master Landlord of the breach, and in doing so shall cooperate and communicate with Subtenant on the subject.

18. MISCELLANEOUS PROVISIONS.

18.1 Attorneys’ Fees. If a suit, action, arbitration or other proceeding of any nature whatsoever, including without limitation any proceeding under the U.S. Bankruptcy Code, is instituted, or the services of an attorney are retained, to interpret or enforce any provision of this Sublease or with respect to any dispute relating to this Sublease, the prevailing party shall be entitled to recover from the losing party its attorneys’ fees, paralegal fees, accountant fees, and other expert fees, and all other fees, costs, and expenses actually incurred and reasonably necessary in connection therewith. In the event of suit, action, arbitration or other proceeding, the amount of fees shall be determined by the judge or arbitrator, shall include fees and expenses incurred on any appeal or review, and shall be in addition to all other amounts provided by law.

18.2 Brokers. Sublandlord and Subtenant each represent and warrant to each other that no brokers or real estate agents were involved in connection with the negotiation or consummation of this Sublease. Each party shall indemnify and hold the other harmless from any claim for a fee or commission by any person claiming such through such party other than the brokers listed in this Section, and from any damages resulting from breach of the representation and warranty in this Section.

18.3 Notices. Notices under this Sublease shall be in writing and shall be effective when actually delivered or two (2) days after depositing in the United States mail, certified, return receipt requested, directed to the other party at the addresses set forth below:

Subtenant:	drugstore.com, Inc.
	411 108th Avenue N.E., Suite 1400
	Bellevue, Washington 98004
	Attn: General Counsel
Sublandlord:	Rod Asher and Associates, Ltd.
	411 108th Avenue N.E., Suite 2050
	Bellevue, Washington 98004
	Attn: Rodney Blumenstein

Either party may change its notice address by not less than ten (10) days prior written notice to the other.

18.4 Delivery of Notice. Subtenant and Sublandlord shall promptly transmit to the other any notice or demands received from Master Landlord or any other party having an interest to which this Sublease is subordinate.

18.5 Submission of Sublease. The submission of this Sublease for review and consideration does not constitute an offer to sublease, or a reservation of or option for subleasing the Sublease Premises. The Sublease shall become effective and binding only upon execution and delivery hereof by Sublandlord and Subtenant, and consent thereto by Master Landlord.

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18.6 Counterparts. This Sublease may be executed in counterparts and be delivered and accepted by facsimile or electronic reproduction of an executed document, each of which shall be deemed an original, all of which taken together shall constitute one and the same instrument, provided that the parties shall, following execution, circulate, execute and deliver to each other one of three (3) ink signature originals, with the remaining original provided to the Master Landlord.

18.7 Complete Agreement. This Sublease constitutes the complete and final agreement of the parties with respect to the matters covered by this Sublease, and supersedes and replaces all prior written and oral agreements. All the Exhibits referenced in and attached to this Sublease are incorporated into this Sublease by this reference and made a part of this Sublease.

18.8 Master Landlord’s Consent. The effectiveness of this Sublease is conditioned on and subject to the written consent of Master Landlord to this Sublease, as required by Section 11 of the Master Lease. Sublandlord agrees to use diligent efforts to obtain such consent within ten (10) days following full execution of this Sublease. If such consent has not been obtained on or before the first day of the Term set forth above, then the Term of this Sublease shall not commence until such consent has been obtained. In such event, Subtenant shall have the right to terminate this Sublease by delivering written notice to Sublandlord. Sublandlord shall pay Master Landlord any review fee or other fee that may be charged by Master Landlord as a result of this Sublease.

IN WITNESS WHEREOF, the parties have executed this Sublease as of the date first set forth above.

SUBLANDLORD:	ROD ASHER AND ASSOCIATES, LTD.
	By:
		Its:

SUBTENANT:	drugstore.com, Inc.
	By:
		Its:

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STATE OF WASHINGTON                )

                                                                )ss.

COUNTY OF                                        )

On this              day of December, 2007, before me personally appeared                                                                                       , to me known to be the                                      of drugstore.com, Inc., the Delaware corporation that executed the within and foregoing instrument, and acknowledged said instrument to be the free and voluntary act and deed of said corporation, for the uses and purposes therein mentioned, and on oath stated that              was authorized to execute said instrument and that the seal affixed, if any, is the corporate seal of said corporation.

IN WITNESS WHEREOF, I have hereunto set my hand and affixed my official seal the day and year first above written.

Signature:

Name:(print)

NOTARY PUBLIC in and for the State

of Washington, residing at 

My appointment expires:

10

STATE OF WASHINGTON                )

                                                                )ss.

COUNTY OF                                        )

On this              day of December, 2007, before me personally appeared                                                                                       , to me known to be the                                      of Rod Asher And Associates, Ltd., the Washington corporation that executed the within and foregoing instrument, and acknowledged said instrument to be the free and voluntary act and deed of said corporation, for the uses and purposes therein mentioned, and on oath stated that              was authorized to execute said instrument and that the seal affixed, if any, is the corporate seal of said corporation.

IN WITNESS WHEREOF, I have hereunto set my hand and affixed my official seal the day and year first above written.

Signature:

Name:(print)

NOTARY PUBLIC in and for the State

of Washington, residing at 

My appointment expires:

11

EX-10.24

Exhibit 10.24

LOAN AND SECURITY AGREEMENT

THIS LOAN AND SECURITY AGREEMENT (this “Agreement”) dated as of March 5, 2009 (the “Effective Date”) by and among (i) SILICON VALLEY BANK, a California corporation with a loan production office located at 380 Interlocken Crescent, Suite 600, Broomfield, Colorado 80021 (“Bank”), and (ii) DRUGSTORE.COM, INC., a Delaware corporation, and each of the other Persons listed as “Borrower” on the signature pages hereto (individually and collectively, jointly and severally, “Borrower”), provides the terms on which Bank shall lend to Borrower and Borrower shall repay Bank. The parties agree as follows:

1 ACCOUNTING AND OTHER TERMS

Accounting terms not defined in this Agreement shall be construed following GAAP. Calculations and determinations must be made following GAAP. Capitalized terms not otherwise defined in this Agreement shall have the meanings set forth in Section 13. All other terms contained in this Agreement, unless otherwise indicated, shall have the meaning provided by the Code to the extent such terms are defined therein.

2 LOAN AND TERMS OF PAYMENT

2.1 Promise to Pay. Borrower hereby unconditionally promises to pay Bank the outstanding principal amount of all Credit Extensions and accrued and unpaid interest thereon as and when due in accordance with this Agreement.

2.1.1 Revolving Advances.

(a) Availability. Subject to the terms and conditions of this Agreement and to deduction of Reserves, Bank shall make Advances not exceeding the Availability Amount. Amounts borrowed under the Revolving Line may be repaid and, prior to the Revolving Line Maturity Date, reborrowed, subject to the applicable terms and conditions precedent herein. Advances shall be in minimum increments of $1,000,000 and multiples of $500,000 in excess thereof.

(b) Termination; Repayment. The Revolving Line terminates on the Revolving Line Maturity Date, when the principal amount of all Advances, the unpaid interest thereon, and all other Obligations relating to the Revolving Line shall be immediately due and payable.

2.1.2 Letters of Credit Sublimit.

As part of the Revolving Line and subject to deduction of Reserves, Bank shall issue or have issued Letters of Credit for Borrower’s account. Such aggregate amounts utilized hereunder shall at all times reduce the amount otherwise available for Advances under the Revolving Line. The face amount of outstanding Letters of Credit (including drawn but unreimbursed Letters of Credit and any Letter of Credit Reserve) may not exceed Two Million Five Hundred Thousand Dollars ($2,500,000), inclusive of Credit Extensions relating to Sections 2.1.3 and 2.1.4. The aggregate amount available to be used for the issuance of Letters of Credit may not exceed (i) the lesser of (A) the Revolving Line or (B) the Borrowing Base, minus (ii) the outstanding principal amount of any Advances (including any amounts used for Cash Management Services and the face amount of any outstanding Letters of Credit (including drawn but unreimbursed Letters of Credit and any Letter of Credit Reserve), minus (iii) the FX Reduction Amount, and (iv) minus (f) the aggregate amount of Advances that have been converted to a Term Loan. If, on the Revolving Line Maturity Date, or the effective date of any termination of this Agreement by Borrower, there are any outstanding Letters of Credit, then no later than five Business Days prior to such date Borrower shall provide to Bank cash collateral (in the form of a Bank certificate of deposit) in an amount equal to 105% of the face amount of all such Letters of Credit plus all interest, fees, and costs due or to become due in connection therewith (as estimated by Bank in its good faith business judgment), to secure all of the Obligations relating to said Letters of Credit. All Letters of Credit shall be in form and substance acceptable to Bank in its sole discretion and shall be subject to the terms and conditions of Bank’s standard Application and Letter of Credit Agreement (the “Letter of Credit Application”). Borrower agrees to execute any further documentation in connection with the Letters of Credit as Bank may reasonably request. Borrower further agrees to be bound by the regulations and interpretations of the issuer of any Letters of Credit guarantied by Bank and opened for Borrower’s account or by Bank’s interpretations of any Letter of Credit issued by Bank for Borrower’s account, and Borrower understands and agrees that Bank shall not be liable for any error, negligence, or mistake, whether of omission or commission, in following Borrower’s instructions or those contained in the Letters of Credit or any modifications, amendments, or supplements thereto.

(a) The obligation of Borrower to immediately reimburse Bank for drawings made under Letters of Credit shall be absolute, unconditional, and irrevocable, and shall be performed strictly in accordance with the terms of this Agreement, such Letters of Credit, and the Letter of Credit Application.

(b) Borrower may request that Bank issue a Letter of Credit payable in a Foreign Currency. If a demand for payment is made under any such Letter of Credit, Bank shall treat such demand as an Advance to Borrower of the equivalent of the amount thereof (plus fees and charges in connection therewith such as wire, cable, SWIFT or similar charges) in Dollars at the then-prevailing rate of exchange in San Francisco, California, for sales of the Foreign Currency for transfer to the country issuing such Foreign Currency.

(c) To guard against fluctuations in currency exchange rates, upon the issuance of any Letter of Credit payable in a Foreign Currency, Bank shall create a reserve (the “Letter of Credit Reserve”) under the Revolving Line in an amount equal to ten percent (10%) of the face amount of such Letter of Credit. The amount of the Letter of Credit Reserve may be adjusted by Bank from time to time to account for fluctuations in the exchange rate. The availability of funds under the Revolving Line shall be reduced by the amount of such Letter of Credit Reserve for as long as such Letter of Credit remains outstanding.

2.1.3 Foreign Exchange Sublimit. As part of the Revolving Line, Borrower may enter into foreign exchange contracts with Bank under which Borrower commits to purchase from or sell to Bank a specific amount of Foreign Currency (each, a “FX Forward Contract”) on a specified date (the “Settlement Date”). Each FX Forward Contract shall have a Settlement Date of at least one (1) FX Business Day after the contract date and shall be subject to a reserve of ten percent (10%) of the outstanding amount of the FX Forward Contract (the “FX Reserve”). The aggregate amount of FX Forward Contracts at any one time may not exceed ten (10 times the amount of the FX Reserve. The amount otherwise available for Credit Extensions under the Revolving Line shall be reduced by an amount equal to the aggregate FX Reserves for all outstanding FX Forward Contracts (the “FX Reduction Amount”). Any amounts needed to fully reimburse Bank will be treated as Advances under the Revolving Line and will accrue interest at the interest rate applicable to Advances.

2.1.4 Cash Management Services Sublimit. Borrower may use up to Two Million Five Hundred Thousand Dollars ($2,500,000), inclusive of Credit Extensions relating to Sections 2.1.2 and 2.13 and the FX Reduction Amount of the Revolving Line for Bank’s cash management services which may include merchant services, direct deposit of payroll, business credit card, and check cashing services identified in Bank’s various cash management services agreements (collectively, the “Cash Management Services”). Any amounts Bank pays on behalf of Borrower for any Cash Management Services will be treated as Advances under the Revolving Line and will accrue interest at the interest rate applicable to Advances.

2.1.5 Term Loan.

(a) Availability. Borrower may elect, upon 30 days prior written notice to Bank, to convert any or all of the outstanding Advances into one or more term loans (such term loan(s) are hereinafter referred to, singly or collectively, as a “Term Loan” or the “Term Loans”), provided that (i) each Term Loan shall be in a minimum increment of $5,000,000, (ii) the aggregate initial principal amount of all Term Loans advanced hereunder shall not exceed the Term Loan Amount, (iii) as a condition to the conversion of Advances to a Term Loan, Borrower shall been in compliance with the covenants (A) contained in Section 6.7(c) hereof for the trailing twelve (12) months preceding the date of conversion, and (B) contained in Sections 6.7(a) and (c) hereof on a pro forma basis after giving effect to the conversion, and (iv) no conversion of Advances to a Term Loan may occur after the date which is 360 days after the Effective Date.

(b) Repayment. On the first Payment Date following the Funding Date for a Term Loan, Borrower shall pay any accrued but unpaid interest with respect to the Term Loan and the Advances which were converted into the Term Loan. Commencing on the next Payment Date, and continuing on the Payment Date of each month thereafter, for each Term Loan, Borrower shall make consecutive equal monthly payments of principal plus interest, in arrears, as calculated by Bank based upon: (1) the amount of the Term Loan, (2) the effective rate of interest, as determined in Section 2.2(a), and (3) an amortization schedule equal to thirty-six (36) months. All unpaid principal and accrued interest with respect to each Term Loan is due and payable in full on the Term Loan Maturity Date with respect to such Term Loan. Payments received after 12:00 noon Pacific time are considered received at the opening of business on the next Business Day. Once repaid, no Term Loan may be reborrowed.

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(c) Mandatory Prepayment Upon Certain Transfers. In the event Borrower Transfers (as hereinafter defined) any part of its business or property (other than those Transfers permitted by Section 7.1 hereof), Borrower shall immediately pay to Bank an amount equal to the sum of: (i) 100% of the net cash proceeds of such Transfer plus accrued interest thereon and (ii) the Prepayment Fee in respect of the amount of the Term Loan prepaid.

(d) Mandatory Prepayment Upon an Acceleration. If (i) a Term Loan is accelerated following the occurrence of an Event of Default or (ii) in the event any law, rule, regulation, ordinance, order, directive, treaty or policy applicable to the Bank or any change therein or in the interpretation or application thereof, made after the date hereof, shall make it unlawful for the Bank to maintain a Term Loan or to claim or receive any amount otherwise payable under this Agreement, Borrower shall immediately pay to Bank an amount equal to the sum of: (i) all outstanding principal plus accrued interest, (ii) the Prepayment Fee in respect of the amount of the Term Loan prepaid, plus (iii) all other sums, that shall have become due and payable, including interest at the Default Rate with respect to any past due amounts.

(e) Permitted Prepayment of Loans. Borrower shall have the option to prepay all, but not less than all, of the Term Loans advanced by Bank under this Agreement, provided Borrower (i) provides written notice to Bank of its election to prepay the Term Loans at least one (1) Business Day prior to such prepayment, and (ii) pays, on the date of such prepayment (A) all outstanding principal plus accrued interest, (B) the Prepayment Fee, plus (C) all other sums, that shall have become due and payable, including interest at the Default Rate with respect to any past due amounts.

(f) Application of Prepayments. Prepayments of a Term Loan shall be applied against all remaining scheduled payments in respect of all Term Loans in the inverse order of maturity.

2.2 Overadvances. If, at any time, the sum of (a) the outstanding principal amount of any Advances (including any amounts used for Cash Management Services), plus (b) the face amount of any outstanding Letters of Credit (including drawn but unreimbursed Letters of Credit and any Letter of Credit Reserve), plus(c)the FX Reduction Amount, plus (d) the outstanding principal amount of all Term Loans exceeds the lesser of either the Revolving Line or the Borrowing Base, Borrower shall immediately pay to Bank in cash such excess.

2.3 Payment of Interest on the Credit Extensions.

(a) Interest Rate.

(i) Advances. Subject to Section 2.3(b), the principal amount outstanding under the Revolving Line shall accrue interest at a floating per annum rate equal to the greater of (a) fifty basis points (0.50%) above the Prime Rate or (b) four and one-half percent (4.50%), which interest shall be payable monthly in accordance with Section 2.3(f) below.

(ii) Term Loans. Subject to Section 2.3(b), the principal amount outstanding under the Term Loans shall accrue interest at a floating per annum rate equal to the greater of (a) fifty basis points (0.50%) above the Prime Rate or (b) four and one-half percent (4.50%), which interest shall be payable monthly in accordance with Section 2.3(f) below.

(b) Default Rate. Immediately upon the occurrence and during the continuance of an Event of Default, Obligations shall bear interest at a rate per annum which is five percentage points (5.00%) above the rate that is otherwise applicable thereto (the “Default Rate”). Payment or acceptance of the increased interest rate provided in this Section 2.3(b) is not a permitted alternative to timely payment and shall not constitute a waiver of any Event of Default or otherwise prejudice or limit any rights or remedies of Bank.

(c) Adjustment to Interest Rate. Changes to the interest rate of any Credit Extension based on changes to the Prime Rate shall be effective on the effective date of any change to the Prime Rate and to the extent of any such change.

(d) 360-Day Year. Interest shall be computed on the basis of a 360-day year for the actual number of days elapsed.

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(e) Debit of Accounts. Bank may debit any of Borrower’s deposit accounts, including the Designated Deposit Account, for principal and interest payments or any other amounts Borrower owes Bank when due. These debits shall not constitute a set-off.

(f) Payments. Unless otherwise provided, interest is payable monthly in arrears on the Payment Date of each month. Payments of principal and/or interest received after 12:00 p.m. Pacific time are considered received at the opening of business on the next Business Day. When any payment is due on a day that is not a Business Day, the payment shall be due the next Business Day and all fees or interest, as applicable, shall continue to accrue until paid.

2.4 Fees. Borrower shall pay to Bank:

(a) Loan Fee. A fully earned, non-refundable loan fee of $62,500.00 on the Effective Date;

(b) Letter of Credit Fee. Bank’s customary fees and expenses for the issuance or renewal of Letters of Credit , including, without limitation, a Letter of Credit Fee of one percent (1.00%) per annum of the face amount of each Letter of Credit issued, upon the issuance, each anniversary of the issuance, and the renewal of such Letter of Credit by Bank;

(c) Unused Revolving Line Facility Fee. A fee (the “Unused Revolving Line Facility Fee”), payable quarterly, in arrears, on a calendar year basis, in an amount equal to three hundred seventy five basis points (0.375%) per annum of the average unused portion of the Revolving Line, as determined by Bank. The utilized portion of the Revolving Line, for the purposes of this calculation, shall not include amounts utilized or reserved under Sections 2.1.1, 2.1.3, or 2.1.4. Borrower shall not be entitled to any credit, rebate or repayment of any Unused Revolving Line Facility Fee previously earned by Bank pursuant to this Section notwithstanding any termination of the Agreement or the suspension or termination of Bank’s obligation to make loans and advances hereunder;

(d) Term Loan Termination Fee. The Termination Fee when due pursuant to the terms of Section 12.1;

(e) Prepayment Fee. The Prepayment Fee when due pursuant to the terms of Section 2.1.5; and

(f) Bank Expenses. All Bank Expenses (including reasonable attorneys’ fees and expenses, plus expenses, for documentation and negotiation of this Agreement) incurred through and after the Effective Date, when due.

2.5 International Vision Direct Ltd. Notwithstanding any other provision of this Agreement to the contrary, International Vision Direct Ltd. (the “Canadian Subsidiary”) shall not be permitted to request or receive Loans hereunder and no cash proceeds of the Loans hereunder shall be made available to the Canadian Subsidiary, directly or indirectly; provided, however that drugstore.com, Inc. may make distributions to the Canadian Subsidiary of cash and/or assets in order to fund the operations of the Canadian Subsidiary in the ordinary course of business.

3 CONDITIONS OF LOANS

3.1 Conditions Precedent to Initial Credit Extension. Bank’s obligation to make the initial Credit Extension is subject to the condition precedent that Bank shall have received, in form and substance satisfactory to Bank, such documents, and completion of such other matters, as Bank may reasonably deem necessary or appropriate, including, without limitation:

(a) Duly executed original signatures to the Loan Documents to which it is a party;

(b) Duly executed original signatures to the Control Agreement[s];

(c) Borrower’s Operating Documents and a good standing certificate of Borrower certified by the Secretary of State of the State of Delaware as of a date no earlier than thirty (30) days prior to the Effective Date;

(d) Secretary’s Certificate with completed Borrowing Resolutions for Borrower;

(e) A payoff letter from Bank;

(f) Certified copies, dated as of a recent date, of financing statement searches, as Bank shall request, accompanied by written evidence (including any UCC termination statements) that the Liens indicated in any such financing statements either constitute Permitted Liens or have been or, in connection with the initial Credit Extension, will be terminated or released;

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(g) The Perfection Certificate executed by Borrower, together with the duly executed original signatures thereto;

(h) A landlord’s consent in favor of Bank for each of Borrower's locations executed by the landlord thereof, together with the duly executed original signatures thereto;

(i) [Reserved];

(j) evidence satisfactory to Bank that the insurance policies required by Section 6.4 hereof are in full force and effect, together with appropriate evidence showing lender loss payable and/or additional insured clauses or endorsements in favor of Bank; and

(k) payment of the fees and Bank Expenses then due as specified in Section 2.4 hereof.

3.2 Conditions Precedent to all Credit Extensions. Bank’s obligations to make each Credit Extension, including the initial Credit Extension, is subject to the following conditions precedent:

(a) except as otherwise provided in Section 3.4(a), timely receipt of an executed Payment/Advance Form;

(b) the representations and warranties in Section 5 shall be true, accurate and complete in all material respects on the date of the Payment/Advance Form and on the Funding Date of each Credit Extension; provided, however, that such materiality qualifier shall not be applicable to any representations and warranties that already are qualified or modified by materiality in the text thereof; and provided, further that those representations and warranties expressly referring to a specific date shall be true, accurate and complete in all material respects as of such date, and no Event of Default shall have occurred and be continuing or result from the Credit Extension. Each Credit Extension is Borrower’s representation and warranty on that date that the representations and warranties in Section 5 remain true, accurate and complete in all material respects; provided, however, that such materiality qualifier shall not be applicable to any representations and warranties that already are qualified or modified by materiality in the text thereof; and provided, further that those representations and warranties expressly referring to a specific date shall be true, accurate and complete in all material respects as of such date; and

(c) in Bank’s sole discretion, there has not been a Material Adverse Change or any material impairment in the general affairs, management, results of operation, financial condition or the prospect of repayment of the Obligations, or any material adverse deviation by Borrower from the most recent business plan of Borrower presented to and accepted by Bank.

3.3 Covenant to Deliver.

Borrower agrees to deliver to Bank each item required to be delivered to Bank under this Agreement as a condition precedent to any Credit Extension. Borrower expressly agrees that a Credit Extension made prior to the receipt by Bank of any such item shall not constitute a waiver by Bank of Borrower’s obligation to deliver such item, and the making of any Credit Extension in the absence of a required item shall be in Bank’s sole discretion.

3.4 Procedures for Borrowing.

(a) Advances. Subject to the prior satisfaction of all other applicable conditions to the making of an Advance set forth in this Agreement, to obtain an Advance (other than Advances under Sections 2.1.2 or 2.1.4), Borrower shall notify Bank (which notice shall be irrevocable) by electronic mail, facsimile, or telephone by 12:00 noon Pacific time on the Funding Date of the Advance. Together with any such electronic or facsimile notification, Borrower shall deliver to Bank by electronic mail or facsimile a completed Payment/Advance Form executed by a Responsible Officer or his or her designee. Bank may rely on any telephone notice given by a person whom Bank believes is a Responsible Officer or designee. Bank shall credit Advances to the Designated Deposit Account. Bank may make Advances under this Agreement based on instructions from a Responsible Officer or his or her designee or without instructions if the Advances are necessary to meet Obligations which have become due.

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(b) Term Loan. Subject to the prior satisfaction of all other applicable conditions to the making of a Term Loan set forth in this Agreement, to obtain a Term Loan, Borrower shall notify Bank (which notice shall be irrevocable) by electronic mail, facsimile, or telephone by 12:00 noon Eastern time thirty (30) Business Days prior to the date the Term Loan is to be made. Together with any such electronic or facsimile notification, Borrower shall deliver to Bank by electronic mail or facsimile a completed Payment/Advance Form executed by a Responsible Officer or his or her designee. Bank may rely on any telephone notice given by a person whom Bank believes is a Responsible Officer or designee. On the Funding Date, Bank shall credit and/or transfer (as applicable) to Borrower's Designated Deposit Account, an amount equal to the applicable Term Loan.

4 CREATION OF SECURITY INTEREST

4.1 Grant of Security Interest. Borrower hereby grants Bank, to secure the payment and performance in full of all of the Obligations, a continuing security interest in, and pledges to Bank, the Collateral, wherever located, whether now owned or hereafter acquired or arising, and all proceeds and products thereof. Borrower represents, warrants, and covenants that the security interest granted herein is and shall at all times continue to be a first priority perfected security interest in the Collateral (subject only to Permitted Liens that may have superior priority to Bank’s Lien under this Agreement). If Borrower shall acquire a commercial tort claim, Borrower shall promptly notify Bank in a writing signed by Borrower of the general details thereof and grant to Bank in such writing a security interest therein and in the proceeds thereof, all upon the terms of this Agreement, with such writing to be in form and substance reasonably satisfactory to Bank.

If this Agreement is terminated, Bank’s Lien in the Collateral shall continue until the Obligations (other than inchoate indemnity obligations) are repaid in full in cash. Upon payment in full in cash of the Obligations and at such time as Bank’s obligation to make Credit Extensions has terminated, Bank shall, at Borrower’s sole cost and expense, release its Liens in the Collateral and all rights therein shall revert to Borrower.

4.2 Authorization to File Financing Statements. Borrower hereby authorizes Bank to file financing statements, without notice to Borrower, with all appropriate jurisdictions to perfect or protect Bank’s interest or rights hereunder, including a notice that any disposition of the Collateral, by either Borrower or any other Person, shall be deemed to violate the rights of Bank under the Code. Such financing statements may indicate the Collateral as “all assets of the Debtor” or words of similar effect, or as being of an equal or lesser scope, or with greater detail, all in Bank’s discretion.

5 REPRESENTATIONS AND WARRANTIES

Borrower represents and warrants as follows at all times unless expressly provided below:

5.1 Due Organization, Authorization; Power and Authority. Borrower and each of its Subsidiaries are duly existing and in good standing as a Registered Organization in its jurisdiction of formation and is qualified and licensed to do business and is in good standing in any jurisdiction in which the conduct of its business or its ownership of property requires that it be qualified except where the failure to do so could not reasonably be expected to have a material adverse effect on Borrower’s business. In connection with this Agreement, Borrower has delivered to Bank a completed certificate signed by Borrower, entitled “Perfection Certificate”. Borrower represents and warrants to Bank that (a) Borrower’s exact legal name is that indicated on the Perfection Certificate and on the signature page hereof; (b) Borrower is an organization of the type and is organized in the jurisdiction set forth in the Perfection Certificate; (c) the Perfection Certificate accurately sets forth Borrower’s organizational identification number or accurately states that Borrower has none; (d) the Perfection Certificate accurately sets forth Borrower’s place of business, or, if more than one, its chief executive office as well as Borrower’s mailing address (if different than its chief executive office); (e) Borrower (and each of its predecessors) has not, in the past five (5) years, changed its jurisdiction of formation, organizational structure or type, or any organizational number assigned by its jurisdiction; and (f) all other information set forth on the Perfection Certificate pertaining to Borrower and each of its Subsidiaries is accurate and complete (it being understood and agreed that Borrower may from time to time update certain information in the Perfection Certificate after the Effective Date to the extent permitted by one or more specific provisions in this Agreement). If Borrower is not now a Registered Organization but later becomes one, Borrower shall promptly notify Bank of such occurrence and provide Bank with Borrower’s organizational identification number.

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The execution, delivery and performance by Borrower of the Loan Documents to which it is a party have been duly authorized, and do not (i) conflict with any of Borrower’s organizational documents, (ii) contravene, conflict with, constitute a default under or violate any material Requirement of Law, (iii) contravene, conflict or violate any applicable order, writ, judgment, injunction, decree, determination or award of any Governmental Authority by which Borrower or any of its Subsidiaries or any of their property or assets may be bound or affected, (iv) require any action by, filing, registration, or qualification with, or Governmental Approval from, any Governmental Authority (except such Governmental Approvals which have already been obtained and are in full force and effect or (v) constitute an event of default under any material agreement by which Borrower is bound. Borrower is not in default under any agreement to which it is a party or by which Borrower or any of its Subsidiaries or any of their property or assets may be bound in which the default could reasonably be expected to have a material adverse effect on Borrower’s business.

5.2 Collateral. Borrower has good title to, has rights in, and the power to transfer each item of the Collateral upon which it purports to grant a Lien hereunder, free and clear of any and all Liens except Permitted Liens. Borrower has no deposit accounts other than the deposit accounts with Bank, the deposit accounts, if any, described in the Perfection Certificate delivered to Bank in connection herewith, or of which Borrower has given Bank notice and taken such actions as are necessary to give Bank a perfected security interest therein. The Accounts are bona fide, existing obligations of the Account Debtors.

The Collateral is not in the possession of any third party bailee (such as a warehouse) except as otherwise provided in the Perfection Certificate. None of the components of the Collateral shall be maintained at locations other than as provided in the Perfection Certificate or as permitted pursuant to Section 7.2. In the event that Borrower, after the date hereof, intends to store or otherwise deliver any portion of the Collateral to a bailee, then Borrower will first receive the written consent of Bank and such bailee must execute and deliver a bailee agreement in form and substance satisfactory to Bank in its sole discretion.

All Inventory is in all material respects of good and marketable quality, free from material defects.

Borrower is the sole owner of its intellectual property, except for non-exclusive licenses granted to its customers in the ordinary course of business. Each patent is valid and enforceable, and no part of the intellectual property has been judged invalid or unenforceable, in whole or in part, and to the best of Borrower’s knowledge, no claim has been made that any part of the intellectual property violates the rights of any third party except to the extent such claim could not reasonably be expected to have a material adverse effect on Borrower’s business. Except as noted on the Perfection Certificate, Borrower is not a party to, nor is bound by, any material license or other agreement with respect to which Borrower is the licensee (a) that prohibits or otherwise restricts Borrower from granting a security interest in Borrower’s interest in such license or agreement or any other property, or (b) for which a default under or termination of which could interfere with the Bank’s right to sell any Collateral. Borrower shall provide written notice to Bank within ten (10) days of entering or becoming bound by any such license or agreement (other than over-the-counter software that is commercially available to the public). Borrower shall take such steps as Bank requests to obtain the consent of, or waiver by, any person whose consent or waiver is necessary for (x) all such licenses or agreements to be deemed “Collateral” and for Bank to have a security interest in it that might otherwise be restricted or prohibited by law or by the terms of any such license or agreement, whether now existing or entered into in the future, and (y) Bank to have the ability in the event of a liquidation of any Collateral to dispose of such Collateral in accordance with Bank’s rights and remedies under this Agreement and the other Loan Documents.

5.3 Accounts Receivable; Inventory. For any Eligible Account in any Borrowing Base Certificate, all statements made and all unpaid balances appearing in all invoices, instruments and other documents evidencing such Eligible Accounts are and shall be true and correct and all such invoices, instruments and other documents, and all of Borrower's Books are genuine and in all respects what they purport to be. Whether or not an Event of Default has occurred and is continuing, Bank may notify any Account Debtor owing Borrower money of Bank’s security interest in such funds and verify the amount of such Eligible Account. All sales and other transactions underlying or giving rise to each Eligible Account shall comply in all material respects with all applicable laws and governmental rules and regulations. Borrower has no knowledge of any actual or imminent Insolvency Proceeding of any Account Debtor whose accounts are Eligible Accounts in any Borrowing Base Certificate. To the best of Borrower’s knowledge, all signatures and endorsements on all documents, instruments, and agreements relating to all Eligible Accounts are genuine, and all such documents, instruments and agreements are legally enforceable in accordance with their terms.

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For any item of Inventory consisting of “Eligible Inventory” in any Borrowing Base Certificate, such Inventory (a) consists of raw materials or finished goods, in good, new, and salable condition, which is not perishable, returned, consigned, obsolete, not sellable, damaged, or defective, and is not comprised of demonstrative or custom inventory, works in progress, packaging or shipping materials, or supplies; (b) meets all applicable governmental standards; (c) has been manufactured in compliance with the Fair Labor Standards Act; (d) is not subject to any Liens, except the first priority Liens granted or in favor of Bank under this Agreement or any of the other Loan Documents; and (e) is located at the locations identified by Borrower in the Perfection Certificate where it maintains Inventory (or any location permitted under Section 7.2) for which Bank has received a bailee waiver.

5.4 Litigation. Except as provided in the Perfection Certificate, as of the Effective Date and at such other times required hereunder, including pursuant to Section 3.2, there are no actions or proceedings pending or, to the knowledge of the Responsible Officers, threatened in writing by or against Borrower or any of its Subsidiaries involving more than Two Hundred Fifty Thousand Dollars ($250,000).

5.5 No Material Deviation/Deterioration in Financial Condition; Financial Statements. All consolidated financial statements for Borrower and any of its Subsidiaries delivered to Bank fairly present in all material respects Borrower’s consolidated financial condition and Borrower’s consolidated results of operations. There has not been any material deterioration in Borrower’s consolidated financial condition since the date of the most recent financial statements submitted to Bank.

5.6 Solvency. The fair salable value of Borrower’s assets (including goodwill minus disposition costs) exceeds the fair value of its liabilities; Borrower is not left with unreasonably small capital after the transactions in this Agreement; and Borrower is able to pay its debts (including trade debts) as they mature.

5.7 Regulatory Compliance. Borrower is not an “investment company” or a company “controlled” by an “investment company” under the Investment Company Act of 1940, as amended. Borrower is not engaged as one of its important activities in extending credit for margin stock (under Regulations X, T and U of the Federal Reserve Board of Governors). Borrower has complied in all material respects with the Federal Fair Labor Standards Act. Neither Borrower nor any of its Subsidiaries is a “holding company” or an “affiliate” of a “holding company” or a “subsidiary company” of a “holding company” as each term is defined and used in the Public Utility Holding Company Act of 2005. Borrower has not violated any laws, ordinances or rules, the violation of which could reasonably be expected to have a material adverse effect on its business. None of Borrower’s or any of its Subsidiaries’ properties or assets has been used by Borrower or any Subsidiary or, to the best of Borrower’s knowledge, by previous Persons, in disposing, producing, storing, treating, or transporting any hazardous substance other than legally. Borrower and each of its Subsidiaries have obtained all consents, approvals and authorizations of, made all declarations or filings with, and given all notices to, all Government Authorities that are necessary to continue their respective businesses as currently conducted.

5.8 Subsidiaries; Investments. Borrower does not own any stock, partnership interest or other equity securities except for Permitted Investments.

5.9 Tax Returns and Payments; Pension Contributions. Borrower and its Subsidiaries have timely filed all required tax returns and reports, and Borrower and its Subsidiaries have timely paid all foreign, federal, state and local taxes, assessments, deposits and contributions owed by Borrower. Borrower may defer payment of any contested taxes, provided that Borrower (a) in good faith contests its obligation to pay the taxes by appropriate proceedings promptly and diligently instituted and conducted, (b) notifies Bank in writing of the commencement of, and any material development in, the proceedings, (c) posts bonds or takes any other steps required to prevent the governmental authority levying such contested taxes from obtaining a Lien upon any of the Collateral that is other than a “Permitted Lien”. Borrower is unaware of any claims or adjustments proposed for any of Borrower's prior tax years which could result in additional taxes becoming due and payable by Borrower. Borrower has paid all amounts necessary to fund all present pension, profit sharing and deferred compensation plans in accordance with their terms, and Borrower has not withdrawn from participation in, and has not permitted partial or complete termination of, or permitted the occurrence of any other event with respect to, any such plan which could reasonably be expected to result in any liability of Borrower, including any liability to the Pension Benefit Guaranty Corporation or its successors or any other governmental agency.

5.10 Use of Proceeds. Borrower shall use the proceeds of the Credit Extensions solely as working capital, to refinance existing Indebtedness owed by Borrower to Bank, and to fund its general business requirements and not for personal, family, household or agricultural purposes.

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5.11 Full Disclosure. No written representation, warranty or other statement of Borrower in any certificate or written statement given to Bank, as of the date such representation, warranty, or other statement was made, taken together with all such written certificates and written statements given to Bank, contains any untrue statement of a material fact or omits to state a material fact necessary to make the statements contained in the certificates or statements not misleading (it being recognized by Bank that the projections and forecasts provided by Borrower in good faith and based upon reasonable assumptions are not viewed as facts and that actual results during the period or periods covered by such projections and forecasts may differ from the projected or forecasted results).

6 AFFIRMATIVE COVENANTS

Borrower shall do all of the following:

6.1 Government Compliance. Maintain its and all its Subsidiaries’ legal existence and good standing in their respective jurisdictions of formation and maintain qualification in each jurisdiction in which the failure to so qualify would reasonably be expected to have a material adverse effect on Borrower’s business or operations. Borrower shall comply, and have each Subsidiary comply, with all laws, ordinances and regulations to which it is subject, noncompliance with which could have a material adverse effect on Borrower’s business.

6.2 Financial Statements, Reports, Certificates.

(a) Deliver to Bank: (i) as soon as available, but no later than thirty (30) days after the last day of each month, a company prepared consolidated balance sheet and income statement covering Borrower’s consolidated operations for such month certified by a Responsible Officer and in a form acceptable to Bank; (ii) as soon as available, but no later than one hundred twenty (120) days after the last day of Borrower’s fiscal year, audited consolidated financial statements prepared under GAAP, consistently applied, together with an unqualified opinion on the financial statements from an independent certified public accounting firm acceptable to Bank in its reasonable discretion; (iii) within five (5) days of delivery, copies of all statements, reports and notices made available to Borrower’s security holders or to any holders of Subordinated Debt; (iv) within five (5) days of filing, all reports on Form 10-K, 10-Q and 8-K filed with the Securities and Exchange Commission or a link thereto on Borrower’s or another website on the internet; (v) as soon as available, but in any event prior to the last day of Borrower’s fiscal year, Borrower’s financial projections for coming fiscal year as approved by Borrower’s Board of Directors; (vi) a prompt report of any legal actions pending or threatened against Borrower or any of its Subsidiaries that could result in damages or costs to Borrower or any of its Subsidiaries of Two Hundred Fifty Thousand Dollars ($250,000) or more; and (vii) budgets, sales projections, operating plans and other financial information reasonably requested by Bank.

(b) Within thirty (30) days after the last day of each month, deliver to Bank a duly completed Borrowing Base Certificate signed by a Responsible Officer, together with (i) aged listings of accounts receivable (including merchant services balances) and accounts payable (by invoice date), (ii) a statement listing all Collateral Accounts maintained by Borrower and the balances/investments therein, and (iii) perpetual inventory reports for the Inventory valued on a first-in, first-out basis at the lower of cost or market (in accordance with GAAP) or such other inventory reports as are requested by Bank in its good faith business judgment.

(c) Within thirty (30) days after the last day of each month, deliver to Bank with the monthly financial statements, a duly completed Compliance Certificate signed by a Responsible Officer setting forth calculations showing compliance with the financial covenants set forth in this Agreement.

(d) Allow Bank to audit Borrower’s Collateral at Borrower’s expense. Such audits shall be conducted no more often than once every twelve (12) months unless an Event of Default has occurred and is continuing.

6.3 Inventory; Returns. Keep all Inventory in good and marketable condition, free from material defects. Returns and allowances between Borrower and its Account Debtors shall follow Borrower’s customary practices as they exist at the Effective Date. Borrower must promptly notify Bank of all returns, recoveries, disputes and claims that involve more than Two Hundred Fifty Thousand Dollars ($250,000).

6.4 Taxes; Pensions. Timely file, and require each of its Subsidiaries to timely file, all required tax returns and reports and timely pay, and require each of its Subsidiaries to timely pay all foreign, federal, state and local taxes, assessments, deposits and contributions owed by Borrower and each of its Subsidiaries, except for deferred payment of any taxes contested pursuant to the terms of Section 5.9 hereof, and shall deliver to Bank, on demand, appropriate certificates attesting to such payments, and pay all amounts necessary to fund all present pension, profit sharing and deferred compensation plans in accordance with their terms.

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6.5 Insurance. Keep its business and the Collateral insured for risks and in amounts standard for companies in Borrower’s industry and location and as Bank may reasonably request. Insurance policies shall be in a form, with companies, and in amounts that are satisfactory to Bank. All property policies shall have a lender’s loss payable endorsement showing Bank as the sole loss payee, and all liability policies shall show, or have endorsements showing, Bank, as an additional insured. All policies (or the loss payable and additional insured endorsements) shall provide that the insurer must endeavor to give Bank at least thirty (30) days notice before canceling, amending, or declining to renew its policy. At Bank’s request, Borrower shall deliver certified copies of policies and evidence of all premium payments. Proceeds payable under any policy shall, at Bank’s option, be payable to Bank on behalf of the Lenders on account of the Obligations. If Borrower fails to obtain insurance as required under this Section 6.5 or to pay any amount or furnish any required proof of payment to third persons and Bank, Bank may make all or part of such payment or obtain such insurance policies required in this Section 6.5, and take any action under the policies Bank deems prudent.

WARNING

Unless you provide us with evidence of the insurance coverage as required herein, we may purchase insurance at your expense to protect our interest. This insurance may, but need not, also protect your interest. If the Collateral becomes damaged, the coverage we purchase may not pay any claim you make or any claim made against you. You may later cancel this coverage by providing evidence that you have obtained property coverage elsewhere. You are responsible for the cost of any insurance purchased by us. The cost of this insurance may be added to the Obligations. If the cost is added to the Obligations, the interest rate on the Term Loans will apply to this added amount. The effective date of coverage may be the date your prior coverage lapsed or the date you failed to provide proof of coverage. This coverage we purchased may be considerably more expensive than insurance you can obtain on your own and may not satisfy any need for property damage coverage or any mandatory liability insurance requirements imposed by applicable law.

6.6 Operating Accounts.

(a) Maintain (i) its primary and its Subsidiaries’ primary operating and other deposit accounts with Bank and Bank’s Affiliates, (ii) a majority of Borrower’s excess cash balances with Bank and Bank’s Affiliates and (iii) at all times at least $7,500,000.00 on deposit in a demand deposit account or other account over which Banks has the written authority from the depository institution to sweep such account at any time; provided, however, that Borrower may maintain accounts numbered 69028108, 69027910, 19538818, 68846716, 68932219, 68846807, 46095220 and 46095212 at Bank of America provided that the aggregate amount on deposit in all such accounts shall at no time exceed $100,000.

(b) Provide Bank five (5) days prior written notice before establishing any Collateral Account at or with any bank or financial institution other than Bank or Bank’s Affiliates. For each Collateral Account that Borrower at any time maintains, Borrower shall cause the applicable bank or financial institution (other than Bank) at or with which any Collateral Account is maintained to execute and deliver a Control Agreement or other appropriate instrument with respect to such Collateral Account to perfect Bank’s Lien in such Collateral Account in accordance with the terms hereunder, which Control Agreement may not be terminated without the prior written consent of the Bank. The provisions of the previous sentence shall not apply to deposit accounts exclusively used for payroll, payroll taxes and other employee wage and benefit payments to or for the benefit of Borrower’s employees and identified to Bank by Borrower as such.

6.7 Financial Covenants.

Borrower shall maintain at all times, to be tested as of the last day of each month, unless otherwise noted:

(a) Adjusted Quick Ratio. (i) prior to the conversion of any Advances to a Term Loan pursuant to Section 2.1.5, an Adjusted Quick Ratio of at least 1.20 to 1.00, and (ii) after the conversion of any Advances to a Term Loan pursuant to Section 2.1.5, an Adjusted Quick Ratio of at least 1.00 to 1.00.

(b) Minimum Free Cash Flow: Borrower shall not permit its Free Cash Flow, tested monthly as of the end of each month, to be less than (i) ($1,000,000) at the end of each month from the Effective Date to and including September 30, 2009, and (ii) $0.00 at the end of each month commencing on October 30, 2009 and thereafter.

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(c) Minimum Fixed Charge Coverage Ratio: Borrower shall not permit its Fixed Charge Coverage Ratio, tested on a trailing twelve-month basis at the end of each month commencing at the end of the month in which the Funding Date with respect to the initial Term Loan occurs, to be less than 1.25 to 1.00.

6.8 Protection of Intellectual Property Rights. Borrower shall: (a) protect, defend and maintain the validity and enforceability of its intellectual property; (b) promptly advise Bank in writing of material infringements of its intellectual property; and (c) not allow any intellectual property material to Borrower’s business to be abandoned, forfeited or dedicated to the public without Bank’s written consent.

6.9 Litigation Cooperation. From the date hereof and continuing through the termination of this Agreement, make available to Bank, without expense to Bank, Borrower and its officers, employees and agents and Borrower's Books, to the extent that Bank may deem them reasonably necessary to prosecute or defend any third-party suit or proceeding instituted by or against Bank with respect to any Collateral or relating to Borrower.

6.10 Further Assurances. Execute any further instruments and take further action as Bank reasonably requests to perfect or continue Bank’s Lien in the Collateral or to effect the purposes of this Agreement.

6.11 Creation/Acquisition of Subsidiaries. In the event Borrower or any Subsidiary creates or acquires any Subsidiary, Borrower and such Subsidiary shall promptly notify Bank of the creation or acquisition of such new Subsidiary and take all such action as may be reasonably required by Bank to cause each such Subsidiary to become a co-Borrower under the Loan Documents and grant a continuing pledge and security interest in and to the assets of such Subsidiary (substantially as described on Exhibit A hereto) and Borrower shall grant and pledge to Bank a perfected security interest in the stock, units or other evidence of ownership of each Subsidiary.

7 NEGATIVE COVENANTS

Borrower shall not do any of the following without Bank’s prior written consent:

7.1 Dispositions. Convey, sell, lease, transfer, assign or otherwise dispose of (collectively, “Transfer”), or permit any of its Subsidiaries to Transfer, all or any part of its business or property, except for Transfers (a) of Inventory in the ordinary course of business; (b) of worn-out or obsolete Equipment; and (c) of non-exclusive licenses for the use of the property of Borrower or its Subsidiaries in the ordinary course of business.

7.2 Changes in Business, Management, Ownership or Business Locations. (a) Engage in or permit any of its Subsidiaries to engage in any business other than the businesses currently engaged in by Borrower and such Subsidiary, as applicable, or reasonably related thereto; (b) liquidate or dissolve; or (c) (i) have a material change in senior management or (ii) enter into any transaction or series of related transactions in which the stockholders of Borrower who were not stockholders immediately prior to the first such transaction own more than 25% of the voting stock of Borrower immediately after giving effect to such transaction or related series of such transactions (other than by the sale of Borrower’s equity securities in a public offering or to venture capital investors so long as Borrower identifies to Bank the venture capital investors prior to the closing of the transaction. Borrower shall not, without at least thirty (30) days prior written notice to Bank: (1) add any new offices or business locations, including warehouses (unless such new offices or business locations contain less than One Hundred Thousand Dollars ($100,000) in Borrower’s assets or property), (2) change its jurisdiction of organization, (3) change its organizational structure or type, (4) change its legal name, or (5) change any organizational number (if any) assigned by its jurisdiction of organization.

7.3 Mergers or Acquisitions. Merge or consolidate, or permit any of its Subsidiaries to merge or consolidate, with any other Person, or acquire, or permit any of its Subsidiaries to acquire, all or substantially all of the capital stock or property of another Person other than Permitted Acquisitions. A Subsidiary may merge or consolidate into another Subsidiary or into Borrower.

7.4 Indebtedness. Create, incur, assume, or be liable for any Indebtedness, or permit any Subsidiary to do so, other than Permitted Indebtedness.

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7.5 Encumbrance. Create, incur, allow, or suffer any Lien on any of its property, or assign or convey any right to receive income, including the sale of any Accounts, or permit any of its Subsidiaries to do so, except for Permitted Liens, permit any Collateral not to be subject to the first priority security interest granted herein, or enter into any agreement, document, instrument or other arrangement (except with or in favor of Bank) with any Person which directly or indirectly prohibits or has the effect of prohibiting Borrower from assigning, mortgaging, pledging, granting a security interest in or upon, or encumbering any of Borrower’s intellectual property, except as is otherwise permitted in Section 7.1 hereof and the definition of “Permitted Liens” herein.

7.6 Maintenance of Collateral Accounts. Maintain any Collateral Account except pursuant to the terms of Section 6.6(b) hereof.

7.7 Distributions; Investments. (a) Pay any dividends or make any distribution or payment or redeem, retire or purchase any capital stock; or (b) directly or indirectly make any Investment other than Permitted Investments, or permit any of its Subsidiaries to do so.

7.8 Transactions with Affiliates. Directly or indirectly enter into or permit to exist any material transaction with any Affiliate of Borrower, except for transactions that are in the ordinary course of Borrower’s business, upon fair and reasonable terms that are no less favorable to Borrower than would be obtained in an arm’s length transaction with a non-affiliated Person.

7.9 Subordinated Debt. (a) Make or permit any payment on any Subordinated Debt, except under the terms of the subordination, intercreditor, or other similar agreement to which such Subordinated Debt is subject, or (b) amend any provision in any document relating to the Subordinated Debt which would increase the amount thereof or adversely affect the subordination thereof to Obligations owed to Bank.

7.10 Compliance. Become an “investment company” or a company controlled by an “investment company”, under the Investment Company Act of 1940, as amended, or undertake as one of its important activities extending credit to purchase or carry margin stock (as defined in Regulation U of the Board of Governors of the Federal Reserve System), or use the proceeds of any Credit Extension for that purpose; fail to meet the minimum funding requirements of ERISA, permit a Reportable Event or Prohibited Transaction, as defined in ERISA, to occur; fail to comply with the Federal Fair Labor Standards Act or violate any other law or regulation, if the violation could reasonably be expected to have a material adverse effect on Borrower’s business, or permit any of its Subsidiaries to do so; withdraw or permit any Subsidiary to withdraw from participation in, permit partial or complete termination of, or permit the occurrence of any other event with respect to, any present pension, profit sharing and deferred compensation plan which could reasonably be expected to result in any liability of Borrower, including any liability to the Pension Benefit Guaranty Corporation or its successors or any other governmental agency.

8 EVENTS OF DEFAULT

Any one of the following shall constitute an event of default (an “Event of Default”) under this Agreement:

8.1 Payment Default. Borrower fails to (a) make any payment of principal or interest on any Credit Extension on its due date, or (b) pay any other Obligations within three (3) Business Days after such Obligations (under (a) or (b) above) are due and payable (which three (3) Business Day grace period shall not apply to payments due on the Maturity Date, or the date of acceleration pursuant to Section 9.1(a) herein). During the cure period, the failure to cure the payment default is not an Event of Default (but no Credit Extension will be made during the cure period);

8.2 Covenant Default.

(a) Borrower fails or neglects to perform any obligation in Sections 6.2, 6.4, 6.5, 6.6 or 6.7 or violates any covenant in Section 7; or

(b) Borrower or any of its Subsidiaries fails or neglects to perform, keep, or observe any other term, provision, condition, covenant or agreement contained in this Agreement or any Loan Documents, and as to any default (other than those specified in this Section 8) under such other term, provision, condition, covenant or agreement that can be cured, has failed to cure the default within ten (10) days after the occurrence thereof;

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provided, however, that if the default cannot by its nature be cured within the ten (10) day period or cannot after diligent attempts by Borrower be cured within such ten (10) day period, and such default is likely to be cured within a reasonable time, then Borrower shall have an additional period (which shall not in any case exceed thirty (30) days) to attempt to cure such default, and within such reasonable time period the failure to cure the default shall not be deemed an Event of Default (but no Credit Extensions shall be made during such cure period). Grace periods provided under this Section shall not apply, among other things, to financial covenants or any other covenants set forth in subsection (a) above;

8.3 Material Adverse Change. A Material Adverse Change occurs;

8.4 Attachment; Levy; Restraint on Business.

(a) (i) The service of process seeking to attach, by trustee or similar process, any funds of Borrower or of any entity under control of Borrower (including a Subsidiary) on deposit with Bank or any Bank Affiliate, or (ii) a notice of lien, levy, or assessment is filed against any of Borrower’s assets by any government agency, and the same under subclauses (i) and (ii) hereof are not, within ten (10) days after the occurrence thereof, discharged or stayed (whether through the posting of a bond or otherwise); provided, however, no Credit Extensions shall be made during any ten (10) day cure period; and

(b) (i) any material portion of Borrower’s assets is attached, seized, levied on, or comes into possession of a trustee or receiver, or (ii) any court order enjoins, restrains, or prevents Borrower from conducting any part of its business;

8.5 Insolvency. (a) Borrower is unable to pay its debts (including trade debts) as they become due or otherwise becomes insolvent; (b) Borrower begins an Insolvency Proceeding; or (c) an Insolvency Proceeding is begun against Borrower and not dismissed or stayed within thirty (30) days (but no Credit Extensions shall be made while of any of the conditions described in clause (a) exist and/or until any Insolvency Proceeding is dismissed);

8.6 Other Agreements. There is a default in any agreement to which Borrower is a party with a third party or parties resulting in a right by such third party or parties, whether or not exercised, to accelerate the maturity of any Indebtedness in an amount in excess of One Hundred Thousand Dollars ($100,000) or that could have a material adverse effect on Borrower’s business;

8.7 Judgments. One or more judgments, orders, or decrees for the payment of money in an amount, individually or in the aggregate, of at least Two Hundred Fifty Thousand Dollars ($250,000) (not covered by independent third-party insurance as to which liability has been accepted by such insurance carrier) shall be rendered against Borrower and shall remain unsatisfied, unvacated, or unstayed for a period of ten (10) days after the entry thereof (provided that no Credit Extensions will be made prior to the satisfaction, vacation, or stay of such judgment, order, or decree);

8.8 Misrepresentations. Borrower or any Person acting for Borrower makes any representation, warranty, or other statement now or later in this Agreement, any Loan Document or in any writing delivered to Bank or to induce Bank to enter this Agreement or any Loan Document, and such representation, warranty, or other statement is incorrect in any material respect when made;

8.9 Subordinated Debt. A default or breach occurs under any agreement between Borrower and any creditor of Borrower that signed a subordination, intercreditor, or other similar agreement with Bank, or any creditor that has signed such an agreement with Bank breaches any terms of such agreement; or

8.11 Governmental Approvals. Any Governmental Approval shall have been (a) revoked, rescinded, suspended, modified in an adverse manner or not renewed in the ordinary course for a full term or (b) subject to any decision by a Governmental Authority that designates a hearing with respect to any applications for renewal of any of such Governmental Approval or that could result in the Governmental Authority taking any of the actions described in clause (a) above, and such decision or such revocation, rescission, suspension, modification or non-renewal (i) has, or could reasonably be expected to have, a Material Adverse Change, or (ii) adversely affects the legal qualifications of Borrower or any of its Subsidiaries to hold such Governmental Approval in any applicable jurisdiction and such revocation, rescission, suspension, modification or non-renewal could reasonably be expected to affect the status of or legal qualifications of Borrower or any of its Subsidiaries to hold any Governmental Approval in any other jurisdiction.

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9 BANK’S RIGHTS AND REMEDIES

9.1 Rights and Remedies. While an Event of Default occurs and continues Bank may, without notice or demand, do any or all of the following:

(a) declare all Obligations immediately due and payable (but if an Event of Default described in Section 8.5 occurs all Obligations are immediately due and payable without any action by Bank);

(b) stop advancing money or extending credit for Borrower’s benefit under this Agreement or under any other agreement between Borrower and Bank;

(c) demand that Borrower (i) deposits cash with Bank in an amount equal to the aggregate amount of any Letters of Credit remaining undrawn, as collateral security for the repayment of any future drawings under such Letters of Credit, and Borrower shall forthwith deposit and pay such amounts, and (ii) pay in advance all Letter of Credit fees scheduled to be paid or payable over the remaining term of any Letters of Credit;

(d) terminate any FX Forward Contracts;

(e) settle or adjust disputes and claims directly with Account Debtors for amounts on terms and in any order that Bank considers advisable, notify any Person owing Borrower money of Bank’s security interest in such funds, and verify the amount of such account;

(f) make any payments and do any acts it considers necessary or reasonable to protect the Collateral and/or its security interest in the Collateral. Borrower shall assemble the Collateral if Bank requests and make it available as Bank designates. Bank may enter premises where the Collateral is located, take and maintain possession of any part of the Collateral, and pay, purchase, contest, or compromise any Lien which appears to be prior or superior to its security interest and pay all expenses incurred. Borrower grants Bank a license to enter and occupy any of its premises, without charge, to exercise any of Bank’s rights or remedies;

(g) apply to the Obligations any (i) balances and deposits of Borrower it holds, or (ii) any amount held by Bank owing to or for the credit or the account of Borrower;

(h) ship, reclaim, recover, store, finish, maintain, repair, prepare for sale, advertise for sale, and sell the Collateral. Bank is hereby granted a non-exclusive, royalty-free license or other right to use, without charge, Borrower’s labels, patents, copyrights, mask works, rights of use of any name, trade secrets, trade names, trademarks, service marks, and advertising matter, or any similar property as it pertains to the Collateral, in completing production of, advertising for sale, and selling any Collateral and, in connection with Bank’s exercise of its rights under this Section, Borrower’s rights under all licenses and all franchise agreements inure to Bank’s benefit;

(i) place a “hold” on any account maintained with Bank and/or deliver a notice of exclusive control, any entitlement order, or other directions or instructions pursuant to any Control Agreement or similar agreements providing control of any Collateral;

(j) demand and receive possession of Borrower’s Books; and

(k) exercise all rights and remedies available to Bank under the Loan Documents or at law or equity, including all remedies provided under the Code (including disposal of the Collateral pursuant to the terms thereof).

9.2 Power of Attorney. Borrower hereby irrevocably appoints Bank as its lawful attorney-in-fact, exercisable upon the occurrence and during the continuance of an Event of Default, to: (a) endorse Borrower’s name on any checks or other forms of payment or security; (b) sign Borrower’s name on any invoice or bill of lading for any Account or drafts against Account Debtors; (c) settle and adjust disputes and claims about the Accounts directly with Account Debtors, for amounts and on terms Bank determines reasonable; (d) make, settle, and adjust all claims under Borrower’s insurance policies; (e) pay, contest or settle any Lien, charge, encumbrance, security interest, and adverse claim in or to the Collateral, or any judgment based thereon, or otherwise take any action to terminate or discharge the same; and (f) transfer the Collateral into the name of Bank or a third party as the Code permits. Borrower hereby appoints Bank as its lawful attorney-in-fact to sign Borrower’s name on any documents necessary to perfect or continue the perfection of Bank’s security interest in the Collateral regardless of whether an Event of Default has occurred until all Obligations have been satisfied in full and Bank is under no further obligation

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to make Credit Extensions hereunder. Bank’s foregoing appointment as Borrower’s attorney in fact, and all of Bank’s rights and powers, coupled with an interest, are irrevocable until all Obligations have been fully repaid and performed and Bank’s obligation to provide Credit Extensions terminates.

9.3 Protective Payments. If Borrower fails to obtain the insurance called for by Section 6.5 or fails to pay any premium thereon or fails to pay any other amount which Borrower is obligated to pay under this Agreement or any other Loan Document, Bank may obtain such insurance or make such payment, and all amounts so paid by Bank are Bank Expenses and immediately due and payable, bearing interest at the then highest applicable rate charged by Bank, and secured by the Collateral. Bank will make reasonable efforts to provide Borrower with notice of Bank obtaining such insurance at the time it is obtained or within a reasonable time thereafter. No payments by Bank are deemed an agreement to make similar payments in the future or Bank’s waiver of any Event of Default.

9.4 Application of Payments and Proceeds. Borrower shall have no right to specify the order or the accounts to which Bank shall allocate or apply any payments required to be made by Borrower to Bank or otherwise received by Bank under this Agreement when any such allocation or application is not specified elsewhere in this Agreement. If an Event of Default has occurred and is continuing, Bank may apply any funds in its possession, whether from Borrower account balances, payments, proceeds realized as the result of any collection of Accounts or other disposition of the Collateral, or otherwise, to the Obligations in such order as Bank shall determine in its sole discretion. Any surplus shall be paid to Borrower or other Persons legally entitled thereto; Borrower shall remain liable to Bank for any deficiency. If Bank, in its good faith business judgment, directly or indirectly enters into a deferred payment or other credit transaction with any purchaser at any sale of Collateral, Bank shall have the option, exercisable at any time, of either reducing the Obligations by the principal amount of the purchase price or deferring the reduction of the Obligations until the actual receipt by Bank of cash therefor.

9.5 Bank’s Liability for Collateral. So long as Bank complies with reasonable banking practices regarding the safekeeping of the Collateral in the possession or under the control of Bank, Bank shall not be liable or responsible for: (a) the safekeeping of the Collateral; (b) any loss or damage to the Collateral; (c) any diminution in the value of the Collateral; or (d) any act or default of any carrier, warehouseman, bailee, or other Person. Borrower bears all risk of loss, damage or destruction of the Collateral.

9.6 No Waiver; Remedies Cumulative. Bank’s failure, at any time or times, to require strict performance by Borrower of any provision of this Agreement or any other Loan Document shall not waive, affect, or diminish any right of Bank thereafter to demand strict performance and compliance herewith or therewith. No waiver hereunder shall be effective unless signed by Bank and then is only effective for the specific instance and purpose for which it is given. Bank’s rights and remedies under this Agreement and the other Loan Documents are cumulative. Bank has all rights and remedies provided under the Code, by law, or in equity. Bank’s exercise of one right or remedy is not an election, and Bank’s waiver of any Event of Default is not a continuing waiver. Bank’s delay in exercising any remedy is not a waiver, election, or acquiescence.

9.7 Demand Waiver. Borrower waives demand, notice of default or dishonor, notice of payment and nonpayment, notice of any default, nonpayment at maturity, release, compromise, settlement, extension, or renewal of accounts, documents, instruments, chattel paper, and guarantees held by Bank on which Borrower is liable.

10 NOTICES

All notices, consents, requests, approvals, demands, or other communication by any party to this Agreement or any other Loan Document must be in writing and shall be deemed to have been validly served, given, or delivered: (a) upon the earlier of actual receipt and three (3) Business Days after deposit in the U.S. mail, first class, registered or certified mail return receipt requested, with proper postage prepaid; (b) upon transmission, when sent by electronic mail or facsimile transmission; (c) one (1) Business Day after deposit with a reputable overnight courier with all charges prepaid; or (d) when delivered, if hand-delivered by messenger, all of which shall be addressed to the party to be notified and sent to the address, facsimile number, or email address indicated below. Bank or Borrower may change its mailing or electronic mail address or facsimile number by giving the other party written notice thereof in accordance with the terms of this Section 10.

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If to Borrower:	Drugstore.Com, Inc.
	411 108th Avenue NE
	Suite 1400
	Bellevue, Washington 98004
	Attn: General Counsel
	Fax: 425.372.3808
	Email: generalcounsel@drugstore.com
If to Bank:	Silicon Valley Bank
	380 Interlocken Crescent
	Suite 600
	Broomfield, Colorado 80021
	Attn: Mr. John Kinzer
	Fax:
	Email: Jkinzer@svb.com
with a copy to:	Riemer & Braunstein, LLP
	Three Center Plaza
	Boston, Massachusetts 02108
	Attn: David A. Ephraim, Esquire
	Fax: (617) 880-3456
	Email: DEphraim@riemerlaw.com

11 CHOICE OF LAW, VENUE, JURY TRIAL WAIVER

Washington law governs the Loan Documents without regard to principles of conflicts of law. Borrower and Bank each submit to the exclusive jurisdiction of the State and Federal courts in Washington; provided, however, that nothing in this Agreement shall be deemed to operate to preclude Bank from bringing suit or taking other legal action in any other jurisdiction to realize on the Collateral or any other security for the Obligations, or to enforce a judgment or other court order in favor of Bank. Borrower expressly submits and consents in advance to such jurisdiction in any action or suit commenced in any such court, and Borrower hereby waives any objection that it may have based upon lack of personal jurisdiction, improper venue, or forum non conveniens and hereby consents to the granting of such legal or equitable relief as is deemed appropriate by such court. Borrower hereby waives personal service of the summons, complaints, and other process issued in such action or suit and agrees that service of such summons, complaints, and other process may be made by registered or certified mail addressed to Borrower at the address set forth in Section 10 of this Agreement and that service so made shall be deemed completed upon the earlier to occur of Borrower’s actual receipt thereof or three (3) days after deposit in the U.S. mails, proper postage prepaid.

TO THE FULLEST EXTENT PERMITTED BY APPLICABLE LAW, BORROWER AND BANK EACH WAIVE THEIR RIGHT TO A JURY TRIAL OF ANY CLAIM OR CAUSE OF ACTION ARISING OUT OF OR BASED UPON THIS AGREEMENT, THE LOAN DOCUMENTS OR ANY CONTEMPLATED TRANSACTION, INCLUDING CONTRACT, TORT, BREACH OF DUTY AND ALL OTHER CLAIMS. THIS WAIVER IS A MATERIAL INDUCEMENT FOR BOTH PARTIES TO ENTER INTO THIS AGREEMENT. EACH PARTY HAS REVIEWED THIS WAIVER WITH ITS COUNSEL.

ORAL AGREEMENTS OR ORAL COMMITMENTS TO LOAN MONEY, EXTEND CREDIT, OR FORBEAR FROM ENFORCING REPAYMENT OF A DEBT ARE NOT ENFORCEABLE UNDER WASHINGTON LAW.

12 GENERAL PROVISIONS

12.1 Termination of Revolving Line Prior to Maturity Date. The Revolving Line may be terminated prior to the Revolving Line Maturity Date by Borrower, effective three (3) Business Days after written notice of termination is given to Bank or if Bank’s obligation to fund Credit Extensions terminates pursuant to the terms of Section 2.1.1(b). Borrower shall prepay on the date specified in the notice all outstanding Advances under

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the Revolving Line and accrued interest thereon through the date of prepayment. Notwithstanding any such termination, Bank’s lien and security interest in the Collateral shall continue until Borrower fully satisfies its Obligations. If such termination is at Borrower’s election or at Bank’s election due to the occurrence and continuance of an Event of Default, Borrower shall pay to Bank, in addition to the payment of any other expenses or fees then-owing, a termination fee in an amount equal to one-half of one percent (0.50%) of the Advances prepaid under Revolving Line provided that no termination fee shall be charged if the credit facility hereunder is replaced with a new facility from another division of Silicon Valley Bank. Upon payment in full of the Obligations and at such time as Bank’s obligation to make Credit Extensions has terminated, Bank shall release its liens and security interests in the Collateral and all rights therein shall revert to Borrower

12.2 Successors and Assigns. This Agreement binds and is for the benefit of the successors and permitted assigns of each party. Borrower may not assign this Agreement or any rights or obligations under it without Bank’s prior written consent (which may be granted or withheld in Bank’s discretion). Bank has the right, without the consent of or notice to Borrower, to sell, transfer, assign, negotiate, or grant participation in all or any part of, or any interest in, Bank’s obligations, rights, and benefits under this Agreement and the other Loan Documents.

12.3 Indemnification. Borrower agrees to indemnify, defend and hold Bank and its directors, officers, employees, agents, attorneys, or any other Person affiliated with or representing Bank (each, an “Indemnified Person”) harmless against: (a) all obligations, demands, claims, and liabilities (collectively, “Claims”) asserted by any other party in connection with the transactions contemplated by the Loan Documents; and (b) all losses or Bank Expenses incurred, or paid by such Indemnified Person from, following, or arising from transactions between Bank and Borrower (including reasonable attorneys’ fees and expenses), except for Claims and/or losses directly caused by such Indemnified Person’s gross negligence or willful misconduct.

12.4 Time of Essence. Time is of the essence for the performance of all Obligations in this Agreement.

12.5 Severability of Provisions. Each provision of this Agreement is severable from every other provision in determining the enforceability of any provision.

12.6 Correction of Loan Documents. Bank may correct patent errors and fill in any blanks in this Agreement and the other Loan Documents consistent with the agreement of the parties.

12.7 Amendments in Writing; Integration. All amendments to this Agreement must be in writing and signed by both Bank and Borrower. This Agreement and the Loan Documents represent the entire agreement about this subject matter and supersede prior negotiations or agreements. All prior agreements, understandings, representations, warranties, and negotiations between the parties about the subject matter of this Agreement and the Loan Documents merge into this Agreement and the Loan Documents.

12.8 Counterparts. This Agreement may be executed in any number of counterparts and by different parties on separate counterparts, each of which, when executed and delivered, is an original, and all taken together, constitute one Agreement.

12.9 Survival. All covenants, representations and warranties made in this Agreement continue in full force until this Agreement has terminated pursuant to its terms and all Obligations (other than inchoate indemnity obligations and any other obligations which, by their terms, are to survive the termination of this Agreement) have been paid in full and satisfied. The obligation of Borrower in Section 12.2 to indemnify Bank shall survive until the statute of limitations with respect to such claim or cause of action shall have run.

12.10 Confidentiality. In handling any confidential information, Bank shall exercise the same degree of care that it exercises for its own proprietary information, but disclosure of information may be made: (a) to Bank’s Subsidiaries or Affiliates; (b) to prospective transferees or purchasers of any interest in the Credit Extensions (provided, however, Bank shall use commercially reasonable efforts to obtain such prospective transferee’s or purchaser’s agreement to the terms of this provision); (c) as required by law, regulation, subpoena, or other order; (d) to Bank’s regulators or as otherwise required in connection with Bank’s examination or audit; (e) as Bank considers appropriate in exercising remedies under the Loan Documents; and (f) to third-party service providers of Bank so long as such service providers have executed a confidentiality agreement with Bank with terms no less restrictive than those contained herein. Confidential information does not include information that either: (i) is in the public domain or in Bank’s possession when disclosed to Bank, or becomes part of the public domain after disclosure to Bank; or (ii) is disclosed to Bank by a third party, if Bank does not know that the third party is prohibited from disclosing the information.

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Bank may use confidential information for any purpose, including, without limitation, for the development of client databases, reporting purposes, and market analysis, so long as Bank does not disclose Borrower’s identity or the identity of any person associated with Borrower unless otherwise expressly permitted by this Agreement. The provisions of the immediately preceding sentence shall survive the termination of this Agreement.

12.11 Right of Set Off. Borrower hereby grants to Bank, a lien, security interest and right of set off as security for all Obligations to Bank, whether now existing or hereafter arising upon and against all deposits, credits, collateral and property, now or hereafter in the possession, custody, safekeeping or control of Bank or any entity under the control of Bank (including a Bank subsidiary) or in transit to any of them. At any time after the occurrence and during the continuance of an Event of Default, without demand or notice, Bank may set off the same or any part thereof and apply the same to any liability or obligation of Borrower even though unmatured and regardless of the adequacy of any other collateral securing the Obligations. ANY AND ALL RIGHTS TO REQUIRE BANK TO EXERCISE ITS RIGHTS OR REMEDIES WITH RESPECT TO ANY OTHER COLLATERAL WHICH SECURES THE OBLIGATIONS, PRIOR TO EXERCISING ITS RIGHT OF SETOFF WITH RESPECT TO SUCH DEPOSITS, CREDITS OR OTHER PROPERTY OF BORROWER ARE HEREBY KNOWINGLY, VOLUNTARILY AND IRREVOCABLY WAIVED.

12.12 Borrower Liability. Any Borrower may, acting singly, request Credit Extensions hereunder. Each Borrower hereby appoints drugstore.com, Inc. as agent for the other for all purposes hereunder, including with respect to requesting Credit Extensions hereunder. Each Borrower hereunder shall be obligated to repay all Credit Extensions made hereunder, regardless of which Borrower actually receives said Advance, as if each Borrower hereunder directly received all Credit Extensions. Each Borrower waives any suretyship defenses available to it under the Code or any other applicable law. Each Borrower waives any right to require Bank to: (i) proceed against any Borrower or any other person; (ii) proceed against or exhaust any security; or (iii) pursue any other remedy. Bank may exercise or not exercise any right or remedy it has against any Borrower or any security it holds (including the right to foreclose by judicial or non-judicial sale) without affecting any Borrower’s liability. Notwithstanding any other provision of this Agreement or other related document, so long as any Obligation remains outstanding and unpaid, each Borrower irrevocably waives during such period any Obligations remain outstanding and unpaid, all rights that it may have at law or in equity (including, without limitation, any law subrogating Borrower to the rights of Bank under this Agreement) to seek contribution, indemnification or any other form of reimbursement from any other Borrower, or any other Person now or hereafter primarily or secondarily liable for any of the Obligations, for any payment made by Borrower with respect to the Obligations in connection with this Agreement or otherwise and all rights that it might have to benefit from, or to participate in, any security for the Obligations as a result of any payment made by Borrower with respect to the Obligations in connection with this Agreement or otherwise. Any agreement providing for indemnification, reimbursement or any other arrangement prohibited under this Section shall be null and void. If any payment is made to a Borrower in contravention of this Section, such Borrower shall hold such payment in trust for Bank and such payment shall be promptly delivered to Bank for application to the Obligations, whether matured or unmatured.

13 DEFINITIONS

13.1 Definitions. As used in this Agreement, the following terms have the following meanings:

“Account” is any “account” as defined in the Code with such additions to such term as may hereafter be made, and includes, without limitation, all accounts receivable and other sums owing to Borrower.

“Account Debtor” is any “account debtor” as defined in the Code with such additions to such term as may hereafter be made.

“Adjusted EBITDA” shall mean (a) Net Income, plus (b) Interest Expense, plus (c) to the extent deducted in the calculation of Net Income, depreciation expense, amortization expense and non-cash expenses (including the impact of stock based compensation expense), plus (d) income tax expense. At Bank’s discretion, Adjusted EBITDA may be adjusted following any extraordinary expenses or income associated with one-time charges such as merger and acquisition expenses, restructuring charges or sales of assets or discontinued business lines.

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“Adjusted Quick Ratio” is the ratio of (i) the Quick Assets of Borrower to (ii) the Current Liabilities of Borrower.

“Advance” or “Advances” means an advance (or advances) under the Revolving Line.

“Affiliate” of any Person is a Person that owns or controls directly or indirectly the Person, any Person that controls or is controlled by or is under common control with the Person, and each of that Person’s senior executive officers, directors, partners and, for any Person that is a limited liability company, that Person’s managers and members.

“Agreement” is defined in the preamble hereof.

“Availability Amount” is (a) the lesser of (i) the Revolving Line or (ii) the amount available under the Borrowing Base minus (b) the amount of all outstanding Letters of Credit (including drawn but unreimbursed Letters of Credit) plus an amount equal to the Letter of Credit Reserve, minus (c) the FX Reduction Amount, minus (d) any amounts used for Cash Management Services, minus (e) the outstanding principal balance of any Advances and minus (f) the aggregate amount of Advances that have been converted to a Term Loan.

“Bank” is defined in the preamble hereof.

“Bank Expenses” are all audit fees and expenses, costs, and expenses (including reasonable attorneys’ fees and expenses) for preparing, amending, negotiating, administering, defending and enforcing the Loan Documents (including, without limitation, those incurred in connection with appeals or Insolvency Proceedings) or otherwise incurred with respect to Borrower.

“Borrower” is defined in the preamble hereof.

“Borrower’s Books” are all Borrower’s books and records including ledgers, federal and state tax returns, records regarding Borrower’s assets or liabilities, the Collateral, business operations or financial condition, and all computer programs or storage or any equipment containing such information.

“Borrowing Base” is (a) 80% of Eligible Accounts, plus (b) the lesser of (i) 70% of the value of Borrower’s Eligible Inventory (valued at the lower of cost or wholesale fair market value) or (ii) 80% of the net liquidation value of Borrower’s Eligible Inventory as reflected in the most recent appraisal of Borrower’s Eligible Inventory received by Bank, plus (c) 50% of the average daily cash balances in Borrower’s operating accounts and/or Eurodollar investment accounts held at Bank and its Affiliates in the month immediately preceding the date of the most recent Borrowing Base Certificate delivered by Borrower to Bank, plus (d) 25% of the average daily balances in Borrower’s other deposit or investment accounts held at Bank and its Affiliates in the month immediately preceding the date of the most recent Borrowing Base Certificate delivered by Borrower to Bank, as determined by Bank from Borrower’s most recent Borrowing Base Certificate; provided, however, that Bank may decrease the foregoing percentages in its good faith business judgment based on events, conditions, contingencies, or risks which, as determined by Bank, may adversely affect Collateral.

“Borrowing Base Certificate” is that certain certificate in the form attached hereto as Exhibit C.

“Borrowing Resolutions” are, with respect to any Person, those resolutions adopted by such Person’s Board of Directors and delivered by such Person to Bank approving the Loan Documents to which such Person is a party and the transactions contemplated thereby, together with a certificate executed by its secretary on behalf of such Person certifying that (a) such Person has the authority to execute, deliver, and perform its obligations under each of the Loan Documents to which it is a party, (b) that attached as Exhibit A to such certificate is a true, correct, and complete copy of the resolutions then in full force and effect authorizing and ratifying the execution, delivery, and performance by such Person of the Loan Documents to which it is a party, (c) the name(s) of the Person(s) authorized to execute the Loan Documents on behalf of such Person, together with a sample of the true signature(s) of such Person(s), and (d) that Bank may conclusively rely on such certificate unless and until such Person shall have delivered to Bank a further certificate canceling or amending such prior certificate.

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“Business Day” is any day that is not a Saturday, Sunday or a day on which Bank is closed.

“Cash Equivalents” means (a) marketable direct obligations issued or unconditionally guaranteed by the United States or any agency or any State thereof having maturities of not more than one (1) year from the date of acquisition; (b) commercial paper maturing no more than one (1) year after its creation and having the highest rating from either Standard & Poor’s Ratings Group or Moody’s Investors Service, Inc.; and (c) Bank’s certificates of deposit issued maturing no more than one (1) year after issue .

“Cash Management Services” is defined in Section 2.1.4.

“Claims” are defined in Section 12.2.

“Code” is the Uniform Commercial Code, as the same may, from time to time, be enacted and in effect in the State of Washington; provided, that, to the extent that the Code is used to define any term herein or in any Loan Document and such term is defined differently in different Articles or Divisions of the Code, the definition of such term contained in Article or Division 9 shall govern; provided further, that in the event that, by reason of mandatory provisions of law, any or all of the attachment, perfection, or priority of, or remedies with respect to, Bank’s Lien on any Collateral is governed by the Uniform Commercial Code in effect in a jurisdiction other than the State of Washington, the term “Code” shall mean the Uniform Commercial Code as enacted and in effect in such other jurisdiction solely for purposes of the provisions thereof relating to such attachment, perfection, priority, or remedies and for purposes of definitions relating to such provisions.

“Collateral” is any and all properties, rights and assets of Borrower described on Exhibit A.

“Collateral Account” is any Deposit Account, Securities Account, or Commodity Account.

“Committed Availability” means, as the date of determination, an amount equal to the Revolving Line minus all outstanding Credit Extensions.

“Commodity Account” is any “commodity account” as defined in the Code with such additions to such term as may hereafter be made.

“Compliance Certificate” is that certain certificate in the form attached hereto as Exhibit D.

“Contingent Obligation” is, for any Person, any direct or indirect liability, contingent or not, of that Person for (a) any indebtedness, lease, dividend, letter of credit or other obligation of another such as an obligation directly or indirectly guaranteed, endorsed, co-made, discounted or sold with recourse by that Person, or for which that Person is directly or indirectly liable; (b) any obligations for undrawn letters of credit for the account of that Person; and (c) all obligations from any interest rate, currency or commodity swap agreement, interest rate cap or collar agreement, or other agreement or arrangement designated to protect a Person against fluctuation in interest rates, currency exchange rates or commodity prices; but “Contingent Obligation” does not include endorsements in the ordinary course of business. The amount of a Contingent Obligation is the stated or determined amount of the primary obligation for which the Contingent Obligation is made or, if not determinable, the maximum reasonably anticipated liability for it determined by the Person in good faith; but the amount may not exceed the maximum of the obligations under any guarantee or other support arrangement.

“Control Agreement” is any control agreement entered into among the depository institution at which Borrower maintains a Deposit Account or the securities intermediary or commodity intermediary at which Borrower maintains a Securities Account or a Commodity Account, Borrower, and Bank pursuant to which Bank obtains control (within the meaning of the Code) over such Deposit Account, Securities Account, or Commodity Account.

“Credit Extension” is any Advance, Letter of Credit, Term Loan, FX Forward Contract, amount utilized for Cash Management Services, or any other extension of credit by Bank for Borrower’s benefit.

“Current Assets” are amounts that under GAAP should be included on that date as current assets on Borrower’s consolidated balance sheet.

“Current Liabilities” are all funded obligations and liabilities of Borrower, including capital leases and amounts owed to Bank and Reserves established by Bank.

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“Default Rate” is defined in Section 2.3(b).

“Deposit Account” is any “deposit account” as defined in the Code with such additions to such term as may hereafter be made.

“Designated Deposit Account” is Borrower’s deposit account, account number 3300380008, maintained with Bank.

“Dollars,” “dollars” and “$” each mean lawful money of the United States.

“Effective Date” is the date set forth in the preamble hereof.

“Eligible Accounts” means Accounts which arise in the ordinary course of Borrower’s business that meet all Borrower’s representations and warranties in Section 5.3. Bank reserves the right, at any time after the Effective Date to adjust any of the criteria set forth below and to establish new criteria in its good faith business judgment. Unless Bank agrees otherwise in writing, Eligible Accounts shall not include:

(a) Accounts that the Account Debtor has not paid within ninety (90) days of invoice date regardless of invoice payment period terms;

(b) Accounts owing from an Account Debtor, fifty percent (50%) or more of whose Accounts have not been paid within ninety (90) days of invoice date;

(c) Accounts owing from an Account Debtor which does not have its principal place of business in the United States;

(d) Accounts billed and/or payable outside of the United States;

(e) Accounts owing from an Account Debtor to the extent that Borrower is indebted or obligated in any manner to the Account Debtor (as creditor, lessor, supplier or otherwise - sometimes called “contra” accounts, accounts payable, customer deposits or credit accounts), with the exception of customary credits, adjustments and/or discounts given to an Account Debtor by Borrower in the ordinary course of its business;

(f) Accounts for which the Account Debtor is Borrower’s Affiliate, officer, employee, or agent;

(g) Accounts with credit balances over ninety (90) days from invoice date;

(h) Accounts owing from an Account Debtor, including Affiliates, whose total obligations to Borrower exceed twenty-five percent (25%) of all Accounts, for the amounts that exceed that percentage, unless Bank approves in writing;

(i) Accounts owing from an Account Debtor which is a United States government entity or any department, agency, or instrumentality thereof unless Borrower has assigned its payment rights to Bank and the assignment has been acknowledged under the Federal Assignment of Claims Act of 1940, as amended;

(j) Accounts for demonstration or promotional equipment, or in which goods are consigned, or sold on a “sale guaranteed”, “sale or return”, “sale on approval”, or other terms if Account Debtor’s payment may be conditional;

(k) Accounts owing from an Account Debtor that has not been invoiced or where goods or services have not yet been rendered to the Account Debtor (sometimes called memo billings or pre-billings);

(l) Accounts subject to contractual arrangements between Borrower and an Account Debtor where payments shall be scheduled or due according to completion or fulfillment requirements where the Account Debtor has a right of offset for damages suffered as a result of Borrower’s failure to perform in accordance with the contract (sometimes called contracts accounts receivable, progress billings, milestone billings, or fulfillment contracts);

(m) Accounts owing from an Account Debtor the amount of which may be subject to withholding based on the Account Debtor’s satisfaction of Borrower’s complete performance (but only to the extent of the amount withheld; sometimes called retainage billings);

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(n) Accounts subject to trust provisions, subrogation rights of a bonding company, or a statutory trust;

(o) Accounts owing from an Account Debtor that has been invoiced for goods that have not been shipped to the Account Debtor unless Bank, Borrower, and the Account Debtor have entered into an agreement acceptable to Bank in its sole discretion wherein the Account Debtor acknowledges that (i) it has title to and has ownership of the goods wherever located, (ii) a bona fide sale of the goods has occurred, and (iii) it owes payment for such goods in accordance with invoices from Borrower (sometimes called “bill and hold” accounts);

(p) Accounts for which the Account Debtor has not been invoiced;

(q) Accounts that represent non-trade receivables or that are derived by means other than in the ordinary course of Borrower’s business;

(r) Accounts consisting of credit card receivables;

(s) Accounts for which Borrower has permitted Account Debtor’s payment to extend beyond 90 days;

(t) Accounts subject to chargebacks or others payment deductions taken by an Account Debtor;

(u) Accounts in which the Account Debtor disputes liability or makes any claim (but only up to the disputed or claimed amount), or if the Account Debtor is subject to an Insolvency Proceeding, or becomes insolvent, or goes out of business;

(v) Accounts owing from an Account Debtor with respect to which Borrower has received deferred revenue (but only to the extent of such deferred revenue);

(w) Accounts for which Bank in its good faith business judgment determines collection to be doubtful; and

(x) other Accounts Bank deems ineligible in the exercise of its good faith business judgment.

“Eligible Inventory” means Inventory that meets all of Borrower’s representations and warranties in Section 5.3 and is otherwise acceptable to Bank in all respects. Eligible Inventory shall not include Inventory aged more than 365 days from its purchase date, in-transit Inventory or Inventory located on dock.

“Equipment” is all “equipment” as defined in the Code with such additions to such term as may hereafter be made, and includes without limitation all machinery, fixtures, goods, vehicles (including motor vehicles and trailers), and any interest in any of the foregoing.

“ERISA” is the Employee Retirement Income Security Act of 1974, and its regulations.

“Event of Default” is defined in Section 8.

“Fixed Charges” means, for any period, the sum of all principal payments due and payable in respect of any term Indebtedness and all cash interest charges due and payable in respect of all Indebtedness during such period.

“Fixed Charge Coverage Ratio” and/or “FCCR” means, with respect to any period, the ratio of (i) Free Cash Flow for such period to (ii) Fixed Charges for such period.

“Foreign Currency” means lawful money of a country other than the United States.

“Free Cash Flow” means at any date of determination, Borrower’s Adjusted EBITDA less (i) capital expenditures (including capitalized software development costs but excluding capital expenditures constituting a Permitted Acquisition and capital expenditures funded by capital leases) and (ii) cash taxes paid by Borrower, in each case for the rolling three-month period ending on the date of determination.

“Funding Date” is any date on which a Credit Extension is made to or on account of Borrower which shall be a Business Day.

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“FX Business Day” is any day when (a) Bank’s Foreign Exchange Department is conducting its normal business and (b) the Foreign Currency being purchased or sold by Borrower is available to Bank from the entity from which Bank shall buy or sell such Foreign Currency.

“FX Forward Contract” is defined in Section 2.1.3.

“FX Reduction Amount” is defined in Section 2.1.3.

“FX Reserve” is defined in Section 2.1.3.

“GAAP” is generally accepted accounting principles set forth in the opinions and pronouncements of the Accounting Principles Board of the American Institute of Certified Public Accountants and statements and pronouncements of the Financial Accounting Standards Board or in such other statements by such other Person as may be approved by a significant segment of the accounting profession, which are applicable to the circumstances as of the date of determination.

“General Intangibles” is all “general intangibles” as defined in the Code in effect on the date hereof with such additions to such term as may hereafter be made, and includes without limitation, all copyright rights, copyright applications, copyright registrations and like protections in each work of authorship and derivative work, whether published or unpublished, any patents, trademarks, service marks and, to the extent permitted under applicable law, any applications therefor, whether registered or not, any trade secret rights, including any rights to unpatented inventions, payment intangibles, royalties, contract rights, goodwill, franchise agreements, purchase orders, customer lists, route lists, telephone numbers, domain names, claims, income and other tax refunds, security and other deposits, options to purchase or sell real or personal property, rights in all litigation presently or hereafter pending (whether in contract, tort or otherwise), insurance policies (including without limitation key man, property damage, and business interruption insurance), payments of insurance and rights to payment of any kind.

“Governmental Approval” is any consent, authorization, approval, order, license, franchise, permit, certificate, accreditation, registration, filing or notice, of, issued by, from or to, or other act by or in respect of, any Governmental Authority.

“Governmental Authority” is any nation or government, any state or other political subdivision thereof, any agency, authority, instrumentality, regulatory body, court, central bank or other entity exercising executive, legislative, judicial, taxing, regulatory or administrative functions of or pertaining to government, any securities exchange and any self-regulatory organization.

“Indebtedness” is (a) indebtedness for borrowed money or the deferred price of property or services, such as reimbursement and other obligations for surety bonds and letters of credit, (b) obligations evidenced by notes, bonds, debentures or similar instruments, (c) capital lease obligations, and (d) Contingent Obligations.

“Indemnified Person” is defined in Section 12.2.

“Insolvency Proceeding” is any proceeding by or against any Person under the United States Bankruptcy Code, or any other bankruptcy or insolvency law, including assignments for the benefit of creditors, compositions, extensions generally with its creditors, or proceedings seeking reorganization, arrangement, or other relief.

“Interest Expense” means for any fiscal period, interest expense (whether cash or non-cash) determined in accordance with GAAP for the relevant period ending on such date, including, in any event, interest expense with respect to any Credit Extension and other Indebtedness of Borrower, including, without limitation or duplication, all commissions, discounts, or related amortization and other fees and charges with respect to letters of credit and bankers’ acceptance financing and the net costs associated with interest rate swap, cap, and similar arrangements, and the interest portion of any deferred payment obligation (including leases of all types).

“Inventory” is all “inventory” as defined in the Code in effect on the date hereof with such additions to such term as may hereafter be made, and includes without limitation all merchandise, raw materials, parts, supplies, packing and shipping materials, work in process and finished products, including without limitation such inventory as is temporarily out of Borrower’s custody or possession or in transit and including any returned goods and any documents of title representing any of the above.

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“Investment” is any beneficial ownership interest in any Person (including stock, partnership interest or other securities), and any loan, advance or capital contribution to any Person.

“Letter of Credit” means a standby letter of credit issued by Bank or another institution based upon an application, guarantee, indemnity or similar agreement on the part of Bank as set forth in Section 2.1.2.

“Letter of Credit Application” is defined in Section 2.1.2(a).

“Letter of Credit Reserve” has the meaning set forth in Section 2.1.2(d).

“Lien” is a claim, mortgage, deed of trust, levy, charge, pledge, security interest or other encumbrance of any kind, whether voluntarily incurred or arising by operation of law or otherwise against any property.

“Liquidity” is Borrower’s unrestricted cash and Cash Equivalents plus the Committed Availability.

“Loan Documents” are, collectively, this Agreement, the Perfection Certificate, any note, or notes or guaranties executed by Borrower, and any other present or future agreement between Borrower and/or for the benefit of Bank in connection with this Agreement, all as amended, restated, or otherwise modified.

“Material Adverse Change” is (a) a material impairment in the perfection or priority of Bank’s Lien in the Collateral or in the value of such Collateral; (b) a material adverse change in the business, operations, or condition (financial or otherwise) of Borrower; or (c) a material impairment of the prospect of repayment of any portion of the Obligations; or (d) Bank determines, based upon information available to it and in its reasonable judgment, that there is a reasonable likelihood that Borrower shall fail to comply with one or more of the financial covenants in Section 6 during the next succeeding financial reporting period.

“Maturity Date” is, as applicable, the Revolving Line Maturity Date or the Term Loan Maturity Date.

“Net Income” means, as calculated on a consolidated basis for Borrower and its Subsidiaries for any period as at any date of determination, the net profit (or loss), after provision for taxes, of Borrower and its Subsidiaries for such period taken as a single accounting period.

“Obligations” are Borrower’s obligation to pay when due any debts, principal, interest, the Prepayment Fee, the Termination Fee, Bank Expenses and other amounts Borrower owes Bank now or later, whether under this Agreement, the Loan Documents, or otherwise, including, without limitation, all obligations relating to letters of credit (including reimbursement obligations for drawn and undrawn letters of credit), cash management services, and foreign exchange contracts, if any, and including interest accruing after Insolvency Proceedings begin and debts, liabilities, or obligations of Borrower assigned to Bank, and the performance of Borrower’s duties under the Loan Documents.

“Operating Documents” are, for any Person, such Person’s formation documents, as certified with the Secretary of State of such Person’s state of formation on a date that is no earlier than 30 days prior to the Effective Date, and, (a) if such Person is a corporation, its bylaws in current form, (b) if such Person is a limited liability company, its limited liability company agreement (or similar agreement), and (c) if such Person is a partnership, its partnership agreement (or similar agreement), each of the foregoing with all current amendments or modifications thereto.

“Payment/Advance Form” is that certain form attached hereto as Exhibit B.

“Payment Date” is the first Business Day of each calendar month.

“Perfection Certificate” is defined in Section 5.1.

“Permitted Acquisition” is an acquisition by Borrower of substantially all the stock or property of any person which results in substantially all of the stock or property of a Person being owned by Borrower following the closing of such transaction, provided that the following criteria have been satisfied in Bank’s discretion: (a) Borrower has provided Bank with no less than thirty (30) days notice prior to the closing of such transaction, including without limitation, the name of the Person that Borrower is acquiring, the total consideration for the transaction (broken out into line items for cash and other property), the form of the transaction (asset purchase, stock

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purchase or otherwise) and any other information reasonably requested by Bank; (b) the Person being acquired is in the same line of business as Borrower as determined by Bank; (c) the cash portion of the purchase price in such transaction is not more than Fifteen Million Dollars ($15,000,000.00) in the aggregate, including any contingent obligations; (d) the aggregate cash portion of the purchase price paid in all such transactions since the Effective Date, including, without limitation, contingent obligations, is not more than Twenty Million Dollars ($20,000,000.00) in the aggregate; (e) the aggregate total purchase price paid in all such transactions since the Effective Date, including, without limitation, contingent obligations, is not more than Thirty Million Dollars ($30,000,000.00) in the aggregate; (f) before and after giving effect to the consummation of the transaction, (1) no Event of Default has occurred and is continuing or could not reasonably be expected to result from such transaction, (2) Borrower is in compliance with all financial covenants in Section 6.7 hereof on a pro forma basis giving effect to such transaction, as demonstrated by Borrower to the reasonable satisfaction of Bank prior to the consummation of the transaction and (3) Borrower shall have minimum Liquidity of not less than $10,000,000, as demonstrated by Borrower to the reasonable satisfaction of Bank prior to the consummation of the transaction; (g) the assets of the target company in such acquisition are free and clear of all Liens that would not otherwise constitute Permitted Liens hereunder at the time of the closing of such transaction; (h) Borrower is the surviving corporation of any such transaction, (i) the transaction is consensual having been approved by the board of directors and shareholders of each party thereto; (j) the Person being acquired shall have achieved positive EBITDA for the trailing twelve month period most recently ended prior to the date of the acquisition, as demonstrated by Borrower to the reasonable satisfaction of Bank prior to the consummation of the transaction; (k) the assets of the target company in such acquisition are free and clear of all Liens that would not otherwise constitute Permitted Liens hereunder at the time of the closing of such transaction and (l) if requested by Bank in its sole discretion, Borrower delivers to Bank, within thirty (30) days of the closing of any such transaction, any documents required by Bank in order for Bank to obtain a first priority security interest in the assets acquired by Borrower (including, without limitation, assets owned by a Subsidiary with respect to which Borrower has acquired all or a portion of such entity’s stock).

“Permitted Indebtedness” is:

(a) Borrower’s Indebtedness to Bank under this Agreement and the other Loan Documents;

(b) Indebtedness existing on the Effective Date and shown on the Perfection Certificate;

(c) Subordinated Debt;

(d) unsecured Indebtedness to trade creditors incurred in the ordinary course of business; and

(e) Indebtedness secured by Permitted Liens;

“Permitted Investments” are:

(a) Investments (including Subsidiaries) shown on the Perfection Certificate which are existing on the Effective Date;

(b) Cash and Cash Equivalents;

(c) Investments consisting of deposit accounts in which Bank has a perfected security interest; and

(d) Investments consisting of Permitted Acquisitions.

“Permitted Liens” are:

(a) Liens existing on the Effective Date and shown on the Perfection Certificate or arising under this Agreement and the other Loan Documents;

(b) Liens for taxes, fees, assessments or other government charges or levies, either not delinquent or being contested in good faith and for which Borrower maintains adequate reserves on its Books, provided that no notice of any such Lien has been filed or recorded under the Internal Revenue Code of 1986, as amended, and the Treasury Regulations adopted thereunder;

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(c) purchase money Liens (i) on Equipment (other than Financed Equipment) acquired or held by Borrower incurred for financing the acquisition of the Equipment, or (ii) existing on Equipment (other than Financed Equipment) when acquired, if the Lien is confined to the property and improvements and the proceeds of the Equipment;

(d) leases or subleases of real property granted in the ordinary course of business, and leases, subleases, non-exclusive licenses or sublicenses of property (other than real property or intellectual property) granted in the ordinary course of Borrower’s business, if the leases, subleases, licenses and sublicenses do not prohibit granting Bank a security interest;

(e) non-exclusive license of intellectual property granted to third parties in the ordinary course of business; and

(f) Liens arising from attachments or judgments, orders, or decrees in circumstances not constituting an Event of Default under Sections 8.4 and 8.7.

“Person” is any individual, sole proprietorship, partnership, limited liability company, joint venture, company, trust, unincorporated organization, association, corporation, institution, public benefit corporation, firm, joint stock company, estate, entity or government agency.

“Prepayment Fee” shall be an additional fee in respect of a Term Loan, payable to Bank, in an amount equal to one-half of one percent (0.50%) of the principal amount of the Term Loan prepaid.

“Prime Rate” is Bank’s most recently announced “prime rate,” even if it is not Bank’s lowest rate.

“Quick Assets” is, on any date, Borrower’s (i) unrestricted cash and Cash Equivalents maintained with Bank and (ii) unrestricted cash and Cash Equivalents maintained in accounts with depository institutions acceptable to Bank which are subject to Control Agreements in form and substance acceptable to Bank.

“Registered Organization” is any “registered organization” as defined in the Code with such additions to such term as may hereafter be made.

“Requirement of Law” is as to any Person, the organizational or governing documents of such Person, and any law (statutory or common), treaty, rule or regulation or determination of an arbitrator or a court or other Governmental Authority, in each case applicable to or binding upon such Person or any of its property or to which such Person or any of its property is subject.

“Reserves” means, as of any date of determination, such amounts as Bank may from time to time establish and revise in good faith reducing the amount of Advances, Letters of Credit and other financial accommodations which would otherwise be available to Borrower under the lending formulas: (a) to reflect events, conditions, contingencies or risks which, as determined by Bank in good faith, do or may affect (i) the Collateral or any other property which is security for the Obligations or its value (including without limitation any increase in delinquencies of Accounts), (ii) the assets or business of Borrower, or (iii) the security interests and other rights of Bank in the Collateral (including the enforceability, perfection and priority thereof); or (b) to reflect Bank’s good faith belief that any collateral report or financial information furnished by or on behalf of Borrower to Bank is or may have been incomplete, inaccurate or misleading in any material respect; or (c) in respect of any state of facts which Bank determines in good faith constitutes an Event of Default or may, with notice or passage of time or both, constitute an Event of Default.

“Responsible Officer” is any of the Chief Executive Officer, President, Chief Financial Officer and Controller of Borrower.

“Revolving Line” is an Advance or Advances in an amount equal to Twenty-Five Million Dollars ($25,000,000.00).

“Revolving Line Maturity Date” is the earlier of March 5, 2011, and the termination of the Revolving Line (i) by Borrower, or (ii) after the occurrence of an Event of Default, by Bank.

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“Secretary’s Certificate” is the Certificate executed by Secretary of the Borrower, in form and substance reasonably acceptable to Bank, certifying that the transaction contemplated by this Agreement, have been authorized.

“Securities Account” is any “securities account” as defined in the Code with such additions to such term as may hereafter be made.

“Subordinated Debt” is indebtedness incurred by Borrower subordinated to all of Borrower’s now or hereafter indebtedness to Bank (pursuant to a subordination, intercreditor, or other similar agreement in form and substance satisfactory to Bank entered into between Bank and the other creditor), on terms acceptable to Bank.

“Subsidiary” means, with respect to any Person, any Person of which more than fifty percent (50.0%) of the voting stock or other equity interests (in the case of Persons other than corporations) is owned or controlled directly or indirectly by such Person or one or more of Affiliates of such Person.

“Term Loan” is a loan made by Bank pursuant to the terms of Section 2.1.5 hereof.

“Term Loan Amount” is an amount equal to Fifteen Million Dollars ($15,000,000).

“Term Loan Maturity Date” with respect to a Term Loan is the date which is 48 months from the Effective Date.

“Transfer” is defined in Section 7.1.

“Unused Revolving Line Facility Fee” is defined in Section 2.4(c).

[Signature page follows.]

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IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed as of the Effective Date.

BORROWER:

DRUGSTORE.COM, INC., a Delaware corporation

By

Name:

Title:

BEAUTY.COM, INC., a Delaware corporation and wholly owned subsidiary of drugstore.com, inc.

By

Name:

Title:

CUSTOM NUTRITION SERVICES, INC., a Delaware corporation and wholly owned subsidiary of drugstore.com, inc.

By

Name:

Title:

DS PHARMACY, INC., a Delaware corporation and wholly owned subsidiary of drugstore.com, inc.

By

Name:

Title:

DS FULFILLMENT, INC., a Delaware corporation and wholly owned subsidiary of drugstore.com, inc.

By

Name:

Title:

DS DISTRIBUTION, INC., a Delaware corporation and wholly owned subsidiary of drugstore.com, inc.

By

Name:

Title:

DS NON-PHARMACEUTICAL SALES, INC., a Delaware corporation and wholly owned subsidiary of drugstore.com, inc.

By

Name:

Title:

DE~LUXE DISTRIBUTORS, INC., a Delaware corporation and wholly owned subsidiary of drugstore.com, inc.

By

Name:

Title:

1

VISION DIRECT, INC., a Texas corporation and wholly owned subsidiary of drugstore.com, inc.

By

Name:

Title:

INTERNATIONAL VISION DIRECT, LTD., a British Columbia, Canada company and wholly owned subsidiary of drugstore.com, inc.

By

Name:

Title:

MICHIGAN ONLINE SALES, INC., a Delaware corporation and wholly owned subsidiary of drugstore.com, inc.

By

Name:

Title:

RAD ONLINE SALES, INC., a Delaware corporation and wholly owned subsidiary of drugstore.com, inc.

By

Name:

Title:

BANK:

SILICON VALLEY BANK

By

Name:

Title:

2

EXHIBIT A – COLLATERAL DESCRIPTION

The Collateral consists of all of Borrower’s right, title and interest in and to the following personal property:

All goods, Accounts (including health-care receivables), Equipment, Inventory, contract rights or rights to payment of money, leases, license agreements, franchise agreements, General Intangibles (except as provided below), commercial tort claims, documents, instruments (including any promissory notes), chattel paper (whether tangible or electronic), cash, deposit accounts, fixtures, letters of credit rights (whether or not the letter of credit is evidenced by a writing), securities, and all other investment property, supporting obligations, and financial assets, whether now owned or hereafter acquired, wherever located; and

All Borrower’s Books relating to the foregoing, and any and all claims, rights and interests in any of the above and all substitutions for, additions, attachments, accessories, accessions and improvements to and replacements, products, proceeds and insurance proceeds of any or all of the foregoing.

Notwithstanding the foregoing, the Collateral does not include any of the following, whether now owned or hereafter acquired any copyright rights, copyright applications, copyright registrations and like protections in each work of authorship and derivative work, whether published or unpublished, any patents, patent applications and like protections, including improvements, divisions, continuations, renewals, reissues, extensions, and continuations-in-part of the same, trademarks, service marks and, to the extent permitted under applicable law, any applications therefor, whether registered or not, and the goodwill of the business of Borrower connected with and symbolized thereby, know-how, operating manuals, trade secret rights, rights to unpatented inventions, and any claims for damage by way of any past, present, or future infringement of any of the foregoing; provided, however, the Collateral shall include all Accounts, license and royalty fees and other revenues, proceeds, or income arising out of or relating to any of the foregoing.

Pursuant to the terms of a certain negative pledge arrangement with Bank, Borrower has agreed not to encumber any of its copyright rights, copyright applications, copyright registrations and like protections in each work of authorship and derivative work, whether published or unpublished, any patents, patent applications and like protections, including improvements, divisions, continuations, renewals, reissues, extensions, and continuations-in-part of the same, trademarks, service marks and, to the extent permitted under applicable law, any applications therefor, whether registered or not, and the goodwill of the business of Borrower connected with and symbolized thereby, know-how, operating manuals, trade secret rights, rights to unpatented inventions, and any claims for damage by way of any past, present, or future infringement of any of the foregoing, without Bank’s prior written consent.

3

EX-10.27

Exhibit 10.27

411 108^th Ave NE • Suite 1400 • Bellevue, Washington 98004 • Telephone 425.372.3200 • Facsimile 425.372.3800

December 31, 2008

Dawn Lepore

drugstore.com, inc.

411 108^th Avenue NE, Suite 1400

Bellevue, WA 98004

Dear Dawn:

The offer letter dated December 28, 2006, entered into between you and the Company is amended and restated effective as of December 31, 2008, as follows.

On behalf of drugstore.com, inc. (the “Company”), we are pleased that you continue to serve as the Company’s President and Chief Executive Officer and Chairman of the Board on the terms set forth in this letter. The terms of this letter are intended to supersede those set forth in your offer letter dated September 21, 2004 (the “2004 Offer Letter”) and the offer letter dated December 28, 2006 (the “2006 Offer Letter”) with respect to your employment, salary and benefits going forward, but except as specifically set forth herein they are not intended to supersede or modify the terms of the Sign-On Bonus, the Time-Based Options or the Performance-Based Options set forth in the 2004 Offer Letter and the 2006 Option set forth in your 2006 Offer Letter. You will continue to report directly to the Company’s board of directors.

You will continue to be eligible for an annual salary of $500,000, along with the Company’s standard employee benefits for Company executives, and you will be entitled to five (5) weeks of vacation each year. Your salary will continue to be paid in accordance with the Company’s standard payroll policies. In addition, you will continue to be eligible to receive an annual target bonus in an amount ranging from 50% to 150% of your annual salary, based on the achievement of pre-determined performance objectives. The performance objectives will be determined by mutual agreement between you and the board of directors or its designated committee. Your compensation package will be reviewed annually by the Company’s board of directors. Payment of your compensation will be subject to the Company’s satisfaction of applicable tax withholding requirements.

If during your employment with the Company there is a Change of Control (as defined below), notwithstanding anything to the contrary in the 2004 Offer Letter, the 2006 Offer Letter, the Time-Based Options, the Performance-Based Options and the 2006 Option will immediately become fully vested and exercisable. “Change of Control” shall mean (a) the sale, lease or other disposition of all or substantially all of the assets of the Company, (b) the acquisition of beneficial ownership of more than 50% of the total voting power represented by the Company’s then outstanding voting securities by any person or group of related persons (other than by any affiliate controlled by the Company or any benefit plan sponsored or maintained by the Company or a subsidiary of the Company), (c) the acquisition of the Company by another entity by means of merger, consolidation or similar transaction after which the stockholders of the Company immediately prior to the occurrence of such merger, consolidation or similar transaction hold less than 50% of the total voting power of the surviving controlling entity, or (d) a change in the composition of the Board such that during any period of two (2) consecutive years, individuals who at the beginning of such period constituted the Board (together with any new directors whose election by such Board or whose nomination for election by the stockholders of the Company was approved by a vote of a majority of the directors of the Company then still in office, who were either directors at the beginning of

December 31, 2008 Page 2

such period or whose election or nomination for election was previously so approved) cease for any reason to constitute a majority of the Board then in office; provided that a reincorporation of the Company shall not be a Change of Control.

In the event that the benefits payable under the 2004 Offer Letter and the 2006 Offer Letter, this letter or otherwise upon or following a Change of Control constitute “parachute payments” within the meaning of Section 280G of the Internal Revenue Code (the “Code”) or any comparable successor provisions, and would otherwise be subject to the excise tax imposed by Section 4999 of the Code or any comparable successor provisions (the “Excise Tax”), your benefits will be either (a) provided to you in full, or (b) provided to you as to such lesser extent that would result in no portion of such benefits being subject to the Excise Tax, whichever amount would result in your receipt of the greatest amount of benefits on an after-tax basis, when taking into account applicable federal, state, local and foreign income and employment taxes, the Excise Tax, and any other applicable taxes, notwithstanding that all or some portion of these benefits may be taxable under the Excise Tax. Unless you and the Company otherwise agree in writing, any determination required under this paragraph will be made in writing in good faith by a nationally recognized accounting firm which is then serving as the Company’s independent auditors (the “Accountants”). Any reduction of benefits hereunder shall occur in the following order: (1) reduction of cash payments; (2) reduction of vesting acceleration of equity awards; and (3) reduction of other benefits paid or provided to you. In the event that acceleration of vesting of equity awards is to be reduced, such acceleration of vesting shall be cancelled in the reverse order of the date of grant for your equity awards. If two or more equity awards are granted on the same date, each award will be reduced on a pro-rata basis. For purposes of making the calculations required by this paragraph, the Accountants may make reasonable assumptions and approximations concerning applicable taxes and may rely on reasonable, good faith interpretations concerning the application of the Code, and other applicable legal authority. You and the Company will furnish to the Accountants such information and documents as the Accountants may reasonably request in order to make a determination under this paragraph. The Company will bear all costs the Accountants may reasonably incur in connection with any calculations contemplated by this paragraph.

If, notwithstanding any reduction described in this and the preceding paragraph, the Internal Revenue Service (“IRS”) determines that you are liable for the Excise Tax as a result of the receipt of the payment of benefits as described above, then you will be obligated to pay back to the Company, within thirty (30) days after a final IRS determination or in the event that you challenge the final IRS determination, a final judicial determination, a portion of the payment equal to the “Repayment Amount.” The Repayment Amount with respect to the payment of benefits will be the smallest such amount, if any, as will be required to be paid to the Company so that your net after-tax proceeds with respect to any payment of benefits (after taking into account the payment of the Excise Tax and all other applicable taxes imposed on such payment) will be maximized. The Repayment Amount with respect to the payment of benefits will be zero if a Repayment Amount of more than zero would not result in your net after-tax proceeds with respect to the payment of such benefits being maximized. If the Excise Tax is not eliminated pursuant to this and the preceding paragraph, you will pay the Excise Tax. Notwithstanding any other provision of this and the preceding paragraph, if (a) there is a reduction in the payment of benefits as described in this and the preceding paragraph, (b) the IRS later determines that you are liable for the Excise Tax, the payment of which would result in the maximization of your net after-tax proceeds (calculated as if your benefits had not previously been reduced), and (c) you pay the Excise Tax, then the Company will pay to you those benefits which were reduced pursuant to this paragraph contemporaneously or as soon as administratively possible after you pay the Excise Tax so that your net after-tax proceeds with respect to the payment of benefits are maximized.

December 31, 2008 Page 3

If your employment is terminated by the Company without Cause or you resign your employment for Good Reason, you will be offered a severance package that includes the equivalent of one year of annual salary and one year of target bonus at the levels in effect at the time of such termination without Cause or for Good Reason, paid in accordance with the Company’s standard payroll policies. In addition, you will receive twelve additional months of vesting credit under the 2006 Option and any other subsequently-granted options for which vesting is exclusively based on your continued service to the Company. Except as described above, such options will not otherwise vest.

Notwithstanding anything to the contrary in this offer letter, no severance payable to you, if any, pursuant to this offer letter, when considered together with any other severance payments or separation benefits that are considered deferred compensation under Section 409A (together, the “Deferred Compensation Separation Benefits”) shall be payable until you have a “separation from service” within the meaning of Section 409A.

Notwithstanding anything to the contrary in this offer letter, if you are a “specified employee” within the meaning of Section 409A at the time of your termination (other than due to death), the Deferred Compensation Separation Benefits that are payable within the first six (6) months following your termination of employment will become payable on the first payroll date that occurs on or after the date six (6) months and one (1) day following the date of your termination of employment. All subsequent Deferred Compensation Separation Benefits, if any, will be payable in accordance with the payment schedule applicable to each payment or benefit. Notwithstanding anything herein to the contrary, if you die following your termination but prior to the six (6) month anniversary of your termination, then any payments delayed in accordance with this paragraph will be payable in a lump sum as soon as administratively practicable after the date of your death and all other Deferred Compensation Separation Benefits will be payable in accordance with the payment schedule applicable to each payment or benefit. These provisions are intended to comply with the requirements of Section 409A so that none of the Deferred Compensation Separation Benefits to be provided hereunder will be subject to the additional tax imposed under Section 409A, and any ambiguities herein will be interpreted to so comply.

Your entitlement to this severance package is subject to your execution of an effective release of claims substantially in the form attached hereto, except as the parties may otherwise agree or except as required by law provided that such release of claims is effective within sixty (60) days following the termination date or such earlier date as required by the release of claims (such deadline, the “Release Deadline”), and your continuing compliance with the Company’s proprietary information and inventions agreement. No severance pursuant to this offer letter will be paid or provided until the release of claims becomes effective. If your Release Deadline is on or before December 15 of the calendar year in which your “separation from service” (within the meaning of Section 409A occurs, any portion of the severance payments provided hereunder that would be considered “Deferred Compensation Separation Benefits” (as defined above) will be made to you on or before December 31 of that calendar year or, if later, (i) such time as required by the payment schedule applicable to each payment or benefit as set forth herein, or (ii) such time as required below. If your Release Deadline is after December 15 of the calendar year in which your “separation from service” (within the meaning of Section 409A) occurs, any portion of the severance payments provided hereunder that would be considered Deferred Compensation Separation Benefits will be made to you on the first payroll date to occur during the calendar year following the calendar year in which such separation from service occurs, or, if later, (i) the first payroll date following the Release Deadline, (ii) such time as required by the payment schedule applicable to each payment or benefit, or (iii) such time as required by Section 409A.

December 31, 2008 Page 4

“Cause” means (a) your willful or negligent failure to comply with the lawful directions of the Company’s Board of Directors, (b) gross negligence or willful misconduct in the performance of your duties to the Company, (c) commission of any act of fraud against the Company that results in an injury to the Company other than a de minimus injury to the Company, or (d) misappropriation of material property of the Company to the material detriment of the Company.

For purposes of this letter agreement, “Good Reason” means your resignation within thirty (30) days following the expiration of any Company cure period (discussed below) following the occurrence of one or more of the following, without your consent: (a) the refusal of the Company to pay or cause to be paid to you your annual salary or any annual bonus after they have been earned; (b) the material reduction of your annual salary without your consent; (c) the material reduction of your target bonus range unaccompanied by any corresponding upward adjustment in any other form of incentive compensation by the Company to you without your consent; (d) a material diminution in your authority, responsibilities, duties as President and Chief Executive Officer (but not as Chairman of the Board of Directors) without your consent; (e) the material relocation of your primary work place for the Company (currently Bellevue, Washington) to a location more than thirty-five (35) miles from its current location without your consent; (f) the failure of the Company to nominate you to serve as a director at each annual stockholder meeting while you are serving as the President and Chief Executive Officer of the Company; or (g) a material reduction in the kind or level of the benefits or perquisites for which you are eligible without your consent, unless the reduction is applicable to substantially all other Company executive officers; provided that the events described in clauses (a), (b), (c), (d), (e), (f), or (g) above shall constitute Good Reason only if the Company fails to cure such event within a reasonable time (not to exceed fifteen (15) business days) after receipt from you of written notice of the event which constitutes Good Reason; provided, further, that “Good Reason” shall cease to exist for an event on the 90th day following its initial existence, unless you have given the Company written notice thereof prior to such date.

If you are terminated for Cause or your employment with the Company terminates for any other reason other than Good Reason or termination by the Company without Cause, you will not receive any severance benefits.

If the Company adopts any other severance policy, plan, program, or arrangement applicable to employees for which you are eligible for benefits, any amounts paid or benefits provided to you under this offer letter in connection with your termination of employment will be reduced by the value of any payments or delivery of benefits by the Company to you on account of your termination of employment under any such policy, plan, program or arrangement maintained by the Company. For avoidance of confusion, you should be aware that at the present time, the Company has no such other severance policy, plan, program or arrangement for which you would be eligible for benefits. Furthermore, to the extent that any federal, state or local laws require the Company to give advance notice or make a payment of any kind to you because of your involuntary termination due to a layoff, reduction in force, plant or facility closing, sale of business, change of control, or any other similar event or reason, the amounts paid or benefits provided to you under this offer letter will be reduced by any amounts so received as required by applicable law.

Following your termination of employment for any reason, you (or upon your death or permanent and total disability, you, your legal representative, or your beneficiary, as applicable) will have until the earliest of (i) one year from the date of such termination, (ii) ) ten (10) years from the date of grant, or (iii) the end of the original option term, in which to exercise the vested and outstanding portion of the 2006

December 31, 2008 Page 5

Option and any options granted thereafter (the “Vested Options”), provided that to the extent not exercised on or prior to the date of your termination of employment, your Vested Options will terminate according to the following schedule: (a) 25% of your Vested Options will terminate three (3) months following your termination, (b) 25% of your Vested Options will terminate six (6) months following your termination, (c) 25% of your Vested Options will terminate nine (9) months following your termination, and (d) 25% of your Vested Options will terminate twelve (12) months following your termination. Any Vested Options exercised during this one-year period will be deemed to be those Vested Options with the nearest expiration date, unless you specify in writing a different application. None of your options will continue to vest following your termination and in no event will you be able to exercise an option after the expiration of the term of the option as set forth in the applicable agreement governing such option.

The Company will continue to indemnify you and provide you with coverage under its D&O insurance policy with respect to your service as an officer and director of the Company to the same extent provided to the Company’s other officers and directors.

Since your employment is “at will,” your employment at drugstore.com may be terminated by you or drugstore.com at any time for any reason or no reason with or without Cause or notice.

The terms of this letter may only be changed by written agreement, although the Company may from time to time, in its sole discretion, adjust the salaries and benefits paid to you and its other employees. This letter will be governed by the laws of the State of Washington, without regard to its conflict of laws provisions.

We are pleased to offer you these modifications to your employment relationship with drugstore.com in recognition of the considerable benefit to the Company that your work has yielded to now. We are very excited about continuing the very beneficial and rewarding relationship we have experienced to date.

Should you have any questions with regard to any of the items indicated above, please contact Robert Hargadon, the Company’s Vice President, Human Resources. Kindly indicate your consent to the terms contained in this offer letter by signing and returning a copy to us by December 31, 2008.

December 31, 2008 Page 6

Sincerely,

drugstore.com, inc.

By:	/s/ William Savoy
Title:	Director

Agreed to and accepted:

Dawn Lepore

/s/ Dawn Lepore

12/31/2008

EX-21.1

Exhibit 21.1

SUBSIDIARIES

Beauty.com, Inc., a Delaware corporation

Custom Nutrition Services, Inc., a Delaware corporation

DS Pharmacy, Inc., a Delaware corporation

DS Fulfillment, Inc., a Delaware corporation

DS Distribution, Inc., a Delaware corporation

DS Non-Pharmaceutical Sales, Inc., a Delaware corporation

De~luxe Distributors, Inc., a Delaware corporation

International Vision Direct, Ltd., a British Columbia, Canada company

Michigan Online Sales, Inc., a Delaware corporation

RAD Online Sales, Inc., a Delaware corporation

Vision Direct, Inc., a Texas corporation

EX-23.1

Exhibit 23.1

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We consent to the incorporation by reference in the following Registration Statements:

(1) Registration Statement (Form S-8, No. 333-83975) pertaining to the 1999 Employee Stock Purchase Plan and 1998 Stock Plan of drugstore.com, inc.;

(2) Registration Statement (Form S-8, No. 333-58174) pertaining to the 1998 Stock Plan of drugstore.com, inc.;

(3) Registration Statement (Form S-8, No. 333-85468) pertaining to the 1998 Stock Plan of drugstore.com, inc.;

(4) Registration Statement (Form S-3, No. 333-130097) and related prospectus of drugstore.com, inc.

(5) Registration Statement (Form S-8, No. 333-153407) pertaining to the 2008 Equity Incentive Plan of drugstore.com, inc.

of our reports dated March 11, 2009, with respect to the consolidated financial statements and schedule of drugstore.com, inc. and the effectiveness of internal control over financial reporting of drugstore.com, inc., included in this Annual Report (Form 10-K) for the year ended December 28, 2008.

/s/ Ernst & Young LLP

Seattle, Washington

March 11, 2009

EX-31.1

Exhibit 31.1

CERTIFICATION

I, Dawn G. Lepore, certify that:

1. I have reviewed this annual report on Form 10-K of drugstore.com, inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors:

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

/s/ Dawn G. Lepore

Dawn G. Lepore

President, Chief Executive Officer and

Chairman of the Board

March 13, 2009

EX-31.2

Exhibit 31.2

CERTIFICATIONS

I, Robert P. Potter, certify that:

1. I have reviewed this annual report on Form 10-K of drugstore.com, inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors:

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

/s/ Robert P. Potter

Robert P. Potter

Vice President and

Chief Accounting Officer

March 13, 2009

EX-32.1

Exhibit 32.1

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report on Form 10-K of drugstore.com, inc. (the “Company”) for the period ending December 28, 2008, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Dawn G. Lepore, President, Chief Executive Officer, and Chairman of the Board of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company.

/s/ Dawn G. Lepore

Dawn G. Lepore

President, Chief Executive Officer, and

Chairman of the Board

A signed original of this written statement required by Section 906 has been provided to drugstore.com, inc. and will be retained by drugstore.com, inc. and furnished to the Securities and Exchange Commission or its staff upon request.

March 13, 2009

EX-32.2

Exhibit 32.2

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report on Form 10-K of drugstore.com, inc. (the “Company”) for the period ending December 28, 2008, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Robert P. Potter, Vice President and Chief Accounting Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company.

/s/ Robert P. Potter

Robert P. Potter

Vice President and

Chief Accounting Officer

A signed original of this written statement required by Section 906 has been provided to drugstore.com, inc. and will be retained by drugstore.com, inc. and furnished to the Securities and Exchange Commission or its staff upon request.

March 13, 2009