10-K

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-K

(Mark One)
R	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the fiscal year ended December 31, 2007
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: 001-33031

SHUTTERFLY, INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware	94-3330068
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)
2800 Bridge Parkway, Suite 101	94065
Redwood City, California (Address of Principal Executive Offices)	(Zip Code)

Registrant’s telephone number, including area code

(650) 610-5200

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

Title of Each Class	Name of Each Exchange on Which Registered
Common Stock, $0.0001 Par Value Per Share	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 R

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

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

Indicate by check mark if disclosure of delinquent filers pursuant to Rule 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.  Yes R     No £

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 definition of “accelerated filer,” “large accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (check one)

Large accelerated Filer £                                                                    Accelerated Filer R     

Non-accelerated Filer £                                                                      Smaller reporting company £

(Do not check if a 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 R

As of June 29, 2007, the last business day of our most recently completed second fiscal quarter, the aggregate market value of our Common Stock held by non-affiliates based on the closing price or our Common Stock on June 29, 2007 as reported on the NASDAQ Global Market was $523,696,054.

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class	Outstanding at February 29, 2008
Common stock, $0.0001 par value per share	25,001,631 shares

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the documents listed below have been incorporated by reference into the indicated parts of this reports, as specified in the responses to the item numbers involved:

Designated portions of the Proxy Statement relating to the 2008 Annual Meeting of the Stockholders to be held on May 22, 2008 (the “Proxy Statement”): Part II (Item 5) and Part III (Items 10, 11, 12, 13 and 14). Except with respect to information specifically incorporated by reference in the Form 10-K, the Proxy Statement is not deemed to be filed as part hereof.

1

Shutterfly, Inc.

Table of Contents

		Page Number
PART I
ITEM 1.	Business	3
ITEM 1A.	Risk Factors	10
ITEM 1B.	Unresolved Staff Comments	18
ITEM 2.	Properties	18
ITEM 3.	Legal Proceedings	18
ITEM 4.	Submission of Matters to a Vote of Security Holders	18
PART II
ITEM 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	19
ITEM 6.	Selected Financial Data	20
ITEM 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	21
ITEM 7A.	Quantitative and Qualitative Disclosures about Market Risk	27
ITEM 8.	Financial Statements and Supplementary Data	28
ITEM 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	47
ITEM 9A.	Controls and Procedures	47
ITEM 9B.	Other Information	47
PART III
ITEM 10.	Directors, Executive Officers and Corporate Governance	48
ITEM 11.	Executive Compensation	48
ITEM 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholders Matters	48
ITEM 13.	Certain Relationships and Related Transactions, and Director Independence	48
ITEM 14.	Principal Accountant Fees and Services	48
PART IV
ITEM 15.	Exhibits and Financial Statement Schedules	48

2

PART I

Except for historical financial information contained herein, the matters discussed in this Form 10-K may be considered forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and subject to the safe harbor created by the Securities Litigation Reform Act of 1995. Such statements include declarations regarding our intent, belief, or current expectations and those of our management. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve a number of risks, uncertainties and other factors, some of which are beyond our control; actual results could differ materially from those indicated by such forward-looking statements. Important factors that could cause actual results to differ materially from those indicated by such forward-looking statements include, but are not limited to: (i) that the information is of a preliminary nature and may be subject to further adjustment; (ii) those risks and uncertainties identified under “Risk Factors;” and (iii) the other risks detailed from time-to-time in our reports and registration statements filed with the Securities and Exchange Commission, or SEC. Except as required by law, we undertake no obligation to revise or update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

ITEM 1.  BUSINESS.

Overview

We are an Internet-based social expression and personal publishing service that enables consumers to share, print and preserve their memories by leveraging our technology, manufacturing, web-design and merchandising capabilities. Today, our primary focus is on helping consumers manage their memories through the powerful medium of photos. We provide a full range of personalized photo-based products and services that make it easy, convenient and fun for consumers to upload, edit, enhance, organize, find, share, create, print and preserve their memories in a creative and thoughtful manner.

Consumers use our products and services to stay connected to their friends and family, to organize their memories in a single location, to tell stories and to preserve their memories for themselves and their children. Our customers purchase physical products both for their own personal use and for giving thoughtful and personalized gifts such as photo books, calendars, greeting cards and other photo-based products and merchandise.

We currently generate the majority of our revenues by producing and selling professionally-bound photo books, personalized calendars, greeting cards, other photo-based merchandise and high-quality prints (ranging in size from wallet-sized to jumbo-sized 20×30 enlargements). We manufacture these items in our Hayward, California and Charlotte, North Carolina manufacturing facilities. By controlling the production process in our own manufacturing facilities, we are able to produce high-quality products, innovate rapidly, maintain a favorable cost structure and ensure timely shipment to customers, even during peak periods of demand. Additionally, we sell a variety of photo-based merchandise that is currently manufactured for us by third parties, such as mugs, mouse pads, coasters, tote bags, desk organizers, puzzles, playing cards, multi-media DVDs, magnets and keepsake boxes, and ancillary products, such as frames, photo albums and scrapbooking accessories.

Our high-quality products and services and the compelling online experience we create for our customers, together with our focus on continuous innovation, have earned us numerous third-party accolades and, more importantly, have allowed us to establish a premium brand. We believe that we realize the benefits of a premium brand through high customer loyalty, low customer acquisition costs and premium pricing.

Our customers are a central part of our business model. They generate most of the content on our service by uploading their photos and storing their memories. In addition, they share their photos electronically with their friends and families, extending and endorsing our brand and creating a sense of community. Finally, by giving Shutterfly-branded products to colleagues, friends and loved ones throughout the year, customers reinforce the Shutterfly brand. Through these various activities, our customers create a viral network of new users and customers.

In addition to driving lower customer acquisition costs through viral marketing, our customers provide input on new features, functionalities and products. Close, frequent customer interactions, coupled with significant investments in sophisticated integrated marketing programs, enable us to fine-tune and tailor our promotions and website presentation to specific customer segments. Consequently, customers are presented with a highly personalized Shutterfly shopping experience, which helps foster a unique and deep relationship with our brand.

Our corporation was formed in 1999 and we have experienced rapid growth since launching our service in December 1999. During fiscal year  2007, we fulfilled more than seven million orders, to more than two million customers, at an average order value of more than $26 per order.

In June 2005, we completed the acquisition of Memory Matrix, Inc., a Nevada engineering firm dedicated to improving the consumer digital photography experience, in exchange for 109,302 shares of common stock.  In June 2007, we acquired for $1.6 million, certain assets and liabilities of CustomAbility, LLC, a New Jersey publishing company that produces customized children’s books under the brand name Make It About Me.  On January 4, 2008, for $10.0 million in cash, and stock consideration of approximately $4.0 million, we acquired Nexo Systems, a privately held on-line sharing and group services company based in Palo Alto, California.

Vision and Mission

Our vision is to make the world a better place by helping people share life’s joy. Our mission is to build an unrivaled service that enables deeper, more personal relationships between our customers and those who matter most in their lives.

We believe that people have an intrinsic desire for social expression, as they wish to capture and share their experiences and pass them on to future generations. Since the beginning of humankind, people have shared detailed stories of their lives through visual expression. Today, with the evolution of digital cameras and technology, millions of people around the world are capturing their memories and communicating in deeper, more meaningful ways.

We believe people will continue to take pictures of important moments in their lives across various occasions throughout the year, including vacations, weddings, birthdays, anniversaries, graduations, family reunions and holidays. Our products and services make sharing, printing and preserving those memories easy, convenient and fun, and allow for our customers to be more thoughtful and creative with their memories. As our customers share these joyous memories, either digitally through our sharing service or physically through giving personalized photo-based gifts, they are enhancing their personal relationships, creating more joy in the world and making the world a better place.

Industry Overview

Historically, preserving photos and creating original, thoughtful compilations of memories was a difficult, expensive, manual, time-consuming and often inconvenient process for consumers. As a result of these constraints, the desire for easy, convenient, versatile, affordable and trusted online photo services has emerged.

Until the widespread adoption of the Internet and digital cameras, there were significant inefficiencies and quality limitations associated with capturing, developing, processing, storing, editing and sharing images. Photos had to be stored in physical form and were vulnerable to deterioration, destruction or loss. Most people chose the limited option of storing their 4x6 prints in shoeboxes or simple photo albums because photography-related markets — including film processing, photo printing and scrapbooking — either did not exist or were not well-integrated. In particular, convenient options for photo production, storage and sharing were very limited; consumers had to settle for ordering duplicate 4x6 prints from either mail-order or local processing labs with varied capabilities and often poor quality control. Furthermore, the “shoebox” approach created significant difficulties for consumers in organizing their photos and limited their ability to be thoughtful and creative with their memories. The photo-related industries had not found a way to capitalize on the public’s need to preserve memories across generations in a secure, convenient, creative and engaging manner.

3

Internet and digital photo-based technology enables consumers to create an archive of memories that extends beyond photos to include highly personalized, more engaging products and services that can be protected and preserved for future generations. We believe that the key forces driving the expansion of the market for these products and services are:

• Proliferation of digital cameras and penetration of high-speed connectivity.  The growing use of digital cameras, largely driven by price decreases, has increased the demand for online photo-printing services. High-bandwidth, high-speed Internet access has spurred the integration of the Internet into daily life and provides consumers with improved performance and speed for sharing information, especially large files sizes such as digital images. Industry sources estimate that in 2007, U.S. digital camera unit sales reached approximately 25 million units.  Industry sources  also estimate that 70% of all U.S. households will have broadband by 2012, with nearly 36 million new broadband subscribers emerging over the next five years. According to Industry Resources, 61.7% or approximately 71.4 million U.S. households have both a digital camera(s) and Internet access.

• Increasing convenience and quality of online photo services.  Online photo services provide multiple advantages over at-home printing. Although at-home photo printing is instantaneous, it requires an investment in a printer, photo paper and ink, resulting in a much higher cost per print and is time consuming. The quality rendered from at-home printers is usually inferior compared to commercially produced prints. In addition, at-home printers are less capable of producing products that require binding and / or finishing, such as photo books, calendars and folded greeting cards.

In contrast, online photo services conveniently provide a wide variety of customized, high-quality photo-based products delivered directly to consumers’ doorsteps.

• Growing consumer desire to find easy, convenient ways to generate personalized content.  Consumers are interested in creating highly customized and personalized photo-based products and merchandise to preserve their precious memories, express their creativity and make gift giving more personal and thoughtful. Improvements in software and photo editing tools have enabled consumers to modify their photos quickly and easily using a personal computer. Consumers are now able to create digital compilations of memories that were previously only possible through a physical and more time-consuming process.

• Participation in online communities.  Consumers have become increasingly comfortable with using the Internet as a forum for sharing and publishing information in open or permission-based networks. Many of the most popular online communities include user-generated, rich-media content such as photos and videos because of visual content’s inherent ability to communicate more powerfully than the written word.

Addressable Markets

Digital cameras, digital image processing and the Internet have dramatically changed the photo-related services market, and have created entirely new ways for consumers to capture, edit, enhance, organize, find, share, create, print and preserve images. In particular, the range and quality of printed photos, photo-based products, photo-based merchandise and ancillary products have expanded and improved significantly, while associated production costs and the time required to create this output have decreased dramatically. Consequently, companies like Shutterfly are now addressing a wide variety of consumer needs and multiple, large markets in ways not possible with earlier technology.

We currently address several adjacent markets related to consumers’ desire to be thoughtful and creative with their memories. These include, but are not limited to:

• Greeting cards and stationery.  According to the Greeting Card Association’s website, U.S. consumers purchase approximately 7 billion greeting cards each year, generating nearly $7.5 billion in retail sales. More than 90 percent of all U.S. households buy greeting cards, with the average household purchasing 30 individual cards per year. The Greeting Card Association also reports that nine out of ten Americans say they look forward to receiving personal letters and greeting cards because cards allow them to keep in touch with friends and family and make them feel they are important to someone else.

• Scrapbooks.  According to a 2007 survey by Creating Keepsakes, the addressable markets for the US scrapbook industry was approximately $2.87 billion in 2007 up from $2.55 billion in 2004.  Additionally, approximately 82% of scrapbookers have at least a college degree and spend almost four hours a week assembling their memories into scrapbooks.

• Calendars.  A 2002 guide published by the Calendar Marketing Association estimated that 500 million calendars are produced annually in the United States and that approximately 98% of American households have at least one calendar.

• Photo prints.  Industry sources estimate that the number of digital images printed in the U.S. in 2006 reached 15 billion.  Total U.S. digital revenue reached approximately $9 billion in 2007, growing to approximately $12 billion in 2011.

• Photo-based merchandise.  Photo-based merchandise is a substantial market opportunity that includes any product that can be customized with the imprint of a digital image. Photo-based merchandise includes, but is not limited to, photo calendars, photo greeting cards and photo books.  Industry sources estimate that U.S. revenue from photo-based merchandise reached approximately $560 million in 2007, growing to approximately $1.5 billion in 2012.

We generally characterize our products as either “personalized products and services” or “prints”. Our personalized products and services revenues are derived from sales of greeting cards, calendars, photo books, and ancillary products such as scrapbooking accessories and other photo-based merchandise, and the related shipping revenue from these sales, while our print revenues are derived from sales of photo prints and the related shipping revenue.  In 2007, 2006 and 2005, our personalized products and services revenues represented approximately 56%, 51% and 42% of our total net revenues, respectively, and our print revenues represented approximately 44%, 49% and 58% of our total net revenues, respectively.

The addressable market for our products and services includes every person who enjoys the memories created by digital photographic devices such as cameras, camera cell phones or camcorders. Although photofinishing products and services are purchased by a broad consumer base, we believe that women, in particular, play a key role in many photo-based purchasing decisions. The U.S. Census Bureau reports that there were approximately 55 million women age 25-44 in 2006.  We believe that securing the loyalty of this core consumer base represents a sizable market opportunity.

Value for Our Customers

Creating value for our customers is the basis for our success. Our tag line is “Tell Your Story,” and we offer customers easy, convenient and fun ways to tell their stories by:

• sharing and preserving memories for family, friends and themselves;

• organizing all of their photos in a safe and easily accessible location;

• maintaining emotional connections with friends and family, despite being time-constrained, through thoughtful and personal photo-based communications and gifts; and

• achieving satisfaction and self-expression through creativity and telling stories via photos and personalized photo-based products and services.

We provide the following benefits to our customers:

4

Broad offering.  We offer a wide variety of premium products to customers, including prints and photo-based products that include, but are not limited to, greeting cards, calendars, photo books, mugs, mouse pads, frames, photo albums and scrapbooking products and accessories. In addition, we provide a number of valuable tools and services, such as the ability to upload and edit photos online, share photos with friends and family and store an unlimited number of photos on our system at no cost. With many creative options from which to choose, we enable customers to become engaged in the Shutterfly experience and feel a sense of pride in their creations.

Exceptional quality and service.  We have built strong relationships with our customers who trust us to preserve and protect their memories in a central storage repository. We enable customers to enhance, share and make projects with their photos at their convenience. Our focus on ease of use, image quality, secure photo storage, high-quality products and first-rate packaging has established Shutterfly as a premium brand. Our customers have come to expect the best quality and service from us. This trust is maintained by fast, consistent fulfillment times, responsive customer service and continuous innovation.

Customer-focused approach.  The entire Shutterfly customer experience reflects our customer-centered approach. Membership is free and offers customers the ability to upload, edit, store and share an unlimited number of photos. Membership is not required to view shared pictures, which can be viewed with a simple click. We conveniently mail orders to our customers’ homes or offices, or directly to a gift recipient. We also offer a year-round direct-mail greeting card service where customers upload their electronic address books to Shutterfly and we mail their cards and party invitations on their behalf. We take special care to focus on our customers’ requests for new features and functionality, products and services.

The Shutterfly Solution

We have developed a portfolio of products and services along with specialized manufacturing capabilities that allow us to offer consumers an easy, convenient and fun way to enjoy, share and preserve their memories. We satisfy traditional consumer needs — by introducing consumers to new forms of communication and creative expression through our website features and functionality, photo prints, and personalized photo-based products and services. We also provide photo printing, storing and sharing. We believe that many people are intimidated by the process of creating photo-based products or merchandise or fear that it will take too much work. We believe that we have removed much of the difficulty and intimidation of the process and have made it easy and enjoyable. In addition to these consumer benefits, we believe that our business model is supported by the following characteristics:

Viral network effect.  We benefit from a viral network in several ways. When our existing customers upload and share their personal memories through photos, they are providing compelling user-generated content that attracts their friends and family to our website, thus enlarging our network of users and potential customers. This implicit endorsement, coupled with user-friendly policies, such as not requiring share recipients to register to view pictures, reinforces our trusted brand and leads to lower customer acquisition costs. In addition, as our customers create and give thoughtful and unique physical gifts such as greeting cards, calendars and photo books, these products create numerous opportunities for potential customers to interact with our brand. Many of our customers also use our website to create community-oriented products such as a photo book celebrating a school play or a yearbook for their children’s soccer team, and they often proactively introduce and sell these items to larger groups of potential new customers. As our products and services delight our customers, they often become enthusiastic evangelists for Shutterfly and introduce our products and services to their friends and family through word-of-mouth referrals and endorsements.

Attractive target demographics reflected in our loyal customer base.  Our customers have described themselves as being interested in maintaining personal connections with friends and family, wanting to tell stories, wishing to preserve their memories for themselves and their children and wanting an offering that is intuitive and easy to use. As a result, we believe that they are looking for an easy and convenient way to be both thoughtful and creative with their memories. Our customers use our website to share, enhance and preserve memories from vacations, holidays and family events and to create gifts for events such as birthdays, weddings, anniversaries, Halloween, Hanukkah, Christmas, Valentine’s Day, Easter, Mother’s Day and Father’s Day. We believe that our customer loyalty is also aided by high switching costs. If a customer were to leave Shutterfly, he or she would have to spend significant time uploading and organizing photos on a new service.

Premium pricing power.  We believe that we are able to maintain premium pricing power for many of our products because of our market position and the loyal customer base we have created. We believe that our market position and loyal customer base exist because we have differentiated ourselves in the marketplace by delivering high-quality products, outstanding customer service, an intuitive and easy user experience and continuous innovation across our products and services.

Deep understanding of our customers.  Customer insights are an important source of new product and service innovation for us, and we continually strive to understand our customers’ needs in order to improve customer satisfaction. We invest significant time and resources to understand and address the needs of our customers through market research, focus groups, customer surveys, usability testing, customer response to promotions and customer service interactions. We believe a coordinated focus on understanding the customer allows us take measures to increase customer loyalty, consumer awareness of Shutterfly, customer satisfaction and repeat purchases.

Vertical integration and superior technology.  We derived approximately 82% of our net revenues in 2007 from products we manufactured in our Hayward, California and Charlotte, North Carolina facilities. Our vertically integrated and highly technical manufacturing approach provides quality control, agility in rolling out new products and ability to secure capacity at critical peak demand periods. We believe that vertical integration provides us with quality, cost, flexibility and innovation advantages, including:

• greater consistency and quality of output;

• increased ability to control and optimize costs for raw materials and production;

• fully automated image processing and print scheduling;

• more flexibility to provide rapid, responsive order fulfillment and processing;

• assured high-quality capacity, even during peak demand such as the fourth quarter holiday season;

• additional insights into new and existing photo products and production processes;

• rapid prototyping, testing and refinement of new products and services; and

• the ability to address customer inquiries quickly.

We have devoted more than eight years to developing our proprietary software, technology and production systems that we believe give us an advantage over our competitors. It is our intention to continue investing in and protecting our proprietary technology, platforms and processes that help us differentiate ourselves from the competition, innovate, and control costs.

5

Our Growth Strategy

Our goal is to grow our business, build a premium lifestyle brand and become the leading online provider of products and services dedicated to improving the sharing and preservation of personal memories through social expression and personal publishing. We believe the combination of our focus, our dedication to customers and the benefits we derive from our vertically integrated production facilities will allow us to profitably capture a significant share of our addressable markets. In addition to strong consumer trends supporting our business — such as the proliferation of digital cameras, higher broadband penetration and greater adoption of Internet related e-commerce and communication services — we believe our growth will be supported by the following initiatives:

Expand customer base.  We intend to expand our customer base and continue to promote the Shutterfly brand. We will leverage existing channels, which include word-of-mouth referrals from existing customers, print advertising, catalogs, online advertising, search engine marketing and complementary alliances with other companies such as Sony, David’s Bridal and Delta Airlines.  We have also begun to expand our customer base through our offerings at Target stores, including in-store placements and ad circulars which complement our retail sales and “print-to-Target” offerings.

Expand product and service offerings.  We will continue to innovate in order to increase the breadth and depth of our products and services, including prints, photo-based merchandise and ancillary products. During 2007, we have launched numerous new products, including “designer” cards, children’s story books, personalized jewelry, holiday ornaments, custom framing, square-format scrapbook pages, digital scrapbooking card, calendar and photo book templates, and licensed content themed photo books including Martha Stewart, Dora the Explorer, Go Diego Go, and the Sesame Street adventure book.

Increase sales to existing customers.  We intend to increase both average order value and repeat orders per customer by expanding our products and services, tailoring our offerings to encourage additional purchases for different holidays and life events and increasing our cross-selling and up-selling activities.

Leverage vertical integration.  We will continue to invest in vertical integration by expanding our in-house production capabilities. We believe this will allow us to extend our objectives to provide the highest quality products and services at the lowest possible costs, to provide exceptional fulfillment and customer service, even at peak demand periods, and to continue to innovate rapidly with new products and services.

Develop new lines of business.  We intend to continue to leverage our existing systems and capabilities to develop additional adjacent product offerings. For example, in 2007 we formed the Shutterfly Scrapbook Advisory Team, a team of scrapbooking experts, to advise us in product and services developments targeted toward scrapbookers.  During the year, we introduced new scrapbook page formats, enhanced the visibility of scrapbooking on the Shutterfly website, and launched a holiday blog for scrapbookers, to provide a forum for discussions around printing holiday scrapbook pages greeting cards using the Shutterfly service.  In 2008, we announced a strategic relationship with CK Media Scrapbooking, the industry’s largest print publisher, and the introduction of two new designer scrapbooks.

International expansion.  We intend to develop additional business opportunities through international expansion, targeting consumers in key geographies where digital camera penetration is high and where Internet usage and e-commerce are widespread.

Products and Services

Using the Shutterfly service is easy, convenient and fun. Our website is designed to be simple, uncluttered and inviting, and we work continuously to enhance the customer experience of the website, while also improving ease of use. In 2007, Shutterfly announced many enhancements to our innovative personal publishing platform, which includes:

• an easy-to-use search capability for our customers to find products and services;

• new adventure books featuring Dora the Explorer and Sesame Street;

• designer cards from popular designers;

• additional photo gift products such as photo ornaments;

• dozens of collage formats on calendars and poster prints; and

• partnership with Target for pick up at Target retail stores.

There are only five navigational “tabs,” which correspond to the primary activities offered by the website — Add Pictures, View & Enhance, Share Online, Order Prints and Shutterfly Store. If consumers decide to either upload pictures or purchase products, they register on the website and begin the following process:

Upload.  Customers can upload digital photos from their computer to our website one at a time, many at once through simple drag-and-drop or by using Shutterfly Studio, our photo organization software. There are no limits to photo file sizes and the upload processes are accelerated by multi-threading, which enables photos to be uploaded simultaneously, thereby reducing image upload times. Unlike some competitive services, we do not compress image files as part of the upload process, which we believe preserves quality and photo resolution.

Organize and find.  Customers initially upload their photos into user-defined albums. We offer multiple ways to further organize and find pictures. For example, customers can automatically sort photos within albums by upload date, photo titles or original filenames. Additionally, customers can quickly search for photos in a number of ways, including by text, date taken, upload date and images ordered on prints or specified products. Customers can also use our “favorites” function to tag their favorite photos with a star rating system on both the website and within Shutterfly Studio.

View and enhance.  Once photos have been uploaded to Shutterfly, customers can choose to view their photos in a variety of ways, including photo slideshows. To improve picture quality, customers also have access to our free online editing and image enhancement tools. In addition to cropping and red-eye removal, we offer a variety of creative options, such as saturating photos with additional color or changing color shots to black-and-white or sepia. Customers are also able to choose from a wide variety of photo borders. We offer free customized back printing on photos and the option to add captions to many of our products. Customers can view and enhance their photos online or on their desktop via Shutterfly Studio, which easily integrates with our website. Shutterfly Studio provides advanced viewing and enhancing capabilities such as full screen slideshows, cropping, red-, blue- and green-eye removal, sharpening, auto adjustments and captioning.

Create.  We enable customers to create a variety of personalized products from their photos, including prints in wallet, 4×6, 5×7, 8×10, 11×14, 16×20 and 20×30 sizes, greeting cards, calendars, photo books and other photo-based products and merchandise. Our highly-interactive, design-it-yourself “creation paths” help even first-time customers make professional-looking, high-quality prints and products. Customers can easily design each product by following simple step-by-step instructions and using intuitive features, such as dragging and dropping an image into a template. Our technology then generates an image of the customer’s product on screen so that customers can make any desired design choices or changes and then view the final product to ensure satisfaction before purchase. Customers can also save in-process projects and return to them at a more convenient time to finish and purchase.

Recent enhancements made possible from innovations in our personal publishing platform include:

• a significantly expanded product offering, with many form factors and design choices including personalized photo covers with printing on the spine, 8x8 Story Books and 12x12 Memory Books;

• a wide variety of background designs including numerous pre-set style templates organized across popular categories such as Wedding, Travel, Birthday, Baby, Kids, Class Year Book, Recipe Book, Portfolio and Journal;

• dozens of collage formats on our greeting-cards and calendars;

• licensed content from Martha Stewart, Dora the Explorer, Go Diego Go, Sesame Street, Clifford the Big Red Dog, Thomas and Friends, and Angelina Ballerina; and

• digi-scrap capabilities which allow for customers to upload their digi-scrap designs onto photo book pages or covers.

6

Share.  We enable our customers to share images in several different ways. Customers can e-mail friends, family and colleagues a link to an individual album that can be viewed as a slideshow of images. In order to view those images, e-mail recipients simply click on the URL link in the e-mail and view images immediately without the need to register with Shutterfly. Recipients can then order prints or save them into their own album. Similarly, customers can share their photo books electronically by sending an e-mail to friends and family with a link to a photo book project, thereby improving the ease of photo book development and collaboration, and sharing of personalized content. Yet another way to share photos is by creating a Shutterfly Collection, which is linked to a personal web address that is powered by Shutterfly. This allows customers to store and share an unlimited number of photo albums. Customers can invite friends and family to view the photos, add additional photos and post comments to both albums and individual photos via the Guestbook feature. To ensure the privacy of Collections, we offer users optional password protection. Shutterfly customers can create up to two free Collections. We also sponsor seasonal and topical photo contests that promote sharing of photos by our customers. To save our customers time, we offer an easy way to copy names, e-mail addresses and mailing addresses from various software such as Outlook, Outlook Express, Entourage, Palm and Eudora into their Shutterfly address book.

In 2008, we announced the acquisition of Nexo Systems and the launch of Shutterfly Gallery.  We believe the acquisition of the Nexo platform will accelerate our innovations in online sharing and collaboration services, giving our viral customers more ways to connect with family and friends with the ability to create personalized, secure websites for sports teams, school activities, clubs and other tight-knit social networks.  And with the launch of Shutterfly Gallery, we are expanding our community sharing platform, allowing customers to post their photo  books, share their thoughts and perspectives on storytelling, ad photo books to their “favorites list, rate and comment on other photo books, and share interesting Gallery projects with friends and family with the “email a friend” feature.

Order and ship.  We provide convenient ordering and flexible shipping options. To order a product after it is created, the customer adds it to his or her shopping cart and completes the billing and shipping information. Shipping addresses can be typed in or easily added directly from a customer’s Shutterfly address book. When a picture or product is being ordered, we flag photos of poor quality, usually due to low resolution, to alert customers of potential quality issues. This helps ensure that a customer does not order an out-of-focus or poor quality picture. Customers can ship single orders to multiple recipients. We also offer several different shipping options, such as next-day, two-day or regular service. Standard turn-around times from the time an order is placed to the time it is shipped are one business day for most print orders and two business days for other photo-based products manufactured by Shutterfly. For our photo-based merchandise manufactured on our behalf by third parties, turn-around times vary, but generally range from two to five days from the time we receive the order and transmit it to our manufacturer. We also offer premium services for addressing, stamping and mailing greeting cards directly to recipients.

Archive.  We provide customers with unlimited storage of their photos, Collections and projects at no cost to the customer. Customers can also order a copy of their photos on a DVD for an extra fee.

Marketing, Advertising and Promotion

We use a variety of integrated marketing programs, including advertising, direct marketing technologies, channels, methods and strategic alliances to attract and retain our customers. These methods include direct marketing over the Internet, e-mail marketing to prospects and existing customers, search engine marketing, and traditional direct marketing mailings such as postcards and seasonal catalogs. In addition, because many of our products are either shared via the Internet or given as gifts, the appearance of our brand on the products and packaging provides ongoing distribution as well as viral advertising.

We place advertisements that target women and families on websites and in publications, contract for targeted e-mail marketing services and contract for advertising placement on leading search engines. We also maintain an affiliate program under which we pay program participants for referral sales generated from hyperlinks to our website from the affiliate’s website and in promotional materials.

We maintain alliances with complementary companies. For example, we have co-marketing and promotion arrangements with companies such as Delta Airlines SkyMiles, David’s Bridal, and Proctor and Gamble.  In addition, in 2007, we began a relationship with Target Corporation where we provided our customers the ability to order their  4x6 prints online and pick them up at select local Target store in as little as an hour.  During the holiday season, we also offered an in-store a suite of prepaid products including photo books, adventure books, photo gifts, and gift cards.  Customers may purchase these products at select Target stores and redeem them online at Shutterfly.com.

In addition, from time to time we create co-branded versions of our website. In general, these arrangements involve payment of a commission to or revenue sharing with these companies for sales of our products and services generated through these websites.

Technology and Production Systems

We use a combination of proprietary and third-party technology, including the following:

Customer relationship management, or CRM, system.  Our integrated CRM system is composed of various sophisticated tools designed to convert first-time customers into repeat buyers. We seek to increase average order sizes by expanding customer awareness, providing targeted, segmented offers to customers and encouraging cross- and up-selling. The system uses a variety of data, including website usage patterns, order size, order frequency, products purchased, seasonality factors, image upload and share usage, as well as customer satisfaction information. This data is continually updated and refreshed in a data warehouse, from which different customer segments are identified and modified on a continuing basis for targeted marketing communications.

By using this deep customer intelligence and ongoing analysis, we are able to offer customers a more personalized website experience and to target them with specific website promotions, discounts, specialized e-mail and direct mail offers. Our promotion engine generates special offers that are account specific and applied automatically at checkout. This enables us to run multiple offers at any given time that are targeted to specific customer profiles.

We are also able to dynamically assign visitors to test and control groups who are shown different versions of our service. This testing enables us to continuously optimize products, pricing, promotions and user interaction with our website. We are able to run multiple tests at once, which enables us to rapidly launch new products and services and enhances our financial results.

Website system.  Our website powers our service and e-commerce functionality. We have designed our user interface to be simple, uncluttered and inviting. There are only five navigational “tabs” that correspond to the primary activities offered by the website — Add Pictures, View & Enhance, Share Online, Order Prints and Shutterfly Store, which includes personalized product creation.

We have designed our website system to be highly available, secure and cost-effective. We can scale to increasing numbers of customers by adding relatively inexpensive industry-standard computers and servers. We have a strong commitment to our privacy policy, and we utilize technologies such as firewalls, encryption technology for secure transmission of personal information between customers’ computers and our website system and intrusion detection systems to ensure compliance with that policy.

Image archive.  We store our customers’ images in our image archive. Once a customer uploads a photo to our website, it is copied to multiple redundant systems, including an off-site copy. We continue to expand our storage capacity to meet increasing customer demand. Our innovative storage architecture provides low storage costs, facilitates the safe, secure archiving of customers’ images and delivers the speed and performance required to enable customers to access, enhance and edit their images in real-time.

When we store and archive a customer’s image, we do not alter or reduce resolution of the original image (for example, we do not reduce the data file size), which preserves the quality and integrity of the image. This approach also lets customers enhance the image using a duplicate, while giving them the ability to recall the original at any time.

Render farm.  Once a customer orders a photo or any photo-based product or photo-based merchandise, our render farm technology performs fully automated image processing on the image prior to production. The customer’s original uploaded image is retrieved from the image archive, and automatic algorithms enhance the color, contrast and sharpness of the image. The render farm also performs customer-requested edits such as crop, borders, customized back-printing and red-eye removal.

To ensure that output is of consistent quality, we apply our proprietary ColorSure technology during this render stage. ColorSure creates an automated mapping of the image’s specific attributes to the printer’s specific print calibrations and attributes, at which time the rendered image is scheduled for production. For example, this allows a photo that is printed on a 4x6 print to look the same as a photo printed on an enlargement or in a photo book, even if they are ordered at separate times.

Production system.  We operate our own production facilities in Hayward, California, and Charlotte, North Carolina.  Our automated production system controls our production processes, including order management and pick, pack and ship operations. Using complex algorithms, the production system analyzes tens of thousands of orders daily and automates the workflow into our high-volume silver halide photofinishing machines and our state-of-the-art digital offset presses.

7

Competition

The market for digital photography products and services is large, evolving and intensely competitive, and we expect competition to increase in the future. We face intense competition from a wide range of companies, including the following:

• online digital photography services companies such as Kodak EasyShare Gallery (formerly known as Ofoto), Snapfish, which is a service of Hewlett-Packard, American Greetings’ Photoworks and Webshots brands, and others;

• “Big Box” retailers such as Wal-Mart, Costco and others that are seeking to offer low cost digital photography products and services. These competitors provide in-store fulfillment and self-service kiosks for printing, which may, among other strategies, offer their customers heavily discounted in-store products and services that compete directly with our offerings;

• drug stores such as Walgreens, CVS and others that offer in-store pick-up from Internet orders;

• regional photography companies such as Wolf Camera and Ritz Camera that have established brands and customer bases in existing photography markets;

• Internet portals and search engines such as Yahoo!, AOL, and Google that offer broad-reaching digital photography and related products and services to their large user bases;

• home printing service providers such as Hewlett-Packard, Epson and Canon, that are seeking to expand their printer and ink businesses by gaining market share in the emerging digital photography marketplace; and

• photo-related software companies such as Adobe, Apple, Microsoft, Corel and others.

We believe the primary competitive factors in attracting and retaining customers are:

• brand recognition and trust;

• quality of products and services;

• breadth of products and services;

• user affinity and loyalty;

• customer service;

• ease of use;

• convenience; and

• price.

We believe that we compete favorably with respect to many of these factors, particularly customer trust and loyalty, quality and breadth of products and services, and customer service. None of our competitors offers a comparable value proposition, trusted brand or singular focus on customers. Many of our competitors promote their products on the basis of low prices or the convenience of same-day availability for digital photos printed in drugstores or other retail outlets. As a general matter, we currently plan to distinguish ourselves from such competitors principally on the basis of product quality and innovation, rather than price or same-day delivery.

The level of competition in our industry has been consistently high since our inception in 1999, and is likely to increase as current competitors improve their offerings and as new participants enter the market or as industry consolidation further develops. These competitors have or could develop a variety of competitive advantages over us, including significantly longer operating histories; larger and broader customer bases; greater brand recognition; greater financial, research and development and distribution resources; and greater ability to acquire, invest in or partner with traditional and online competitors. Well-funded new entrants may choose to prioritize growing their market share and brand awareness instead of profitability. We may be unable to compete successfully against current and future competitors, and competitive pressures could harm our business and prospects.

Intellectual Property

Protecting our intellectual property rights is part of our strategy for continued growth and competitive differentiation. We seek to protect our proprietary rights through a combination of patent, copyright, trade secret and trademark law. We enter into confidentiality and proprietary rights agreements with our employees, consultants and business partners, and control access to and distribution of our proprietary information.  In February 2008, we entered into a licensing arrangement with a third party for certain of our patented technology.  Under the terms of the license, we expect to receive annual installment payments of the license fee beginning at the time of the contract execution, and continuing through March 2010.  We expect to enter into other similar arrangements with third parties who seek to use our patented technology or infringe on our patented technology.

As of December 31, 2007, we had 21 issued patents, which expire at various dates between November 2019 and May 2025, and more than 30 patent applications pending in the United States. Our issued patents and patent applications relate generally to the user interface for our website, our computer network infrastructure and software, personalized photo-related products and automated workflow and digital printing. We intend to pursue corresponding patent coverage in additional countries to the extent we believe such coverage is appropriate and cost efficient. However, we cannot be certain that any of our pending or any future applications will be granted. In addition, third parties could bring invalidity, co-inventorship or similar claims with respect to any of our currently issued patents or any patents that may be issued to us in the future.

We have in the past received claims, and in the future a third party may claim, that we have infringed its patent rights. This can result in litigation and/or require us to enter into a license agreement with a third party. For example, effective May 1, 2005, Shutterfly entered into a settlement and license agreement to resolve litigation with respect to alleged infringement of certain processes under U.S. patents relating to uploading, storing, sharing, accessing, downloading and/or requesting or obtaining digital images or prints of digital images or merchandise to which such images are applied. Under the terms of the agreement, Shutterfly paid $2.0 million for a license to certain patents, including a non-exclusive, fully-paid up, royalty-free, worldwide license to the patents underlying the litigation, and a mutual release of claims.

Our primary brand is “Shutterfly.” We hold registrations for the Shutterfly service mark in our major markets of the United States and Canada, as well as in the European Community, Mexico, Japan, Australia and New Zealand. We also hold “Shutterfly.com” Internet domain registrations in the United States, Mexico, Australia and New Zealand, and a “Shutterfly and Design” trademark, “Shutterfly Express”, “Shutterfly Collections” and “Postcards by Shutterfly” service mark registrations in the United States. An additional application for the Shutterfly mark is pending in Brazil. We also hold a registration for the “VividPics” service mark in the United States and Mexico, and have pending applications for additional marks, including “Shutterfly Studio”, a “Shutterfly Studio and Design” trademark, “Your pictures and more”, “Marking it personal”, and “Memory Vault”.

During 2007, we also acquired the trademark to our tagline, “Tell Your Story.”

These brand registrations are a critical component of our marketing programs. If we lose the ability to use our Shutterfly mark in a particular country or our domain name, we could be forced to either incur significant additional expenses to market our products within that country or elect not to sell products in that country. In addition, regulations governing domain names and laws protecting trademarks and similar proprietary rights could change in ways that block or interfere with our ability to use our current brand and to acquire or maintain the domain names that utilize the name Shutterfly in all of the countries in which we currently or intend to conduct business.

8

Government Regulation

The legal environment of the Internet is evolving rapidly in the United States and elsewhere. The manner in which existing laws and regulations will be applied to the Internet in general, and how they will relate to our business in particular, is unclear in many cases. Accordingly, we often cannot be certain how existing laws will apply in the online context, including with respect to such topics as privacy, defamation, pricing, credit card fraud, advertising, taxation, sweepstakes, promotions, content regulation, quality of products and services and intellectual property ownership and infringement. In particular, laws relating to the liability of providers of online services for activities of their users are currently unsettled both within the United States and abroad.

Numerous laws have been adopted at the national and state level in the United States that could have an impact on our business. These laws include the following:

• The CAN-SPAM Act of 2003 and similar laws adopted by a number of states. These laws are intended to regulate unsolicited commercial e-mails, create criminal penalties for unmarked sexually-oriented material and e-mails containing fraudulent headers and control other abusive online marketing practices.

• The Communications Decency Act, which gives statutory protection to online service providers who distribute third-party content.

• The Digital Millennium Copyright Act, which is intended to reduce the liability of online service providers for listing or linking to third-party websites that include materials that infringe copyrights or other rights of others.

• The Children’s Online Privacy Protection Act and the Prosecutorial Remedies and Other Tools to End Exploitation of Children Today Act of 2003, which are intended to restrict the distribution of certain materials deemed harmful to children and impose additional restrictions on the ability of online services to collect user information from minors. In addition, the Protection of Children From Sexual Predators Act of 1998 requires online service providers to report evidence of violations of federal child pornography laws under certain circumstances.

• Statutes adopted in the State of California require online services to report certain breaches of the security of personal data, and to report to California consumers when their personal data might be disclosed to direct marketers.

To resolve some of the remaining legal uncertainty, we expect new laws and regulations to be adopted over time that will be directly applicable to the Internet and to our activities. Any existing or new legislation applicable to Shutterfly could expose us to substantial liability, including significant expenses necessary to comply with such laws and regulations, and could dampen the growth in the use of the Internet in general.

We post on our website our privacy policies and practices concerning the use and disclosure of user data. Any failure by us to comply with our posted privacy policies, Federal Trade Commission requirements or other privacy-related laws and regulations could result in proceedings by governmental or regulatory bodies that could potentially harm our business, results of operations and financial condition. In this regard, there are a large number of legislative proposals before the United States Congress and various state legislative bodies regarding privacy issues related to our business. It is not possible to predict whether or when such legislation may be adopted, and certain proposals, if adopted, could harm our business through a decrease in user registrations and revenues. These decreases could be caused by, among other possible provisions, the required use of disclaimers or other requirements before users can utilize our services.

Due to the global nature of the Internet, it is possible that the governments of other states and foreign countries might attempt to regulate its transmissions or prosecute us for violations of their laws. We might unintentionally violate such laws, such laws may be modified and new laws may be enacted in the future. Any such developments could harm our business, operating results and financial condition. We may be subject to legal liability for our online services. The law relating to the liability of providers of these online services for activities of their users is currently unsettled both within the United States and abroad. Claims may be threatened against us for aiding and abetting, defamation, negligence, copyright or trademark infringement, or other theories based on the nature and content of information to which we provide links or that may be posted online.

Employees

As of December 31, 2007, we had 431 full time employees. Approximately 124 employees were engaged in engineering, 179 in photo lab operations, 57 in sales and marketing, 16 in customer service and 55 in general and administrative functions. During the peak holiday season, we obtain contract workers on a temporary basis from third-party outsourcing firms. For example, during our peak production day in the fourth quarter of 2007, we used approximately 1,000 temporary workers to assist in our production and fulfillment operations during high-demand periods. None of our employees is represented by a labor union or is covered by a collective bargaining agreement. We have never experienced any employment-related work stoppages and consider our employee relations to be good.

Available Information

Our Internet website is located at http://www.shutterfly.com. The information on our website is not a part of this annual report. We make available free of charge on our website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. Our SEC reports can be accessed through the investor relations section of our Internet website.

The public may also read and copy any materials we file with the Securities and Exchange Commission at the Securities and Exchange Commission’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the Securities and Exchange Commission at 1-800-SEC-0330. The Securities and Exchange Commission also maintains an Internet website that contains reports, proxy and information statements and other information regarding issuers that file electronically with the Securities and Exchange Commission. The Securities and Exchange Commission’s Internet website is located at http://www.sec.gov.

9

ITEM 1A. RISK FACTORS

Our net revenues, operating results and cash requirements are affected by the seasonal nature of our business.

Our business is highly seasonal, with a high proportion of our net revenues, net income and operating cash flows generated during the fourth quarter. For example, we generated approximately 52% of our net revenues for 2007 in the fourth quarter of 2007, and the net income that we generated during the fourth quarter of 2007 was necessary for us to achieve profitability on an annual basis for 2007. In addition, we incur significant additional expenses in the period leading up to the fourth quarter holiday season in anticipation of higher sales volume in that period, including expenses related to the hiring and training of temporary workers to meet our seasonal needs, additional inventory and equipment purchases and increased advertising. If we are unable to accurately forecast and respond to consumer demand for our products during the fourth quarter, our financial results, reputation and brand will suffer and the market price of our common stock would likely decline.

In addition, we base our operating expense budgets on expected net revenue trends. A portion of our expenses, such as office, lab facility, and various equipment leases and various personnel costs, are largely fixed and are based on our expectations of our peak levels of operations. We may be unable to adjust spending quickly enough to offset any unexpected revenue shortfall. Accordingly, any shortfall in net revenues may cause significant variation in operating results in any quarter.

Our limited operating history makes it difficult to assess the exact impact of the seasonal factors on our business or whether our business is susceptible to cyclical fluctuations in the U.S. economy. In addition, our historically rapid growth may have overshadowed whatever seasonal or cyclical factors might have influenced our business to date. Seasonal or cyclical variations in our business may become more pronounced over time and may harm our future operating results.

We are also subject to macro-economic fluctuations in the U.S. economy.  Recent macro-economic issues involving sub-prime mortgages and liquidity issues, as well as liquidity issues in the auction rate securities that we invest in, may negatively impact the economy and our growth.  If these issues persist, or if the economy enters a prolonged period of decelerating growth, our results of operations may be harmed.

If we are unable to meet our production requirements, our net revenues and results of operations would be harmed.

We believe that we must significantly grow our current production capability to meet our projected net revenue targets. We expect to spend between $43 million and $47 million in capital expenditures in 2008, representing a range of between 17.5% and 18.5% of our expected fiscal year 2008 net revenues, and a portion of which we expect will be used to add manufacturing capacity. During, 2007, we opened a new manufacturing and production plant in Charlotte, North Carolina. Our inability to meet our production requirements could lead to customer dissatisfaction and damage to our reputation and brand, which would result in reduced net revenues. Moreover, if the costs of meeting production requirements, including capital expenditures, were to exceed our expectations, our results of operations would be harmed.

In addition, we face significant production risks at peak holiday seasons, including the risks of obtaining sufficient qualified seasonal production personnel. A majority of our workforce during the fourth quarter of 2007 was seasonal, temporary personnel. We have had difficulties in the past finding a sufficient number of qualified seasonal employees, and our failure to obtain qualified seasonal production personnel both in our Hayward, CA and Charlotte, NC production plants could harm our operations.

Our quarterly financial results may fluctuate, which may lead to volatility in our stock price.

Our future revenues and operating results may vary significantly from quarter-to-quarter due to a number of factors, many of which are difficult for us to predict and control. Factors that could cause our quarterly operating results to fluctuate include:

• demand for our products and services, including seasonal demand;

• our pricing and marketing strategies and those of our competitors;

• our ability to attract visitors to our website and convert those visitors into customers;

• our ability to retain customers and encourage repeat purchases;

• our ability to sustain our profit margins, and our ability to diversify our product offerings and sell to consumers photo-based products such as photo books, calendars and cards;

• the costs of customer acquisition;

• our ability to manage our production and fulfillment operations;

• the costs to produce our prints and photo-based products and merchandise and to provide our services;

• the costs of expanding or enhancing our technology or website;

• a significant increase in returns and credits, beyond our estimated allowances, for customers who are not satisfied with our products;

• declines or disruptions to the travel industry;

• variations in weather, particularly heavy rain and snow which tend to depress travel and picture taking;

• the timing of holidays;

• volatility in our stock price, which may lead to higher stock-based compensation expense;

• consumer preferences for digital photography services; and

• improvements to the quality, cost and convenience of desktop printing of digital pictures and products.

Based on the factors cited above, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. It is possible that in one or more future quarters, our operating results may be below the expectations of public market analysts and investors. In that event, the trading price of our common stock may decline.

We have incurred operating losses in the past and may not be able to sustain profitability in the future.

We have periodically experienced operating losses since our inception in 1999. In particular, we make investments in our business that generally result in operating losses in each of the first three quarters of our fiscal year. This typically enables us to generate the majority of our net revenue during the fourth quarter and to achieve profitability for the full fiscal year. If we are unable to produce our products and provide our services at commercially reasonable costs, if revenues decline or if our expenses exceed our expectations, we may not be able to sustain or increase profitability on a quarterly or annual basis.

10

We have a limited public company operating history, which makes it difficult to evaluate our business and prospects for the future.

We became a public company in September 2006, and we have only a limited public operating history on which investors can base an evaluation of our business and future prospects. We face many risks, uncertainties, expenses and difficulties. To address these risks and uncertainties, we must do the following:

• maintain and increase the size of our customer base;

• maintain and enhance our brand;

• maintain and grow our website and customer operations;

• enhance and expand our products and services;

• successfully execute our business and marketing strategy;

• continue to develop and upgrade our technology and information processing systems;

• continue to enhance our service to meet the needs of a changing market;

• provide superior customer service;

• respond to competitive developments; and

• attract, integrate, retain and motivate qualified personnel.

We may be unable to accomplish one or more of these requirements, which could cause our business to suffer. Accomplishing one or more of these requirements might be very expensive, which could harm our financial results.

If we are not able to reliably meet our data storage and management requirements, customer satisfaction and our reputation could be harmed.

As a part of our current business model, we offer our customers free unlimited online storage and sharing of photographs and, as a result, must store and manage multiple petabytes of data. This results in immense system requirements and substantial ongoing technological challenges, both of which are expected to continue to increase over time. If we are not able to reliably meet these data storage and management requirements, we could have disruptions in services which could impair customer satisfaction and our reputation and lead to reduced net revenues and increased expenses. Moreover, if the cost of meeting these data storage and management requirements exceeds our expectations, our results of operations would be harmed.

Our data storage system could suffer damage or interruption from human error, fire, flood, power loss, telecommunications failure, break-ins, terrorist attacks, acts of war and similar events. In addition, our primary storage facilities are located near a major fault line, increasing our susceptibility to the risk that an earthquake could significantly harm our data storage system. If we experience disruption to our redundant systems located at our data storage center, such disruption could result in the deletion or corruption of customer stored images. For example, in 2007, we experienced a loss of a small number of customer images due to an isolated server failure.

Interruptions to our website, information technology systems, print production processes or customer service operations could damage our reputation and brand and substantially harm our business and results of operations.

The satisfactory performance, reliability and availability of our website, information technology systems, printing production processes and customer service operations are critical to our reputation, and our ability to attract and retain customers and maintain adequate customer satisfaction. We currently conduct periodic site maintenance several times a quarter that sometimes requires us to take the website down. The scheduled down times are planned at non-peak hours, typically at midnight. Any interruptions that result in the unavailability of our website or reduced order fulfillment performance or customer service could result in negative publicity, damage our reputation and brand and cause our business and results of operations to suffer. This risk is heightened in the fourth quarter, as we experience significantly increased traffic to our website during the holiday season. Any interruption that occurs during such time would have a disproportionately negative impact than if it occurred during a different quarter.

We depend in part on third parties to implement and maintain certain aspects of our communications and printing systems. Therefore many of the causes of system interruptions or interruptions in the production process may be outside of our control. As a result, we may not be able to remedy such interruptions in a timely manner, or at all. Our business interruption insurance policies do not address all potential causes of business interruptions that we may experience, and any proceeds we may receive from these policies in the event of a business interruption may not fully compensate us for the revenues we may lose.

We may have difficulty managing our growth and expanding our operations successfully.

We have grown from 275 employees as of December 31, 2006 to 431 employees as of December 31, 2007. We have website operations, offices and customer support centers in Redwood City, California and Mesa, Arizona, and production facilities in Hayward, California and Charlotte, North Carolina. Our growth has placed, and will continue to place, a strain on our administrative and operational infrastructure. Our ability to manage our operations and growth will require us to continue to refine our operational, financial and management controls, human resource policies and reporting systems.

If we are unable to manage future expansion, we may not be able to implement improvements to our controls, policies and systems in an efficient or timely manner and may discover deficiencies in existing systems and controls. Our ability to provide a high-quality customer experience could be compromised, which would damage our reputation and brand and substantially harm our business and results of operations.

During 2008, we plan to implement a new enterprise resource planning system (“ERP”) as part of our strategy to provide scale in our operations.  These projects are expensive, complex, and subject to delays.  If we are not able to effectively manage the deployment of this new ERP system, our results of operations, or our ability to provide timely financial reporting information may be harmed.

Competitive pricing pressures, particularly with respect to 4×6 print pricing and shipping, may harm our business and results of operations.

Demand for our products and services is sensitive to price. Many external factors, including our production and personnel costs and our competitors’ pricing and marketing strategies, can significantly impact our pricing strategies. If we fail to meet our customers’ price expectations, we could lose customers, which would harm our business and results of operations.

Changes in our pricing strategies have had, and may continue to have, a significant impact on our net revenues and net income. From time to time, we have made changes to our pricing structure for 4×6 prints in order to remain competitive.  In December, 2007, one of our competitors lowered their list prices on 4×6 prints from $0.12 to $0.09.  To date, we have not made any additional changes to the price of our 4×6 prints as a result of this price cut.  However, a drop in our 4×6 prices, without a corresponding increase in volume, or decreases in volume as a result of competitive pressures would negatively impact our net revenues and could adversely affect our gross margins and overall profitibility.

We generate a significant portion of our net revenues from the fees we collect from shipping our products. For example, these fees represented approximately 19%, 20% and 19% of our net revenues in 2007, 2006 and 2005 respectively.   We offer discounted or free shipping, with a minimum purchase requirement, during promotional periods to attract and retain customers. If free shipping offers extend beyond a limited number of occasions, are not based upon a minimum purchase requirement or become commonplace, our net revenues and results of operations would be negatively impacted. In addition, Shutterfly occasionally offers free or discounted products and services to attract and retain customers. In the future, if we increase these offers to respond to actions taken by our competitors, our results of operations may be harmed.

11

We face intense competition from a range of competitors and may be unsuccessful in competing against current and future competitors.

The digital photography products and services industries are intensely competitive, and we expect competition to increase in the future as current competitors improve their offerings and as new participants enter the market or as industry consolidation further develops. Competition may result in pricing pressures, reduced profit margins or loss of market share, any of which could substantially harm our business and results of operations. We face intense competition from a wide range of companies, including the following:

• Online digital photography services companies such as Kodak EasyShare Gallery (formerly known as Ofoto), Snapfish, which is a service of Hewlett-Packard, American Greetings’ Photoworks and Webshots brands, and others;

• “Big Box” retailers such as Wal-Mart, Costco and others that are seeking to offer low cost digital photography products and services, such as in-store fulfillment and self-service kiosks for printing; these competitors may, among other strategies, offer their customers heavily discounted in-store products and services that compete directly with our offerings;

• Drug stores such as Walgreens, CVS and others that offer in-store pick-up from Internet orders;

• Regional photography companies such as Wolf Camera and Ritz Camera that have established brands and customer bases in existing photography markets;

• Internet portals and search engines such as Yahoo!, AOL, Google that offer broad-reaching digital photography and related products and services to their large user bases;

• Home printing service providers such as Hewlett-Packard, Epson and Canon, that are seeking to expand their printer and ink businesses by gaining market share in the emerging digital photography marketplace; and

• Photo-related software companies such as Adobe, Apple, Microsoft, Corel and others.

Many of our competitors have significantly longer operating histories, larger and broader customer bases, greater brand and name recognition and greater financial, research and development and distribution resources, and operate in more geographic areas than we do. The numerous choices for digital photography services can cause confusion for consumers, and may cause them to select a competitor with greater name recognition. Some competitors are able to devote substantially more resources to website and systems development, or to investments or partnerships with traditional and online competitors. Competitors that are well-funded, particularly new entrants, may choose to prioritize growing their market share and brand awareness instead of profitability. Competitors and new entrants in the digital photography products and services industries may develop new products, technologies or capabilities that could render obsolete or less competitive many of the products, services and content that we offer. We may be unable to compete successfully against current and future competitors, and competitive pressures could harm our business and prospects.

If we are unable to adequately control the costs associated with operating our business, our results of operations will suffer.

The primary costs in operating our business are related to producing and shipping products, acquiring customers, compensating our personnel and acquiring equipment and technology and leasing facilities. If we are unable to keep these costs aligned with the level of revenues that we generate, our results of operations would be harmed. Controlling our business costs is challenging because many of the factors that impact these costs are beyond our control. For example, the costs to produce prints, such as the costs of photographic print paper, could increase due to a shortage of silver or an increase in worldwide energy prices.  In addition, we may become subject to increased costs by the third-party shippers that deliver our products to our customers, and we may be unable to pass along any increases in shipping costs to our customers. The costs of online advertising and keyword search could also increase significantly due to increased competition, which would increase our customer acquisition costs.

We invest in securities that are subject to market risk and the recent issues in the financial markets could adversely affect the value of our assets.

At December 31, 2007, we had $122.6 million in cash and cash equivalents and $3.0 million in short-term investments.  Included in these amounts, are investments in money market funds, commercial paper, and U.S. government agency securities, which are subject to general credit, liquidity, market and interest rate risks, and which may be exacerbated by the current financial market credit and liquidity issues.  During the year ended December 31, 2007, we determined that any declines in the fair value of our investments were temporary.  There may be further declines in the value of these investments, which we may determined to be other-than-temporary. These market risks associated with our investment portfolio may have a negative adverse effect on our results of operations, liquidity, and financial condition.

At February 29, 2008, $52.3 million of our marketable securities portfolio was invested in AAA rated investments in auction-rate debt securities. Auction-rate securities are long-term variable rate bonds tied to short-term interest rates. After the initial issuance of the securities, the interest rate on the securities is reset periodically, at intervals established at the time of issuance (primarily every twenty-eight days), based on market demand for a reset period. Auction-rate securities are bought and sold in the marketplace through a competitive bidding process often referred to as a “Dutch auction”. If there is insufficient interest in the securities at the time of an auction, the auction may not be completed and the rates may be reset to predetermined “penalty” or “maximum” rates. Following such a failed auction, we would not be able to access our funds that are invested in the corresponding auction-rate securities until a future auction of these investments is successful or new buyers express interest in purchasing these securities in between reset dates.

As a result of the current negative liquidity conditions in the global credit markets, in February 2008, auctions for $42.3 million of original par value of our auction-rate securities failed, rendering these securities temporarily illiquid through the normal auction process. At the time of our initial investment and through the date of this Report, all of our auction-rate securities remain AAA rated. The assets underlying each security are student loans and 95% of the principal amounts are guaranteed by the Federal Family Education Loan Program (FFELP).  Since we cannot predict when future auctions related to $52.3 million of our auction-rate securities will be successful, it may become necessary to classify this amount as long-term marketable securities in our consolidated balance sheet in future periods. In addition, if the underlying issuers are unable to successfully clear future auctions or if their credit rating deteriorates and the deterioration is deemed to be other-than-temporary, we would be required to adjust the carrying value of the auction-rate securities through an impairment charge to earnings. Any of these events could materially affect our results of operations and our financial condition.

To access these funds in future periods, it may be necessary to attempt to sell these securities at an amount below our original purchase value.  However, based on our ability to access our cash and cash equivalents and our other liquid investments, totaling $53.7 million at February 29, 2008, and our expected operating cash flows, we believe that we currently have adequate working capital resources to fund our operations and we do not expect to be required to sell these securities at a loss.

The loss of key personnel and an inability to attract and retain additional personnel could affect our ability to successfully grow our business.

We are highly dependent upon the continued service and performance of our senior management team and key technical, marketing and production personnel. In addition, a majority of our executive team has recently joined Shutterfly, and has tenure of less than one year.  The loss of these key employees, each of whom is “at will” and may terminate his or her employment relationship with us at any time, may significantly delay or prevent the achievement of our business objectives.

We believe that our future success will also depend in part on our continued ability to identify, hire, train and motivate qualified personnel. We face intense competition for qualified individuals from numerous technology, marketing, financial services, manufacturing and e-commerce companies. In addition, competition for qualified personnel is particularly intense in the San Francisco Bay Area, where our headquarters are located. We may be unable to attract and retain suitably qualified individuals who are capable of meeting our growing operational and managerial requirements, or we may be required to pay increased compensation in order to do so.  Our failure to attract and retain qualified personnel could impair our ability to implement our business plan.

Our evergreen option pool is limited to the lesser of a) 4.62% of stock options issued and outstanding on the December 31 immediately prior to the date of increase or b) a lesser number as determined by the Board.  , In order to attract key personnel, during 2007, the Board authorized additional inducement stock option grants totaling 380,000 to supplement our option pool.  In the future, attracting key personnel may require a level of option grants in excess of the amount available in our option pool.  Accordingly the Board may authorize additional inducement grants which could further dilute existing shareholders.

12

If we are unable to attract customers in a cost-effective manner, or if we were to become subject to e-mail blacklisting, traffic to our website would be reduced and our business and results of operations would be harmed.

Our success depends on our ability to attract customers in a cost-effective manner. We rely on a variety of methods to bring visitors to our website and promote our products, including paying fees to third parties who drive new customers to our website, purchasing search results from online search engines, e-mail and direct mail. We pay providers of online services, search engines, directories and other website and e-commerce businesses to provide content, advertising banners and other links that direct customers to our website. We also use e-mail and direct mail to offer free products and services to attract customers, and we offer substantial pricing discounts to encourage repeat purchases. Our methods of attracting customers, including acquiring customer lists from third parties, can involve substantial costs, regardless of whether we acquire new customers. Even if we are successful in acquiring and retaining customers, the cost involved in these efforts impact our results of operations. Customer lists are typically recorded as intangible assets and may be subject to impairment charges if the fair value of that list exceeds its carrying value.  These potential impairment charges could harm our results from operations.  If we are unable to enhance or maintain the methods we use to reach consumers, if the costs of attracting customers using these methods significantly increase, or if we are unable to develop new cost-effective means to obtain customers, our ability to attract new customers would be harmed, traffic to our website would be reduced and our business and results of operations would be harmed.

In addition, various private entities attempt to regulate the use of e-mail for commercial solicitation. These entities often advocate standards of conduct or practice that significantly exceed current legal requirements and classify certain e-mail solicitations that comply with current legal requirements as unsolicited bulk e-mails, or “spam.” In addition, we have noted unauthorized “spammers” utilize our domain name to solicit spam. Some of these entities maintain blacklists of companies and individuals, and the websites, Internet service providers and Internet protocol addresses associated with those entities or individuals that do not adhere to what the blacklisting entity believes are appropriate standards of conduct or practices for commercial e-mail solicitations. If a company’s Internet protocol addresses are listed by a blacklisting entity, e-mails sent from those addresses may be blocked if they are sent to any Internet domain or Internet address that subscribes to the blacklisting entity’s service or purchases its blacklist. From time to time we are blacklisted, sometimes without our knowledge, which could impair our ability to market our products and services, communicate with our customers and otherwise operate our business.

We may not succeed in promoting, strengthening and continuing to establish the Shutterfly brand, which would prevent us from acquiring new customers and increasing revenues.

A component of our business strategy is the continued promotion and strengthening of the Shutterfly brand. Due to the competitive nature of the digital photography products and services markets, if we are unable to successfully promote the Shutterfly brand, we may fail to substantially increase our net revenues. Customer awareness of, and the perceived value of, our brand will depend largely on the success of our marketing efforts and our ability to provide a consistent, high-quality customer experience. To promote our brand, we have incurred, and will continue to incur, substantial expense related to advertising and other marketing efforts.

Our ability to provide a high-quality customer experience also depends, in large part, on external factors over which we may have little or no control, including the reliability and performance of our suppliers and third-party Internet and communication infrastructure providers. For example, some of our products, such as select photo-based merchandise, are produced and shipped to customers by our third-party vendors, and we rely on these vendors to properly inspect and ship these products. In addition, we rely on third-party shippers, including the U.S. Postal Service and United Parcel Service, to deliver our products to customers. Strikes or other service interruptions affecting these shippers could impair our ability to deliver merchandise on a timely basis. Our products are also subject to damage during delivery and handling by our third-party shippers. Our failure to provide customers with high-quality products in a timely manner for any reason could substantially harm our reputation and our efforts to develop Shutterfly as a trusted brand. The failure of our brand promotion activities could adversely affect our ability to attract new customers and maintain customer relationships, which would substantially harm our business and results of operations.

Purchasers of digital photography products and services may not choose to shop online, which would harm our net revenues and results of operations.

The online market for digital photography products and services is less developed than the online market for other consumer products. If this market does not gain widespread acceptance, our business may suffer. Our success will depend in part on our ability to attract customers who have historically used traditional retail photography services or who have produced photographs and other products using self-service alternatives, such as printing at home. Furthermore, we may have to incur significantly higher and more sustained advertising and promotional expenditures or reduce the prices of our products and services in order to attract additional online consumers to our website and convert them into purchasing customers. Specific factors that could prevent prospective customers from purchasing from us include:

• the inability to physically handle and examine product samples;

• delivery time associated with Internet orders;

• concerns about the security of online transactions and the privacy of personal information;

• delayed shipments or shipments of incorrect or damaged products; and

• inconvenience associated with returning or exchanging purchased items.

If purchasers of digital photography products and services do not choose to shop online, our net revenues and results of operations would be harmed.

If affordable broadband access does not become widely available to consumers, our revenue growth will likely suffer.

Because our business currently involves consumers uploading and downloading large data files, we are highly dependent upon the availability of affordable broadband access to consumers. Many areas of the country still do not have broadband access, and the cost of broadband access may be too expensive for many potential customers. To the extent that broadband access is not available or not adopted by consumers due to cost, our revenue growth would likely suffer.

If the single facility where substantially all of our computer and communications hardware is located fails or if our production facilities fail, our business and results of operations would be harmed.

Our ability to successfully receive and fulfill orders and to provide high-quality customer service depends in part on the efficient and uninterrupted operation of our computer and communications systems. Substantially all of the computer hardware necessary to operate our website is located at a single third-party hosting facility in Santa Clara, California, and our production facilities are located in Hayward, California and Charlotte, North Carolina. Our systems and operations could suffer damage or interruption from human error, fire, flood, power loss, insufficient power availability, telecommunications failure, break-ins, terrorist attacks, acts of war and similar events. In addition, Hayward is located on, and Santa Clara is located near, a major fault line, increasing our susceptibility to the risk that an earthquake could significantly harm the operations of these facilities. We maintain business interruption insurance, however, this insurance may be insufficient to compensate us for losses that may occur, particularly from interruption due to an earthquake which is not covered under our current policy. We do not presently have redundant systems in multiple locations, although we are considering an additional data center in our new facility in Charlotte. In addition, the impact of any of these disasters on our business may be exacerbated by the fact that we are still in the process of developing our formal disaster recovery plan and we do not have a final plan in place.

13

Capacity constraints and system failures could prevent access to our website, which could harm our reputation and negatively affect our net revenues.

Our business requires that we have adequate capacity in our computer systems to cope with the high volume of visits to our website. As our operations grow in size and scope, we will need to improve and upgrade our computer systems and network infrastructure to ensure reliable access to our website, in order to offer customers enhanced and new products, services, capacity, features and functionality. The expansion of our systems and infrastructure may require us to commit substantial financial, operational and technical resources before the volume of our business increases, with no assurance that our net revenues will increase.

Our ability to provide high-quality products and service depends on the efficient and uninterrupted operation of our computer and communications systems. If our systems cannot be expanded in a timely manner to cope with increased website traffic, we could experience disruptions in service, slower response times, lower customer satisfaction, and delays in the introduction of new products and services. Any of these problems could harm our reputation and cause our net revenues to decline.

Our technology, infrastructure and processes may contain undetected errors or design faults that could result in decreased production, limited capacity or reduced demand.

Our technology, infrastructure and processes may contain undetected errors or design faults. These errors or design faults may cause our website to fail and result in loss of, or delay in, market acceptance of our products and services. If we experience a delay in a website release that results in customer dissatisfaction during the period required to correct errors and design faults, we would lose revenue. In the future, we may encounter scalability limitations, in current or future technology releases, or delays in the commercial release of any future version of our technology, infrastructure and processes that could seriously harm our business.

We currently depend on third party suppliers for our photographic print paper, printing machines and other supplies, which expose us to risks if these suppliers fail to perform under our agreements with them.

We have historically relied on an exclusive supply relationship with Fuji Photo Film U.S.A. to supply all of our photographic paper for silver halide print production, such as 4×6 prints. We have an agreement with Fuji that expires in April 2010, but if Fuji fails to perform in accordance with the terms of our agreement and if we are unable to secure a paper supply from a different source in a timely manner, we would likely fail to meet customer expectations, which could result in negative publicity, damage our reputation and brand and harm our business and results of operations. We purchase other photo-based supplies from third parties on a purchase order basis, and, as a result, these parties could increase their prices, reallocate supply to others, including our competitors, or choose to terminate their relationship with us. In addition, we purchase or rent the machines used to produce certain of our photo-based products from Hewlett-Packard, which is one of our primary competitors in the area of online digital photography services. This competition may influence their willingness to provide us with additional products or services. If we were required to switch vendors of machines for photo-based products, we may incur delays and incremental costs, which could harm our operating results.

We currently outsource some of our production of photo-based products to third parties, which exposes us to risks if these parties fail to perform under our agreements with them.

We currently outsource the production of some our photo-based products to third parties. If these parties fail to perform in accordance with the terms of our agreements and if we are unable to secure another outsource partner in a timely manner, we would likely fail to meet customer expectations, which could result in negative publicity, damage our reputation and brand and harm our business and results of operations.

If we are unable to develop, market and sell new products and services that address additional market opportunities, our results of operations may suffer.  In addition, we may need to expand beyond our current customer demographic to grow our business.

Although historically we have focused our business on consumer markets for silver halide prints, such as 4×6 prints, and photo-based products, such as photo books and calendars, we intend to address, and demand may shift to, new products and services. In addition, we believe we may need to address additional markets and expand our customer demographic in order to further grow our business. We may not successfully expand our existing services or create new products and services, address new market segments or develop a significantly broader customer base. Any failure to address additional market opportunities could result in loss of market share, which would harm our business, financial condition and results of operations.

We may undertake acquisitions to expand our business, which may pose risks to our business and dilute the ownership of our existing stockholders.

A key component of our business strategy includes strengthening our competitive position and refining the customer experience on our website through internal development. However, from time to time, we may selectively pursue acquisitions of businesses, like our June 2007 acquisition of Make it About Me! (“MIAM”), our January 2008 acquisition of Nexo Systems (“Nexo”) and other technologies or services. Integrating any newly acquired businesses, technologies or services is likely to be expensive and time consuming. To finance any acquisition, it may be necessary for us to raise additional funds through public or private financings. Additional funds may not be available on terms that are favorable to us, and, in the case of equity financings, would result in dilution to our stockholders. Also, the value of our stock may be insufficient to attract acquisition candidates.  If we do complete any acquisitions, we may be unable to operate the acquired businesses profitably or otherwise implement our strategy successfully. If we are unable to integrate MIAM, Nexo, or any other newly acquired entities, technologies or services effectively, our business and results of operations will suffer. The time and expense associated with finding suitable and compatible businesses, technologies or services could also disrupt our ongoing business and divert our management’s attention. Future acquisitions by us could also result in large and immediate write-offs or assumptions of debt and contingent liabilities, any of which could substantially harm our business and results of operations.

Our net revenues and results of operations are affected by the level of vacation and other travel by our customers, and any declines or disruptions in the travel industry could harm our business.

Because vacation and other travel is one of the primary occasions in which our customers utilize their digital cameras, our net revenues and results of operations are affected by the level of vacation and other travel by our customers. Accordingly, downturns or weaknesses in the travel industry could harm our business. Travel expenditures are sensitive to business and personal discretionary spending levels and tend to decline during general economic downturns. Events or weakness in the travel industry that could negatively affect the travel industry include price escalation in the airline industry or other travel-related industries, airline or other travel related strikes, safety concerns, including terrorist activities, inclement weather and airline bankruptcies or liquidations. In addition, high gasoline prices may lead to reduced travel in the United States. Any decrease in vacation or travel could harm our net revenues and results of operations.

Failure to adequately protect our intellectual property could substantially harm our business and results of operations.

We rely on a combination of patent, trademark, trade secret and copyright law and contractual restrictions to protect our intellectual property. These protective measures afford only limited protection. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our website features and functionalities or to obtain and use information that we consider proprietary, such as the technology used to operate our website, our production operations and our trademarks.

As of December 31, 2007, we had 21 patents issued and more than 30 patent applications pending in the United States. We intend to pursue corresponding patent coverage in other countries to the extent we believe such coverage is appropriate and cost efficient. We cannot ensure that any of our pending applications will be granted. In addition, third parties have in the past and could in the future bring infringement, invalidity, co-inventorship or similar claims with respect to any of our currently issued patents or any patents that may be issued to us in the future. Any such claims, whether or not successful, could be extremely costly, could damage our reputation and brand and substantially harm our business and results of operations.

Our primary brand is “Shutterfly.” We hold registrations for the Shutterfly service mark in our major markets of the United States and Canada, as well as in the European Community, Mexico, Japan, Australia and New Zealand. An additional application for the Shutterfly mark is pending in Brazil. Our competitors may adopt names similar to ours, thereby impeding our ability to build brand identity and possibly leading to customer confusion. In addition, there could be potential trade name or trademark infringement claims brought by owners of marks that are similar to Shutterfly or one of our other marks. The Shutterfly brand is a critical component of our marketing programs. If we lose the ability to use the Shutterfly service mark in any particular market, we could be forced to either incur significant additional marketing expenses within that market, or elect not to sell products in that market. Any claims or customer confusion related to our marks could damage our reputation and brand and substantially harm our business and results of operations.

14

If we become involved in intellectual property litigation or other proceedings related to a determination of rights, we could incur substantial costs, expenses or liability, lose our exclusive rights or be required to stop certain of our business activities.

Third parties may sue us for infringing its intellectual property rights. In June 2007, we were sued by FotoMedia Technologies, LLC alleging patent infringement.  In February 2008, we were also sued by Parallel Networks, also alleging patent infringement.  Likewise, we may need to resort to litigation to enforce our intellectual property rights or to determine the scope and validity of third-party proprietary rights.

The cost to us of any litigation or other proceeding relating to intellectual property rights, whether or not initiated by us and even if resolved in our favor, could be substantial, and the litigation would divert our management’s efforts from growing our business. Some of our competitors may be able to sustain the costs of complex intellectual property litigation more effectively than we can because they have substantially greater resources. Uncertainties resulting from the initiation and continuation of any litigation could limit our ability to continue our operations.

Alternatively, we may be required to, or decide to, enter into a license with a third party. For example, in May 2005, we entered into a settlement and license agreement to resolve litigation brought by a third party with respect to our alleged infringement of its patents. Under the terms of the agreement, we agreed to pay the third party a total of $2.0 million, and we received a license to its patents. Any future license required under any other party’s patents may not be made available on commercially acceptable terms, if at all. In addition, such licenses are likely to be non-exclusive and, therefore, our competitors may have access to the same technology licensed to us. If we fail to obtain a required license and are unable to design around a patent, we may be unable to effectively conduct certain of our business activities, which could limit our ability to generate revenues and harm our results of operations and possibly prevent us from generating revenues sufficient to sustain our operations.

The inability to acquire or maintain domain names for our website could substantially harm our business and results of operations.

We currently are the registrant of the Internet domain name for our website, Shutterfly.com, as well as various related domain names. Domain names generally are regulated by Internet regulatory bodies and are controlled also by trademark and other related laws. The regulations governing domain names could change in ways that block or interfere with our ability to use relevant domains. Also, we might not be able to prevent third parties from registering or retaining domain names that interfere with our consumer communications, or infringe or otherwise decrease the value of our trademarks and other proprietary rights. Regulatory bodies also may establish additional generic or country-code top-level domains or modify the requirements for holding domain names. As a result, we might not be able to acquire or maintain the domain names that utilize the name Shutterfly in all of the countries in which we currently or intend to conduct business. This could substantially harm our business and results of operations.

We may be subject to past or future liabilities for collection of sales and use taxes, and the payment of corporate level taxes.

Our policies concerning the collection of sales and use taxes and the payment of certain corporate level taxes has been based upon decisions of the U.S. Supreme Court that determine when a taxpayer is deemed to have nexus with a state sufficient to impose tax obligations under the Commerce Clause of the U.S. Constitution. Those Supreme Court decisions require that the taxpayer be physically present before a state can require the collection of sales and use taxes. States are currently attempting to expand the definition of what constitutes physical presence for sales and use taxes.  At the same time, the standard governing the imposition of other taxes, for instance, corporate income taxes, is less established and a number of state courts have recently concluded that the Commerce Clause definition of nexus should be expanded to include either “physical” or “economic” presence (essentially marketing activities) which is a broader definition than is used for sales and use tax.

In reliance upon the U.S. Supreme Court’s decisions, we have continued to collect sales and use taxes in California, Nevada, Pennsylvania, North Carolina, New York, New Jersey, and Arizona where we have employees and/or property. Starting in June 2007, we also began collecting sales and use taxes in other states where we have implemented joint sales efforts with Target Corporation.

While we believe the U.S. Supreme Court decisions support our policies concerning the collection and payment of taxes, tax authorities could disagree with our interpretations. If sustained, those authorities might seek to impose past as well as future liability for taxes and/or penalties. Such impositions could also impose significant administrative burdens and decrease our future sales. Moreover, the U.S. Congress has been considering various initiatives that could limit or supersede the U.S. Supreme Court’s position regarding sales and use taxes.

Our effective tax rate may be subject to fluctuation from federal and state audits, and disqualifying dispositions of stock options.

We recently resolved an audit examination by the State of California for the 2003 tax year, with a favorable result. Future audits of other tax years or by other taxing authorities could also lead to fluctuations in our effective tax rate because the taxing authority may disagree with certain assumptions we have made regarding appropriate credits and deductions in filing our tax returns.

Under current stock option tax regulations, we are entitled to a stock option compensation tax deduction when employees exercise and sell their incentive stock options within a two year period for a taxable gain. Our current effective tax rate estimate does not incorporate this deduction as the extent of the deduction, based on employee option disposition activity is not currently determinable. These disqualifying dispositions could lead to future fluctuations in our effective tax rate for any given quarter or year.

Government regulation of the Internet and e-commerce is evolving, and unfavorable changes or failure by us to comply with these regulations could substantially harm our business and results of operations.

We are subject to general business regulations and laws as well as regulations and laws specifically governing the Internet and e-commerce. Existing and future laws and regulations may impede the growth of the Internet or other online services. These regulations and laws may cover taxation, restrictions on imports and exports, customs, tariffs, user privacy, data protection, pricing, content, copyrights, distribution, electronic contracts and other communications, consumer protection, the provision of online payment services, broadband residential Internet access and the characteristics and quality of products and services. It is not clear how existing laws governing issues such as property use and ownership, sales and other taxes, libel and personal privacy apply to the Internet and e-commerce as the vast majority of these laws were adopted prior to the advent of the Internet and do not contemplate or address the unique issues raised by the Internet or e-commerce. Those laws that do reference the Internet are only beginning to be interpreted by the courts and their applicability and reach are therefore uncertain. For example, the Digital Millennium Copyright Act, or DMCA, is intended, in part, to limit the liability of eligible online service providers for including (or for listing or linking to third-party websites that include) materials that infringe copyrights or other rights of others. Portions of the Communications Decency Act, or CDA, are intended to provide statutory protections to online service providers who distribute third-party content. We rely on the protections provided by both the DMCA and CDA in conducting our business. Any changes in these laws or judicial interpretations narrowing their protections will subject us to greater risk of liability and may increase our costs of compliance with these regulations or limit our ability to operate certain lines of business. The Children’s Online Protection Act and the Children’s Online Privacy Protection Act are intended to restrict the distribution of certain materials deemed harmful to children and impose additional restrictions on the ability of online services to collect user information from minors. In addition, the Protection of Children From Sexual Predators Act of 1998 requires online service providers to report evidence of violations of federal child pornography laws under certain circumstances. The costs of compliance with these regulations may increase in the future as a result of changes in the regulations or the interpretation of them. Further, any failures on our part to comply with these regulations may subject us to significant liabilities. Those current and future laws and regulations or unfavorable resolution of these issues may substantially harm our business and results of operations.

15

Legislation regarding copyright protection or content interdiction could impose complex and costly constraints on our business model.

Because of our focus on automation and high volumes, our operations do not involve, for the vast majority of our sales, any human-based review of content. Although our website’s terms of use specifically require customers to represent that they have the right and authority to reproduce the content they provide and that the content is in full compliance with all relevant laws and regulations, we do not have the ability to determine the accuracy of these representations on a case-by-case basis. There is a risk that a customer may supply an image or other content that is the property of another party used without permission, that infringes the copyright or trademark of another party, or that would be considered to be defamatory, pornographic, hateful, racist, scandalous, obscene or otherwise offensive, objectionable or illegal under the laws or court decisions of the jurisdiction where that customer lives. There is, therefore, a risk that customers may intentionally or inadvertently order and receive products from us that are in violation of the rights of another party or a law or regulation of a particular jurisdiction. If we should become legally obligated in the future to perform manual screening and review for all orders destined for a jurisdiction, we will encounter increased production costs or may cease accepting orders for shipment to that jurisdiction. That could substantially harm our business and results of operations.

Our practice of offering free products and services could be subject to judicial or regulatory challenge.

We regularly offer free products and free shipping as an inducement for customers to try our products. Although we believe that we conspicuously and clearly communicate all details and conditions of these offers — for example, that customers are required to pay shipping, handling and/or processing charges to take advantage of the free product offer — we may be subject to claims from individuals or governmental regulators that our free offers are misleading or do not comply with applicable legislation. These claims may be expensive to defend and could divert management’s time and attention. If we become subject to such claims in the future, or are required or elect to curtail or eliminate our use of free offers, our results of operations may be harmed.

Any failure by us to protect the confidential information of our customers and networks against security breaches and the risks associated with credit card fraud could damage our reputation and brand and substantially harm our business and results of operations.

A significant prerequisite to online commerce and communications is the secure transmission of confidential information over public networks. Our failure to prevent security breaches could damage our reputation and brand and substantially harm our business and results of operations. For example, a majority of our sales are billed to our customers’ credit card accounts directly, orders are shipped to a customer’s address, and customers log on using their e-mail address. We rely on encryption and authentication technology licensed from third parties to effect the secure transmission of confidential information, including credit card numbers. Advances in computer capabilities, new discoveries in the field of cryptography or other developments may result in a compromise or breach of the technology used by us to protect customer transaction data. In addition, any party who is able to illicitly obtain a user’s password could access the user’s transaction data, personal information or stored images. Any compromise of our security could damage our reputation and brand and expose us to a risk of loss or litigation and possible liability, which would substantially harm our business and results of operations. In addition, anyone who is able to circumvent our security measures could misappropriate proprietary information or cause interruptions in our operations. We may need to devote significant resources to protect against security breaches or to address problems caused by breaches.

In addition, under current credit card practices, we are liable for fraudulent credit card transactions because we do not obtain a cardholder’s signature. We do not currently carry insurance against this risk. To date, we have experienced minimal losses from credit card fraud, but we continue to face the risk of significant losses from this type of fraud. Our failure to adequately control fraudulent credit card transactions could damage our reputation and brand and substantially harm our business and results of operations.

Changes in regulations or user concerns regarding privacy and protection of user data could harm our business.

Federal, state and international laws and regulations may govern the collection, use, sharing and security of data that we receive from our customers. In addition, we have and post on our website our own privacy policies and practices concerning the collection, use and disclosure of customer data. Any failure, or perceived failure, by us to comply with our posted privacy policies or with any data-related consent orders, Federal Trade Commission requirements or other federal, state or international privacy-related laws and regulations could result in proceedings or actions against us by governmental entities or others, which could potentially harm our business. Further, failure or perceived failure to comply with our policies or applicable requirements related to the collection, use or security of personal information or other privacy-related matters could damage our reputation and result in a loss of customers.

International expansion will require management attention and resources and may be unsuccessful, which could harm our future business development and existing domestic operations.

To date, we have conducted limited international operations, but we intend to expand into international markets in order to grow our business. These expansion plans will require significant management attention and resources and may be unsuccessful. We have limited experience adapting our products to conform to local cultures, standards and policies. We may have to compete with local companies which understand the local market better than we do. In addition, to achieve satisfactory performance for consumers in international locations it may be necessary to locate physical facilities, such as production facilities, in the foreign market. We do not have experience establishing such facilities overseas. We may not be successful in expanding into any international markets or in generating revenues from foreign operations. In addition, different privacy, censorship and liability standards and regulations and different intellectual property laws in foreign countries may cause our business to be harmed.

16

The success of our business depends on continued consumer adoption of digital photography

Our growth is highly dependent upon the continued adoption by consumers of digital photography. The digital photography market is rapidly evolving, characterized by changing technologies, intense price competition, additional competitors, evolving industry standards, frequent new service announcements and changing consumer demands and behaviors. To the extent that consumer adoption of digital photography does not continue to grow as expected, our revenue growth would likely suffer. Moreover, we face significant risks that, if the market for digital photography evolves in ways that we are not able to address due to changing technologies or consumer behaviors, pricing pressures, or otherwise, our current products and services may become less attractive, which would likely result in the loss of customers, as well as lower net revenues and/or increased expenses.

Maintaining and improving our financial controls and the requirements of being a public company may strain our resources, divert management’s attention and affect our ability to attract and retain qualified board members.

As a public company, we are subject to the reporting requirements of the Securities Exchange Act of 1934, the Sarbanes-Oxley Act of 2002 and the rules and regulations of The NASDAQ Stock Market. The requirements of these rules and regulations will likely continue to increase our legal, accounting and financial compliance costs, make some activities more difficult, time-consuming or costly and may also place undue strain on our personnel, systems and resources.

The Sarbanes-Oxley Act requires, among other things, that we maintain effective disclosure controls and procedures and effective internal control over financial reporting. Significant resources and management oversight are required to design, document, test, implement and monitor internal control over relevant processes and to, remediate any deficiencies. As a result, management’s attention may be diverted from other business concerns, which could harm our business, financial condition and results of operations. These efforts also involve substantial accounting related costs. In addition, if we are unable to continue to meet these requirements, we may not be able to remain listed on The NASDAQ Global Market.

Under the Sarbanes-Oxley Act and the rules and regulations of The NASDAQ Stock Market, we are required to maintain a board of directors with a majority of independent directors. These rules and regulations may make it more difficult and more expensive for us to maintain directors’ and officers’ liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to maintain coverage. If we are unable to maintain adequate directors’ and officers’ insurance, our ability to recruit and retain qualified directors and officers, especially those directors who may be considered independent for purposes of NASDAQ rules, will be significantly curtailed.

Our stock price may be volatile or may decline regardless of our operating performance.

The market price of our common stock may fluctuate significantly in response to numerous factors, many of which are beyond our control, including:

• price and volume fluctuations in the overall stock market;

• changes in operating performance and stock market valuations of other technology companies generally, or those in our industry in particular;

• the financial projections we may provide to the public, any changes in these projections or our failure to meet these projections;

• changes in financial estimates by any securities analysts who follow our company, our failure to meet these estimates or failure of those analysts to initiate or maintain coverage of our stock;

• ratings downgrades by any securities analysts who follow our company;

• the public’s response to our press releases or other public announcements, including our filings with the SEC;

• announcements by us or our competitors of significant technical innovations, acquisitions, strategic partnerships, joint ventures or capital commitments;

• introduction of technologies or product enhancements that reduce the need for our products;

• market conditions or trends in our industry or the macro-economy as a whole;

• impairment or loss in value of our investments in auction rate securities;

• the loss of key personnel;

• lawsuits threatened or filed against us;

• future sales of our common stock by our executive officers, directors and significant stockholders; and

• other events or factors, including those resulting from war, incidents of terrorism or responses to these events.

Some provisions in our restated certificate of incorporation and restated bylaws and Delaware law may deter third parties from acquiring us.

Our restated certificate of incorporation and restated bylaws contain provisions that may make the acquisition of our company more difficult without the approval of our board of directors, including the following:

• our board is classified into three classes of directors, each with staggered three-year terms;

• only our chairman, our chief executive officer, our president, or a majority of our board of directors is authorized to call a special meeting of stockholders;

• our stockholders may take action only at a meeting of stockholders and not by written consent;

• vacancies on our board of directors may be filled only by our board of directors and not by stockholders;

• our certificate of incorporation authorizes undesignated preferred stock, the terms of which may be established and shares of which may be issued without stockholder approval; and

• advance notice procedures apply for stockholders to nominate candidates for election as directors or to bring matters before an annual meeting of stockholders.

These anti-takeover defenses could discourage, delay or prevent a transaction involving a change in control of our company. These provisions could also discourage proxy contests and make it more difficult for stockholders to elect directors of their choosing and to cause us to take other corporate actions they desire.

In addition, we are subject to Section 203 of the Delaware General Corporation Law, which, subject to some exceptions, prohibits “business combinations” between a Delaware corporation and an “interested stockholder,” which is generally defined as a stockholder who becomes a beneficial owner of 15% or more of a Delaware corporation’s voting stock, for a three-year period following the date that the stockholder became an interested stockholder.  Section 203 could have the effect of delaying, deferring or preventing a change in control that our stockholders might consider to be in their best interests.

17

ITEM 1B.  UNRESOLVED STAFF COMMENTS.

Not applicable.

ITEM 2.  PROPERTIES.

We maintain our corporate headquarters in Redwood City, California in a leased facility of approximately 60,420 square feet. The lease for this facility expires on May 31, 2010.

We maintain our West-coast production and fulfillment operations in Hayward, California in leased facilities totaling approximately 71,708 square feet.  Leases for these facilities expire between September 30, 2009 and July 31, 2010. We have an option to extend these leases for five years and a first right of refusal to lease any immediately adjacent contiguous space.

We maintain our East-coast production and fulfillment operations in Charlotte, North Carolina in leased facilities totaling approximately 102,400 square feet. The lease for the facility commenced on the May 31, 2007, and continues through 2014. We have an option to extend the lease for three additional periods of either three or five years in length, and first rights of refusal to lease space in certain adjacent buildings.

We have certain temporary office space in Mesa, Arizona in leased facilities totaling approximately 1,000 square feet.  The lease for the facility commenced on September 26, 2007 and expires on September 30, 2008.

We believe that our existing facilities are adequate to meet our needs through the first half of 2008, although we expect to require additional corporate facilities to handle future growth. We believe that suitable additional space will be available in the future on commercially reasonably terms as needed.

ITEM 3.  LEGAL PROCEEDINGS.

On August 29, 2006, our former Chief Financial Officer, Virender Ahluwalia, sued us in San Mateo County Superior Court alleging causes of action for reformation of contract, breach of contract and breach of fiduciary duty. The plaintiff claimed that he was entitled to exercise stock options for an additional 15,535 shares of our common stock because his vesting schedule should have been deemed to have started one year earlier than the date stated in our corporate records. In addition, the plaintiff claimed that the we initially did not advise him that withholding taxes were due at the time of exercise of his nonqualified stock options to purchase 292,674 shares of common stock in 2005, but that we later modified that tax advice, extended his option exercise date, and required that he make provision for the applicable withholding taxes at the time of exercise of such options. The plaintiff claimed he was damaged by having to immediately sell a portion of those shares upon his exercise in order to raise the funds necessary to pay applicable withholding taxes. He also claimed that the calculation of the fair market value of the shares for the purpose of calculating his tax liability was improper. The plaintiff was seeking compensatory and punitive damages. The case was stayed and sent to binding arbitration, and following a hearing on the legal issues and an evidentiary hearing, the Arbitrator issued a Final Award on November 16, 2007 finding us not liable and dismissed all claims brought by Mr. Ahluwalia.   

On or about June 18, 2007, Fotomedia Technologies, LLC filed suit in the United States District Court for the Eastern District of Texas against us and several other defendants alleging patent infringement.  The Fotomedia Complaint sought unspecified damages, costs, interest and attorneys’ fees, and a permanent injunction.  In lieu of answering the Fotomedia Complaint, we moved to dismiss it under Rule 12 of the Federal Rules of Civil Procedure, by joining in a motion to the same effect filed by co-defendant Photobucket.com, Inc.  While the motion was pending and not yet decided, on or about November 6, 2007, Fotomedia filed an Amended Complaint.  The Amended Complaint likewise alleges infringement of the same patents and seeks unspecified damages, costs, interest and attorneys’ fees, and a permanent injunction.  However, the amended complaint dropped the allegations of willful infringement against us in connection with one of the patents-at-issue. Defendants moved to dismiss the Amended Complaint as well.  The motion at this time is fully briefed but has not yet been ruled upon.  As such, we have not yet been required to file an answer or other responsive pleading.  On January 8, 2008, the court held a status conference and set May 28, 2009, as the date for the claims construction hearing, and set November 2, 2009 as the date for trial.  Subsequently, the parties agreed upon and submitted orders that establish a case schedule, which the court entered on February 29, 2008.

On or about February 5, 2008, Parallel Networks, LLC filed a lawsuit in the Eastern District of Texas against the Company and other companies alleging patent infringement.  The Parallel Networks Complaint seeks damages of an unspecified amount, attorneys’ fees, and an injunction against all parties.  We have not yet answered or otherwise responded to the complaint.  

In addition, in the ordinary course of our business, we are subject to periodic lawsuits, investigations and claims. Although we cannot predict with certainty the ultimate resolution of lawsuits, investigations and claims asserted against us, we do not believe that any other currently pending legal proceeding to which we are a party is likely to harm our business, results of operations, cash flows or financial condition.

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

Not applicable.

18

PART II

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

Shutterfly’s common stock has been traded on the NASDAQ Global Market under the symbol “SFLY” since September 29, 2006. As of February 29, 2008, there were approximately 154 stockholders of record, excluding stockholders whose shares were held in nominee or street name by brokers. We have not paid any cash dividends and do not currently have plans to do so in the foreseeable future.

The following table sets forth the high and low sales price per share for Shutterfly’s common stock for the periods indicated:

Year Ended December 31, 2006	High	Low
Third Quarter	$16.73	$15.01
Fourth Quarter	$16.29	$12.05
Year Ended December 31, 2007	High	Low
First Quarter	$18.53	$13.38
Second Quarter	$22.92	$15.92
Third Quarter	$32.46	$21.80
Fourth Quarter	$36.40	$25.59

We have never paid cash dividends on our capital stock.  It is our present policy to retain earnings to finance the growth and development of our business and, therefore, we do not anticipate paying any cash dividends in the foreseeable future.

Purchases of Equity Securities of the Issuer and Affiliated Purchasers

Neither we nor any affiliated purchaser repurchased any of our equity securities in the fourth quarter of fiscal year 2007.

Use of Proceeds

The S-1 relating to our initial public offering was declared effective by the SEC on September 28, 2006 (Registration Statement File No. 333-135426), and the offering commenced the same day. J.P. Morgan Securities Inc. acted as the sole book-running manager for the offering and Piper Jaffray & Co. and Jefferies & Company, Inc. acted as co-managers of the offering.

The securities registered were 5,800,000 shares of common stock, plus 870,000 additional shares to cover the underwriters’ over-allotment option. The underwriters’ over-allotment option expired on October 28, 2006, and was not exercised by the underwriters. The aggregate public offering price of the offering amount registered, including shares to cover the underwriters’ over-allotment option, was $100,050,000. We sold 5,800,000 shares of our common stock for an aggregate offering price of $87,000,000, and the offering has terminated.

Expenses incurred in connection with the issuance and distribution of the securities registered were as follows:

• Underwriting discounts and commissions — $6,090,000

• Other expenses — $2,442,000

• Total expenses — $8,533,000

None of such payments were direct or indirect payments to any of our directors or officers or their associates or to persons owning ten percent or more of our common stock or direct or indirect payments to others.

The net offering proceeds to us after deducting underwriters’ discounts and the total expenses described above was approximately $78.5 million.

Through December 31, 2007, we have used approximately half of these proceeds to purchase capital equipment, acquire a business, and for general operating purposes.  We expect to continue to use the remainder of the net proceeds for general corporate purposes, including working capital, operating expenses, and capital expenditures. In addition, we may also use a portion of the net proceeds for the acquisition of, or investment in, companies, technologies, products or assets that complement our business.

Our management retains broad discretion in the allocation and use of the net proceeds of our initial public offering, and investors must rely on the judgment of our management regarding the application of the net proceeds. Pending specific utilization of the net proceeds as described above, we have invested the net proceeds of the offering in short-term, interest-bearing obligations, investment grade instruments, certificates of deposit or direct or guaranteed obligations of the United States. The investment objective with respect to net proceeds is capital preservation and liquidity so that such funds are readily available to fund our operations.

19

ITEM 6.  SELECTED FINANCIAL DATA.

The consolidated statements of income data for the years ended December 31, 2007, 2006 and 2005 and the consolidated balance sheet data as of December 31, 2007 and 2006 have been derived from our audited consolidated financial statements included elsewhere in this annual report. The consolidated statements of income data for the years ended December 31, 2004 and 2003 and the consolidated balance sheet data as of December 31, 2005, 2004 and 2003 have been derived from our audited consolidated financial statements not included in this annual report. The following selected consolidated financial data should be read in conjunction with our “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and consolidated financial statements and related notes to those statements included elsewhere in this annual report.

	Year Ended December 31,
	2007	2006	2005	2004	2003
	(In thousands, except per share amounts)
Consolidated Income Statement Data:
Net revenues	$186,727	$123,353	$83,902	$54,499	$31,395
Cost of net revenues(1)	84,111	55,491	36,941	24,878	14,310
Gross profit	102,616	67,862	46,961	29,621	17,085
Operating expenses:
Technology and development(1)	28,635	19,087	13,152	7,433	4,970
Sales and marketing(1)	33,363	21,940	15,252	7,705	3,991
General and administrative(1)	29,557	19,216	13,657	10,126	5,629
Total operating expense	91,555	60,243	42,061	25,264	14,590
Income from operations	11,061	7,619	4,900	4,357	2,495
Interest expense	(179)	(266)	(367)	(471)	(392)
Other income (expense) net	5,515	2,387	(103)	81	9
Income before income taxes and cumulative effect of change in accounting principle	16,397	9,740	4,430	3,967	2,112
(Provision) / benefit for income taxes(2)	(6,302)	(3,942)	24,060	(258)	(68)
Net income before cumulative effect of change in accounting principle(2)	10,095	5,798	28,490	3,709	2,044
Cumulative effect of change in accounting principle	—	—	442	—	—
Net income (2)	$10,095	$5,798	$28,932	$3,709	$2,044
Net income per share:
Basic	$       0.42	$       0.67	$     1.45	$       —	$       —
Diluted	$       0.38	$       0.56	$     1.02	$       —	$       —
Weighted Average Shares
Basic	24,295	8,622	3,255	2,231	1,574
Diluted	26,273	10,331	4,609	2,231	1,574

__________

(1) Includes stock-based compensation as follows:

	Year Ended December 31,
	2007	2006	2005	2004	2003
	(In thousands)
Cost of net revenues	$189	$     96	$     28	$     21	$         3
Technology and development	880	736	826	263	32
Sales and marketing	877	521	239	117	11
General and administration	2,055	947	2,217	1,790	124
	$4,001	$2,300	$3,310	$2,191	$     170

(2) See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies and Estimates — Income Taxes” for a discussion of the uncertainty related to our deferred tax asset.

	December 31,
	2007	2006	2005	2004	2003
	(In thousands)
Consolidated Balance Sheet Data:
Cash, cash equivalents, and short term investments	$125,584	$119,051	$39,153	$13,781	$10,670
Property and equipment, net	48,416	30,919	20,761	11,723	5,140
Working capital	104,025	102,165	22,687	690	2,002
Total assets	208,770	180,160	89,552	29,865	17,754
Capital lease obligations, less current portion	107	1,742	3,646	2,709	1,314
Preferred stock warrant liability	—	—	1,535	—	—
Redeemable convertible preferred stock	—	—	89,652	69,822	69,668
Total stockholders’ equity (deficit)	170,566	151,326	(27,262)	(59,568)	(65,333)

20

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

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This document, including the following Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that are based upon our current expectations. These forward-looking statements include statements related to our expectations regarding the seasonality of our business, the decline in average selling prices for prints, our capital expenditures for 2008 and the sufficiency of our cash and cash equivalents and cash generated from operations for the next 12 months and our ability to grow our personalized products and services as a percentage of our total revenues, as well as other statements regarding our future operations, financial condition and prospects and business strategies. In some cases, you can identify forward-looking statements by terminology such as “project,” “believe,” “anticipate,” “plan,” “expect,” “estimate,” “intend,” “continue,” “should,” “would,” “could,” “potentially,” “will,” or “may,” or the negative of these terms or other comparable terminology. Forward-looking statements involve risks and uncertainties. Our actual results and the timing of events could differ materially from those anticipated in our forward-looking statements as a result of many factors, including but not limited to, the seasonality of our business, whether we are able to expand our customer base and increase our product and service offering, competition in our marketplace and the other risks set forth below under “Risk Factors” in Part I, Item 1A of this report. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. We assume no obligation to update any of the forward-looking statements after the date of this report or to compare these forward-looking statements to actual results.

Overview

We are an Internet-based social expression and personal publishing service that enables consumers to share, print and preserve their memories by leveraging our technology, manufacturing, web-design and merchandising capabilities. Today, our primary focus is on helping consumers manage their memories through the powerful medium of photos. We provide a full range of personalized photo-based products and services that make it easy, convenient and fun for consumers to upload, edit, enhance, organize, find, share, create, print and preserve their memories in a creative and thoughtful manner.

Consumers use our products and services to stay connected to their friends and family, to organize their memories in a single location, to tell stories and to preserve their memories for themselves and their children. Our customers purchase physical products both for their own personal use and for giving thoughtful and personalized gifts such as photo books, calendars, greeting cards and other photo-based products and merchandise.

We currently generate the majority of our net revenues by producing and selling professionally-bound photo books, personalized calendars, greeting cards, other photo-based merchandise and high-quality prints (ranging in size from wallet to jumbo-sized 20×30 enlargements). We manufacture substantially all of these items in our Hayward, California and Charlotte, North Carolina manufacturing facilities. By controlling the production process in our own manufacturing facilities, we are able to produce high-quality products, innovate rapidly, maintain a favorable cost structure and ensure timely shipment to customers, even during peak periods of demand. Additionally, we sell a variety of photo-based merchandise that is currently manufactured for us by third parties, such as mugs, mouse pads, coasters, tote bags, desk organizers, puzzles, playing cards, multi-media DVDs, magnets and keepsake boxes, and ancillary products, such as frames, photo albums and scrapbooking accessories.

Our high-quality products and services and the compelling online experience we create for our customers, together with our focus on continuous innovation, have earned us numerous third-party accolades and, more importantly, have allowed us to establish a premium brand. We believe that we realize the benefits of a premium brand through high customer loyalty, low customer acquisition costs and premium pricing.

Our customers are a central part of our business model. They generate most of the content on our service by uploading their photos and storing their memories. In addition, they share their photos electronically with their friends and families, extending and endorsing our brand and creating a sense of community. Finally, by giving Shutterfly-branded products to colleagues, friends and loved ones throughout the year, customers reinforce the Shutterfly brand. Through these various activities, our customers create a viral network of new users and customers.

In addition to driving lower customer acquisition costs through viral marketing, our customers provide input on new features, functionalities and products. Close, frequent customer interactions, coupled with significant investments in sophisticated integrated marketing programs, enable us to fine-tune and tailor our promotions and website presentation to specific customer segments. Consequently, customers are presented with a highly personalized Shutterfly shopping experience, which helps foster a unique and deep relationship with our brand.

Our corporation was formed in 1999 and we have experienced rapid growth since launching our service in December 1999. During fiscal year 2007, we fulfilled more than seven million orders, to more than two million customers, at an average order value of more than $26 per order.

In June 2005, we completed the acquisition of Memory Matrix, Inc., a Nevada engineering firm dedicated to improving the consumer digital photography experience, in exchange for 109,302 shares of common stock.  In June 2007, we acquired for $1.6 million, certain assets and liabilities of CustomAbility, LLC, a New Jersey publishing company that produces customized children’s books under the brand name Make It About Me.  On January 4, 2008, for $10.0 million in cash and stock consideration of approximately $4.0 million, we acquired Nexo Systems, a privately held on-line sharing and group services company based in Palo Alto, California.

Basis of Presentation

Net Revenues.  We generate revenues primarily from the printing and shipping of photo-based products, such as photo books, cards and calendars, photo prints, photo-based merchandise, such as mugs, mouse pads and magnets, and ancillary products such as frames, photo albums and scrapbooking accessories. Revenues are recorded net of estimated returns, promotions redeemed by customers and other discounts. Customers place orders via our website and pay primarily using credit cards.

Our personalized products and services revenues are derived from the sale of photo-based products, photo-based merchandise and ancillary products and services, and the related shipping revenues. Referral fees are also included in personalized products and services revenue.  We believe our products and services are differentiated from other traditional photo processors by our high quality production and numerous form factors and templates, which are key to attracting and retaining customers.

Our print revenues are derived from sales of our photo processing of digital images, including sales of 4×6 prints, and the related shipping revenues. From time to time, we have made changes to our pricing structure for 4×6 prints in order to remain competitive.  In December, 2007, one of our competitors lowered their list prices on 4×6 prints from $0.12 to $0.09.  To date, we have not made any additional changes to the price of our 4×6 prints as a result of this price cut.  However, a drop in our 4×6 prices, without a corresponding increase in volume, or decreases in volume as a result of competitive pressures would negatively impact our net revenues and could adversely affect our gross margins and overall profitability.

To offset these periodic price declines and continue to generate net income, we have continued to invest in large scale manufacturing technology to enable us to reduce the cost of manufacturing prints. We have also continued to recruit highly qualified personnel with specialized skills in print manufacturing. We believe that these strategies have allowed us, and will continue to allow us, to compete successfully with other companies in our industry. In addition, we continue to focus on diversifying our business towards the large and growing market for personalized products and services.

Our business is subject to seasonal fluctuations. In particular, we generate a substantial portion of our revenues during the holiday season in the calendar fourth quarter. We also typically experience increases in net revenues during other shopping-related seasonal events, such as Easter, Mother’s Day, Father’s Day, and Halloween. We generally experience lower net revenues during the first, second and third calendar quarters and, as is typical in the retail industry, have incurred and may continue to incur losses in these quarters. Due to the relatively short lead time required to fulfill product orders, usually one to three business days, order backlog is not material to our business.

To further understand net revenue trends, we monitor several key metrics including:

Total Customers.  We closely monitor total customers as a key indicator of demand.  Total customers include the number of transacting customers in a given period.  We seek to expand our customer base by empowering our existing customers with sharing and collaboration services (such as Shutterfly Gallery, the Nexo platform, and Shutterfly Collections), and by conducting integrated marketing and advertising programs.  Total customers have increased on an annual basis for each year since inception, and we anticipate that this trend will continue.

Average Order Value.  Average order value is net revenues for a given period divided by the total number of customer orders recorded during that same period. We seek to increase average order value as a means of increasing net revenues. Average order value has increased on an annual basis for each year since 2000, and we anticipate that this trend will continue in the future.

Total Number of Orders.  We closely monitor total number of orders as a leading indicator of net revenue trends. We recognize the net revenues associated with an order when the products have been shipped and all other revenue recognition criteria have been met.  Orders are typically processed and shipped within two business days after a customer places an order. Total number of orders has increased on an annual basis for each year since 2000, and we anticipate that this trend will continue in the future.

21

Personalized Products and Services Revenues as Percentage of Net Revenues.  We continue to innovate and improve our personalized products and services and expect the net revenues from these products and services to increase as percentage of net revenues as we continue to diversify our product offerings.  Personalized products and services as a percentage of total net revenue increased from 51% in 2006 to 56% in 2007.  In addition, as a percentage of total net revenues, revenues from 4x6 prints have been declining; from 37% in 2005, to 28% in 2006, and to 22% in 2007.

We believe the analysis of these metrics and others provides us with important information on our overall net revenue trends and operating results. Fluctuations in these metrics are not unusual and no single factor is determinative of our net revenues and operating results.

Cost of Net Revenues.  Cost of net revenues consist primarily of direct materials (the majority of which consists of paper, ink, and photo book covers), payroll and related expenses for direct labor, shipping charges, packaging supplies, distribution and fulfillment activities, rent for production facilities, depreciation of production equipment, and third-party costs for photo-based merchandise. Cost of net revenues also includes payroll and related expenses for personnel engaged in customer service. In addition, cost of revenues includes any third-party software or patents licensed, as well as the amortization of acquired developed technology and capitalized website development costs.

Operating Expenses.  Operating expenses consist of technology and development, sales and marketing, and general and administrative expenses. We anticipate that each of the following categories of operating expenses will increase in absolute dollar amounts, but remain relatively consistent as a percentage of net revenues.

Technology and development expense consists primarily of personnel and related costs for employees and contractors engaged in the development and ongoing maintenance of our website, infrastructure and software. These expenses include depreciation of the computer and network hardware used to run our website and store the customer data, as well as amortization of purchased software. Technology and development expense also includes colocation and bandwidth costs.

Sales and marketing expense consists of costs incurred for marketing programs and personnel and related expenses for our customer acquisition, product marketing, business development and public relations activities. Our marketing efforts consist of various online and offline media programs, such as e-mail and direct mail promotions, the purchase of keyword search terms and various strategic alliances. We depend on these efforts to attract customers to our service.

General and administrative expense includes general corporate costs, including rent for our corporate offices, insurance, depreciation on information technology equipment and legal and accounting fees. In addition, general and administrative expense includes personnel expenses of employees involved in executive, finance, accounting, human resources, information technology and legal roles. Third-party payment processor and credit card fees are also included in general and administrative expense and have historically fluctuated based on revenues during the period.

Interest Expense.  Interest expense consists of interest costs recognized under our capital lease obligations and other borrowings.

Other Income (Expense), Net.  Other income (expense), net consists primarily of the interest income on our cash and investment accounts and the net income (expense) related to changes in the fair value of convertible preferred stock warrants.  Subsequent to the completion of our initial public offering on October 4, 2006, all of our warrants to purchase shares of preferred stock converted into warrants to purchase shares of common stock. Accordingly, the liability for the convertible preferred stock warrants was reclassified as common stock and additional paid-in capital and the warrants are no longer subject to re-measurement.

Income Taxes.  Historically, we have only been subject to taxation in the United States because we have sold almost all of our products to customers in the United States. If we continue to sell our products primarily to customers located within the United States, we anticipate that our long-term future effective tax rate will range between 38% and 45%.

Critical Accounting Policies and Estimates

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, or GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. In many instances, we could have reasonably used different accounting estimates, and in other instances, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ significantly from the estimates made by our management. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation of our financial condition or results of operations will be affected.

In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application, while in other cases, management’s judgment is required in selecting among available alternative accounting standards that allow different accounting treatment for similar transactions. We believe that the accounting policies discussed below are the most critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates.

Revenue Recognition.  We generate revenues primarily from the printing and shipping of prints and other photo-based products, and referral fees. We generally recognize revenues from product sales upon shipment when persuasive evidence of an arrangement exists (typically through the use of a credit card or receipt of a check), the selling price is fixed or determinable and collection of resulting receivables is reasonably assured. Revenues from amounts billed to customers, including prepaid orders, are deferred until shipment of fulfilled orders. We provide our customers with a 100% satisfaction guarantee whereby products can be returned within a 30-day period for a reprint or refund. We maintain an allowance for estimated future returns based on historical data.  During the year ended December 31, 2007, returns totaled less than 1% of net revenues and have been within management’s expectations. We periodically provide incentive offers to our customers in exchange for setting up an account and to encourage purchases. Such offers include free products and percentage discounts on current purchases. Discounts, when accepted by customers, are treated as a reduction to the purchase price of the related transaction and are included in net revenues. Production costs related to free products are included in costs of revenues upon redemption.  Shipping charged to customers is recognized as revenue at the time of shipment.  Revenue from referral fees for click-throughs is recognized in the period that the click-through impression is delivered.

Inventories.  Our inventories consist primarily of paper, photo book covers and packaging supplies and are stated at the lower of cost on a first-in, first-out basis or net realizable value. The value of inventories is reduced by an estimate for excess and obsolete inventories. The estimate for excess and obsolete inventories is based upon management’s review of utilization of inventories in light of projected sales, current market conditions and market trends.

Software and Website Development Costs.  We capitalize eligible costs associated with software developed or obtained for internal use in accordance with the AICPA Statement of Position No. 98-1 and EITF Issue No. 00-2. Accordingly, payroll and payroll-related costs incurred in the development phase are capitalized and amortized over the product’s estimated useful life, which is generally three years. Costs associated with minor enhancements and maintenance for our website are expensed as incurred.

Income Taxes.  We use the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized by applying the statutory tax rates in effect in the years in which the differences between the financial reporting and tax filing bases of existing assets and liabilities are expected to reverse. We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance against our deferred tax assets. We believe that all net deferred tax assets shown on our balance sheet are more likely than not to be realized in the future and no valuation allowance is necessary. In the event that actual results differ from those estimates or we adjust those estimates in future periods, we may need to record a valuation allowance, which will impact deferred tax assets and the results of operations in the period the change in made.

Stock-based Compensation Expense.  Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123R, “Share-Based Payment,” using the prospective transition method, which requires us to apply the provisions of SFAS No. 123R only to new awards granted, and to awards modified, repurchased or cancelled, after the effective date. Under this transition method, stock-based compensation expense recognized beginning January 1, 2006 is based on the following: (a) the grant-date fair value of stock option awards granted or modified after January 1, 2006; and (b) the balance of deferred stock-based compensation related to stock option awards granted prior to January 1, 2006, which was calculated using the intrinsic value method as previously permitted under APB Opinion No. 25.

Under SFAS No 123R, we estimate the fair value of stock options granted using the Black-Scholes valuation model. This model requires us to make estimates and assumptions including, among other things, estimates regarding the length of time an employee will retain vested stock options before exercising them, the estimated volatility of our common stock price and the number of options that will be forfeited prior to vesting. The fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. Changes in these estimates and assumptions can materially affect the determination of the fair value of stock-based compensation and consequently, the related amount recognized in our consolidated statements of operations.

22

Results of Operations

The following table presents the components of our income statement as a percent of net revenues:

	Year Ended December 31,
	2007	2006	2005
Net revenues	100%	100%	100%
Cost of revenues	45%	45%	44%
Gross profit	55%	55%	56%
Operating expenses:
Technology and development	15%	15%	16%
Sales and marketing	18%	18%	18%
General and administrative	16%	16%	16%
Income from operations	6%	6%	6%
Interest expense	0%	0%	0%
Other income, net	2%	2%	0%
Income before income taxes	8%	8%	6%
Benefit (provision) for income taxes	(3)%	(3)%	29%
Net income	5%	5%	35%

Comparison of the Years Ended December 31, 2007 and 2006

	Year Ended December 31,
	2007	2006	$  Change	% Change
	(In thousands)
Net revenues	$186,727	$ 123,353	$  63,374	51%
Cost of net revenues	$84,111	$    55,491	$  28,620	52%
Percentage of net revenues	45%	45%	-	-
Gross profit	$102,616	$    67,862	$  34,754	51%

Net revenues increased $63.4 million, or 51%, from 2006 to 2007. Revenue growth was attributable to the increases in both print and personalized products and services revenues. Personalized products and services (“PPS”) revenues increased $42.9 million, or 69%, to $105.3 million from 2006 to 2007. This change was the result of increased revenue across our entire PPS product base, and most significantly through increased sales of photo books, calendars, folded greeting cards, and referral fees.  PPS made up 56% of revenues in 2007, up from 51% in 2006.  Print revenues increased $20.5 million, or 34%, to $81.4 million from 2006 to 2007. This increase was primarily the result of increased revenues from 4x6, large format and photocard print sizes.  As a percentage of total net revenue, 4x6 print revenues declined in 2007, decreasing from 28% in 2006 to 22% in 2007.  Net revenue increases were also the result of year-over-year increases in all of our key metrics: customers, orders, and average order value, as noted below:

	Year Ended December 31,
	2007	2006	Change	% Change
	(In thousands, except AOV amounts)
Customers	2,357	1,725	632	37%
Orders	7,062	5,105	1,957	38%
Average order value	$26.44	$24.16	$2.28	9%

Cost of net revenues increased $28.6 million, or 52%, from 2006 to 2007. As a percentage of net revenues, cost of net revenues remained flat, at 45%, from 2006 to 2007.  Overall, this increase was primarily the result of the increased volume of shipped products, and incremental costs associated with launching our second manufacturing facility in Charlotte, North Carolina.  These costs were offset by savings in labor and shipping costs, reflecting efficiencies in both the reduced cost of labor between the North Carolina and California manufacturing facilities and closer shipping routes to our east coast customers.

	Year Ended December 31,
	2007	2006	$  Change	% Change
	(In thousands)
Technology and development	$28,635	$19,087	$   9,548	50%
Percentage of net revenues	15%	15%	-	-
Sales and marketing	$33,363	$21,940	$ 11,423	52%
Percentage of net revenues	18%	18%	-	-
General and administrative	$29,557	$19,216	$ 10,341	54%
Percentage of net revenues	16%	16%	-	-

Our technology and development expense increased $9.5 million, or 50%, from 2006 to 2007. As a percentage of net revenues, technology and development expense remained flat at 15% from 2006 to 2007.  The overall increase in technology and development expense was attributable to increased personnel and related costs for employees and consultants involved with website development and website infrastructure support teams, which totaled $3.2 million, as well as increased third-party hosting expenses which increased by $0.8 million.  In 2007, we capitalized $3.1 million in eligible costs associated with software developed or obtained for internal use, up from $1.3 million in 2006.  We also continued to invest in our website infrastructure hardware to support our continued revenue growth, which resulted in increased depreciation expense of $3.7 million.  Stock-based compensation expense was $0.9 million in 2007, compared to $0.7 million in 2006.

Our sales and marketing expense increased $11.4 million, or 52%, from 2006 to 2007. Also as a percentage of net revenues, total sales and marketing expense remained flat at 18% from 2006 to 2007.  For 2007, personnel and related costs for employees and consultants increased by $2.5 million, and our expenditures incurred on customer acquisition and promotion costs increased by $8.2 million. In addition, stock-based compensation expense was $0.9 million in 2007, compared to $0.5 million in 2006.

Our general and administrative expense increased $10.3 million, or 54%, from 2006 to 2007, and remained flat as a percentage of net revenues at 16% in that same period.  Personnel and related costs increased by $3.3 million in 2007 reflecting increased hiring in 2007 and an increase in stock-based compensation to $2.1 million, in 2007, compared to $0.9 million in 2006. Accounting and legal fees increased by $1.2 million in 2007, and consulting expenses increased by $2.2 million.  Of that combined increase of $3.4 million, approximately $2.2 million was associated with our efforts to comply with the Sarbanes-Oxley Act of 2002.  Additionally, rent and related facilities charges increased by $0.8 million for 2007 reflecting our additional square footage in Redwood City.  Payment processing fees paid to third parties increased by $1.5 million during 2007 due to increased order volumes. In 2006, we made a non-recourse, non-refundable contribution of 65,000 shares of common stock to Silicon Valley Community Foundation, a California non-profit public benefit corporation, in order to establish the Shutterfly Foundation as a corporate-advised charitable fund within the Community Foundation, and recognized $0.9 million of charitable contribution expense for 2006. We had no charitable contribution expense in 2007.

	Year Ended December 31,
	2007	2006	Change
	(In thousands)
Interest Expense	$(179)	$(266)	$     87
Other income, net	$5,515	$2,387	$3,128

Interest expense decreased by $0.1 million for 2007, due primarily to a decrease in interest expense on capitalized lease obligations.

23

Other income (expense), net, increased by $3.1 million for 2007, due to larger invested cash balances for the full year 2007, versus 2006.  In 2006, other income (expense), net also included $0.1 million of income related to changes in the fair value of our redeemable convertible preferred stock warrants.  Upon the completion of our initial public offering on October 4, 2006, all of our warrants to purchase shares of preferred stock converted into warrants to purchase shares of common stock and accordingly, no additional amounts for the change in fair value for the warrants will be recorded.

	Year Ended December 31,
	2007	2006
	(In thousands)
Income tax provision	$(6,302)	$(3,942)
Effective tax rate	38%	40%

The provision for income taxes was $6.3 million for 2007, compared to a provision of $3.9 million for 2006.  Our effective tax rate was 38% in 2007, down from 40% in 2006.  This decrease in our effective tax rate is primarily the result of a favorable resolution of a state tax audit by California, as well as the changes that were made to our ongoing research and development tax credits reserves.  Other factors, such as the volume of disqualifying dispositions also contributed to the reduction in our tax rate, year-over-year.

As of December 31, 2007, we had approximately $31 million of federal and $32 million of state net operating loss carryforwards available to reduce future taxable income. These net operating loss carryforwards begin to expire in 2020 and 2011 for federal and state tax purposes, respectively.

	Year Ended December 31,
	2007	2006	$  Change		% Change
	(In thousands)
Income before income taxes	$16,397	$9,740		$  6,657	68%
Net income	$10,095	$5,798		$  4,297	74%
Percentage of net revenues	5%	5%		-	-

Net income increased by $4.3 million, or 74%, for 2007 as compared to 2006. As a percentage of net revenue, net income was flat at 5% in both FY06 and FY07.  Overall, our net income growth in absolute dollars is attributable to our revenue growth year-over-year; with all other income statement items increasing in-proportion to net revenue increases.

Comparison of the Years Ended December 31, 2006 and 2005

	Year Ended December 31,
	2006	2005	$  Change	% Change
	(In thousands)
Net revenues	$123,353	$83,902	$  39,451	47%
Cost of net revenues	$55,491	$36,941	$  18,550	50%
Percentage of net revenues	45%	44%	-	-
Gross profit	67,862	46,961	20,901	45%

Net revenues increased $39.5 million, or 47%, from 2005 to 2006. Net revenue growth was attributable to the increases in both print and PPS revenues. PPS revenues increased $27.2 million, or 77%, to $62.4 million from 2005 to 2006 primarily due to increased sales of photo books, calendars, folded greeting cards and photo-based merchandise, which caused PPS revenues to increase to 51% of revenues in 2006 from 42% in 2005. Print revenues increased $12.2 million, or 25%, to $60.9 million from 2005 to 2006 primarily due to increased sales volumes of 4x6 prints, but negatively affected by a decrease in 4x6 print average selling prices due to competitive pricing pressures. We reduced the list price of our 4x6 prints by 34% from $0.29 to $0.19 in the fourth quarter of 2005.  As a percentage of total revenue, 4x6 print revenue declined in 2006, decreasing from 37% in 2005 to 28% in 2006.  Net revenue increases were also the result of year-over-year increases in all of our key metrics including, customers, orders, and average order value, as noted below:

	Year Ended December 31,
	2006	2005	Change	% Change
	(In thousands, except AOV amounts)
Customers	1,725	1,219	506	42%
Orders	5,105	3,650	1,455	40%
Average order value	$24.16	$22.99	$1.17	5%

Cost of net revenues increased $18.6 million, or 50%, from 2005 to 2006. The cost of net revenues increase was driven by the increased volume of shipped products. Cost of net revenues as a percentage of net revenues increased by 1% from 2005 to 2006. The increase was the result of the 34% decline in the list 4x6 print prices, partially offset by the favorable impact of lower paper prices we negotiated in September 2005, lower shipping costs we negotiated in September 2006, and the reorganization of our workflows to achieve greater efficiencies which occurred during the third and fourth quarters of 2005.

	Year Ended December 31,
	2006	2005	$  Change	% Change
	(In thousands)
Technology and development	$19,087	$13,152	$   5,935	45%
Percentage of net revenues	15%	16%	-	-
Sales and marketing	$21,940	$15,252	$  6,688	44%
Percentage of net revenues	18%	18%	-	-
General and administrative	$19,216	$13,657	$  5,559	41%
Percentage of net revenues	16%	16%	-	-

Our technology and development expense increased $5.9 million, or 45%, from 2005 to 2006.  As a percentage of net revenues, technology and development expense decreased 1% from 2005 to 2006.  The absolute dollar increase was attributable to increased personnel and related costs for employees and consultants involved with website development and website infrastructure support teams, which increased by $3.1 million, as well as increased third-party hosting expenses which increased by $0.6 million. In 2006, we capitalized $1.3 million in eligible costs associated with software developed or obtained for internal use, a slight decrease from the $1.7 million in 2005. We also continued to invest in our website infrastructure hardware to support our continued revenue growth, which resulted in increased depreciation expense of $1.8 million. Stock-based compensation expense was $0.7 million in 2006, compared to $0.8 million in 2005.

Our sales and marketing expense increased $6.7 million, or 44%, from 2005 to 2006, and remained flat as a percentage of net revenues year-over-year.  For 2006, personnel and related costs for employees and consultants increased by $1.9 million, and our expenditures incurred on customer acquisition and promotion costs increased by $4.6 million. In addition, stock-based compensation expense was $0.5 million in 2006, compared to $0.2 million in 2005.

Our general and administrative expense increased $5.6 million, or 41%, from 2005 to 2006, and also remained flat as a percentage of revenue year over year.  Personnel and related costs increased by $1.6 million in 2006. While legal fees decreased by $0.8 million in 2006, accounting fees increased by $0.8 million. Consulting expenses increased by $0.8 million, while rent and related facilities charges increased by $1.0 million for 2006. Payment processing fees paid to third parties increased by $1.2 million during 2006 due to increased order volumes. In September 2006, we made a non-recourse, non-refundable contribution of 65,000 shares of common stock to Silicon Valley Community Foundation, a California non profit public benefit corporation, in order to establish the Shutterfly Foundation as a corporate-advised charitable fund within the Community Foundation, and recognized $0.9 million of charitable contribution expense for 2006. We intend to work with Silicon Valley Community Foundation to develop a charitable program dedicated to enhancing communities in the San Francisco Bay Area and around the world. We had no charitable contribution expense in 2005 and we do not expect to make further donations to the Silicon Valley Community Foundation for the foreseeable future. Stock-based compensation was $0.9 million, in 2006, compared to $2.2 million in 2005.

24

	Year Ended December 31,
	2006	2005	Change
	(in thousands)
Interest expense	$(266)	$(367)	$   101
Other income (expense), net	$2,387	$(103)	$2,490

Interest expense decreased by $0.1 million, or 28%, for 2006, due primarily to a decrease in interest expense on capitalized lease obligations.

Other income (expense), net, totaled $2.4 million for 2006, an increase over the prior year other expense amount of $0.1 million.  This income is due to larger invested cash balances from our initial public offering and higher interest rates. For 2006, other income (expense), net also included $0.1 million of income related to changes in the fair value of our redeemable convertible preferred stock warrants. Upon the completion of our initial public offering on October 4, 2006, all of our warrants to purchase shares of preferred stock converted into warrants to purchase shares of common stock and accordingly, no additional amounts for the change in fair value for the warrants will be recorded.

	Year Ended December 31
	2006	2005
	(In thousands)
Income tax benefit (provision)	$(3,942)	$24,060
Effective tax rate	40%	494%

The provision for income taxes was $3.9 million for 2006, compared to a benefit of $24.1 million for 2005, due to changes in our effective tax rate as a result of releasing our valuation allowance in the fourth quarter of 2005.

	Year Ended December 31,
	2006	2005	$  Change	% Change
	(In thousands)
Income before income taxes and cumulative effect of change in accounting principle	$9,740	$4,430	$   5,310	120%
Net income	$5,798	$   28,932	$(23,134)	(80%)
Percentage of net revenue	5%	35%	-	-

Net income decreased by $23.1 million, or 80%, for 2006 as compared to 2005. Included in 2005 net income was a $24.1 million non-cash tax benefit due to releasing our net deferred tax valuation allowance in the fourth quarter of 2005. Net income for 2005 also increased by $0.4 million for a cumulative effect of a change in accounting principle related to the adoption of FSP 150-5 in July 2005. We believe that income before income taxes and cumulative effect of change in accounting principle is relevant and useful information to assist investors in comparing our performance between 2006 and 2005. Income before income taxes and cumulative effect of change in accounting principle increased by $5.3 million, or 120%, from $4.4 million in 2005 to $9.7 million in 2006.

Liquidity and Capital Resources

	Year Ended December 31,
	2007	2006	2005
	(In thousands)
Consolidated Statement of Cash Flows Data:
Capital expenditures	$34,993	$20,681	$10,858
Acquisition of business and intangibles, net of cash acquired	2,858	-	(239)
Depreciation and amortization	17,796	10,747	6,522
Cash flows from operating activities	42,219	23,485	18,606
Cash flows from investing activities	(40,823)	(20,681)	(10,613)
Cash flows from financing activities	2,135	77,094	17,379

Historically we have financed our operations and capital expenditures through operations, private sales of preferred stock, our initial public offering, lease financing and the use of bank and related-party loans. As a result of our initial public offering in September 2006, we raised approximately $80.9 million of proceeds, net of underwriters’ discount, which we received on October 4, 2006. At December 31, 2007 we had $125.6 million of cash, cash equivalents, and short term investments. Cash equivalents are compromised of money market funds and commercial paper.  Short term investments is comprised of US government agency securities.

At February 29, 2008, $52.3 million of our marketable securities portfolio was invested in AAA rated investments in auction-rate debt securities. Auction-rate securities are long-term variable rate bonds tied to short-term interest rates. After the initial issuance of the securities, the interest rate on the securities is reset periodically, at intervals established at the time of issuance (primarily every twenty-eight days), based on market demand for a reset period. Auction-rate securities are bought and sold in the marketplace through a competitive bidding process often referred to as a “Dutch auction”. If there is insufficient interest in the securities at the time of an auction, the auction may not be completed and the rates may be reset to predetermined “penalty” or “maximum” rates. Following such a failed auction, we would not be able to access our funds that are invested in the corresponding auction-rate securities until a future auction of these investments is successful or new buyers express interest in purchasing these securities in between reset dates.

As a result of the current negative liquidity conditions in the global credit markets, in February 2008, auctions for $42.3 million of original par value of our auction-rate securities failed, rendering these securities temporarily illiquid through the normal auction process. At the time of our initial investment and through the date of this Report, all of our auction-rate securities remain AAA rated. The assets underlying each security are student loans and 95% of the principal amounts are guaranteed by the Federal Family Education Loan Program (FFELP).  Since we cannot predict when future auctions related to $52.3 million of our auction-rate securities will be successful, it may become necessary to classify this amount as long-term marketable securities in our consolidated balance sheet in future periods. In addition, if the underlying issuers are unable to successfully clear future auctions or if their credit rating deteriorates and the deterioration is deemed to be other-than-temporary, we would be required to adjust the carrying value of the auction-rate securities through an impairment charge to earnings. Any of these events could materially affect our results of operations and our financial condition.

To access these funds in future periods, it may be necessary to attempt to sell these securities at an amount below our original purchase value.  However, based on our ability to access our cash and cash equivalents and our other liquid investments, totaling $53.7 million at February 29, 2008, and our expected operating cash flows, we believe that we currently have adequate working capital resources to fund our operations for at least the next 12 months.  

The adequacy of these resources to meeting our liquidity needs beyond the next 12 months will depend on our growth, operating results, the capital expenditures required to meet possible increased demand for our products, and the resolution of the auction rate securities auction failures.   If we require additional capital resources to grow our business internally or to acquire complementary technologies and businesses at any time in the future, we may seek to sell additional equity or enter into working capital financing arrangements. The sale of additional equity could result in additional dilution to our stockholders. Financing arrangements may not be available to us, or may not be in amounts or on terms acceptable to us.

25

Our industry is competitive and has endured periods of intense price competition. Because we plan to finance our operations and capital expenses largely through our operations, and because our results of operations are sensitive to the level of competition we face, increased competition could adversely affect our liquidity and capital resources. Increased competition could do so both by reducing our net revenues and net income, as a result of reduced sales, reduced prices and increased promotional activities, among other factors, as well as by requiring us to spend cash on advertising and marketing in an effort to maintain or increase market share in the face of such competition. In addition, we intend to increase many of our expenses, including some capital expenses, in advance of anticipated higher future revenues. However, such increased expenses, while intended to support anticipated increases in future revenues, must be funded from current capital resources or from borrowings or equity financings. As a result, our ability to grow our business relying largely on funds from our operations is sensitive to competitive pressures and other risks relating to our liquidity or capital resources.

We anticipate capital expenditures of between $43 million to $47 million for 2008.  These expenditures will be used to purchase machinery and equipment to support the growth in our business and to increase our production capacity and help enable us to respond more quickly and efficiently to customer demand. This range of capital expenditures, while significant, is not outside the ordinary course of our business or materially different from how we have expanded our business in the past. We believe that such capital expenditures will have a positive effect on our results of operations if demand increases in line with increases in our production capacity. However, these capital expenditures will have a negative effect on our results of operations if demand does not increase as we expect, and will have a negative effect on our results of operations in the short term if demand does not increase simultaneously, as we expect, with the capital expenditures spent to support increased demand.

Operating Activities.  For 2007, net cash provided by operating activities was $42.2 million, primarily due to our net income of $10.1 million and the net change in operating assets and liabilities of $4.2 million, adjusted for non-cash items including $17.8 million of depreciation and amortization expense, $5.9 million of provision for deferred income taxes, and $4.0 million of stock-based compensation.

For 2006, net cash provided by operating activities was $23.5 million, primarily due to our net income of $5.8 million and the net change in operating assets and liabilities of $0.7 million, adjusted for non-cash items including $10.7 million of depreciation and amortization expense, $3.2 million of provision for income taxes, $2.3 million of stock-based compensation and $0.9 million for charitable contribution expense related to our September 2006 donation of 65,000 shares to Silicon Valley Community Foundation. We do not expect to make additional donations to Silicon Valley Community Foundation in the foreseeable future.

In 2005, net cash provided from operating activities of $18.6 million resulted from net income of $28.9 million that was adjusted for $6.2 million of depreciation and amortization, $23.8 million of income tax benefit and $3.3 million of non-cash amortization of stock-based compensation. In addition, net cash from operating activities increased due to a $4.1 million increase in accounts payable and accrued liabilities due to seasonally high balances at December 31, 2005 related to increased purchasing for the fourth quarter holiday season. Accounts payable and accrued liability balances were higher as of December 31, 2005 compared to as of December 31, 2004 due to higher sales in the 2005 fourth quarter holiday season.

Investing Activities.  For 2007, net cash used in investing activities included $35.0 million for capital expenditures for computer and network hardware for our website infrastructure and information technology systems, capital expenditures for production equipment for our manufacturing and production operations at our California and North Carolina facilities, and capitalized website development costs related to projects that were placed into service.  Additional cash of $3.0 million and $2.9 million was used for purchases of short-term investments and acquisition of “Make-it-About-Me,” respectively.

For 2006, cash used in investing activities was $20.7 million for capital expenditures for computer and network hardware to support our website infrastructure and information technology computer hardware, capital expenditures for production equipment for our manufacturing and production operations at our Hayward, California facilities, and capitalized website development costs related to projects that were placed into service.

For 2005, net cash used in investing activities was $10.6 million for capital expenditures for computer and network hardware to support our website infrastructure and information technology computer hardware, capital expenditures for production equipment for our manufacturing and production operations at our Hayward, California facilities, and capitalized website development costs related to projects that were placed into service.

Financing Activities.  Our financing activities for 2007 provided cash of $2.1 million, primarily from $5.0 million of proceeds from issuance of common stock, offset by $2.8 million of capitalized lease obligations.

Our financing activities for 2006 provided cash of $77.1 million, primarily from $78.5 million of IPO proceeds, net of underwriters’ fees and offering costs, offset by $1.4 million of capitalized lease obligations.

For 2005, we generated cash of $17.4 million, primarily the result of receiving net proceeds of $19.8 million from the sale of our Series F preferred stock in November 2005. This increase in cash was offset by $2.4 million in principal payments on capital lease obligations.

Contractual Obligations

We lease office space in Redwood City, California and production facilities in Hayward, California under various non-cancelable operating leases that expire between 2009 and 2010. In 2006, we entered into a non-cancelable operating lease for our new production facility in Charlotte, North Carolina.  The lease commenced in May, 2007, and will expire in 2014. We also lease website infrastructure computer and network hardware, production equipment, information technology equipment and software under various capital leases that expire through the year 2011. We also have a co-location agreement with a third-party hosting facility that expires in 2009. As a result of our growth strategies, we believe that our liquidity and capital resources requirements will grow in absolute dollars but will be generally consistent with historical periods on an annual basis as a percentage of net revenues. We anticipate leasing additional office space, production facilities and hosting facilities in future periods, consistent with our historical business model.

The following are contractual commitments at December 31, 2007, associated with lease obligations and other arrangements:

	Total	Less Than 1 Year	1-3 Years	3-5 Years	More Than 5 Years
	(In thousands)
Contractual Obligations
Capital lease obligations	$     975	$864	$111	$     —	$     —
Operating lease obligations	9,391	2,548	4,766	2,077	—
Purchase obligations(1)	2,821	2,620	201	—	—
Total contractual obligations	$13,187	$6,032	$5,078	$2,077	$___ - ---

__________

(1)  Purchase obligations include commitments under non-cancelable marketing agreements, license agreements, and third-party hosting services.

Other than the obligations, liabilities and commitments described above, we have no significant unconditional purchase obligations or similar instruments. We are not a guarantor of any other entities’ debt or other financial obligations.

Off-Balance Sheet Arrangements

We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not have any undisclosed borrowings or debt, and we have not entered into any synthetic leases. We are, therefore, not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.  In December, 2007, we had signed a definitive agreement to acquire Nexo Systems (“Nexo”) for total cash proceeds of $10.0 million and stock consideration of approximately $4.0 million.  This transaction closed on January 4, 2008 and that amount was paid on that date.  As part of our June 2007 acquisition of Make It About Me! (“MIAM”), we agreed to make additional earnout payments if certain milestones are achieved over the next 12 months.  As of December 31, 2007, the total potential earnout payment is $0.4 million.

26

Recent Accounting Pronouncements

In September 2006, the FASB issued FAS No. 157, “Fair Value Measurements” (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. In February 2008, the FASB issued a staff position that delays the effective date of SFAS 157 for all nonfinancial assets and liabilities except for those recognized or disclosed at least annually. Except for the delay for nonfinancial assets and liabilities, SFAS 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within such years. The Company does not expect the adoption of FAS 157 will have a material effect on its financial position and results of operations.

In February 2007, the FASB issued FAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“FAS 159”) which permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. FAS 159 was effective for the Company on January 1, 2008. The Company does not expect the adoption of FAS 159 will have a material effect on its financial position and results of operations.

In December 2007, the FASB issued FAS No. 141R, “Business Combinations” (“FAS 141R”) which replaces FAS No. 141 and establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. FAS 141R also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. This Statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Early adoption of FAS 141R is prohibited. The Company is currently evaluating the impact, if any, of adopting FAS 141R on its financial position and results of operations.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“FAS 160”) which amends ARB 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. In addition to the amendments to ARB 51, this Statement amends FASB Statement No. 128, Earnings per Share; so that earnings-per-share data will continue to be calculated the same way those data were calculated before this Statement was issued. This Statement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company is currently evaluating the impact, if any, of adopting FAS 160 on its financial position and results of operations.

ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

Interest Rate and Credit Risk.  We have exposure to interest rate risk that relates primarily to our investment portfolio. All of our current investments are classified as cash equivalents and short-term investments and carried at cost, which approximates market value. We do not currently use or plan to use derivative financial instruments in our investment portfolio. The risk associated with fluctuating interest rates is limited to our investment portfolio and we do not believe that a 10% change in interest rates will have a significant impact on our interest income, operating results or liquidity.

As of December 31, 2007, our cash and cash equivalents were maintained by financial institutions in the United States and our deposits may be in excess of insured limits. We believe that the financial institutions that hold our investments are financially sound and, accordingly, minimal credit risk exists with respect to these investments.

Inflation.  We do not believe that inflation has had a material effect on our current business, financial condition or results of operations. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could harm our business, financial condition and results of operations.

27

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

SHUTTERFLY, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Report of Independent Registered Public Accounting Firm	29
Consolidated Balance Sheets	30
Consolidated Statements of Income	31
Consolidated Statements of Redeemable Convertible Preferred Stock and Stockholders’ Equity (Deficit)	32
Consolidated Statements of Cash Flows	35
Notes to Consolidated Financial Statements	36
Schedule II – Valuation and Qualifying Accounts	47

28

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders

Shutterfly, Inc.

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of redeemable convertible preferred stock and stockholders' equity (deficit), and of cash flows present fairly, in all material respects, the financial position of Shutterfly, Inc. and its subsidiaries (the "Company") at December 31, 2007 and December 31, 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America.  In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.  Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).  The Company's management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management's Report on Internal Control over Financial Reporting appearing under Item 9A.  Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company's internal control over financial reporting based on our audits (which was an integrated audit in 2007).  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 audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects.  Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation.  Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk.  Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

As discussed in Note 2 to the consolidated financial statements, the Company changed the manner in which it accounts for uncertainty in income taxes in 2007 and the manner in which it accounts for share-based compensation in 2006.  In addition, as discussed in Note 3 to the consolidated financial statements, the Company changed the manner in which it accounts for freestanding warrants for redeemable convertible preferred stock in 2005.

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 (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) 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 (iii) 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.

/s/  PricewaterhouseCoopers LLP

San Jose, California

March 6, 2008

29

SHUTTERFLY, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share amounts)

	December 31,
	2007			2006
ASSETS
Current assets:
Cash and cash equivalents	$	122,582		$	119,051
Short-term investments		3,002			—
Accounts receivable, net		4,480			2,164
Inventories		4,788			2,493
Deferred tax asset, current portion		1,677			2,129
Prepaid expenses and other current assets		4,510			2,760
Total current assets		141,039			128,597
Property and equipment, net		48,416			30,919
Goodwill and intangible assets, net		3,859			1,396
Deferred tax asset, net of current portion		13,294			18,754
Other assets		2,162			494
Total assets	$	208,770		$	180,160
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	8,783		$	9,385
Accrued liabilities		18,724			8,808
Deferred revenue		8,699			6,278
Current portion of capital lease obligations		808			1,961
Total current liabilities		37,014			26,432
Other liabilities		1,083			660
Capital lease obligations, less current portion		107			1,742
Total liabilities		38,204			28,834
Commitments and contingencies (Note 6)
Stockholders’ equity:
Undesignated preferred stock, $0.0001 par value; 5,000 shares authorized at December 31, 2007 and 2006, respectively; no shares issued and outstanding		—			—
Common stock, $0.0001 par value; 100,000 shares authorized; 24,805 and 23,705 shares issued and outstanding at December 31, 2007 and December 31, 2006, respectively		2			2
Additional paid-in capital		190,849			181,890
Accumulated other comprehensive loss		(12	)		(35	)
Deferred stock-based compensation		(28	)		(191	)
Accumulated deficit		(20,245	)		(30,340	)
Total stockholders’ equity		170,566			151,326
Total liabilities and stockholders’ equity	$	208,770		$	180,160

The accompanying notes are an integral part of these consolidated financial statements.

30

SHUTTERFLY, INC.

CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share amounts)

	December 31,
	2007			2006			2005
Net revenues	$	186,727		$	123,353		$	83,902
Cost of net revenues(1)		84,111			55,491			36,941
Gross profit		102,616			67,862			46,961
Operating expenses(1):
Technology and development		28,635			19,087			13,152
Sales and marketing		33,363			21,940			15,252
General and administrative		29,557			19,216			13,657
		91,555			60,243			42,061
Income from operations		11,061			7,619			4,900
Interest expense		(179	)		(266	)		(367	)
Other income (expense), net		5,515			2,387			(103	)
Income before income taxes and cumulative effect of change in accounting principle		16,397			9,740			4,430
(Provision) benefit for income taxes		(6,302	)		(3,942	)		24,060
Net income before cumulative effect of change in accounting principle		10,095			5,798			28,490
Cumulative effect of change in accounting principle, net of tax benefit		—			—			442
Net income	$	10,095		$	5,798		$	28,932
Net income per share — basic and diluted:
Before cumulative effect of change in accounting principle	$	0.42		$	0.67		$	1.31
Cumulative effect of change in accounting principle, net of tax benefit		—			—			0.14
Basic	$	0.42		$	0.67		$	1.45
Diluted	$	0.38		$	0.56		$	1.02
Weighted average shares:
Basic		24,295			8,622			3,255
Diluted		26,273			10,331			4,609
______________
(1) Stock-based compensation is allocated as follows (Notes 2 and 7):
Cost of net revenues	$	189		$	96		$	28
Technology and development		880			736			826
Sales and marketing		877			521			239
General and administrative		2,055			947			2,217

The accompanying notes are an integral part of these consolidated financial statements.

31

SHUTTERFLY, INC.

CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND

STOCKHOLDERS’ EQUITY (DEFICIT)

(In thousands)

	Redeemable							Accumulated
	Convertible				Additional	Deferred		Other	Total
	Preferred Stock		Common Stock		Paid-In	Stock-Based	Accumulated	Comprehensive	Stockholders’
	Shares	Amount	Shares	Amount	Capital	Compensation	Deficit	Loss	Equity (Deficit)
Balances, December 31, 2004	12,448	$69,822	2,827	$—	$   7,505	$(2,003)	$(65,070)	$    —	$(59,568)
Issuance of common stock upon exercise of options, net of repurchases	—	—	750	—	205	—	—	—	205
Issuance of Series F preferred stock, net of issuance cost of $131	1,354	19,830	—	—	—	—	—	—	—
Stock-based compensation expense in connection with option modifications	—	—	—	—	—	1,100	—	——	1,100
Shares issued in connection with a settlement agreement with a former employee	—	—	65	—	352	—	—	—	352
Vested shares issued upon acquisition	—	—	109	—	656	—	—	—	656
Restricted shares issued upon acquisition	—	—	—	—	671	(671)	—	—	—
Vesting of restricted shares	—	—	39	—	—	500	—	—	500
Deferred stock-based compensation, net of cancellations	—	—	—	—	2,261	(2,261)	—	—	—
Tax benefit of stock options	—	—	—	—	365	—	—	—	365
Amortization of deferred stock-based compensation, net of cancellations	—	—	—	—	—	1,710	—	—	1,710
Reclassification of preferred stock warrants to liability	—	—	—	—	(1,514)	—	—	—	(1,514)
Comprehensive income:
Net income	—	—	—	—	—	—	28,932	—	28,932
Total comprehensive income	—	—	—	—	—	—	—	—	28,932
Balances, December 31, 2005	13,802	$89,652	3,790	$—	$10,501	$(1,625)	$(36,138)	$    —	$(27,262)

The accompanying notes are an integral part of these consolidated financial statements.

32

SHUTTERFLY, INC.

CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND

STOCKHOLDERS’ EQUITY (DEFICIT) (Continued)

(In thousands)

	Redeemable							Accumulated
	Convertible				Additional	Deferred		Other	Total
	Preferred Stock		Common Stock		Paid-In	Stock-Based	Accumulated	Comprehensive	Stockholders’
	Shares	Amount	Shares	Amount	Capital	Compensation	Deficit	Loss	Equity (Deficit)
Balances, December 31, 2005	13,802	$89,652	3,790	$—	$10,501	$(1,625)	$(36,138)	$    —	$(27,262)
Issuance of common stock upon exercise of options, net of repurchases	—	—	127	—	101	—	—	—	101
Issuance of common stock upon effective date of initial public offering (“IPO”), net of underwriting fees of $6,090 and other expenses of $2,442	—	—	5,800	1	78,467	—	—	—	78,468
Issuance of Series A preferred stock upon net exercise of warrants	61	143	—	—	(143)	—	—	—	(143)
Transfer of preferred stock warrant liability related to Series A preferred stock	—	—	—	—	871	—	—	—	871
Automatic conversion of preferred stock to common stock upon effective date of IPO	(13,863)	(89,795)	13,863	1	89,794	—	—	—	89,795
Transfer of preferred stock warrant liability upon conversion of preferred stock warrants into common stock warrants	—	—	—	—	510	—	—	—	510
Reversal of unearned stock based compensation upon modification of options	—	—	—	—	(526)	526	—	—	—
Vesting of restricted shares	—	—	60	—	—	94	—	—	94
Cancellation of common stock options and restricted shares	—	—	—	—	(249)	249	—	—	—
Amortization of deferred stock-based compensation, net of cancellations	—	—	—	—	—	565	—	—	565
Employees stock-based compensation expense recognized under SFAS No. 123R, net of estimated forfeiture	—	—	—	—	1,641	—	—	—	1,641
Donation of common stock to a charitable foundation	—	—	65	—	923	—	—	—	923
Change in unrealized loss in investments, net of tax	—	—	—	—	—	—	—	(35)	(35)
Net income	—	—	—	—	—	—	5,798	—	5,798
Total comprehensive income	—	—	—	—	—	—	—	—	5,763
Balances, December 31, 2006	—	—	23,705	$    2	$181,890	$(191)	$(30,340)	$(35)	$151,326

The accompanying notes are an integral part of these consolidated financial statements.

33

SHUTTERFLY, INC.

CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND

STOCKHOLDERS’ EQUITY (DEFICIT) (Continued)

(In thousands)

	Redeemable							Accumulated
	Convertible				Additional	Deferred		Other	Total
	Preferred Stock		Common Stock		Paid-In	Stock-Based	Accumulated	Comprehensive	Stockholders’
	Shares	Amount	Shares	Amount	Capital	Compensation	Deficit	Loss	Equity(Deficit)
Balances, December 31, 2006	—	—	23,705	$    2	$181,890	$(191)	$(30,340)	$(35)	$151,326
Issuance of common stock upon net exercise of warrants	—	—	27	—	—	—	—	—	—
Issuance of common stock upon exercise of options, net of repurchases	—	—	1,073	—	4,983	—	—	—	4,983
Cancellation of common stock options and restricted shares	—	—	—	—	(162)	162	—	—	—
Amortization of deferred stock-based compensation, net of cancellations	—	—	—	—	—	1	—	—	1
Employees stock-based compensation expense recognized under SFAS No. 123R, net of estimated forfeiture	—	—	—	—	4,111	—	—	—	4,111
Tax benefit of stock options	—	—	—	—	27	—	—	—	27
Change in unrealized loss in investments, net of tax	—	—	—	—	—	—	—	23	23
Net income	—	—	—	—	—	—	10,095	—	10,095
Total comprehensive income	—	—	—	—	—	—	—	—	10,118
Balances, December 31, 2007	—	—	24,805	$    2	$190,849	$    (28)	$(20,245)	$(12)	$170,566

The accompanying notes are an integral part of these consolidated financial statements.

34

SHUTTERFLY, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

	Year Ended December 31,
	2007			2006			2005
Cash flows from operating activities:
Net income	$	10,095		$	5,798		$	28,932
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation and amortization		17,384			10,525			6,246
Amortization of intangible assets		412			222			276
Amortization of deferred stock-based compensation, net of cancellations		4,001			2,300			3,310
Charitable contribution expense for shares issued to charitable foundation		—			923			—
Change in carrying value of preferred stock warrant liability		—			(152	)		21
Loss/(gain) on disposal of property and equipment		262			(29	)		207
Deferred income taxes		5,880			3,199			(23,833	)
Changes in operating assets and liabilities, net of effects of acquisition
Accounts receivable, net		(2,316	)		(1,215	)		(547	)
Inventories		(2,290	)		(1,419	)		(253	)
Prepaid expenses and other current assets		(1,750	)		(1,171	)		(398	)
Other assets		(1,668	)		(121	)		(40	)
Accounts payable		(602	)		5,514			(434	)
Accrued and other liabilities		10,390			(2,603	)		4,550
Deferred revenue		2,421			1,714			569
Net cash provided by operating activities		42,219			23,485			18,606
Cash flows from investing activities:
Purchases of property and equipment		(34,993	)		(20,681	)		(10,858	)
Acquisition of business and intangible assets, net of cash acquired		(2,858	)		—			239
Purchases of short term investments		(3,000	)		—			—
Proceeds from sale of property and equipment		28			—			6
Net cash used in investing activities		(40,823	)		(20,681	)		(10,613	)
Cash flows from financing activities:
Principal payments of capital lease obligations		(2,840	)		(1,446	)		(2,379	)
Proceeds from IPO shares issued, net of issuance costs		—			78,468			—
Proceeds from term loan		—			—			2,571
Repayment of term loan		—			—			(2,571	)
Principal payment of note payable obligation		—			—			(192	)
Proceeds from issuance of redeemable convertible preferred stock, net of issuance costs		—			—			19,830
Proceeds from issuance of common stock upon exercise of stock options		4,975			83			134
Repurchases of common stock		—			(11	)		(14	)
Net cash provided by financing activities		2,135			77,094			17,379
Net increase in cash and cash equivalents		3,531			79,898			25,372
Cash and cash equivalents, beginning of period		119,051			39,153			13,781
Cash and cash equivalents, end of period	$	122,582		$	119,051		$	39,153
Supplemental disclosures of cash flow information
Cash paid during the period for interest	$	198		$	205		$	410
Cash paid during the period for income taxes		812			—			70
Supplemental schedule of non-cash investing and financing activities
Additions to property and equipment acquired under capital lease obligations and notes payable		—			—			3,516
Net non-cash assets acquired upon acquisition		—			—			551
Vested shares issued upon acquisition		—			—			656
Restricted shares issued upon acquisition		—			—			724
Reclassification of preferred stock warrants to liability		—			—			1,514
Deferred stock-based compensation, net of cancellations		—			—			1,225
Deferred stock-based compensation in connection with option modifications		—			—			1,100
Tax benefit of stock options recorded in additional paid-in capital		27			—			365
Conversion of preferred stock		—			89,795			—
Conversion of preferred stock warrant liability into APIC		—			1,381			—
Preferred stock warrants exercised on net basis		—			143			—

The accompanying notes are an integral part of these consolidated financial statements.

35

SHUTTERFLY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 — Description of Business

Shutterfly, Inc., (the “Company”) was incorporated in the state of Delaware in 1999 and began its services in December 1999. The Company is an Internet-based social expression and personal publishing service that enables customers to share, print and preserve their memories by leveraging a technology-based platform and manufacturing processes. The Company provides customers a full range of products and services to organize and archive digital images; share pictures; order prints and create an assortment of personalized items such as cards, calendars and photo books. The Company is headquartered in Redwood City, California.

On September 29, 2006, the Company completed its initial public offering (“IPO”) in which the Company sold 5,800,000 shares at a price to the public of $15.00 per share. As a result of the IPO, a total of $87.0 million in gross proceeds was raised, with net proceeds to the Company of $78.5 million after deducting underwriting fees and commissions of $6.1 million and other offering costs of $2.4 million. Upon the closing of the IPO, all shares of the Company’s outstanding redeemable convertible preferred stock automatically converted into an aggregate of 13,862,773 common shares.

Note 2 — Summary of Significant Accounting Policies

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiary. The wholly owned subsidiary was dissolved in 2006 and was merged into the Company. All intercompany transactions and balances have been eliminated.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenues and expenses during the reporting period. Significant items subject to such estimates and assumptions include intangible assets valuation and useful lives, excess and obsolete inventories, deferred tax valuation allowance, legal contingencies, and the valuation of equity instruments among others. Actual results could differ from these estimates.

Cash, Cash Equivalents and Short Term Investments

The Company considers all highly liquid investments purchased with original maturities (at the date of purchase) of three months or less to be cash equivalents. Management determines the appropriate classification of cash equivalents at the time of purchase and reevaluates such designations at each balance sheet date.  Cash equivalents consist principally of money market funds and commercial paper. Short term investments consist entirely of U.S. government agency securities.

At December 31, 2007, all investments are classified as “available-for-sale.”  In accordance with Statement of Financial Accounting Standards No 115, Accounting for Certain Investments in Debt and Equity Securities (“SFAS 115”) available-for-sale securities are carried at fair value, with the unrealized gains and losses, net of tax reported in a separate component of accumulated other comprehensive income (loss) in shareholders’ equity. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are reported in other income (expense), net. The cost of securities sold is based on the specific identification method. Interest on securities classified as available-for-sale is included as a component of other income (expense), net.  The contractual maturities for all of the Company’s available for sale securities are less than one year.

See Note 11 for a discussion of the Company’s investment in auction rate securities subsequent to December 31, 2007.

Fair Value of Financial Instruments

The carrying amount of certain of the Company’s financial instruments, including accounts receivable and accounts payable, are carried at cost, which approximates their fair value because of their short-term maturities. Based on borrowing rates available to the Company for loans with similar terms, the carrying value of capital lease obligations, approximates fair value.

Concentration of Credit Risk

Financial instruments that potentially subject the Company to credit risk consist principally of cash, cash equivalents, short term investments, and accounts receivable. Most of the Company’s cash and cash equivalents as of December 31, 2007, were deposited with financial institutions in the United States and Company policy restricts the amount of credit exposure to any one issuer and to any one type of investment. Deposits held with financial institutions may exceed federally insured limits.

The Company’s accounts receivable are derived primarily from sales to customers located in the United States who make payments through credit cards, sales of our products in retail stores, and click-through referral fees.  Credit card receivables settle relatively quickly and the Company maintains allowances for potential credit losses based on historical experience. To date, such losses have not been material and have been within management’s expectations.   Excluding amounts due from credit cards, as of December 31, 2007, two customers accounted for 43% and 11% of the Company’s net accounts receivable. And as of December 31, 2006, one customer accounted for 14% of the Company’s net accounts receivable.

Inventories

Inventories are stated at the lower of cost on a first-in, first-out basis or net realizable value. The value of inventories is reduced by estimates for excess and obsolete inventories. The estimate for excess and obsolete inventories is based upon management’s review of utilization of inventories in light of projected sales, current market conditions and market trends. Inventories are primarily raw materials and consist principally of paper, photo book covers and packaging supplies.

Property and Equipment

Property and equipment, including equipment under capital leases, are stated at historical cost, less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated lives of the assets, generally three to five years. Amortization of equipment acquired under capital lease obligations is computed using the straight-line method over the shorter of the remaining lease term or the estimated useful life of the related assets, generally three to four years. Leasehold improvements are amortized over their estimated useful lives, or the lease term if shorter, generally three to seven years. Upon retirement or sale, the cost and related accumulated depreciation are removed from the balance sheet and the resulting gain or loss is reflected in operating expenses. Major additions and improvements are capitalized, while replacements, maintenance and repairs that do not extend the life of the asset are charged to expense as incurred.

36

SHUTTERFLY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Website Development Costs

The Company capitalizes eligible costs associated with software developed or obtained for internal use in accordance with AICPA Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, and EITF 00-02, Accounting for Web Site Development Costs. Accordingly, the Company expenses all costs that relate to the planning and post implementation phases. Costs incurred in the development phase are capitalized and amortized over the product’s estimated useful life, generally three years. Costs associated with minor enhancements and maintenance for the Company’s website are expensed as incurred.

Long-Lived Assets

The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable in accordance with Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS No. 144”). Recoverability is measured by comparison of the carrying amount to the future net cash flows which the assets are expected to generate. If such assets are considered to be impaired, the

 impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the projected discounted future cash flows arising from the asset using a discount rate determined by management to be commensurate with the risk inherent to the Company’s current business model.

Goodwill and Intangible Assets

The Company accounts for intangible assets and goodwill in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”). Goodwill and intangible assets with indefinite lives are not amortized but are tested for impairment on an annual basis or whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. Intangible assets with finite useful lives are amortized using the straight-line method over their useful lives and are reviewed for impairment in accordance with SFAS No. 144.

Intangible assets from acquisitions are amortized on a straight-line basis over the estimated useful lives which range from one to five years.

Preferred Stock Warrants

Warrants and other similar instruments related to shares that are redeemable are accounted for in accordance with Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity (“SFAS No. 150”). Under SFAS No. 150, warrants that were related to the Company’s redeemable convertible preferred stock were recorded as liabilities on the consolidated balance sheet. The warrants were subject to re-measurement at each balance sheet date and any change in fair value was recognized as a component of other income (expense), net. Subsequent to the Company’s IPO and the associated conversion of the Company’s outstanding redeemable convertible preferred stock to common stock, the warrants to exercise the redeemable convertible preferred stock converted into common stock warrants; accordingly, the liability related to the redeemable convertible preferred stock warrants was transferred to common stock and additional paid-in-capital and the common stock warrants are no longer subject to re-measurement.

Revenue Recognition

The Company generally recognizes revenue from product sales, net of applicable sales tax upon shipment when persuasive evidence of an arrangement exists, the selling price is fixed or determinable and collection of resulting receivables is reasonably assured. Revenues from amounts billed to customers, including prepaid orders, are deferred until shipment of fulfilled orders or until the prepaid period expires.  Shipping charged to customers is recognized as revenue at the time of shipment.

The Company provides its customers with a 100% satisfaction guarantee whereby products can be returned within a 30-day period for a reprint or refund. The Company maintains an allowance for estimated future returns based on historical data. The provision for estimated returns is included in deferred revenue.

The Company periodically provides incentive offers to its customers in exchange for setting up an account and to encourage purchases. Such offers include free products and percentage discounts on current purchases. Discounts, when accepted by customers, are treated as a reduction to the purchase price of the related transaction and are presented in net revenues. Production costs related to free products are included in cost of revenues upon redemption.

Revenue from referral fees for click-throughs is recognized in the period that the click-through impression is delivered.

Advertising Costs

Advertising costs are expensed as incurred, except for direct mail advertising which is expensed when the advertising first takes place.  Total direct mail costs capitalized as of December 31, 2007 and December 31, 2006 was $355,000 and $0.  Total advertising  costs are included in selling and marketing expenses and totaled approximately $10,800,000, $5,710,000 and $4,878,000 during the years ended December 31, 2007, 2006 and 2005, respectively.

Stock-Based Compensation

Prior to January 1, 2006, the Company accounted for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”), and related interpretations, and followed the disclosure provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”). Under APB No. 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of the Company’s stock and the exercise price. Employee stock-based compensation determined under APB No. 25 is recognized based on guidance provided in Financial Accounting Standards Board Interpretation No.  28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans (“FIN 28”), which provides for accelerated expensing over the option vesting period.

The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123, Emerging Issues Task Force Abstract No. 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services (“EITF 96-18”), and FIN 28.

Effective January 1, 2006, the Company adopted the fair value provisions of Statement of Financial Accounting Standards No. 123R, Share-Based Payment (“SFAS No. 123R”), which supersedes its previous accounting under APB 25. SFAS No. 123R requires the recognition of compensation expense, using a fair-value based method, for costs related to all share-based payments including stock options. SFAS No. 123R requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The Company adopted SFAS No. 123R using the prospective transition method, which requires that for nonpublic entities that used the minimum value method for either pro forma or financial statement recognition purposes, SFAS No. 123R shall be applied to option grants after the required effective date. For options granted prior to the SFAS No. 123R effective date, which the requisite service period has not been performed as of January 1, 2006, the Company will continue to recognize compensation expense on the remaining unvested awards under the intrinsic-value method of APB 25. In addition, the Company will continue amortizing those awards valued prior to January 1, 2006 utilizing an accelerated amortization schedule while all option grants valued after January  1, 2006 will be expensed on a straight-line basis over the requisite period.

In November 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FAS 123R-3, Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.  The Company has elected to adopt the prospective transition method provided in the FASB Staff Position for calculating the tax effects of stock-based compensation pursuant to SFAS No. 123R.

37

SHUTTERFLY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Income Taxes

The Company accounts for income taxes under the liability method. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities and net operating loss and credit carryforwards using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

The Company accounts for uncertain tax positions in accordance with FASB Interpretation No. 48 Accounting for Uncertainty in Income Taxes (“FIN 48”), an interpretation of FASB Statement No. 109 (“SFAS 109”). The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous. The Company is required to make subjective assumptions and judgments regarding its income tax exposures. Interpretations and guidance surrounding income tax laws and regulations change over time. As such, changes in the Company’s subjective assumptions and judgments can materially affect amounts recognized in the consolidated balance sheets and statements of operations.

The Company’s policy is to recognize interest and /or penalties related to all tax positions in income tax expense.  To the extent that accrued interest and penalties do not ultimately become payable, amounts accrued will be reduced and reflected as a reduction of the overall income tax provision in the period that such determination is made.  No interest and penalties were accrued as of the date of adoption of FIN 48 or at December 31, 2007.

Net Income Per Share

Basic net income per share attributed to common shares is computed by dividing the net income attributable to common shares for the period by the weighted average number of common shares outstanding during the period as reduced by the weighted average unvested common shares subject to repurchase by the Company. Net income available to common stockholders is calculated using the two class method as the net income less preferred stock dividends for the period and amounts allocated to preferred stock to reflect the rights of the preferred stock to receive dividends in preference to common stock.

Diluted net income per share attributed to common shares is computed by dividing the net income attributable to common shares for the period by the weighted average number of common and potential common shares outstanding during the period, if the effect of each class of potential common shares is dilutive. Potential common shares include restricted common stock, common stock subject to repurchase rights, and incremental shares of common stock issuable upon the exercise of stock options and warrants and upon conversion of preferred stock.

	Year Ended December 31,
	2007			2006			2005
Historical net income per share:	In thousands, except per share amounts
Numerator
Net income before cumulative effect of change in accounting principle	$	10,095		$	5,798		$	28,490
Cumulative effect of change in accounting principle		—			—			442
Net income		10,095			5,798			28,932
Income allocable to preferred stockholders		—			—			(24,212	)
Net income allocable to common stockholders	$	10,095		$	5,798		$	4,720
Denominator
Weighted-average common shares outstanding		24,309			8,729			3,619
Less: Weighted-average unvested common shares subject to repurchase		(14	)		(107	)		(364	)
Denominator for basic net income per share		24,295			8,622			3,255
Dilutive effect of stock options and shares subject to repurchase		1,978			1,709			1,307
Dilutive effect of outstanding preferred stock warrants		—			—			47
Denominator for diluted net income per share		26,273			10,331			4,609
Net income per share — basic and diluted
Before cumulative effect of change in accounting principle	$	0.42		$	0.67		$	1.31
Cumulative effect of change in accounting principle		—			—			0.14
Net income per share — basic	$	0.42		$	0.67		$	1.45
Net income per share — diluted	$	0.38		$	0.56		$	1.02

The following weighted-average outstanding options and convertible preferred stock were excluded from the computation of diluted net income per common share for the periods presented because including them would have had an anti-dilutive effect:

	Year Ended December 31,
	2007		2006		2005
	In thousands
Options to purchase common stock		385		1,367		153
Convertible preferred stock (as converted basis)		—		10,509		12,633

Comprehensive Income (Loss)

FASB Statement No. 130, Reporting Comprehensive Income, establishes standards for reporting and displaying comprehensive income and comprehensive loss and its components in the consolidated financial statements. Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. Comprehensive income (loss) is composed of net income (loss) and unrealized gains and losses on marketable securities, which are disclosed in the accompanying consolidated statements of redeemable convertible preferred stock and shareholders’ equity (deficit).

The components of accumulated other comprehensive income (loss) were as follows (in thousands):

	Year Ended December 31,
	2007		2006			2005
Unrealized income (loss) in investments, net of tax of $13 and $19	$	23	$	(35	)	$	—
Net income		10,095		5,798			28,932
Total comprehensive income	$	10,118	$	5,763		$	28,932

38

SHUTTERFLY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Segment Reporting

The Company operates in one industry segment — digital photofinishing services. The Company operates in one geographic area, being the United States of America.

FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for reporting information about operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. The Company’s chief operating decision maker is its Chief Executive Officer. The Company’s Chief Executive Officer reviews financial information presented on a consolidated basis for purposes of allocating resources and evaluating financial performance. The Company has one business activity and there are no segment managers who are held accountable for operations, operating results and plans for products or components below the consolidated unit level. Accordingly, the Company reports as a single operating segment.

Recent Accounting Pronouncements

In September 2006, the FASB issued FAS No. 157, “Fair Value Measurements” (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. In February 2008, the FASB issued a staff position that delays the effective date of SFAS 157 for all nonfinancial assets and liabilities except for those recognized or disclosed at least annually. Except for the delay for nonfinancial assets and liabilities, SFAS 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within such years. The Company does not expect the adoption of FAS 157 will have a material effect on its financial position and results of operations.

In February 2007, the FASB issued FAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“FAS 159”) which permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. FAS 159 was effective for the Company on January 1, 2008. The Company does not expect the adoption of FAS 159 will have a material effect on its financial position and results of operations.

In December 2007, the FASB issued FAS No. 141R, “Business Combinations” (“FAS 141R”) which replaces FAS No. 141 and establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. FAS 141R also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. This Statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Early adoption of FAS 141R is prohibited. The Company is currently evaluating the impact, if any, of adopting FAS 141R on its financial position and results of operations.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“FAS 160”) which amends ARB 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. In addition to the amendments to ARB 51, this Statement amends FASB Statement No. 128, Earnings per Share; so that earnings-per-share data will continue to be calculated the same way those data were calculated before this Statement was issued. This Statement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company is currently evaluating the impact, if any, of adopting FAS 160 on its financial position and results of operations.

Note 3 — Change in Accounting Policy

On June 29, 2005, the FASB issued Staff Position 150-5, Issuer’s Accounting under FASB Statement No. 150 (“SFAS 150”) for Freestanding Warrants and Other Similar Instruments on Shares That Are Redeemable (“FSP 150-5”). Under FSP 150-5, the freestanding warrants that were related to the Company’s redeemable convertible preferred stock were classified as liabilities and were recorded at fair value. The Company previously accounted for freestanding warrants for the purchase of redeemable convertible preferred stock under EITF Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services (“EITF 96-18”).

The Company adopted FSP 150-5 and accounted for the cumulative effect of the change in accounting principle as of July 1, 2005. For the year ended December 31, 2005, the impact of the change in accounting principle was to increase net income by $442,000, or $0.14 per share. There was $464,000 of additional expense recorded in other income (expense), net to reflect the increase in fair value between July 1, 2005 and December 31, 2005. In the year ended December 31, 2006, the Company recorded $153,000 of additional income reflected as other income (expense), net to reflect the decrease in fair value of the warrants. There were no amounts recorded in 2007.

Note 4 — Balance Sheet Components

Cash, Cash Equivalents, and Short Term Investments

The components of the Company’s cash, cash equivalents, and short term investments, including the unrealized gains (losses) associated with each are as follows:

	December 31, 2007							December 31, 2006
	Book Value		Gross Unrealized Gains/(Losses)			Fair Value		Book Value		Gross Unrealized Gains/(Losses)			Fair Value
	In thousands							In thousands
Cash	$	15,955	$	-		$	15,955	$	9,154	$	-		$	9,154
Cash Equivalents
Money Market Funds		22,363		-			22,363		17,829		-			17,829
Commercial Paper		84,284		(20	)		84,264		92,123		(54	)		92,068
Total Cash Equivalents		106,647		(20	)		106,627		109,952		(54	)		109,897
US Government Agency Securities		3,000		2			3,002		-		-			-
Total Cash, Cash Equivalents, and   Short Term Investments	$	125,602	$	(18	)	$	125,584	$	119,106	$	(54	)	$	119,051

The contractual maturities for all of the Company’s available for sale securities are less than one year (See subsequent event Note 11.)

Property and Equipment

	December 31,
	2007			2006
	In thousands
Computer and other equipment	$	66,663		$	41,880
Software		12,745			8,791
Leasehold improvements		7,952			4,903
Furniture and fixtures		2,282			1,348
		89,642			56,922
Less: Accumulated depreciation and amortization		(41,226	)		(26,003	)
Net property and equipment	$	48,416		$	30,919

39

SHUTTERFLY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Property and equipment includes $5,121,000 and $6,502,000 of equipment and software under capital leases at December 31, 2007 and 2006, respectively. Accumulated depreciation of assets under capital leases totaled $3,798,000 and $3,820,000 at December 31, 2007 and 2006, respectively.

Depreciation and amortization expense for the years ended December 31, 2007, 2006 and 2005 was $17,384,000, $10,525,000 and $6,246,000, respectively.

The Company has capitalized website development costs incurred in the application development phase and unamortized cost is included in property and equipment and totaled approximately $3,619,000 and $2,582,000 at December 31, 2007 and 2006, respectively. These amounts included $111,000 and $0 of stock based compensation expense.  Amortization of capitalized costs totaled approximately $1,467,000, $993,000, and $404,000 for the years ended December 31, 2007, 2006 and 2005, respectively.

Intangible Assets

Intangible assets are composed of the following at December 31:

	Weighted Average	December 31,
	Useful Life	2007		2006
		In thousands
Purchased technology	12 Years	$	3,350	$	2,030
Less: accumulated amortization			(905)		(634)
			2,445		1,396
Customer relationships	3 Years		990		—
Less: accumulated amortization			(110)		---
			880		---
Licenses and other	3 Years		186		—
Less: accumulated amortization			(31)		---
			155		---
Acquired workforce	1 Year		279		279
Less: accumulated amortization			(279)		(279)
Total		$	3,480	$	1,396

Purchased technology is amortized over a period ranging from 5 to 16 years.  Licenses and other is amortized over a period ranging from three to five years.

In August 2007, the Company entered into an agreement with a competitor to acquire the customer list of that competitor without restriction of use. The acquisition amount totaled $990,000 and was paid in September 2007.  The Company recorded this payment as an intangible asset, and is being amortized ratably over its estimated life through August 2010.  The Company recorded amortization expense of $110,000 in 2007.

Intangible asset amortization expense for the years ended December 31, 2007, 2006 and 2005 was $412,000, $222,000 and $276,000 respectively. Amortization of existing intangible assets is estimated to be as follows (in thousands):

Year Ending:
2008	$	783
2009		783
2010		643
2011		395
2012		251
Thereafter		625
	$	3,480

Accrued Liabilities

	December 31,
	2007		2006
	In thousands
Accrued marketing expenses	$	4,101	$	1,822
Accrued compensation		3,053		1,201
Accrued purchases		1,414		483
Accrued income and sales taxes		3,682		1,235
Accrued consultant expenses		1,516		884
Accrued production facility expenses		3,283		1,784
Accrued other		1,675		1,399
	$	18,724	$	8,808

40

SHUTTERFLY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 5 — Acquisitions

Make It About Me

On June 14, 2007, the Company acquired CustomAbility, LLC, a publishing company that produces customized children’s books under the brand name Make It About Me (“MIAM”). This acquisition augmented the Company’s personal publishing platform. The transaction was accounted for as a purchase business combination.

The total purchase price of $1,632,000 consisted of $1,600,000 in cash consideration and approximately $32,000 in transaction fees. The initial purchase price was allocated to the assets and liabilities acquired based on their fair value, with the majority of the cost being allocated to purchased technology of $1,320,000 and licensed content of $150,000.  The identifiable intangible assets have useful lives not exceeding five years, and a weighted average life of 4.8 years. No amount was allocated to in-process research and development and $179,000 was initially allocated to goodwill. Goodwill represents the excess of the purchase price over the fair value of the net tangible and intangible assets acquired and for tax purposes, will be amortized over 15 years.

In addition to the initial cash consideration, the sellers of MIAM can earn additional consideration totaling $200,000 and $400,000 if certain contingencies are met. If these contingencies are met, these earn-out payments will be recorded as additional goodwill.  The first contingency was met as of November 2007, increasing goodwill by $200,000.  This amount was subsequently paid in January 2008.

Prior to the acquisition, the Company was as a reseller of MIAM’s publishing products. As a part of this transaction, the existing fulfillment agreement between the two parties was cancelled. No gain or loss resulted from the settlement of this pre-existing relationship.

Memory Matrix

On June 1, 2005, the Company acquired 100% of Memory Matrix, Inc., (“Memory Matrix”) a Nevada corporation, in exchange for 109,302 shares of common stock. The acquisition was effected using a “reverse triangular” merger in which a wholly owned Shutterfly subsidiary was merged with and into Memory Matrix, resulting in Memory Matrix becoming a wholly owned subsidiary of Shutterfly. Memory Matrix was considered to be a “developmental stage” enterprise and did not meet the definition of a “business” under SFAS No. 141, Business Combinations, for business combination purposes. In accordance with SFAS No. 141, the acquisition of Memory Matrix was accounted for as an acquisition of assets.

As additional consideration for the acquisition, the Company also issued 120,698 shares of common stock to the employees of Memory Matrix, subject to vesting and repurchase rights over a period of 18 months, in exchange for unvested Memory Matrix restricted shares held by such employees prior to the merger. $671,000 of deferred stock-based compensation was recorded based on the intrinsic value of the shares at the time of the acquisition. The Company recognized $0 and $94,000 of stock-based compensation expense for the year ended December 31, 2007 and 2006, respectively, relating to the vesting of the restricted shares.

The total purchase price was $690,000, based on an estimated per share fair value of $6.00 on the date of the transaction, and was allocated to various tangible and intangible assets including:  acquired workforce of $279,000 and purchased technology of $564,000.

These were offset by other net liabilities of $153,000 which consisted primarily of a deferred tax liability of $336,000, other assumed liabilities of $100,000, and cash and other assets of $283,000. In addition, the Company recorded a deferred tax asset on the date of acquisition of $201,000, which was offset in full by a valuation allowance. In the fourth quarter of 2005, the valuation allowance was released, which reduced non-current intangibles accordingly.

The acquired workforce intangible asset was amortized on a straight-line basis over one year. The net core technology asset is amortized on a straight-line basis over the asset’s life, which is estimated as three years.

Note 6 — Commitments and Contingencies

Leases

The Company leases office and production space under various non-cancelable operating leases that expire no later than November 2014. Rent expense was $1,925,000, $1,295,000 and $1,181,000, for the years ended December 31, 2007, 2006 and 2005, respectively.

Rent expense is recorded on a straight-line basis over the lease term. When a lease provides for fixed escalations of the minimum rental payments, the difference between the straight-line rent charged to expense, and the amount payable under the lease is recognized as deferred rent.

The Company leases certain equipment, software and colocation services under non-cancelable capital leases, operating leases or long-term agreements that expire at various dates through the year 2011. The leased equipment is subject to a security interest. The total outstanding obligation under capital leases at December 31, 2007 and 2006 was $915,000 and $3,703,000, respectively.

At December 31, 2007, the total future minimum payments under non-cancelable scheduled rentals are as follows:

	Operating Leases		Capital Leases
Year Ending:	In thousands
2008	$	2,548	$	864
2009		2,508		93
2010		1,537		12
2011		721		6
2012		742		—
Thereafter		1,335		—
Total minimum lease payments	$	9,391	$	975
Less: amount representing interest				(60	)
Present value of future minimum lease payments				915
Less: current portion				(808	)
Non-current portion of capital lease obligations			$	107

Purchase obligations consist of non-cancelable marketing agreements, co-location services and printing equipment rental. As of December 31, 2007, the Company’s purchase obligations totaled $2,821,000.

Indemnifications

In the normal course of business, the Company enters into contracts and agreements that contain a variety of representation and warranties and provide for general indemnifications. The Company’s exposure under these agreements is unknown because it involves future claims that may be made against the Company, but have not yet been made. To date, the Company has not paid any claims or been required to defend any action related to its indemnification obligations. However, the Company may record charges in the future as a result of these indemnification obligations.

Contingencies

From time to time, the Company may have certain contingent liabilities that arise in the ordinary course of its business activities. The Company accrues contingent liabilities when it is probable that future expenditures will be made and such expenditures can be reasonably estimated.

41

SHUTTERFLY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Legal Matters

On August 29, 2006, our former Chief Financial Officer, Virender Ahluwalia, sued the Company in San Mateo County Superior Court alleging causes of action for reformation of contract, breach of contract and breach of fiduciary duty. The plaintiff claimed that he was entitled to exercise stock options for an additional 15,535 shares of the Company’s common stock because his vesting schedule should have been deemed to have started one year earlier than the date stated in the Company’s corporate records. In addition, the plaintiff claimed that the Company initially did not advise him that withholding taxes were due at the time of exercise of his nonqualified stock options to purchase 292,674 shares of common stock in 2005, but that the Company later modified that tax advice, extended his option exercise date, and required that he make provision for the applicable withholding taxes at the time of exercise of such options. The plaintiff claimed he was damaged by having to immediately sell a portion of those shares upon his exercise in order to raise the funds necessary to pay applicable withholding taxes. He also claimed that the calculation of the fair market value of the shares for the purpose of calculating his tax liability was improper. The plaintiff was seeking compensatory and punitive damages. The case was stayed and sent to binding arbitration, and following a hearing on the legal issues and an evidentiary hearing, the Arbitrator issued a Final Award on November 16, 2007 finding the Company not liable and dismissed all claims brought by Mr. Ahluwalia.

On or about June 18, 2007, Fotomedia Technologies, LLC filed suit in the United States District Court for the Eastern District of Texas, against the Company and several other defendants alleging patent infringement.  The Fotomedia Complaint sought unspecified damages, costs, interest and attorneys’ fees, and a permanent injunction.  In lieu of answering the Fotomedia Complaint, the Company moved to dismiss it under Rule 12 of the Federal Rules of Civil Procedure, by joining in a motion to the same effect filed by co-defendant Photobucket.com, Inc.  While the motion was pending and not yet decided, on or about November 6, 2007, Fotomedia filed an Amended Complaint.  The Amended Complaint likewise alleges infringement of the same three patents and seeks unspecified damages, costs, interest and attorneys’ fees, and a permanent injunction.  However, the amended complaint dropped the allegations of willful infringement against the Company in connection with one of the patents-at-issue.  Defendants moved to dismiss the Amended Complaint as well.  The motion at this time is fully briefed but has not yet been ruled upon.  As such, the Company has not yet been required to file an answer or other responsive pleading.  On January 8, 2008, the court held a status conference and set May 28, 2009, as the date for the claims construction hearing, and set November 2, 2009 as the date for trial.  Subsequently, the parties agreed upon and submitted orders that establish a case schedule, which the court entered on February 29, 2008.  At this time, the Company does not believe that the amount of potential loss, if any, is reasonably estimable.

On or about February 5, 2008, Parallel Networks, LLC filed a lawsuit in the Eastern District of Texas against the Company and other companies, alleging patent infringement.  The Parallel Networks Complaint seeks damages of an unspecified amount, attorneys’ fees, and an injunction against all parties.  The Company has not yet answered or otherwise responded to the complaint At this time, the Company does not believe that the amount of potential loss, if any, is reasonably estimable.

From time to time, the Company may be involved in various legal proceedings arising in the ordinary course of business. At December 31, 2007, in the opinion of management, there are no other matters that are expected to have a material adverse effect on the Company’s financial position, results of operations or cash flows.

Note 7 — Common Stock

In October 2006, the Company completed its IPO of common stock in which it sold and issued 5,800,000 shares of common stock, at an issue price of $15.00 per share. As a result of the IPO, a total of $87.0 million in gross proceeds was raised, with net proceeds to the Company of $78.5 million after deducting underwriting fees and commissions of $6.1 million and other offering costs of $2.4 million.

Upon the closing of the IPO, all shares of the Company’s redeemable convertible preferred stock outstanding automatically converted into 13,862,773 shares of common stock.

Warrants for Common Stock

During 2007, two warrant holders exercised their warrants for an aggregate of 27,299 shares of common stock.  The transactions were effected through a net-exercise, and as a result, no cash proceeds were received by the Company.  As of December 31, 2007, there were no remaining warrants outstanding.

Upon the effective date of the IPO, warrants to purchase 40,816 shares of redeemable convertible preferred stock converted into warrants to purchase 40,816 shares of common stock, and warrants to purchase 40,816 shares of redeemable convertible preferred stock expired.

As discussed in Note 3, in 2005 the Company reclassified the freestanding preferred stock warrants as a liability and began adjusting the warrants to fair value at each reporting period until the completion of the IPO.

1999 Stock Plan

In September 1999, the Company adopted the 1999 Stock Plan (the “1999 Plan”). Under the 1999 Plan, the Company issued shares of common stock and options to purchase common stock to employees, directors and consultants. Options granted

under the Plan were incentive stock options or non-qualified stock options. Incentive stock options (“ISO”) were granted only to Company employees, which includes officers and directors of the Company. Non-qualified stock options (“NSO”) and stock purchase rights were able to be granted to employees and consultants. Options under the Plan were to be granted at prices not less than 85% of the deemed fair value of the shares on the date of the grant as determined by the Company’s Board of Directors (“the Board”), provided, however, that (i) the exercise price of an ISO and NSO was not less than 100% and 85% of the deemed fair value of the shares on the date of grant, respectively, and (ii) the exercise price of an ISO and NSO granted to a 10% stockholder was not less than 110% of the deemed fair value of the shares on the date of grant. The Board determined the period over which options become exercisable. The term of the options was to be no longer than five years for ISOs for which the grantee owns greater than 10% of the voting power of all classes of stock and no longer than ten years for all other options. Options granted under the 1999 Plan generally vested over four years. The Board of Directors determined that no further grants of awards under the 1999 Plan would be made after the Company’s IPO.

2006 Equity Incentive Plan

In June 2006, the Board adopted, and in September 2006 the Company’s stockholders approved, the 2006 Equity Incentive Plan (the “2006 Plan”), and all shares of common stock available for grant under the 1999 Plan transferred to the 2006 Plan. The 2006 Plan provides for the grant of ISOs to employees (including officers and directors who are also employees) of the Company or of a parent or subsidiary of the Company, and for the grant of all other types of awards to employees, officers, directors, consultants, independent contractors and advisors of the Company or any parent or subsidiary of the Company, provided such consultants, independent contractors and advisors render bona-fide services not in connection with the offer and sale of securities in a capital-raising transaction. Other types of awards under the 2006 Plan include NSO restricted stock awards, stock bonus awards, restricted stock units, and performance shares.

Options issued under the 2006 Plan are generally for periods not to exceed 10 years and are issued at the fair value of the shares of common stock on the date of grant as determined by the Board. Prior to the Company’s IPO, the Board determined the fair value of common stock in good faith based on the best information available to the Board and Company’s management at the time of the grant. Following the IPO, the fair value of the Company’s common stock is determined by the last sale price of such stock on the Nasdaq Global Market. Options issued under the 2006 Plan typically vest with respect to 25% of the shares one year after the options’ vesting commencement date, and the remainder ratably on a monthly basis over the following three years. Option holders under the 2006 Plan are allowed to exercise options prior to vesting.

At the time of adoption of the 2006 Plan, there were 1,358,352 shares of common stock authorized for issuance under the 2006 Plan, plus 92,999 shares of common stock from the 1999 Plan that were unissued. The 2006 Plan provides for automatic replenishments on January 1 of 2008, 2009, and 2010, of the lesser of a) 4.62% of stock options issued and outstanding on the December 31 immediately prior to the date of increase or b) a lesser number as determined by the Board.

42

SHUTTERFLY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Inducement Options

 During 2007, the Company offered employment inducement stock option grant awards to three executives.  These inducement grants were approved by the Company’s Board of Directors and were not issued under a shareholder approved plan.  A total of 380,000 NSOs were granted.  These options have a 10 year term, and vest over a four year period from the initial date of hire of each of the executives.

Stock Option Activity

A summary of the status of the Company’s stock option plans at December 31, 2007 and changes during the periods then ended is presented in the table below (share numbers and aggregate intrinsic value in thousands):

	Shares Available for Grant			Number of Options Outstanding			Weighted Average Exercise Price		Weighted Average Contractual Term (Years)	Aggregate Intrinsic Value
Balances, December 31, 2004		510			1,336			0.40
Additional authorized		2,720			—			—
Granted		(2,372	)		2,372			5.12
Exercised		—			(315	)		0.35
Forfeited, cancelled or expired		501			(375	)		2.89
Balances, December 31, 2005		1,359			3,018			3.91
Additional authorized		2,055			—			—
Granted		(2,269	)		2,269			11.11
Exercised		—			(52	)		1.61
Forfeited, cancelled or expired		233			(201	)		6.10
Balances, December 31, 2006		1,378			5,034			7.28
Additional authorized (inducement grants)		380			—			—
Granted		(2,217	)		2,217			22.17
Exercised		—			(1,049	)		4.75
Forfeited, cancelled or expired		560			(560	)		9.36
Balances, December 31, 2007		101			5,642		$	13.39	8.1	$71,253
Options vested and expected to vest at December 31, 2007					5,165		$	12.92	8.0	$67,468
Options vested at December 31, 2007					1,917		$	7.05	6.9	$35,610

As of December 31, 2006 and 2005, there were 1,485,000 and 489,000 options vested, respectively.

During the 12 months ended December 31, 2007, the Company granted stock options to purchase an aggregate of 2,216,694 shares of common stock with a weighted average grant-date fair value of $9.33 per share.

Options granted in 2006 are grouped as follows:

	Options Granted		Weighted Average Fair Value		Weighted Average Exercise Price
Options with exercise price less than reassessed market price on the grant date		255	$	4.43	$	10.00
Options with exercise price equal to reassessed market price on the grant date		2,014	$	5.06	$	11.25
Total		2,269	$	4.99	$	11.11

The total fair value of options that vested during the 12 months ended December 31, 2007 was $5,250,000.  The total intrinsic value of options exercised during the twelve months ended December 31, 2007, 2006, and 2005 was $18,136,000, $531,000 and $3,274,000 respectively. Net cash proceeds from the exercise of stock options were $4,975,000 for the twelve months ended December 31, 2007.  As permitted by SFAS 123R, the Company has deferred the recognition of its excess tax benefit from stock option exercises of approximately $5.3 million until it is actually realized.  During 2007, the Company recognized $27,000 of non-qualified tax benefit in state tax jurisdictions where the Company did not have any net operating loss carry forwards.

Early Exercise of Employee Options

Stock options granted under the 1999 Plan provides employee option holders the right to elect to exercise unvested options in exchange for restricted common stock. Unvested shares, which amounted to 5,000, 31,000 and 138,000 at December 31, 2007, 2006 and 2005, respectively, were subject to a repurchase right held by the Company at the original issuance price in the event the optionees’ employment is terminated either voluntarily or involuntarily. For exercises of employee options, this right lapses 25% on the first anniversary of the vesting start date and in 36 equal monthly amounts thereafter. These repurchase terms are considered to be a forfeiture provision and do not result in variable accounting. In accordance with EITF No. 00-23, Issues Related to the Accounting for Stock Compensation under APB No. 25, the shares purchased by the employees pursuant to the early exercise of stock options are not deemed to be outstanding until those shares vest. In addition, cash received from employees for exercise of unvested options is treated as a refundable deposit shown as a liability in the Company’s financial statements. As of December 31, 2007, 2006 and 2005, cash received for early exercise of options of $0, $9,000 and $38,000, was included in refundable deposits, respectively. Amounts so recorded are transferred into common stock and additional paid-in capital as the shares vest.

43

SHUTTERFLY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Stock-based Compensation Associated with Awards to Employees

All options granted were intended to be exercisable at a price per share not less than fair market value of the shares of the Company’s stock underlying those options on their respective dates of grant. The Board determined these fair market values in good faith based on the best information available to the Board and Company’s management at the time of the grant. Although the Company believes these determinations accurately reflect the historical value of the Company’s common stock, management has retroactively revised the valuation of its common stock for the purpose of calculating stock-based compensation expense. Accordingly, in the periods ending December 31, 2004 and 2005 for such stock and options issued to employees, the Company has recorded deferred stock-based compensation of $2,299,000 and $1,225,000 respectively, net of cancellations, of which the Company amortized $1,000, $565,000 and $1,547,000 of stock-based compensation in the years ended December 31, 2007, 2006 and 2005, respectively.

At December 31, 2007, the Company had deferred stock-based compensation under APB 25, as shown in the consolidated statement of redeemable convertible preferred stock and stockholders’ equity of $28,000, which is expected to be fully amortized in 2008.

On July 28, 2004, the Company entered into a transition agreement with one of its executive officers whereby vesting of previously granted options was accelerated resulting in a new measurement date at the date of modification. This executive officer resigned effective January 31, 2005. A total of 316,000 shares would have been forfeited under the original option terms resulting in total compensation expense of $1,145,000. The total compensation expense was measured in accordance with guidance provided by Financial Accounting Standards Board Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation, an Interpretation of APB Opinion No. 25 (“FIN 44”), as the intrinsic value of the modified award at the date of modification in excess of the amount measured at the original measurement date. A total of $164,000 and $981,000 was recognized in the years ended December 31, 2005 and 2004, respectively.

On August 13, 2004 the Company entered into a transition agreement with one of its executive officers. Upon termination, the agreement provided for acceleration of 25% of the officer’s unvested options. The agreement also provided for an extension of the time to exercise any vested options, from 90 days to 270 days from the date of the officer’s termination. In February 2005, this executive officer resigned and 17,000 shares that would have been forfeited under the original option terms were accelerated, resulting in total stock-based compensation expense of $65,000. In November 2005, this executive officer exercised options for 293,000 shares. As expense recognition for the additional 276,000 shares was contingent on whether this executive officer took the benefit of the vesting extension, additional stock-based compensation expense was not recognized until the November exercise when $1,035,000 was recorded. Stock-based compensation expense for the February and November 2005 charges was measured in accordance with guidance provided by FIN 44 as the intrinsic value of the modified award at the date of modification in excess of the amount measured at the original measurement date.

Adoption of SFAS No. 123R

The Company adopted SFAS No. 123R on January 1, 2006. Under SFAS No. 123R, the Company estimated the fair value of each option award on the date of grant using the Black-Scholes option-pricing model using the assumptions noted in the following table. Expected volatility is based on the historical and implied volatility of a peer group of publicly traded entities. The expected term of options gave consideration to historical exercises, post vest cancellations and the options contractual term. The risk-free rate for the expected term of the option is based on the U.S. Treasury Constant Maturity at the time of grant. The assumptions used to value options granted during the twelve months ended December 31, 2007 and December 31, 2006 were as follows

	Year Ended December 31, 2007			Year Ended December 31, 2006
Dividend yield		—			—
Annual risk free rate of return		4.1	%		5.0	%
Expected volatility		45.0	%		45.8	%
Expected term (years)		4.4			4.6

Employee stock-based compensation expense recognized during the periods ended December 31, 2007 and December 31, 2006 was calculated based on awards ultimately expected to vest and has been reduced for estimated forfeitures. SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

As a result of adopting SFAS No. 123R on January 1, 2006, the Company’s net income for the twelve months ended December 31, 2006, was lower by $1,950,000 net of tax effect, than if the Company had continued to account for stock-based compensation under APB 25. Basic and diluted net income per share for the twelve months ended December 31, 2006 would have been higher by $0.23 if the Company had not adopted SFAS No. 123R.  At December 31, 2007, the Company had $21,618,000 of total unrecognized compensation expense under SFAS No. 123R, net of estimated forfeitures, related to stock option plans that will be recognized over a weighted-average period of approximately three years.  In accordance with SFAS No. 123R, unamortized compensation expense on stock option grants after January 1, 2006 is not included in deferred stock-based compensation on the equity statement. The balance in deferred stock-based compensation as of December 31, 2007 is $28,000, which is comprised primarily of employee stock option grants prior to January 1, 2006.

In 2006, based on a reassessment of the value of its common stock during 2005, the Company offered to the employees who were granted options from January 2005 to October 2005 the ability to amend the terms of their options to increase the exercise prices in order to help them avoid potential adverse personal income tax consequences. On June 29, 2006 and December 22, 2006, options to purchase 1,789,217 and 3,480 shares, respectively, of the Company’s common stock that had been granted at exercise prices ranging from $5.00 to $5.50 per share were amended to exercise prices between $5.50 and $6.56 per share. No other terms of the option grants were modified. The transactions were deemed to be modifications under SFAS No. 123R; deferred stock-based compensation computed under APB 25 was reduced by $526,000 which will be amortized under SFAS No. 123R, and there was no incremental stock-based compensation expenses from the amendments.

Note 8 — Income Taxes

The components of the provision for income taxes is as follows (in thousands):

	December 31,
	2007		2006		2005
Federal:
Current	$	206	$	610	$	(187	)
Deferred		5,146		2,809		(20,230	)
	$	5,352	$	3,419	$	(20,417	)
State:
Current	$	216	$	133	$	(40	)
Deferred		734		390		(3,603	)
	$	950	$	523	$	(3,643	)
Total income tax expense (benefit):
Current	$	422	$	743	$	(227	)
Deferred		5,880		3,199		(23,833	)
	$	6,302	$	3,942	$	(24,060	)

44

SHUTTERFLY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The Company’s actual tax expense (benefit) differed from the statutory federal income tax rate of 34.0%, as follows:

	December 31,
	2007			2006			2005
Income tax expense at statutory rate		34.0	%		34.0	%		34.0	%
State income taxes		4.5	%		5.8	%		5.8	%
Stock-based compensation		2.0	%		4.3	%		10.7	%
Non-qualified deductions		—			—			(13.1	)%
Change in valuation allowance		—			—			(527.7	)%
Other		(2.1	)%		(3.7	)%		(3.5	)%
		38.4	%		40.4	%		(493.8	)%

At December 31, 2007, the Company had approximately $31.0 million and $32.0 million of federal and state net operating loss carryforwards, respectively, to reduce future regular taxable income. These carryforwards will expire beginning in the year 2020 through 2022 for federal and 2011 through 2012 for state purposes, if not utilized.

The Tax Reform Act of 1986 limits the use of net operating loss and tax credit carryforwards in the case of an “ownership change” of a corporation or separate return loss year limitations. Any ownership changes, as defined, may restrict utilization of carryforwards.

The Company also had federal and state research and development credit carryforwards of approximately $1.0 million and $1.0 million for federal and state income tax purposes, respectively, at December 31, 2007. The research and development credits may be carried forward over a period of 20 years for federal tax purposes, and indefinitely for California tax purposes.

The components of the net deferred tax assets as of December 31, 2007 and 2006 are as follows (in thousands):

	December 31,
	2007		2006
Deferred tax assets:
Net operating loss carryforwards	$	7,481	$	17,028
Reserves and other tax benefits		3,485		2,111
Tax credits		2,715		1,800
Depreciation and amortization		1,196		32
Other		94		19
Deferred tax assets		14,971		20,990
Deferred tax liabilities:
Other deferred tax liabilities		—		(107	)
Deferred tax liabilities		—		(107	)
Valuation allowance		—		—
Net deferred tax assets	$	14,971	$	20,883

As of January 1, 2007, the date of adoption of FIN 48, the Company had $1,200,000 of unrecognized tax benefits. The amount of unrecognized tax benefits that, if recognized, would decrease the Company’s provision for income taxes and increase net income is $1,000,000, net of the federal benefit for state taxes. There was no significant cumulative impact to retained earnings as a result of the adoption of FIN 48. The total unrecognized tax benefits relate to reserves against the Company’s research and development tax credits claimed on Federal and California returns.

Subsequent to adoption and during the twelve-month period ended December 31, 2007, the Company revised its reserve estimate related to research and development tax credits as a result of the conclusion of an audit by the California Franchise Tax Board for the September 30, 2004 tax year. This change in estimate resulted in a decrease in unrecognized tax benefits from $1,200,000 to $497,000. The amount of unrecognized tax benefits that, if recognized, would decrease the Company’s provision of income taxes and increase net income is $448,000, net of the federal benefit for state taxes. As of December 31, 2007, the Company booked an additional $259,000 for unrecognized tax benefits for fiscal 2007.  A reconciliation of the beginning and ending amounts of unrecognized income tax benefits during the 12-month period ended December 31, 2007 is as follows (in thousands):

Balance of unrecognized tax benefits at January 1, 2007	$	1,200
Additions for tax positions of prior years		—
Additions for tax positions related to 2007		259
Reductions for tax positions of prior years		(607	)
Settlement of franchise tax audit		(96	)
Lapses in statutes of limitations		—
Balance of unrecognized tax benefits at December 31, 2007	$	756

The company does not expect the balance of unrecognized tax benefits to significantly increase or decrease in the next 12 months.

Our fiscal year end for federal and state tax purposes was September 30. During the period ended June 30, 2007, the taxing authorities granted our request to change our fiscal year end for tax purposes to December 31. In September 2007, we filed a short period income tax return for federal and state purposes covering October 1, 2006 through December 31, 2006. This filing did not have a material impact on our income tax provision.  As of December 31, 2007, the Company is subject to taxation in the United States, California, North Carolina, New Jersey, New York, and Arizona. The Company is subject to examination for tax years including and after 2003 for the United States, 2004 for California, and 2007 for the remaining jurisdictions.

Note 9 — Employee Benefit Plan

In 2000, the Company established a 401(k) plan under the provisions of which eligible employees may contribute an amount up to 50% of their compensation on a pre-tax basis, subject to IRS limitations. The Company matches employees’ contributions at the discretion of the Board.

In 2007 and 2005, there were no discretionary contributions. In 2006, the Company made a discretionary contribution of $63,000.

Note 10 — Related Party Transactions

On June 1, 2005, the Company acquired Memory Matrix (see Note 5). Monaco Partners, L.P., a beneficial owner of the Company’s capital stock, owned 14.1% of Memory Matrix immediately prior to the closing of the acquisition. James H. Clark, who is a stockholder of the Company, and was a member of the Board, controlled Monaco Partners, L.P. Mr. Clark was a member of the board of directors of Memory Matrix immediately prior to the acquisition.

45

SHUTTERFLY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 11 – Subsequent Events

Nexo Acquisition:  On January 4, 2008, the Company completed its acquisition of Nexo Systems for $10.0 million in cash and $4.0 million in restricted stock.  In addition, the two founders of Nexo joined the Company as vice presidents.  The acquisition was accounted for as a purchase business combination, and the restricted stock will be recorded as compensation expense over the vesting term of approximately two years.

Intellectual Property License Agreement:  On February 8, 2008, the Company entered into a license arrangement of certain of its patented technology to a third party.  Under the terms of the license, the third party will pay the license fee in annual installments through March 2010, each of which will be recorded as a reduction of operating expense in the period that the license installment is received.

Auction Rate Securities:  At February 29, 2008, $52.3 million of our marketable securities portfolio was invested in AAA rated investments in auction-rate debt securities. Auction-rate securities are long-term variable rate bonds tied to short-term interest rates. After the initial issuance of the securities, the interest rate on the securities is reset periodically, at intervals established at the time of issuance (primarily every twenty-eight days), based on market demand for a reset period. Auction-rate securities are bought and sold in the marketplace through a competitive bidding process often referred to as a “Dutch auction”. If there is insufficient interest in the securities at the time of an auction, the auction may not be completed and the rates may be reset to predetermined “penalty” or “maximum” rates. Following such a failed auction, we would not be able to access our funds that are invested in the corresponding auction-rate securities until a future auction of these investments is successful or new buyers express interest in purchasing these securities in between reset dates.

As a result of the current negative liquidity conditions in the global credit markets, in February 2008, auctions for $42.3 million of original par value of our auction-rate securities failed, rendering these securities temporarily illiquid through the normal auction process. At the time of our initial investment and through the date of this Report, all of our auction-rate securities remain AAA rated. The assets underlying each security are student loans and 95% of the principal amounts are guaranteed by the Federal Family Education Loan Program (FFELP).  Since we cannot predict when future auctions related to $52.3 million of our auction-rate securities will be successful, it may become necessary to classify this amount as long-term marketable securities in our consolidated balance sheet in future periods. In addition, if the underlying issuers are unable to successfully clear future auctions or if their credit rating deteriorates and the deterioration is deemed to be other-than-temporary, we would be required to adjust the carrying value of the auction-rate securities through an impairment charge to earnings. Any of these events could materially affect our results of operations and our financial condition.

To access these funds in future periods, it may be necessary to attempt to sell these securities at an amount below our original purchase value.  However, based on our ability to access our cash and cash equivalents and our other liquid investments, totaling $53.7 million at February 29, 2008, and our expected operating cash flows, we believe that we currently have adequate working capital resources to fund our operations.

Note 12 — Quarterly Financial Data (Unaudited, in thousands)

	Year Ended December 31, 2007
	First Quarter			Second Quarter			Third Quarter			Fourth Quarter
Net Revenues	$	26,705		$	29,877		$	32,602		$	97,543
Gross Profit		13,671			15,045			15,362			58,538
Net income (loss)	$	(1,060	)	$	(2,439	)	$	(3,314	)	$	16,909
Net income (loss) per common share:
Basic	$	(0.04	)	$	(0.10	)	$	(0.14	)	$	0.68
Diluted	$	(0.04	)	$	(0.10	)	$	(0.14	)	$	0.63
	Year Ended December 31, 2006
	First Quarter			Second Quarter			Third Quarter			Fourth Quarter
Net Revenues	$	16,883		$	19,637		$	21,155		$	65,678
Gross Profit		8,134			9,881			10,289			39,558
Net income (loss)	$	(1,565	)	$	(2,093	)	$	(2,747	)	$	12,203
Net income (loss) allocable to common shareholders	$	(1,565	)	$	(2,093	)	$	(2,747	)	$	12,203
Net income (loss) per common share:
Basic	$	(0.41	)	$	(0.54	)	$	(0.70	)	$	0.53
Diluted	$	(0.41	)	$	(0.54	)	$	(0.70	)	$	0.50

46

Schedule II

Valuation and Qualifying Accounts

	Balance at		Additions								Balance at
	Beginning		Charged to Costs		Charged to Other						End of
	of Period		and Expenses		Accounts			Deductions			Period
	In thousands
Allowance for Doubtful Accounts Receivable
Year ended December 31, 2005	$	—	$	37	$	—		$	(16	)	$	21
Year ended December 31, 2006	$	21		—		—			(21	)		—
Year ended December 31, 2007		—		—		—			—			—
Deferred tax valuation allowance
Year ended December 31, 2005	$	25,008	$	—	$	(230	)(1)	$	(24,778	)(2)	$	—
Year ended December 31, 2006		—		—		—			—			—
Year ended December 31, 2007		—		—		—			—			—

__________

(1)	Reflects amounts related to items with no income statement effect.
(2)	Decrease in the Valuation allowance is due to the reversal of the valuation allowance in the fourth quarter of 2005.

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURE.

Not applicable.

ITEM 9A.  CONTROLS AND PROCEDURES.

Evaluation of Disclosure Controls and Procedures

We carried out an evaluation required by the Securities Exchange Act of 1934, under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as of December 31, 2007.  Based on this evaluation, our principal executive officer and principal financial officer concluded that, as of December 31, 2007, our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specific in the SEC’s rules and forms and to provide reasonable assurance that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosures.

Management’s Report on Internal Control over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) of the Securities Exchange Act of 1934.  Management has assessed the effectiveness of our internal control over financial reporting as of December 31, 2007 based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.  As a result of this assessment, management concluded that, as of December 31, 2007, our internal control over financial reporting was effective in providing reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

PricewaterhouseCoopers LLP, the independent registered public accounting firm that also audited our financial statements included in this Annual Report on Form 10-K, audited the effectiveness of internal control over financial reporting as of December 31, 2007, and issued their related attestation report which is included herein.

Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting during the quarter ended December 31, 2007 that materially affected, or are reasonable likely to materially affect, our internal control over financial reporting.

Limitation on Effectiveness of 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 upon certain assumptions and can provide only reasonable, not absolute, assurance that its objectives will be met.  Further, 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 the Company have been detected.

ITEM 9B.  OTHER INFORMATION.

None.

47

PART III

ITEM 10.  DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.

The information concerning our directors required by this Item is incorporated by reference to the section in our Proxy Statement entitled “Proposal No. 1 — Election of Directors.”

The information concerning our executive officers required by this Item is incorporated by reference to the section in our Proxy Statement entitled “Executive Officers.”

The information concerning compliance with Section 16(a) of the Securities Exchange Act of 1934 required by this Item is incorporated by reference to the section in our Proxy Statement entitled “Section 16(a) Beneficial Ownership Reporting Compliance.”

We have adopted a written code of ethics for financial employees that applies to our principal executive officer, principal financial officer, principal accounting officer, controller and other employees of the finance department designated by the Company’s Chief Financial Officer. This code of ethics, titled the “Code of Ethics for Chief Executive Officer and Senior Financial Department Personnel,” can be found on our website at www.shutterfly.com.  We intend to make all required disclosures concerning any amendments to, or waivers from, our code of ethics on our website.

The information concerning material changes to the procedures by which stockholders may recommend nominees to the Board of Directors required by this Item is incorporated by reference to information set forth in the Proxy Statement, in the section entitled “Information Regarding the Board of Directors and its Committees.”

The information concerning the audit committee of the Board of Directors and the audit committee financial experts required by this Item is incorporated by reference to information set forth in the Proxy Statement, in the section entitled “Information Regarding the Board of Directors and its Committees.”

ITEM 11.  EXECUTIVE COMPENSATION.

The information required by this Item with respect to executive compensation and the compensation committee of the Board of Directors is incorporated by reference to information set forth in the Proxy Statement.

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

The information required by this Item is incorporated by reference to information set forth in the Proxy Statement under the headings “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information.”

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

The information required by this Item with respect to director independence is incorporated by reference to information set forth in the Proxy Statement.

The information concerning certain relationships and related transactions required by this Item is incorporated by reference to the section in our Proxy Statement entitled “Certain Transactions.”

ITEM 14.  PRINCIPAL ACCOUNTANT FEES AND SERVICES.

The information concerning principal accountant fees and services required by this Item is incorporated by reference to the section in our Proxy Statement entitled “Ratification of Selection of Independent Registered Public Accounting Firm.”

PART IV

ITEM 15.  EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.

(a) The following documents are filed as part of this annual report:

1. Financial Statements.  The consolidated financial statements of Shutterfly, Inc. are incorporated by reference to Part II, Item 8 of this annual report.

2. Financial Statement Schedules.  The Valuation and Qualifying Accounts schedule is incorporated by reference to Part II, Item 8 of this annual report.

3. Exhibits.

48

		Incorporated by Reference
Exhibit Number	Exhibit Description	Form	File No.	Date of First Filing	Exhibit Number	Provided Herewith
3.01	Registrants’ Restated Certificate of Incorporation.	S-1	333-135426	June 29, 2006	3.03
3.02	Registrant’s Restated Bylaws.	S-1	333-135426	June 29, 2006	3.05
4.01	Form of Registrant’s common stock certificate.	S-1	333-135426	June 29, 2006	4.01
4.02	Fifth Amended and Restated Investors’ Rights Agreement, dated as of November 11, 2005, by and among the Registrant and certain investors of Registrant.	S-1	333-135426	June 29, 2006	4.02
10.01	Form of Indemnity Agreement.	S-1	333-135426	June 29, 2006	10.01
10.02	1999 Stock Plan and forms of stock option agreement and a stock option exercise agreement.*	S-1	333-135426	June 29, 2006	10.02
10.03	2006 Equity Incentive Plan and forms of stock option agreement, stock option exercise agreement, restricted stock agreement, restricted stock unit agreement, stock appreciation right agreement and stock bonus agreement.*	S-1/A	333-135426	June 29, 2006	10.03
10.04	Lease Agreement, as amended, dated July 5, 1999, by and between the Registrant and Westport Joint Venture, as amended to date.	S-1	333-135426	June 29, 2006	10.04
10.05	Agreement of Lease, dated as of August 1, 2005, by and between the Registrant and DCT-CA 2004 RN Portfolio L, LP, as amended to date	S-1	333-135426	June 29, 2006	10.05
10.06	Lease, dated as of March 7, 2000, by and between the Registrant and 3168 Corporate Place Associates, LLC, as amended to date.	S-1	333-135426	June 29, 2006	10.06
10.07	Lease, dated as of April 6, 2000, by and between the Registrant and 3168 Corporate Place Associates, LLC, as amended to date	S-1	333-135426	June 29, 2006	10.07
10.08	Offer letter dated January 5, 2005 for Jeffrey T. Housenbold.*	S-1	333-135426	June 29, 2006	10.08
10.09	Offer letter dated June 23, 2004 for Stephen E. Recht.*	S-1	333-135426	June 29, 2006	10.09
10.10	Offer letter dated July 22, 2001 for Jeannine M. Smith Thomas.*	S-1	333-135426	June 29, 2006	10.10
10.11	Offer letter dated July 12, 2001 for Andrew F. Young.*	S-1	333-135426	June 29, 2006	10.11
10.12	Offer letter dated March 25, 2005 for Douglas J. Galen.*	S-1	333-135426	June 29, 2006	10.12
10.13	Offer letter dated April 3, 2006 for Stanford S. Au.*	S-1	333-135426	June 29, 2006	10.13
10.14	Supply agreement, dated as of September 15, 2005, by and between Registrant and Fuji Photo Film U.S.A., Inc.**	S-1	333-135426	June 29, 2006	10.14
10.15	Offer letter dated January 17, 2007 for Dwayne Black.*	10-K	001-33031	March 20, 2007	10.15
10.16	Confidential Separation Agreement and General Release of Claims, dated January 23, 2007, by and between the Registrant and Jeannine M. Smith Thomas.*	10-K	001-33031	March 20, 2007	10.16
10.17	Confidential Separation Agreement and General Release of Claims, dated January 19, 2007, by and between the Registrant and Andrew F. Young.*	10-K	001-33031	March 20, 2007	10.17
10.18	Supply Agreement, dated as of April 20, 2007, by and between the Registrant and FujiFilm U.S.A., Inc. **	10-Q	001-33031	August 1, 2007	10.18
10.19	Offer Letter dated May 17, 2007 for Kathryn E. Olson.*					X
10.20	Offer letter dated November 27, 2007 for Mark J. Rubash. *					X
10.21	Confidential Separation Agreement and General Release of Claims, dated December 10, 2007, by and between the Registrant and Stephen E. Recht.*					X
10.22	Lease Agreement, as amended, dated as of December 22, 2006, by and between the Registrant and 3915 Shopton Road, LLC, as amended to date.					X
10.23	First Amendment to Lease (Expansion), dated as of April 30, 2007, by and between the Registrant and Westport Office Park, LLC, as amended to date.					X
21.01	Subsidiaries of the Registrant					X
23.01	Consent of Independent Registered Public Accounting Firm					X
24.01	Power of Attorney. (See page 79 of this Form 10-K)					X
31.01	Certification of Chief Executive Officer Pursuant to Securities Exchange Act Rule 13a-14(a)					X
31.02	Certification of Chief Financial Officer Pursuant to Securities Exchange Act Rule 13a-14(a)					X
32.01	Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 and Securities Exchange Act Rule 13a-14(b).***					X
32.02	Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 and Securities Exchange Act Rule 13a-14(b).***					X

*	Represents a management contract or compensatory plan.
**	Confidential treatment has been granted for certain portions of this document pursuant to an application for confidential treatment sent to the Securities and Exchange Commission. Such portions are omitted from this filing and were filed separately with the Securities and Exchange Commission.
***	This certification is not deemed “filed” for purposes of Section 18 of the Securities Exchange Act, or otherwise subject to the liability of that section. Such certification will not be deemed to be incorporated by reference into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that Shutterfly specifically incorporates it by reference.

49

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.

SHUTTERFLY, INC.                                                  

(Registrant)

By: /s/  Mark J. Rubash

Mark J. Rubash

Sr. Vice President and Chief Financial Officer

Dated: March 10, 2008

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Jeffrey T. Housenbold and Mark J. Rubash, jointly and severally, his or her attorneys-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Report on Form 10-K and to file same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitutes, may do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and dates indicated.

Signature	Title	Date
/s/  Jeffrey T. Housenbold Jeffrey T. Housenbold	President, Chief Executive Officer and Director (Principal Executive Officer)	March 10, 2008
/s/  Mark J. Rubash                                       Mark J. Rubash	Sr. Vice President and Chief Financial Officer (Principal Financial Officer)	March 10, 2008
/s/  Philip A. Marineau Philip A. Marineau	Chairman of the Board of Directors	March 10, 2008
/s/  Patricia A. House Patricia A. House	Director	March 10, 2008
/s/  Eric J. Keller Eric J. Keller	Director	March 10, 2008
/s/  Nancy J. Schoendorf Nancy J. Schoendorf	Director	March 10, 2008
/s/  James N. White James N. White	Director	March 10, 2008
/s/  Stephen J. Killeen Stephen J. Killeen	Director	March 10, 2008

EX-10.19

Exhibit 10.19

Personal and Confidential

May 17, 2007

Kathryn E. Olson

3 Circle Avenue

Mill Valley, CA 94941

RE: Offer of Employment

Dear Kathryn:

Shutterfly, Inc. (the “Company” or “Shutterfly”) is pleased to offer you the opportunity to join Shutterfly. You are being offered a position as Senior Vice President and Chief Marketing Officer reporting to me. If you decide to join us, your start date will be May 31, 2007.

Compensation

Your annual base pay will be $250,000, less applicable taxes and withholdings. You will be paid semimonthly in accordance with the Company’s normal payroll procedure. Additionally, you will be eligible to participate in the Executive Bonus Plan to be approved by the Compensation Committee for 2007. Under the Executive Bonus Plan, it is anticipated that you will be eligible for a bonus of up to 30% of your base pay based upon you and the Company reaching certain performance goals.

Hire in Bonus

Shutterfly will provide you with a hire in bonus of $50,000 less applicable withholding.  If you terminate prior to one (1) year of employment you will be responsible for reimbursing the Company a prorated portion of the bonus.

Stock Option

Subject to the approval of the Company’s Board of Directors, you will be granted a stock option (the “Option”) to purchase 200,000 shares of the Company’s Common Stock, at an exercise price equal to the fair market value of the Common Stock on the date the Board grants your Option in accordance with the Board’s stock option grant procedures.  Since you will be an executive officer, our procedure provides for stock option grants only four times a year (on February 29, May 31, August 31 and November 30). Therefore, since your start date is May 31, your vesting start date and pricing for the option will both occur on such date. Your Option will be subject to terms, conditions and restrictions similar to those contained in the Company’s 2006 Equity Incentive Plan (the “Plan”) and the execution of a stock option agreement adopted pursuant to such Plan.

Change in Control

If the Company is subject to a Corporate Transaction (as defined in the Plan) whereas, (1) you will no longer be the Chief Marketing Officer of Shutterfly, or (2) your role is materially diminished, or (3) the corporate office is moved 50 miles or more and you choose not to relocate with the Company, then the Company will agree to pay you severance of six (6) months following the termination of your employment and accelerate your vesting schedule by 12 months from that date.   Your severance pay will be paid in accordance with the Company’s standard payroll procedures.  However, to receive this severance you must (1) sign a general release (in a form prescribed by the Company) and (b) return all the Company property.

Relocation

Shutterfly will provide reimbursement for actual relocation expenses, not to exceed $25,000.  Such relocation expenses may include the following: the cost of packing and unpacking, moving and insuring household goods and personal effects of your household goods to your new location.  Some of these reimbursed relocation expenses may be considered income and therefore taxable under federal and/or state laws.  You are encouraged to seek advice from a personal tax advisor to determine the impact of relocation income and new location taxes.  If you voluntarily terminate your employment in the first year of employment you will be responsible for reimbursing the Company a prorated portion of the relocation expenses.

Benefits

As an employee, you will also be eligible to receive certain employee benefits including medical and dental coverage. The medical, dental and vision coverage begin on your date of hire as an employee. Additionally, you are eligible to participate in the Company’s 401(k) plan. The Company reserves the right to revise or discontinue any or all of its benefit plans, at any time, in the Company’s sole discretion. Enclosed is some information on the Company benefit plans.

Holidays

Shutterfly generally observes twelve (12) paid holidays each calendar year. The holiday schedule may change at management’s discretion.

Paid Time Off

In order to allow you flexibility with your free time, the Company has a paid time off policy. You begin to accrue paid time off on your date of hire. You will accrue fifteen (15) days of paid time off per year for your first three (3) years of employment, subject to the paid time off policy.

Introductory Period

Your first ninety (90) days of work is known as an “Introductory Period”. This “getting acquainted” period gives the Company the opportunity to determine your ability to perform your job. It also provides you with the opportunity to determine if you are satisfied with the job and the Company.  Either you or the Company can terminate the employment relationship at any time during or after the Introductory Period, with or without Cause or advance notice.

Employment Eligibility Verification

For purposes of federal immigration law, you will be required to provide to the Company documentary evidence of your identity and eligibility for employment in the United States.  Such documentation must be provided to us within three (3) business days of your date of hire with the Company, or our employment relationship with you may be terminated.

Employment at Will

If you choose to accept this offer, your employment with the Company will be voluntarily entered into and will be for no specified period. As a result, you will be free to resign at any time, for any reason, as you deem appropriate. The Company will have a similar right and may terminate its employment relationship with you at any time, with or without Cause or advance notice.

Acceptance of Offer

To indicate your acceptance of the terms of this offer, please sign and date in the space provided below and return an executed copy to Shutterfly; 2800 Bridge Parkway; Redwood City, CA 94065; Attention: Human Resources or via Fax to (650) 610–5280 no later than May 24, 2007 after which this offer will expire. A duplicate original is enclosed for your records. In addition to this letter, your offer of employment is conditioned upon your: (1) completion and signing of the Shutterfly employment application; (2) successful completion of a background and reference check and (3) your signing of the Shutterfly Employee Invention Assignment and Confidentiality Agreement (and any other similar agreements relating to proprietary rights between you and the Company).

In the event of any dispute or claim relating to or arising out of your employment relationship with the Company, this agreement, or the termination of your employment with the Company for any reason (including, but not limited to, any claims of breach of contract, wrongful termination or age, sex, race, national origin, disability or other discrimination or harassment), all such disputes shall be fully, finally and exclusively resolved by binding arbitration conducted by JAMS under JAMS Employment Arbitration Rules and Procedures then in effect, which are available online at JAMS’ website at www.jamsadr.org You and the Company hereby waive your respective rights to have any such disputes or claims tried before a judge or jury.

This letter agreement, the Shutterfly Employee Invention Assignment and Confidentiality Agreement, the Plan and the stock option agreement for the Option constitute the entire agreement between you and the Company regarding the terms and conditions of your employment with the Company and together supersede any prior representations or agreements, whether written or oral. This letter, along with any agreements herein, may not be modified or amended except by a written agreement signed by the Chief Executive Officer of the Company.  If we do not hear from you by May 17, 2007 we will assume you have decided not to join Shutterfly.

We look forward to your positive response and welcoming you to the Shutterfly team.

Sincerely,

/s/ Jeff Housenbold

Jeff Housenbold

CEO & President

Enclosures

Acknowledged and Agreed:

I agree to and accept employment with Shutterfly on the terms and conditions set forth in this agreement. I understand and agree that my employment with the Company is at-will.

Signature:  /s/Kathryn E. Olson                                                      Date:   May 18, 2007

Kathryn E. Olson

Start Date: May 31, 2007

EXHIBIT A

EMPLOYEE INVENTION ASSIGNMENT AND

CONFIDENTIALITY AGREEMENT

In consideration of, and as a condition of my employment with Shutterfly, Inc., a Delaware corporation (the “Company”), I hereby represent to, and agree with the Company as follows:

1.Purpose of Agreement.  I understand that the Company is engaged in a continuous program of research, development, production and marketing in connection with its business and that it is critical for the Company to preserve and protect its “Proprietary Information” (as defined in Section 7 below), its rights in “Inventions” (as defined in Section 2 below) and in all related intellectual property rights.  Accordingly, I am entering into this Employee Invention Assignment and Confidentiality Agreement (this “Agreement”) as a condition of my employment with the Company, whether or not I am expected to create inventions of value for the Company.

2.Disclosure of Inventions.  I will promptly disclose in confidence to the Company all inventions, improvements, designs, original works of authorship, formulas, processes, compositions of matter, computer software programs, databases, mask works and trade secrets that I make or conceive or first reduce to practice or create, either alone or jointly with others, during the period of my employment, whether or not in the course of my employment, and whether or not patentable, copyrightable or protectable as trade secrets (the “Inventions”).

3.Work for Hire; Assignment of Inventions.  I acknowledge and agree that any copyrightable works prepared by me within the scope of my employment are “works for hire” under the Copyright Act and that the Company will be considered the author and owner of such copyrightable works.  I agree that all Inventions that (i) are developed using equipment, supplies, facilities or trade secrets of the Company, (ii) result from work performed by me for the Company, or (iii) relate to the Company’s business or current or anticipated research and development (the “Assigned Inventions”), will be the sole and exclusive property of the Company and are hereby irrevocably assigned by me to the Company.  Attached hereto as Exhibit A is a list describing all inventions, original works of authorship, developments and trade secrets which were made by me prior to the date of this Agreement, which belong to me and which are not assigned to the Company (“Prior Inventions”).  I acknowledge and agree that if I use any of my Prior Inventions in the scope of my employment, or include them in any product or service of the Company, I hereby grant to the Company a perpetual, irrevocable, nonexclusive, world-wide, royalty-free license to use, disclose, make, sell, copy, distribute, modify and create works based on, perform or display such Prior Inventions and to sublicense third parties with the same rights.

4.Labor Code Section 2870 Notice.  I have been notified and understand that the provisions of Sections 3 and 5 of this Agreement do not apply to any Assigned Invention that qualifies fully under the provisions of Section 2870 of the California Labor Code, which states as follows:

ANY PROVISION IN AN EMPLOYMENT AGREEMENT WHICH PROVIDES THAT AN EMPLOYEE SHALL ASSIGN, OR OFFER TO ASSIGN, ANY OF HIS OR HER RIGHTS IN AN INVENTION TO HIS OR HER EMPLOYER SHALL NOT APPLY TO AN INVENTION THAT THE EMPLOYEE DEVELOPED ENTIRELY ON HIS OR HER OWN TIME WITHOUT USING THE EMPLOYER’S EQUIPMENT, SUPPLIES, FACILITIES, OR TRADE SECRET INFORMATION EXCEPT FOR THOSE INVENTIONS THAT EITHER:  (1) RELATE AT THE TIME OF CONCEPTION OR REDUCTION TO PRACTICE OF THE INVENTION TO THE EMPLOYER’S BUSINESS, OR ACTUAL OR DEMONSTRABLY ANTICIPATED RESEARCH OR DEVELOPMENT OF THE EMPLOYER; OR (2) RESULT FROM ANY WORK PERFORMED BY THE EMPLOYEE FOR THE EMPLOYER.  TO THE EXTENT A PROVISION IN AN EMPLOYMENT AGREEMENT PURPORTS TO REQUIRE AN EMPLOYEE TO ASSIGN AN INVENTION OTHERWISE EXCLUDED FROM BEING REQUIRED TO BE ASSIGNED UNDER CALIFORNIA LABOR CODE SECTION 2870(a), THE PROVISION IS AGAINST THE PUBLIC POLICY OF THIS STATE AND IS UNENFORCEABLE.

5.Assignment of Other Rights.  In addition to the foregoing assignment of Assigned Inventions to the Company, I hereby irrevocably transfer and assign to the Company:  (i) all worldwide patents, patent applications, copyrights, mask works, trade secrets and other intellectual property rights, including but not limited to rights in databases, in any Assigned Inventions, along with any registrations of or applications to register such rights; and (ii) any and all “Moral Rights” (as defined below) that I may have in or with respect to any Assigned Inventions.  I also hereby forever waive and agree never to assert any and all Moral Rights I may have in or with respect to any Assigned Inventions, even after termination of my work on behalf of the Company.  “Moral Rights” mean any rights to claim authorship of or credit on an Assigned Inventions, to object to or prevent the modification or destruction of any Assigned Inventions or Prior Inventions licensed to Company under Section 3, or to withdraw from circulation or control the publication or distribution of any Assigned Inventions or Prior Inventions licensed to Company under Section 3, and any similar right, existing under judicial or statutory law of any country or subdivision thereof in the world, or under any treaty, regardless of whether or not such right is denominated or generally referred to as a “moral right.”

6.Assistance.  I agree to assist the Company in every proper way to obtain for the Company and enforce patents, copyrights, mask work rights, trade secret rights and other legal protections for the Company’s Assigned Inventions in any and all countries.  I will execute any documents that the Company may reasonably request for use in obtaining or enforcing such patents, copyrights, mask work rights, trade secrets and other legal protections.  My obligations under this paragraph will continue beyond the termination of my employment with the Company, provided that the Company will compensate me at a reasonable rate after such termination for time or expenses actually spent by me at the Company’s request on such assistance.  I appoint the Secretary of the Company as my attorney-in-fact to execute documents on my behalf for this purpose.

7.Proprietary Information.  I understand that my employment by the Company creates a relationship of confidence and trust with respect to any information of a confidential or secret nature that may be disclosed to me by the Company or a third party that relates to the business of the Company or to the business of any parent, subsidiary, affiliate, customer or supplier of the Company or any other party with whom the Company agrees to hold information of such party in confidence (the “Proprietary Information”).  Such Proprietary Information includes, but is not limited to, Assigned Inventions, marketing plans, product plans, business strategies, financial information, forecasts, personnel information, customer lists and data, and domain names.

8.Confidentiality.  At all times, both during my employment and after its termination, I will keep and hold all such Proprietary Information in strict confidence and trust.  I will not use or disclose any Proprietary Information without the prior written consent of the Company, except as may be necessary to perform my duties as an employee of the Company for the benefit of the Company.  Upon termination of my employment with the Company, I will promptly deliver to the Company all documents and materials of any nature pertaining to my work with the Company and, upon Company request, will execute a document confirming my agreement to honor my responsibilities contained in this Agreement.  I will not take with me or retain any documents or materials or copies thereof containing any Proprietary Information.

9.No Breach of Prior Agreement.  I represent that my performance of all the terms of this Agreement and my duties as an employee of the Company will not breach any invention assignment, proprietary information, confidentiality or similar agreement with any former employer or other party.  I represent that I will not bring with me to the Company or use in the performance of my duties for the Company any documents or materials or intangibles of a former employer or third party that are not generally available to the public or have not been legally transferred to the Company.

10.Efforts; Duty Not to Compete.  I understand that my employment with the Company requires my undivided attention and effort during normal business hours.  While I am employed by the Company, I will not, without the Company’s express prior written consent, provide services to, or assist in any manner, any business or third party if such services or assistance would be in direct conflict with the Company’s business interests.

11.Notification.  I hereby authorize the Company to notify third parties, including, without limitation, customers and actual or potential employers, of the terms of this Agreement and my responsibilities hereunder.

12.Non-Solicitation of Employees/Consultants.  During my employment with the Company and for a period of one (1) year thereafter, I will not directly or indirectly solicit away employees or consultants of the Company for my own benefit or for the benefit of any other person or entity.

13.Non-Solicitation of Suppliers/Customers.  During my employment with the Company and after termination of my employment, I will not directly or indirectly solicit or take away suppliers or customers of the Company if the identity of the supplier or customer or information about the supplier or customer relationship is a trade secret or is otherwise deemed confidential information within the meaning of California law.

14.Name & Likeness Rights.  I hereby authorize the Company to use, reuse, and to grant others the right to use and reuse, my name, photograph, likeness (including caricature), voice, and biographical information, and any reproduction or simulation thereof, in any form of media or technology now known or hereafter developed (including, but not limited to, film, video and digital or other electronic media), both during and after my employment, for whatever purposes the Company deems necessary.

15.Injunctive Relief.  I understand that in the event of a breach or threatened breach of this Agreement by me the Company may suffer irreparable harm and will therefore be entitled to injunctive relief to enforce this Agreement.

16.Governing Law; Severability.  This Agreement will be governed by and construed in accordance with the laws of the State of California, without giving effect to its laws pertaining to conflict of laws.  If any provision of this Agreement is determined by any court or arbitrator of competent jurisdiction to be invalid, illegal or unenforceable in any respect, such provision will be enforced to the maximum extent possible given the intent of the parties hereto.  If such clause or provision cannot be so enforced, such provision shall be stricken from this Agreement and the remainder of this Agreement shall be enforced as if such invalid, illegal or unenforceable clause or provision had (to the extent not enforceable) never been contained in this Agreement.

17.Counterparts.  This Agreement may be executed in any number of counterparts, each of which when so executed and delivered will be deemed an original, and all of which together shall constitute one and the same agreement.

18.Entire Agreement.  This Agreement and the documents referred to herein constitute the entire agreement and understanding of the parties with respect to the subject matter of this Agreement, and supersede all prior understandings and agreements, whether oral or written, between or among the parties hereto with respect to the specific subject matter hereof.

19.Amendment and Waivers.  This Agreement may be amended only by a written agreement executed by each of the parties hereto.  No amendment of or waiver of, or modification of any obligation under this Agreement will be enforceable unless set forth in a writing signed by the party against which enforcement is sought.  Any amendment effected in accordance with this section will be binding upon all parties hereto and each of their respective successors and assigns.  No delay or failure to require performance of any provision of this Agreement shall constitute a waiver of that provision as to that or any other instance.  No waiver granted under this Agreement as to any one provision herein shall constitute a subsequent waiver of such provision or of any other provision herein, nor shall it constitute the waiver of any performance other than the actual performance specifically waived.

20.Successors and Assigns; Assignment.  Except as otherwise provided in this Agreement, this Agreement, and the rights and obligations of the parties hereunder, will be binding upon and inure to the benefit of their respective successors, assigns, heirs, executors, administrators and legal representatives.  The Company may assign any of its rights and obligations under this Agreement.  No other party to this Agreement may assign, whether voluntarily or by operation of law, any of its rights and obligations under this Agreement, except with the prior written consent of the Company.

21.Further Assurances.  The parties agree to execute such further documents and instruments and to take such further actions as may be reasonably necessary to carry out the purposes and intent of this Agreement.

22.“At Will” Employment.  I understand that this Agreement does not constitute a contract of employment or obligate the Company to employ me for any stated period of time.  I understand that I am an “at will” employee of the Company and that my employment can be terminated at any time, with or without notice and with or without cause, for any reason or for no reason, by either the Company or myself.  I acknowledge that any statements or representations to the contrary are ineffective, unless put into a writing signed by the Company.  I further acknowledge that my participation in any stock option or benefit program is not to be construed as any assurance of continuing employment for any particular period of time.  This Agreement shall be effective as of the first day of my employment by the Company, which is May 18, 2007.

SHUTTERFLY, INC.		Employee:
By:	/s/ Jeff Housenbold	/s/ Kathryn E. Olson
	Jeff Housenbold CEO & President	Kathryn E. Olson

Signature Page to Employee Invention Assignment and Confidentiality Agreement

APPENDIX A

California Labor Code Section 2870.  Application of provision providing that employee shall assign or offer to assign rights in invention to employer.

1.           Any provision in an employment agreement which provides that an employee shall assign, or offer to assign, any of his or her rights in an invention to his or her employer shall not apply to an invention that the employee developed entirely on his or her own time without using the employer’s equipment, supplies, facilities, or trade secret information except for those inventions that either:

(a)           Relate at the time of conception or reduction to practice of the invention to the employer’s business, or actual or demonstrably anticipated research or development of the employer; or

(b)           Result from any work performed by the employee for his employer.

2.           To the extent a provision in an employment agreement purports to require an employee to assign an invention otherwise excluded from being required to be assigned under paragraph 1, the provision is against the public policy of this state is unenforceable.

APPENDIX B

PRIOR MATTER

EX-10.20

Exhibit 10.20

Personal and Confidential

November 27, 2007

Mark J. Rubash

3392 Monte Sereno Terrace

Fremont, CA 94539

RE: Offer of Employment

Dear Mark:

Shutterfly, Inc. (the “Company” or “Shutterfly”) is pleased to offer you the opportunity to join Shutterfly. You are being offered a position as Senior Vice President, Chief Financial Officer reporting to me. If you decide to join us, then your anticipated start date will be November 29, 2007.

Compensation

Your annual base pay will be $280,000, less applicable taxes and withholdings. You will be paid semimonthly in accordance with the Company’s normal payroll procedure. Additionally, you will be eligible to participate in the Executive Bonus Plan to be approved by the Compensation Committee for 2008. Under the Executive Bonus Plan, it is anticipated that you will be eligible for a bonus of up to 30% of your base pay based upon you and the Company reaching certain performance goals.

Hire in Bonus

Shutterfly will provide you with a hire in bonus of $37,500, repayable on a pro-rata basis if you voluntarily terminate your employment with the Company within twelve (12) months from your actual employment start date.

Stock Option

Subject to the approval of the Company’s Board of Directors, you will be granted a stock option (the “Option”) to purchase 270,000 shares of the Company’s Common Stock, at an exercise price equal to the fair market value of the Common Stock on the date the Board grants your Option in accordance with the Board’s stock option grant procedures.  Since you will be an executive officer, our procedure provides for stock option grants only four times a year (on February 29, May 31, August 31 and November 30). Therefore, based on your anticipated start date above, the grant of your Option is anticipated to occur on November 30, 3007, and this is also anticipated to be your vesting start date.  Your Option will be subject to terms, conditions and restrictions similar to those contained in the Company’s 2006 Equity Incentive Plan (the “Plan”) and the execution of a stock option agreement adopted pursuant to such Plan.

Severance

After expiration of the Introductory Period (defined below), if your employment is involuntarily terminated without Cause (as defined below), then you will receive an amount (the “Severance”) equal to six (6) months salary (determined using the monthly rate in effect on the date of termination of your employment) which will be paid over the following six (6) months (subject to a six-month delay if such delay is required to avoid the penalty taxes that may otherwise be imposed by Section 409A of the Internal Revenue Code of 1986, as amended), provided you have executed, and not revoked, a general release of claims in favor of the Company (in a form prescribed by the Company) and returned all Company property.

“Cause” shall mean your (i) gross negligence or willful misconduct in the performance of your duties; (ii) commission of any act of fraud or material dishonesty with respect to the Company; (iii) conviction of, or plea of guilty or “no contest” to, a felony or a crime of moral turpitude or dishonesty; (iv) material breach of any proprietary information and inventions agreement with the Company, including the Employee Invention Assignment and Confidentiality Agreement attached to this letter as Exhibit A, or any other unauthorized use or disclosure of the Company’s confidential information or trade secrets; or (v) repeated failure to perform the duties reasonably assigned to you after receiving written notification of such failure and a reasonable opportunity to cure such failure which shall not be less than 30 days following such notice.

Change in Control Benefits

If the Company is subject to a Corporate Transaction (as defined in the Plan) and within the first six (6) months following such Corporate Transaction (1) you resign because either you are no longer the Chief Financial Officer of the Company or your role is materially diminished from your role immediately prior to such Corporate Transaction, (2) you resign because the Company’s corporate office at which you work is moved at least 50 miles from its location immediately prior to such Corporate Transaction or (3) your employment is terminated by the Company, or a successor corporation, other than for Cause (as defined above), then (A) you will receive the Severance (on the terms and conditions provided above) and (B) if the Option is assumed in the Corporate Transaction, on the date of such termination you shall vest in an additional number of shares as would have vested in the twelve (12) months following the date of such termination, and the Option shall remain exercisable for the applicable period specified in the stock option agreement (the Option’s vesting acceleration and the Severance are collectively referred to as the “Change in Control Benefits”).  Your receipt of the Change of Control Benefits is conditioned on you having first executed, and not revoked, a general release of claims in favor of the Company (in a form prescribed by the Company) and the return of all Company property.

Benefits

As an employee, you will also be eligible to receive certain employee benefits including medical and dental coverage. The medical, dental and vision coverage begin on your date of hire as an employee. Additionally, you are eligible to participate in the Company’s 401(k) plan. The Company reserves the right to revise or discontinue any or all of its benefit plans, at any time, in the Company’s sole discretion. Enclosed is some information on the Company benefit plans.

Holidays

Shutterfly generally observes twelve (12) paid holidays each calendar year. The holiday schedule may change at management’s discretion.

Paid Time Off

In order to allow you flexibility with your free time, the Company has a paid time off policy. You begin to accrue paid time off on your date of hire. You will accrue fifteen (15) days of paid time off per year for your first three (3) years of employment, subject to the paid time off policy.

Introductory Period

Your first ninety (90) days of work is known as an “Introductory Period”. This “getting acquainted” period gives the Company the opportunity to determine your ability to perform your job. It also provides you with the opportunity to determine if you are satisfied with the job and the Company.  Either you or the Company can terminate the employment relationship at any time during or after the Introductory Period, with or without Cause or advance notice.

Employment Eligibility Verification

For purposes of federal immigration law, you will be required to provide to the Company documentary evidence of your identity and eligibility for employment in the United States.  Such documentation must be provided to us within three (3) business days of your date of hire with the Company, or our employment relationship with you may be terminated.

Employment at Will

If you choose to accept this offer, your employment with the Company will be voluntarily entered into and will be for no specified period. As a result, you will be free to resign at any time, for any reason, as you deem appropriate. The Company will have a similar right and may terminate its employment relationship with you at any time, with or without Cause or advance notice.

Acceptance of Offer

To indicate your acceptance of the terms of this offer, please sign and date in the space provided below and return an executed copy to Shutterfly; 2800 Bridge Parkway; Redwood City, CA 94065; Attention: Human Resources or via Fax to (650) 610–5280 no later than November 29, 2007 after which this offer will expire. A duplicate original is enclosed for your records. In addition to this letter, your offer of employment is conditioned upon your: (1) completion and signing of the Shutterfly employment application; (2) successful completion of a background and reference check and (3) your signing of the Shutterfly Employee Invention Assignment and Confidentiality Agreement (and any other similar agreements relating to proprietary rights between you and the Company).

In the event of any dispute or claim relating to or arising out of your employment relationship with the Company, this agreement, or the termination of your employment with the Company for any reason (including, but not limited to, any claims of breach of contract, wrongful termination or age, sex, race, national origin, disability or other discrimination or harassment), all such disputes shall be fully, finally and exclusively resolved by binding arbitration conducted by JAMS under JAMS Employment Arbitration Rules and Procedures then in effect, which are available online at JAMS’ website at www.jamsadr.org You and the Company hereby waive your respective rights to have any such disputes or claims tried before a judge or jury.

This letter agreement, the Shutterfly Employee Invention Assignment and Confidentiality Agreement, the Plan and the stock option agreement for the Option constitute the entire agreement between you and the Company regarding the terms and conditions of your employment with the Company and together supersede any prior representations or agreements, whether written or oral. This letter, along with any agreements herein, may not be modified or amended except by a written agreement signed by the Chief Executive Officer of the Company.  If by November 29, 2007, we have not received a copy of this letter executed by you, then we will assume you have decided not to join the Company.

We look forward to your positive response and welcoming you to the Shutterfly team.

Sincerely,

/s/ Jeff Housenbold

Jeff Housenbold

CEO & President

Enclosures

Acknowledged and Agreed:

I agree to and accept employment with Shutterfly on the terms and conditions set forth in this agreement. I understand and agree that my employment with the Company is at-will.

Signature: /s/ Mark J. Rubash                                           Date:   November 27, 2007

  Mark J. Rubash

Exhibit A: Employee Invention Assignment and Confidentiality Agreement

EXHIBIT A

EMPLOYEE INVENTION ASSIGNMENT AND CONFIDENTIALITY AGREEMENT

In consideration of, and as a condition of my employment with Shutterfly, Inc., a Delaware corporation (the “Company”), I hereby represent to, and agree with the Company as follows:

1.Purpose of Agreement.  I understand that the Company is engaged in a continuous program of research, development, production and marketing in connection with its business and that it is critical for the Company to preserve and protect its “Proprietary Information” (as defined in Section 7 below), its rights in “Inventions” (as defined in Section 2 below) and in all related intellectual property rights.  Accordingly, I am entering into this Employee Invention Assignment and Confidentiality Agreement (this “Agreement”) as a condition of my employment with the Company, whether or not I am expected to create inventions of value for the Company.

2.Disclosure of Inventions.  I will promptly disclose in confidence to the Company all inventions, improvements, designs, original works of authorship, formulas, processes, compositions of matter, computer software programs, databases, mask works and trade secrets that I make or conceive or first reduce to practice or create, either alone or jointly with others, during the period of my employment, whether or not in the course of my employment, and whether or not patentable, copyrightable or protectable as trade secrets (the “Inventions”).

3.Work for Hire; Assignment of Inventions.  I acknowledge and agree that any copyrightable works prepared by me within the scope of my employment are “works for hire” under the Copyright Act and that the Company will be considered the author and owner of such copyrightable works.  I agree that all Inventions that (i) are developed using equipment, supplies, facilities or trade secrets of the Company, (ii) result from work performed by me for the Company, or (iii) relate to the Company’s business or current or anticipated research and development (the “Assigned Inventions”), will be the sole and exclusive property of the Company and are hereby irrevocably assigned by me to the Company.  Attached hereto as Exhibit A is a list describing all inventions, original works of authorship, developments and trade secrets which were made by me prior to the date of this Agreement, which belong to me and which are not assigned to the Company (“Prior Inventions”).  I acknowledge and agree that if I use any of my Prior Inventions in the scope of my employment, or include them in any product or service of the Company, I hereby grant to the Company a perpetual, irrevocable, nonexclusive, world-wide, royalty-free license to use, disclose, make, sell, copy, distribute, modify and create works based on, perform or display such Prior Inventions and to sublicense third parties with the same rights.

4.Labor Code Section 2870 Notice.  I have been notified and understand that the provisions of Sections 3 and 5 of this Agreement do not apply to any Assigned Invention that qualifies fully under the provisions of Section 2870 of the California Labor Code, which states as follows:

ANY PROVISION IN AN EMPLOYMENT AGREEMENT WHICH PROVIDES THAT AN EMPLOYEE SHALL ASSIGN, OR OFFER TO ASSIGN, ANY OF HIS OR HER RIGHTS IN AN INVENTION TO HIS OR HER EMPLOYER SHALL NOT APPLY TO AN INVENTION THAT THE EMPLOYEE DEVELOPED ENTIRELY ON HIS OR HER OWN TIME WITHOUT USING THE EMPLOYER’S EQUIPMENT, SUPPLIES, FACILITIES, OR TRADE SECRET INFORMATION EXCEPT FOR THOSE INVENTIONS THAT EITHER:  (1) RELATE AT THE TIME OF CONCEPTION OR REDUCTION TO PRACTICE OF THE INVENTION TO THE EMPLOYER’S BUSINESS, OR ACTUAL OR DEMONSTRABLY ANTICIPATED RESEARCH OR DEVELOPMENT OF THE EMPLOYER; OR (2) RESULT FROM ANY WORK PERFORMED BY THE EMPLOYEE FOR THE EMPLOYER.  TO THE EXTENT A PROVISION IN AN EMPLOYMENT AGREEMENT PURPORTS TO REQUIRE AN EMPLOYEE TO ASSIGN AN INVENTION OTHERWISE EXCLUDED FROM BEING REQUIRED TO BE ASSIGNED UNDER CALIFORNIA LABOR CODE SECTION 2870(a), THE PROVISION IS AGAINST THE PUBLIC POLICY OF THIS STATE AND IS UNENFORCEABLE.

5.Assignment of Other Rights.  In addition to the foregoing assignment of Assigned Inventions to the Company, I hereby irrevocably transfer and assign to the Company:  (i) all worldwide patents, patent applications, copyrights, mask works, trade secrets and other intellectual property rights, including but not limited to rights in databases, in any Assigned Inventions, along with any registrations of or applications to register such rights; and (ii) any and all “Moral Rights” (as defined below) that I may have in or with respect to any Assigned Inventions.  I also hereby forever waive and agree never to assert any and all Moral Rights I may have in or with respect to any Assigned Inventions, even after termination of my work on behalf of the Company.  “Moral Rights” mean any rights to claim authorship of or credit on an Assigned Inventions, to object to or prevent the modification or destruction of any Assigned Inventions or Prior Inventions licensed to Company under Section 3, or to withdraw from circulation or control the publication or distribution of any Assigned Inventions or Prior Inventions licensed to Company under Section 3, and any similar right, existing under judicial or statutory law of any country or subdivision thereof in the world, or under any treaty, regardless of whether or not such right is denominated or generally referred to as a “moral right.”

6.Assistance.  I agree to assist the Company in every proper way to obtain for the Company and enforce patents, copyrights, mask work rights, trade secret rights and other legal protections for the Company’s Assigned Inventions in any and all countries.  I will execute any documents that the Company may reasonably request for use in obtaining or enforcing such patents, copyrights, mask work rights, trade secrets and other legal protections.  My obligations under this paragraph will continue beyond the termination of my employment with the Company, provided that the Company will compensate me at a reasonable rate after such termination for time or expenses actually spent by me at the Company’s request on such assistance.  I appoint the Secretary of the Company as my attorney-in-fact to execute documents on my behalf for this purpose.

7.Proprietary Information.  I understand that my employment by the Company creates a relationship of confidence and trust with respect to any information of a confidential or secret nature that may be disclosed to me by the Company or a third party that relates to the business of the Company or to the business of any parent, subsidiary, affiliate, customer or supplier of the Company or any other party with whom the Company agrees to hold information of such party in confidence (the “Proprietary Information”).  Such Proprietary Information includes, but is not limited to, Assigned Inventions, marketing plans, product plans, business strategies, financial information, forecasts, personnel information, customer lists and data, and domain names.

8.Confidentiality.  At all times, both during my employment and after its termination, I will keep and hold all such Proprietary Information in strict confidence and trust.  I will not use or disclose any Proprietary Information without the prior written consent of the Company, except as may be necessary to perform my duties as an employee of the Company for the benefit of the Company.  Upon termination of my employment with the Company, I will promptly deliver to the Company all documents and materials of any nature pertaining to my work with the Company and, upon Company request, will execute a document confirming my agreement to honor my responsibilities contained in this Agreement.  I will not take with me or retain any documents or materials or copies thereof containing any Proprietary Information.

9.No Breach of Prior Agreement.  I represent that my performance of all the terms of this Agreement and my duties as an employee of the Company will not breach any invention assignment, proprietary information, confidentiality or similar agreement with any former employer or other party.  I represent that I will not bring with me to the Company or use in the performance of my duties for the Company any documents or materials or intangibles of a former employer or third party that are not generally available to the public or have not been legally transferred to the Company.

10.Efforts; Duty Not to Compete.  I understand that my employment with the Company requires my undivided attention and effort during normal business hours.  While I am employed by the Company, I will not, without the Company’s express prior written consent, provide services to, or assist in any manner, any business or third party if such services or assistance would be in direct conflict with the Company’s business interests.

11.Notification.  I hereby authorize the Company to notify third parties, including, without limitation, customers and actual or potential employers, of the terms of this Agreement and my responsibilities hereunder.

12.Non-Solicitation of Employees/Consultants.  During my employment with the Company and for a period of one (1) year thereafter, I will not directly or indirectly solicit away employees or consultants of the Company for my own benefit or for the benefit of any other person or entity.

13.Non-Solicitation of Suppliers/Customers.  During my employment with the Company and after termination of my employment, I will not directly or indirectly solicit or take away suppliers or customers of the Company if the identity of the supplier or customer or information about the supplier or customer relationship is a trade secret or is otherwise deemed confidential information within the meaning of California law.

14.Name & Likeness Rights.  I hereby authorize the Company to use, reuse, and to grant others the right to use and reuse, my name, photograph, likeness (including caricature), voice, and biographical information, and any reproduction or simulation thereof, in any form of media or technology now known or hereafter developed (including, but not limited to, film, video and digital or other electronic media), both during and after my employment, for whatever purposes the Company deems necessary.

15.Injunctive Relief.  I understand that in the event of a breach or threatened breach of this Agreement by me the Company may suffer irreparable harm and will therefore be entitled to injunctive relief to enforce this Agreement.

16.Governing Law; Severability.  This Agreement will be governed by and construed in accordance with the laws of the State of California, without giving effect to its laws pertaining to conflict of laws.  If any provision of this Agreement is determined by any court or arbitrator of competent jurisdiction to be invalid, illegal or unenforceable in any respect, such provision will be enforced to the maximum extent possible given the intent of the parties hereto.  If such clause or provision cannot be so enforced, such provision shall be stricken from this Agreement and the remainder of this Agreement shall be enforced as if such invalid, illegal or unenforceable clause or provision had (to the extent not enforceable) never been contained in this Agreement.

17.Counterparts.  This Agreement may be executed in any number of counterparts, each of which when so executed and delivered will be deemed an original, and all of which together shall constitute one and the same agreement.

18.Entire Agreement.  This Agreement and the documents referred to herein constitute the entire agreement and understanding of the parties with respect to the subject matter of this Agreement, and supersede all prior understandings and agreements, whether oral or written, between or among the parties hereto with respect to the specific subject matter hereof.

19.Amendment and Waivers.  This Agreement may be amended only by a written agreement executed by each of the parties hereto.  No amendment of or waiver of, or modification of any obligation under this Agreement will be enforceable unless set forth in a writing signed by the party against which enforcement is sought.  Any amendment effected in accordance with this section will be binding upon all parties hereto and each of their respective successors and assigns.  No delay or failure to require performance of any provision of this Agreement shall constitute a waiver of that provision as to that or any other instance.  No waiver granted under this Agreement as to any one provision herein shall constitute a subsequent waiver of such provision or of any other provision herein, nor shall it constitute the waiver of any performance other than the actual performance specifically waived.

20.Successors and Assigns; Assignment.  Except as otherwise provided in this Agreement, this Agreement, and the rights and obligations of the parties hereunder, will be binding upon and inure to the benefit of their respective successors, assigns, heirs, executors, administrators and legal representatives.  The Company may assign any of its rights and obligations under this Agreement.  No other party to this Agreement may assign, whether voluntarily or by operation of law, any of its rights and obligations under this Agreement, except with the prior written consent of the Company.

21.Further Assurances.  The parties agree to execute such further documents and instruments and to take such further actions as may be reasonably necessary to carry out the purposes and intent of this Agreement.

22.“At Will” Employment.  I understand that this Agreement does not constitute a contract of employment or obligate the Company to employ me for any stated period of time.  I understand that I am an “at will” employee of the Company and that my employment can be terminated at any time, with or without notice and with or without cause, for any reason or for no reason, by either the Company or myself.  I acknowledge that any statements or representations to the contrary are ineffective, unless put into a writing signed by the Company.  I further acknowledge that my participation in any stock option or benefit program is not to be construed as any assurance of continuing employment for any particular period of time.  This Agreement shall be effective as of the first day of my employment by the Company, which is [date].

SHUTTERFLY, INC.		Employee:
By:	/s/ Jeff Housenbold	/s/ Mark J. Rubash
	Jeff Housenbold CEO & President	Mark J. Rubash

Signature Page to Employee Invention Assignment and Confidentiality Agreement

APPENDIX A

California Labor Code Section 2870.  Application of provision providing that employee shall assign or offer to assign rights in invention to employer.

1.           Any provision in an employment agreement which provides that an employee shall assign, or offer to assign, any of his or her rights in an invention to his or her employer shall not apply to an invention that the employee developed entirely on his or her own time without using the employer’s equipment, supplies, facilities, or trade secret information except for those inventions that either:

(a)           Relate at the time of conception or reduction to practice of the invention to the employer’s business, or actual or demonstrably anticipated research or development of the employer; or

(b)           Result from any work performed by the employee for his employer.

2.           To the extent a provision in an employment agreement purports to require an employee to assign an invention otherwise excluded from being required to be assigned under paragraph 1, the provision is against the public policy of this state is unenforceable.

APPENDIX B

PRIOR MATTER

EX-10.21

Exhibit 10.21

SEPARATION AGREEMENT

AND GENERAL RELEASE OF CLAIMS

THIS SEPARATION AGREEMENT AND GENERAL RELEASE OF CLAIMS (“Agreement”) is entered into by and between Stephen E. Recht, his heirs, successors, assigns, agents or representatives of any kind (collectively, “Employee”) and Shutterfly, Inc., its officers, directors, stockholders, investors, assigns, attorneys, agents, independent contractors, employees, predecessors, successors, affiliates or other representatives of any kind (collectively, the “Company”).  This Agreement will become effective on the eighth day after it is signed by Employee (the “Effective Date”), provided that Employee has not revoked this Agreement (by written notice to Doug Appleton, Vice President, Legal at the Company) prior to that date in accordance with the revocation terms contained herein.

RECITALS

A.Employee is employed by the Company as its Chief Financial Officer pursuant to the terms of an offer letter dated June 23, 2004 (the “Offer Letter”).

B.Employee’s employment relationship with the Company shall be terminated without cause.

C.In accordance with the Offer Letter, Employee is entitled to certain severance benefits in exchange for signing this Agreement.  In addition, Employee shall be provided with additional severance benefits not set forth in the Offer Letter.

Accordingly, in consideration of the terms, conditions and covenants contained herein, the parties agree as follows:

1.Termination of Employment; Transition Period.  Employee’s employment relationship with the Company shall be terminated as of the earlier of (a) February 9, 2008, or (b) the date he enters into a working relationship as an employee, independent contractor, consultant, or other type of worker in exchange for compensation of any kind (the “Termination Date”), subject to the following provisions:

(a)Through the Termination Date, Employee will provide continued employment services to the Company to transition his work to the new Chief Financial Officer for the Company, as requested by the Company (the “Transition Period”).

(b)In the event Employee enters into a working relationship as an employee, independent contractor, consultant, or other type of worker in exchange for compensation of any kind during the Transition Period, he must notify the Company and the Termination Date will be as of the date of such notice.

2.Severance Benefits.  As of the Termination Date, Employee will be paid all final wages and accrued, unused paid time off that Employee earned during his employment with the Company through the Termination Date in accordance with applicable law.

In addition to these mandatory payments and benefits, upon the Termination Date (provided the Employee has not terminated this Agreement prior to February 9, 2008 and Employee is not in breach of this Agreement), Employee shall receive the following severance benefits:

(a)Severance payment.  A severance payment in the amount of Two Hundred Fifty Thousand Dollars ($250,000.00), which is equal to twelve (12) months’ pay at Employee’s final base pay rate,and less applicable withholding taxes and regular deductions, payable in a lump sum within three (3) days following the Termination Date, but no earlier than eight (8) days following Employee’s execution of this Agreement, provided that Employee has not revoked this Agreement.

(b)Accelerated Stock Vesting.  Employee shall vest in such additional number of shares as would have vested in the twelve (12) months following the Termination Date.

(c)Bonus.  In the event that the Company pays bonuses to the senior executive officers of the Company , and provided that Employee is providing satisfactory performance in accordance with this Agreement, Employee shall receive his year-end bonus payment pro-rata with the other senior executive officers, payable in a lump sum no later than three (3) days following the Termination Date, but no earlier than eight (8) days following Employee’s execution of this Agreement, provided that Employee has not revoked this Agreement.

(d)COBRA premiums.  If Employee is covered under the Company’s group health plan as of the Termination Date and he timely elects to continue his group coverage pursuant to federal/state law (COBRA), the Company will reimburse Employee upon submission of written proof of premium payment for six (6) months of the applicable COBRA premiums as COBRA is provided in accordance with the terms of the applicable plans and the law, beginning on the first of the month following Company’s receipt of Employee’s COBRA election notice until the earlier of (i) the date Employee becomes covered under another group or individual health plan, or (ii) the last day of the six-month period described herein.  Employee shall at all times be responsible for making his premium payments pursuant to COBRA in order to maintain such coverage, and the Company shall not be responsible for making any direct payments to any health care or insurance provider on behalf of Employee.

Employee further understands that the severance benefits set forth in Sections 2(a)-(d) above shall be provided contingent upon Employee’s execution of and compliance with the terms of this Agreement.  Employee understands and acknowledges that he shall not be entitled to any payments or benefits from the Company other than those expressly set forth in this Section 2, and that he would not be entitled to the payment and benefits set forth in Sections 2(a)-(d) above in the absence of signing this Agreement

3.General Release.

In consideration of the severance compensation and benefits to be paid to Employee pursuant to Section 2(a)-(d) above, Employee and his heirs, successors, assigns, agents or representatives of any kind fully release the Company, its officers, directors, stockholders, investors, assigns, attorneys, agents, independent contractors, employees, predecessors, successors, affiliates or other representatives of any kind (the “Released Parties”) of and from any and all claims, liabilities, obligations, demands, actions and causes of action, whether now known or unknown, that Employee now has, or at any other time had, or shall or may have against those Released Parties based upon or arising out of any matter, cause, fact, thing, act or omission whatsoever occurring or existing at any time up to and including the Effective Date of this Agreement.

This release includes specifically but not exclusively and without limiting the generality of the foregoing, any claims of breach of contract, wrongful termination, retaliation, fraud, defamation, infliction of emotional distress or discrimination based upon national origin, race, age, sex, sexual orientation, disability or other personal characteristic protected by state and federal law or any other form of discrimination or harassment under the Civil Rights Act of 1964, the Age Discrimination In Employment Act of 1967, as amended, the Older Workers Benefit Protection Act, the Americans with Disabilities Act, the Fair Employment and Housing Act, the California Labor Code or any other applicable state or federal law.  However, this Release is not intended to bar any claims that, by statute, may not be waived, such as claims for workers’ compensation benefits, unemployment insurance benefits, and any challenges to the validity of Employee’s release of claims under the Age Discrimination in Employment Act of 1967, as amended, as set forth in this Agreement.

Employee acknowledges that he has read section 1542 of the Civil Code of the State of California, which states in full:

A GENERAL RELEASE DOES NOT EXTEND TO CLAIMS WHICH THE CREDITOR DOES NOT KNOW OR SUSPECT TO EXIST IN HIS OR HER FAVOR AT THE TIME OF EXECUTING THE RELEASE, WHICH IF KNOWN BY HIM OR HER MUST HAVE MATERIALLY AFFECTED HIS OR HER SETTLEMENT WITH THE DEBTOR.

Notwithstanding Section 1542, Employee agrees that this Agreement shall act as a release of all past and future claims that may arise from or related to his employment or termination from employment with the Company, whether such claims are currently known or unknown, foreseen or unforeseen, contingent or absolute.  Employee intentionally and specifically waives any rights he may have under the provisions of Section 1542, as well as under any other statutes or common law principles of similar effect, and assumes full responsibility for any injuries, damages, losses or liabilities that he may hereafter incur with respect to such claims.

4.No Assignment or Transfer; No Voluntary Participation in Claims.  Employee represents and warrants that there has been no assignment or other transfer of any interest in any claim that he may have against the Company and agrees to indemnify and hold the Company harmless from any liabilities, claims, demands, damages, costs, expenses and attorneys’ fees incurred by the Company as a result of any assertion of assignment or transfer.

Employee agrees that he shall not voluntarily participate in any claim, action, complaint, or lawsuit considered or brought against the Company, and that he shall not encourage or solicit other persons or entities to consider or bring any claim, action, complaint, or lawsuit against the Company, at any time, now or in the future.  Nothing in this section shall prohibit Employee from responding to a valid subpoena or other order of a court or agency with appropriate jurisdiction to compel his response.

5.Review / Revocation Period.

(a)Employee acknowledges and agrees that (i) Employee has read and understands the terms of this Agreement; (ii) Employee has been advised in writing to consult with an attorney before executing this Agreement; (iii) that Employee has obtained and considered such legal counsel as Employee deems necessary; (iv) that Employee has been given up to twenty-one (21) days to consider whether or not to enter into this Agreement (although Employee may elect not to use the full 21-day period at Employee’s option); and (v) that by signing this Agreement, Employee acknowledges that Employee does so freely, knowingly, and voluntarily.

(b)This Agreement shall not become effective or enforceable until the eighth day after Employee signs this Agreement.  Employee may revokeEmployee’s acceptance of this Agreement within seven (7) days after the date Employee signs it.  Employee’s revocation must be in writing and received by Doug Appleton, Vice President, Legal at the Company by 5:00 p.m. Pacific Time on the seventh day following his execution of this Agreement in order to be effective.  If Employee does not revoke his acceptance within the seven (7) day period, Employee’s acceptance of this Agreement shall become binding and enforceable on the Effective Date and the benefits described above shall become due and payable in accordance with Section 2.

6.Confidentiality.

(a)Employee acknowledges and agrees that he shall continue to be bound by and comply with the terms of the proprietary rights, assignment of inventions and/or confidentiality agreements between the Company and Employee.

(b)Employee agrees that he shall not directly or indirectly disclose any of the terms of this Agreement to anyone other than his immediate family, financial advisors or legal counsel, except as such disclosure may be required for accounting or tax reporting purposes or as otherwise may be required by law.

(c) Employee understands and agrees that he may not use or disclose the Company’s confidential and proprietary business information learned in the course of his employment with the Company for his own benefit or for the benefit of any other person or entity.

7.Return of Employer Property.  On or before the Termination Date, Employee will return to the Company, in good working condition, all Company property and equipment that is in Employee’s possession or control, including, but not limited to, any files, records, computers, computer equipment, passwords, cell phones, credit cards, keys, programs, manuals, business plans, financial records, and all documents (and any copies thereof) that Employee prepared or received in the course of his employment with the Company.

8.Non-Disparagement; No Defamation.  Company and Employee agree that they will not, at any time in the future, make any critical or disparaging statements about the other (in the case of Employee, he shall not disparage the Company, its products, services, employees or other agents or representatives), unless such statements are made truthfully in response to a subpoena or other legal process.

9.Nonsolicitation of Employees and Customers.  Employee agrees that for a period of one (1) year following the Termination Date, he will not, either on his own behalf or on behalf of another person or entity, by using or disclosing the trade secrets or confidential, proprietary, or business information of the Company: (a) solicit or take away employees, independent contractors or consultants of the Company for the purpose of hiring them or encouraging them to refrain from working for the Company; or (b) solicit or take away suppliers or customers of the Company or encourage them to refrain from doing business with the Company.  Notwithstanding the foregoing, nothing prevents Employee from soliciting business from any supplier or customer of the Company that is unrelated to the business conducted by the Company.

10.Attorney’s Fees.  In the event of any legal action relating to or arising out of this Agreement, the prevailing party shall be entitled to recover from the losing party its attorneys’ fees and costs incurred in that action.

11.No Admission of Liability.  Employee and the Company understand and acknowledge that this Agreement constitutes a compromise and settlement of disputed claims.  No action taken by the parties hereto, or either of them, either previously or in connection with this Agreement, shall be deemed or construed to be (a) an admission of truth or falsity of any claims heretofore made or (b) an acknowledgement or admission by either Party of any fault or liability whatsoever to the other party or to any third party.

12.Consult with Attorney.  Each party represents that it has been advised of his or its right to consult with an attorney and to seek legal representation of his or its choosing in the execution of this Agreement, and has carefully read and understands the scope and effect of the provisions of this Agreement.  Neither party has relied upon any representations or statements made by the other party hereto which are not specifically set forth in this Agreement.

13.Miscellaneous.  This Agreement constitutes the entire agreement between the parties with respect to the subject matter hereof and supersedes all prior negotiations and agreements, whether written or oral, with the exception of any stock option agreements between the parties and any agreements described in Section 6(a) herein.  This Agreement may be modified or amended only with the written consent of Employee and an authorized officer of the Company, provided, however, that the Company may amend or modify this Agreement in order to comply with the provisions of Section 409A of the Internal Revenue Code, to the extent applicable.  No oral waiver, amendment or modification will be effective under any circumstances whatsoever.

EMPLOYEE UNDERSTANDS THAT HE SHOULD CONSULT WITH AN ATTORNEY PRIOR TO SIGNING THIS AGREEMENT AND THAT HE IS GIVING UP ANY LEGAL CLAIMS HE HAS AGAINST THE PARTIES RELEASED ABOVE BY SIGNING THIS AGREEMENT.  EMPLOYEE ACKNOWLEDGES THAT HE IS SIGNING THIS AGREEMENT KNOWINGLY, WILLINGLY AND VOLUNTARILY IN EXCHANGE FOR THE BENEFITS DESCRIBED HEREIN.

Dated:  December 10, 2007	By: /s/ Stephen E. Recht  Stephen E. Recht
Dated:  December 10, 2007	SHUTTERFLY, INC. By: /s/ Jeff Housenbold  Jeff Housenbold, President & CEO

EX-10.22

Exhibit 10.22

LEASE AGREEMENT

BY AND BETWEEN

3915 SHOPTON ROAD, LLC

(AS LANDLORD)

AND

SHUTTERFLY, INC.

(AS TENANT)

LEASE AGREEMENT

THIS LEASE AGREEMENT (the “Lease”) made and entered into as of the 22nd day of December, 2006 (the “Lease Date”), by and between

3915 SHOPTON ROAD, LLC, a North Carolina limited liability company

hereinafter called “Landlord”; and

SHUTTERFLY, Inc., a Delaware corporation

hereinafter called “Tenant”:

W I T N E S S E T H:

In consideration of the mutual covenants and agreements contained herein, the parties hereto agree for themselves, their successors and assigns, as follows:

1.           DESCRIPTION OF PREMISES.  Landlord hereby leases to Tenant, and Tenant hereby accepts and rents from Landlord, that certain office/warehouse space (the “Premises”) containing approximately 102,400 rentable square feet located in the building known as 18-B (the “Building”) in Shopton Ridge Business Park (the “Business Park”), Charlotte, North Carolina, said Building being located on a parcel of real property more particularly described on Exhibit ”A” attached hereto.  For purposes of this Lease, Tenant’s “proportionate share” shall be one hundred percent (100%).

2.           TERM.  Unless otherwise adjusted as hereinbelow provided, the term of this Lease shall commence on the later to occur of April 30, 2007 or upon substantial completion of Landlord’s Work (the “Commencement Date”) and shall end at midnight on the date (the “Expiration Date”) which is the last day of the eighty-ninth (89th) month after the Commencement Date (as same may be adjusted as hereinbelow provided).  As used herein, the term “Lease Year” shall mean each consecutive twelve-month period of the Lease term, beginning with the Commencement Date (as same may be adjusted as hereinbelow provided) or any anniversary thereof.  Within five (5) days following the Commencement Date, Tenant shall execute and deliver to Landlord duplicate originals of a written agreement in the form attached to this Lease as Exhibit F.

3.           RENTAL.  During the full term of this Lease, Tenant shall pay to Landlord, without notice, demand, reduction (except as may be applicable pursuant to paragraph 13 or paragraph 19 herein or as otherwise provided in this Lease), setoff or any defense, a total rental (the “Annual Rental”) consisting of the sum total of the following:

(a)           Minimum Rental.  Commencing on the first day of the ninth (9th) month following the Commencement Date(the “Rent Commencement Date”), as the same may be adjusted pursuant to the last sentence of Section 4 hereof, and continuing through the remainder of the initial eighty-nine (89) month term of this Lease, Tenant shall pay an annual minimum rental (the “Minimum Rental”) equal to Six and 48/100 Dollars ($6.48) per rentable square foot of space in the Premises during Lease Year 1, increasing every year thereafter during the term at a rate of three percent (3%),  based on 102,400 square feet, including the “free Annual Rent”, as set forth below.  If the actual square footage of the Premises, as determined by Landlord’s architect and certified to Landlord and Tenant, shall be greater or lesser than 102,400 square feet based on the final as-built square footage after completion of the Improvements described on Exhibit ”C” to this Lease, then the Minimum Rental shall be adjusted based on the actual square footage of the Premises.  The Minimum Rental shall be payable in equal monthly installments, each in advance on or before the first day of each month.  If the Rent Commencement Date is a date other than the first day of a calendar month, the Minimum Rental shall be prorated daily from such date to the first day of the next calendar month and paid on the Rent Commencement Date.

Period	80,000 SF Space Annual Rent	22,400 SF Space Annual Rent	Total Space Annual Amount
Months 1-8	FREE	FREE	FREE
Months 9-13	$216,000.00	FREE	$216,000.00
Months 14-20	$302,400.00	$84,672.00	$387,072.00
Months 21-32	$533,600.00	$149,408.00	$683,008.00
Months 33-44	$549,600.00	$153,888.00	$703,488.00
Months 45-56	$565,600.00	$158,368.00	$723,968.00
Months 57-68	$582,400.00	$163,072.00	$745,472.00
Months 69-80	$599,200.00	$167,776.00	$766,976.00
Months 81-89	$462,600.00	129,528.00	$592,128.00

(b)           Tenant’s Share of Taxes.  Subject to the terms set forth in Section 3(j) below, Tenant shall pay an amount equal to Tenant’s “proportionate share” of ad valorem taxes (or any tax hereafter imposed in lieu thereof) with respect to the Building and the Business Park.  Tenant’s share of taxes shall be paid as provided in subparagraph (e) below.  Provided, any increase in ad valorem taxes on the Premises as a result of alterations, additions or improvements made by, for or on account of Tenant shall be reimbursed by Tenant to Landlord as Additional Rent (as defined below) within thirty (30) days after receipt of written demand therefor.

(c)           Tenant’s Share of Insurance Premiums.  Subject to the terms set forth in Section 3(j) below, Tenant shall pay an amount equal to Tenant’s “proportionate share” of premiums charged for fire and extended coverage and liability insurance with all endorsements carried by Landlord on the Building payable for any calendar year (including any applicable partial calendar year).  Tenant’s proportionate share of premiums shall be paid as provided in subparagraph (e) below.

(d)           Tenant’s Share of Common Area Operating and Maintenance Costs.  Subject to the terms set forth in Section 3(j) below, Tenant shall pay an amount equal to Tenant’s “proportionate share” of the reasonable costs for operating and maintaining the Building’s common areas, including, but not limited to, the cost of grass mowing, shrub care and general landscaping, irrigation systems, maintenance and repair to parking and loading areas, driveways, sidewalks, exterior lighting, garbage collection and disposal, common water and sewer, common plumbing, common signs and other facilities shared by the various tenants in the Building, the administrative costs associated therewith including management fees, which shall be capped at 3% of the Minimal Rental actually collected by Landlord from the Building during the initial term and any subsequent renewal period(s), and of the Building’s share of the common area operating and maintenance costs for the entire Business Park.  Landlord shall use good faith efforts to keep the operating and maintenance costs in line with costs for other similarly situated business centers.  Tenant’s proportionate share shall be paid as provided in subparagraph (e) below.  Notwithstanding any term, covenant or condition as set forth in this Lease, costs for operating and maintaining the Building’s common areas and the Business Park’s common areas (but only during such time as Landlord and/or its affiliate own a majority of the Business Park and control the operation of the Business Park) shall specifically exclude the following:

(i) replacement of capital items (unless amortized over the useful life of such item according to normal accounting procedures (a) but only to the extent that such replacements reduce other direct expenses and are made after the Commencement Date or (b) for replacements that are required under any governmental law or regulation that was not applicable to the Building as of the Commencement Date).

(ii) financing and refinancing costs and principal and interest payments on mortgages and deeds of trust,

(iii) costs and expenses covered by insurance,

(iv) Landlord's insurance deductible,

(v) depreciation,

(vi) above market payments made to affiliates of Landlord, inside or related contractors and executives,

(vii) income, profit, franchise, rent, sales, gift, estate, succession, inheritance, foreign ownership, foreign control, transfer, capital levy, and/or personal property taxes payable by Landlord,

(viii) any and all costs of Landlord for any clean-up, remediation, environmental surveys/assessments, compliance with environmental laws, consulting fees, treatment and monitoring charges, transportation expenses and disposal fees, etc., and

(ix) rent under any ground or underlying lease.

(e)           Payment of Proportionate Share.  Subject to the terms set forth in Section 3(j) below, Tenant shall pay to Landlord each month, along with Tenant’s installments of Minimum Rental a sum equal to one-twelfth (1/12) of the amount estimated by Landlord (in its reasonable discretion) as Tenant’s proportionate share of the taxes, insurance premiums and common area maintenance costs for each calendar year during the Lease term (such amounts, together with any other sums payable by Tenant to Landlord hereunder other than Minimum Rental being referred to as “Additional Rent”).  Landlord will provide Tenant with Landlord’s estimate of Tenant’s proportionate share of taxes, insurance premiums and common area operating and maintenance expenses amount for the year this Lease commences within sixty (60) days after the Rent Commencement Date and for each future upcoming calendar year on or before December 31 of each calendar year during the term hereof.  If Landlord fails to notify Tenant of Tenant’s revised proportionate share amount by such date, Tenant shall continue to pay the monthly installments of the proportionate share amount last payable by Tenant until notified by Landlord of such new estimated amount.  No later than April 30 of each calendar year of the term, Landlord shall deliver to Tenant a written statement setting forth the actual amount of Tenant’s proportionate share for taxes, insurance premiums and all common area operating and maintenance costs for the preceding calendar year.  Tenant shall pay the total amount of any balance due shown on such statement within thirty (30) days after its delivery.  In the event such annual costs and increases decrease for any such year, Landlord shall, at its sole election, either reimburse Tenant for any overage paid within ten (10) days after delivery of such statement, or apply the overage against the monthly installment(s) of any Annual Rental next due from Tenant until such overage has been recovered by Tenant.  For the calendar year in which this Lease commences, Tenant’s proportionate share shall be prorated from the Commencement Date through December 31 of such year.  Further, Tenant shall be responsible for the payment of Tenant’s proportionate share of taxes, insurance premiums and common area operating and maintenance costs for the calendar year in which this Lease term expires, prorated from January 1 thereof through the Expiration Date.  Upon the Expiration Date, Tenant shall pay any unpaid estimated proportionate shares within thirty (30) days after the Expiration Date, which estimate shall be made by Landlord based upon actual and estimated costs for such year.

(f)           Tenant’s Share of Mechanical Maintenance and Inspection Costs.  Pursuant to Paragraph 10 herein, Tenant shall be responsible, at its sole cost, for routine mechanical maintenance and inspection services to the heating, ventilation and air conditioning (“HVAC”) equipment supplying the Premises.

(g)             Intentionally deleted.

(h)           Late Payment.  If any monthly installment of Minimum Rental, Additional Rent (if any) or any other sum due and payable pursuant to this Lease remains due and unpaid ten (10) days after said amount becomes due, Tenant shall pay as Additional Rent hereunder a late payment charge of a sum equal to five percent (5%) of the unpaid rent or other payment (“Late Charge”).  All unpaid rent and other sums of whatever nature owed by Tenant to Landlord under this Lease shall bear interest from the fifteenth (15th) day after the due date thereof until paid at the lesser of fifteen percent (15%) per annum or the maximum interest rate per annum allowed by law (“Interest Charge”).  Acceptance by Landlord of any payment from Tenant hereunder in an amount less than that which is currently due shall in no way affect Landlord’s rights under this Lease and shall in no way constitute an accord and satisfaction.  Notwithstanding the foregoing, for the first two late payments by Tenant in any Lease Year, Tenant shall have five (5) days from receipt of written notice from Landlord to make such late payment before such Late Charge and Interest Charge shall apply.

(i)           Audit.  Tenant shall have the right, from time to time, to audit Landlord’s books and records as they relate to any costs and expenses for which Tenant is responsible under this Lease during the previous calendar year of the Lease term.  Any such audit shall be conducted during Landlord’s regular business hours at the offices of Landlord where such records are kept utilizing an independent third party (which shall be the same entity that Tenant uses for similar auditing functions for other building(s) owned or leased by Tenant) designated by Tenant, on a non-contingency basis.  In the event any such audit reveals that the costs and expenses for which Tenant has paid Tenant’s proportionate share of such costs relative to any audit period exceed actual costs and expenses for which Tenant is responsible for paying its proportionate share, either: (i) Landlord shall credit or refund any overpayment to Tenant within thirty (30) days of such audit report; or (ii) Tenant shall pay to Landlord any underpayment within thirty (30) days of such audit report, as applicable.  All costs and expenses of any such audit shall be paid by Tenant, unless such audit discloses a discrepancy in the amount of five percent (5%) or more in which case Landlord shall pay for such audit, up to a maximum amount of $5,000.  Tenant may perform such an audit no more than once each calendar year during the Lease term and Tenant shall maintain all information reviewed during such audit in a confidential manner, only disclosing such information to Tenant’s accountants, legal counsel, officers and managers.  Tenant’s right to audit shall in no way relieve Tenant’s obligations to pay Common Area Expenses due to Landlord within thirty (30) days after receipt of an invoice therefor.

(j)           Controllable Operating Expenses Cap.  In no event shall Tenant’s Controllable Operating Expenses, as defined in herein, for any calendar year from and after 2008 exceed the Controllable Operating Expenses Cap.  As used herein, the term “Controllable Operating Expenses Cap” shall mean: (i) relative to the calendar year 2008, the amount obtained by multiplying the amount of Controllable Operating Expenses for calendar year 2007 by 1.05; and (ii) relative to each calendar year subsequent to calendar year 2008, the amount obtained by multiplying the Controllable Operating Expenses Cap for the previous calendar year by 1.05.  “Controllable Operating Expenses” shall mean all operating and maintenance costs chargeable pursuant to this Lease other than: (i) property taxes, including but not limited to, personal and ad valorem taxes; (ii) cost of all insurance coverage for the Building and the common areas, including, but not limited to, the cost of fire, casualty, rental abatement, boiler and machinery, worker’s compensation and liability insurance applicable to the Building and the common areas and Landlord’s personal property used in connection therewith; (iii) all charges for gas, water, sewerage service, electricity and other utilities furnished to the Building and the common areas; (iv) ice and snow removal; and (v) the Building’s proportionate share of any and all assessments and other charges payable by Landlord relative to the Business Park under the terms of any applicable restrictive covenants, agreements or similar documents.

4.           DELIVERY OF POSSESSION.  Landlord will deliver the Premises to Tenant on the Commencement Date, with Landlord’s Work (as defined in Paragraph 1 of Exhibit ”C” attached hereto) substantially completed in accordance with the Final Plans and Specifications (as defined in paragraph 1 of said Exhibit ”C”), subject to revisions as mutually agreed to in writing by Landlord and Tenant, as evidenced, if requested by Tenant, by the certification of Landlord’s architect or other designated engineering  representative.  Tenant shall be given access to the Premises upon written request to Landlord not more than sixty (60) days prior to the Commencement Date, for the purposes of preparing the Premises for Tenant’s use.  With the exception of any Annual Rental payments due, all terms and conditions of this Lease shall apply to Tenant upon such occupancy.  Tenant shall coordinate such occupancy with Landlord and shall not interfere with Landlord’s completion of Landlord’s Work.  If Landlord for any reason whatsoever cannot substantially complete Landlord’s Work and deliver possession of the Premises to Tenant on the Commencement Date as above specified, this Lease shall not be void or voidable nor shall Landlord be liable to Tenant for any loss or damage resulting therefrom; but in that event  (except to the extent that any such delay(s) has been caused by Tenant or its agent(s), employee(s), contractor(s) or subcontractor(s) (collectively, “Tenant Delay Factors”), and provided that in each such instance Landlord first gives Tenant written notice that if Tenant does not so cure its act or omission within two (2) business days the same will thereafter be considered a Tenant Delay Factor, the Commencement Date shall be adjusted to be the date when Landlord does in fact substantially complete Landlord’s Work and deliver possession of the Premises to Tenant.  Notwithstanding anything herein to the contrary, in the event Landlord’s Work is not complete by the date which is one hundred twenty (120) days after the later to occur of: (i) waiver or expiration of the Contingency (as defined in Section 7 of Exhibit “E” hereof); and (ii) approval by Landlord and Tenant of space plans and construction drawings for the Premises (such date referred to herein as the “Delivery Date”), except for reasons of Tenant Delay Factors or force majeure, which force majeure delays shall only be extended by up to 45 days, Tenant shall be granted three (3) days of free Minimal Rental for every day beyond the Delivery Date until Landlord’s Work has been complete, and the Rent Commencement Date shall be adjusted accordingly.  In the event Landlord is unable to deliver the Premises by September 30, 2007, Tenant may terminate this Lease with no further obligation by providing Landlord written notice on or before October 10, 2007.

5.           ALTERATIONS AND IMPROVEMENTS BY TENANT.

(a)           Tenant shall make no structural changes respecting the Premises or the Building and shall make no changes of any kind respecting the Premises or the Building that are visible from the exterior of the Premises or the Building, without Landlord’s approval, which shall not be unreasonably withheld.  Any interior nonstructural changes or other alterations, additions, or improvements to the Premises costing in excess of $20,000 in any single instance shall be made by or on behalf of Tenant only with the prior written consent of Landlord, which consent shall not be unreasonably withheld or delayed. Prior to any such consent by Landlord, Tenant shall submit to Landlord reasonably detailed plans and specifications covering the proposed work.  If Landlord notifies Tenant of any objections to the proposed alterations, Tenant must (i) revise the plans and specifications to the extent reasonably necessary to secure the Landlord’s approval and (ii) submit such revised plans and specifications for Landlord’s approval.  Tenant shall thereafter have the alterations performed in accordance with the approved plans and specifications.  After completion, Tenant shall deliver to Landlord an “as-built” set of plans and specifications.

(b)           Tenant shall not permit any lien or claim of lien against the Premises to exist or come into being as a result of any construction work performed on behalf of or at the direction of Tenant at the Premises and Tenant shall bond off or release of record any lien within thirty (30) days of being filed against the Premises.  Tenant is not Landlord’s agent or nominee in connection with any construction activities performed by or for Tenant on the Premises and Landlord shall not be liable for the contracts or liabilities of Tenant.  Tenant agrees that any damage to the Premises caused by Tenant’s construction work shall be repaired at Tenant’s sole cost and expense.  No later than thirty (30) days after completion of any work in the Premises by Tenant (including, but not limited to, the addition of equipment, cables or any material that must be inspected), Tenant shall provide to Landlord (i) an affidavit from the general contractor performing the work that same has been substantially completed in accordance with the approved plans and specifications and that all mechanics and materialmen in connection therewith have been paid in full; (ii) a waiver of lien with respect to such construction work executed by the general contractor and each subcontractor, except as to any contractor for which Tenant has obtained a bond to pay any claims by such persons; and (iii) a certificate of occupancy from the applicable governmental authorities, if required, evidencing completion of such work in accordance all applicable laws, codes and ordinances.  In the event a certificate of occupancy cannot be obtained for the Premises due to any action or inaction by Tenant, Tenant shall be in default hereunder and must immediately comply with any and all requirements to obtain a certificate of occupancy.

(c)           All alterations, additions or improvements (collectively, “Alterations”), including without limitation all partitions, walls, railings, carpeting, floor and wall coverings and other fixtures (excluding, however, Tenant’s trade fixtures as described in the paragraph entitled “Trade Fixtures and Equipment” below) made by, for, or at the direction of Tenant shall, at the expiration or earlier termination of this Lease, become the property of Landlord, , and shall remain upon the Premises at the expiration or earlier termination of this Lease, provided, however, that Tenant shall have the right (but not the obligation) to remove all Alterations and other items in the Premises or the Building (such as chillers and generators), except that Tenant shall be obligated to remove those Alterations which Landlord designates in writing for removal at the time Landlord grants its consent to such Alterations.   Tenant shall repair any damage caused to the Premises by said removal of Alterations.

6.           USE OF PREMISES.

(a)           Tenant shall use the Premises only for manufacturing, warehousing and distribution, general office, data center and ancillary uses, and for any other legal purpose.  Tenant shall comply with all laws, ordinances, orders, regulations or zoning classifications of any lawful governmental authority, agency or other public or private regulatory authority (including insurance underwriters or rating bureaus) having jurisdiction over the Premises (collectively, “Legal Requirements”) to the extent made necessary by reason of Tenant’s particular use or occupancy of the Premises.  Tenant shall not do any act or follow any practice relating to the Premises which shall constitute a nuisance or detract in any way from the reputation of the Building.  Tenant’s duties in this regard shall include allowing no noxious or offensive odors, fumes, gases, smoke, dust, steam or vapors, or any loud or disturbing noise or vibrations to originate in or emit from the Premises in excess of  what is commercially reasonable.

(b)           Without limiting the generality of (a) above, and excepting only office supplies and cleaning materials used by Tenant in its ordinary day to day business operations (but not held for sale, storage or distribution) customarily used in facilities such as the Building, and then only to the extent same are used, stored (but not any bulk storage), transported, and disposed of strictly in accordance with all applicable laws, regulations and manufacturer’s recommendations), the Premises shall not be used for the treatment, storage, transportation to or from, use or disposal of toxic or hazardous wastes, materials, or substances, or any other substance that is prohibited, limited or regulated by any governmental or quasi-governmental authority or that, even if not so regulated, could or does pose a hazard to health and safety of the occupants of the Building or surrounding property except for chemicals and other substances used in connection with Tenant’s photo-developing and merchandising processes and services provided such chemicals and other substances are brought into the Premises, used, stored and disposed of in accordance with all Legal Requirements and Environmental Laws.

(c)           Landlord hereby represents and warrants to Tenant that as of the Commencement Date, the Premises and Building shall be in compliance with all applicable Legal Requirements, including without limitation, Environmental Laws (as hereinafter defined).

(d)           Tenant has previously been furnished with a copy of any applicable restrictive covenants relating to the Building and the Business Park, and Tenant shall abide by these restrictions in connection with its use of the Premises.

(e)           Tenant shall exercise due care in its use and occupancy of the Premises and shall not commit or allow waste to be committed on any portion of the Premises; and at the expiration or earlier termination of this Lease, Tenant shall deliver the Premises to Landlord in as good condition as same were on the date of completion of the Improvements in the Premises or were thereafter placed by Landlord or Tenant, ordinary wear and tear, condemnation, fire or other casualty and acts of God and the elements alone excepted.

(f)           Tenant shall save Landlord harmless from any claims, liabilities, penalties, fines, costs, expenses or damages resulting from the failure of Tenant to comply with the provisions of this paragraph 6.  This indemnification shall survive the termination or expiration of this Lease.

7.           TAXES.

(a)           Tenant shall pay any taxes, documentary stamps or assessments of any nature imposed or assessed upon Tenant’s trade fixtures, equipment, machinery, inventory, merchandise or other personal property located on the Premises and owned by or in the custody of Tenant as promptly as all such taxes or assessments may become due and payable without any delinquency.  Tenant shall provide Landlord with copies of all paid receipts respecting such tax or charge upon request by Landlord.

(b)           Landlord shall pay, subject to reimbursement from Tenant as provided in paragraph 3 herein, all ad valorem property taxes which are now or hereafter assessed upon the Building and the Premises, except as otherwise expressly provided in this Lease.

8.           FIRE AND EXTENDED COVERAGE INSURANCE.  Landlord shall maintain and pay for fire insurance, with extended coverage, covering the Building equal to at least one hundred percent (100%) of the replacement cost thereof.  Tenant shall not do or cause to be done or permit on the Premises or in the Building anything deemed extrahazardous on account of fire and Tenant shall not use the Premises or the Building in any manner which will cause an increase in the premium rate for any insurance in effect on the Building or a part thereof.  If, because of anything done, caused to be done, permitted or omitted by Tenant or its agent(s), contractor(s), employee(s), invitee(s), licenses(s), servant(s) subcontractor(s) or subtenant(s) the premium rate for any kind of insurance in effect on the Building or any part thereof shall be raised, Tenant shall pay Landlord on demand the amount of any such increase in premium which Landlord shall pay for such insurance and if Landlord shall demand that Tenant remedy the condition which caused any such increase in an insurance premium rate, Tenant shall remedy such condition within five (5) days after receipt of such demand.  Tenant shall maintain and pay for all fire and extended coverage insurance on its contents in the Premises, including trade fixtures, equipment, machinery, merchandise or other personal property belonging to or in the custody of Tenant.

9.           LANDLORD’S COVENANT TO REPAIR AND REPLACE.

(a)           During the term of this Lease, Landlord shall be responsible only for repairs or replacements, at its sole cost and expense, to the roof, exterior walls, floor slab, structural members (including foundation and subflooring of the Premises) and for the central plumbing and electrical systems serving the entire Building up to the respective applicable points of entry of same into the Premises.  Landlord’s repairs and replacements shall be made within a reasonable time.  If the need for such repairs or replacements is the result of the negligence, misconduct or intentional acts or omissions of Tenant, its agent(s), contractor(s), employee(s), invitee(s), licensee(s), servant(s), subcontractor(s) or subtenant(s) and the expense of such repairs or replacements are not fully covered and paid by Landlord’s insurance, then Tenant shall pay Landlord the full amount of expenses not covered.  Landlord’s duty to repair or replace as prescribed in this paragraph shall be Tenant’s sole remedy and shall be in lieu of all other warranties or guaranties of Landlord, express or implied.

(b)           Landlord shall not be liable for any failure to make any repairs or to perform any maintenance required of Landlord hereunder unless such failure shall persist for thirty (30) days (except in case of emergency) after written notice from Tenant setting forth the need for such repair(s) or replacement(s) in reasonable detail has been received by Landlord.  Except as set forth in the paragraph of this Lease, entitled “Damage or Destruction of Premises” or elsewhere in this Lease, there shall be no abatement of rent.  There shall be no liability of Landlord by reason of any injury to or interference with Tenant’s business arising from the making of any repairs, replacements, alterations or improvements to any portion of the Building or the Premises, or to fixtures, appurtenances and equipment therein, provided that Landlord uses reasonable efforts to minimize interference with Tenant’s use and occupancy of the Premises.  In the event of any failure by Landlord to perform any of its obligations hereunder, Tenant (except in the case of an emergency) shall take no action without having first given Landlord thirty (30) days written notice of any such default.  Following such notice and failure by Landlord to cure, Tenant shall have the right to take the necessary actions to perform Landlord's uncured obligations hereunder and invoice Landlord for the actual and reasonable costs and expenses thereof, unless Landlord has diligently commenced to perform its uncured obligations hereunder within said thirty (30) day period.  Landlord shall remit payment to Tenant within thirty (30) days of receipt of a paid invoice and applicable lien waivers from Tenant.  If Landlord fails to remit payment to Tenant within the aforesaid thirty (30) day period, Tenant shall have the right to offset and deduct such sum; such offset not to exceed twenty-five percent (25%) of Minimum Rental for each month until Tenant is made whole.

10.           TENANT’S COVENANT TO REPAIR.  Tenant shall be responsible for the repair, replacement and maintenance in good order and condition of all parts and components of the Premises, other than those specified for repair, replacement and maintenance by Landlord above, including without limitation the plumbing, wiring, electrical systems, HVAC system (subject to the provisions below), glass and plate glass, and the equipment and machinery constituting fixtures, unless such repairs or replacements are required as a result of the negligence or intentional misconduct of Landlord, its agent(s), contractor(s), employee(s), invitee(s), or subcontractor(s) in which event Landlord shall be responsible for such repairs.  Tenant’s duty to maintain the HVAC system shall specifically include the duty to enter into and maintain at Tenant’s sole expense during the entire term of this Lease a contract(s) for the routine and periodic maintenance and regular inspection of such HVAC system, the replacement of filters as recommended and the performance of other recommended periodic servicing in accordance with applicable manufacturer’s standards and recommendations.  Such contract (a) shall be with a reputable contractor reasonably satisfactory to Landlord; (b) shall satisfy the requirements for routine and periodic maintenance, if any, necessary to keep all applicable manufacturer’s warranties in full force and effect; and (c) shall provide that in the event this Lease expires or is earlier terminated for any reason whatsoever that said contract shall be immediately terminable by Landlord or Tenant without any cost, expense or other liability on the part of Landlord.   Notwithstanding, Landlord shall pay up to $1,000 in each instance toward replacement of the HVAC system, any major component of the HVAC system(s) and/or any operating system (unless the same is caused by the negligence of Tenant, its employees, contractors or agents).  In the event the costs for replacement of any HVAC system, any major component of the HVAC system(s) and/or any operating system not caused by the negligence of Tenant, its employees, contractors or agents is greater than $1,000 in each instance, Landlord shall pay the same which shall be amortized over the useful life of such replaced system (based upon standard accounting principles) and charged to Tenant proportionately.  Tenant shall be obligated to pay all such costs within thirty (30) days after notice from Landlord.

11.           TRADE FIXTURES AND EQUIPMENT.  Any trade fixtures installed in the Premises at Tenant’s expense shall remain Tenant’s personal property and Tenant shall have the right at any time during the term of this Lease to remove such trade fixtures.  Upon removal of any trade fixtures, Tenant shall immediately restore the portion of the Premises damaged by such removal to the condition required by Section 6(e) of this Lease. Any trade fixtures not removed by Tenant after the expiration or an earlier termination of the Lease shall become, at Landlord’s sole election, either (i) the property of Landlord, in which event Landlord shall be entitled to handle and dispose of same in any manner Landlord deems fit without any liability or obligation to Tenant or any other third party with respect thereto, or (ii) subject to Landlord’s removing such property from the Premises and storing same, all at Tenant’s expense and without any recourse against Landlord with respect thereto.  Without limiting the generality of the foregoing, the following property shall in no event be deemed to be “trade fixtures” and Tenant shall not remove any such property from the Premises under any circumstances, regardless of whether installed by Landlord or Tenant:  (a) any air conditioning, air ventilating or heating fixtures or equipment (with the exception of a portable dehumidifier installed by Tenant in the Premises); (b) any lighting fixtures or equipment; (c) any dock levelers; (d) any carpeting or other permanent floor coverings; (e) any paneling or other wall coverings; or (f) plumbing fixtures and equipment.

12.           UTILITIES.  Tenant shall pay for all utilities or services related to its use of the Premises, including, without limitation, electricity, gas, heat, water, sewer, telephone and janitorial services.  All utilities shall, as of the Commencement Date, have separate meters at Landlord’s sole expense.     Landlord shall not be responsible for the stoppage or interruption of utilities services other than as required by its limited covenant to repair and replace set forth above, nor shall Landlord be liable for any damages caused by or from the plumbing and sewer systems, provided, however, that Annual Rental shall abate if any utility service is not provided to the Premises for more than five (5) continuous days due to Landlord’s negligence.  Tenant shall have the right to place a generator and chiller outside the Premises in a location approved by Landlord and Tenant.

13.           DAMAGE OR DESTRUCTION OF PREMISES.  If the Premises are damaged by fire or other casualty, either in whole or in part, but no part of the Premises is rendered untenantable for Tenant’s business, Landlord shall cause such damage to be repaired (to the extent of the Base Building (as hereinafter defined) and Landlord’s Work) without unreasonable delay and the Annual Rental shall not be abated.  If by reason of such casualty the Premises are rendered untenantable in Tenant’s business, either in whole or in part, Landlord shall cause the damage to be repaired or replaced (to the extent of the Base Building and Landlord’s Work) without unreasonable delay, and, in the interim, the Annual Rental shall be proportionately reduced as to such portion of the Premises as is rendered untenantable.  Any such abatement of rent shall not, however, create an extension of the term of this Lease.  Provided, however, if by reason of such casualty, the Premises are rendered untenantable in some material portion, and the amount of time required to repair the damage using due diligence is in excess of one hundred twenty (120) days, then either party shall have the right to terminate this Lease by giving written notice of termination within sixty (60) days after the date of casualty, and the Annual Rental shall abate as of the date of such casualty in the event of such termination.  Notwithstanding the other provisions of this paragraph, in the event there should be a casualty loss to the Premises to the extent of fifty percent (50%) or more of their replacement value or if the Premises are rendered untenantable for the conduct of Tenant’s business operations during the last twelve (12) months of the initial term or any extended term, either party may, at its option, terminate this Lease by giving written notice within sixty (60) days after the date of the casualty and Annual Rental  shall abate as of the date of such notice.  Except as provided herein, Landlord shall have no obligation to rebuild or repair in case of fire or other casualty, and no termination under this paragraph shall affect any rights of Landlord or Tenant hereunder because of prior defaults of the other party.  Tenant shall give Landlord immediate notice of any fire or other casualty in the Premises.

14.           GOVERNMENTAL ORDERS.  Except as hereinbelow set forth regarding compliance of the physical structure of the Premises with the applicable requirements of the Americans with Disabilities Act and the implementing regulations (the “ADA”) as of the Commencement Date, Tenant agrees, at its own expense, to comply promptly with all requirements of any legally constituted public authority that may be in effect from time to time made necessary by reason of Tenant’s particular use or occupancy of the Premises.  Landlord agrees to comply promptly with any such requirements if not made necessary by reason of Tenant’s particular use or occupancy, at its sole cost and expense.  With regard to the physical structure of the Premises, Landlord agrees to construct the Premises in compliance with the applicable requirements of the ADA in effect as of the Commencement Date (it being understood that under no circumstances shall Tenant be responsible for any costs incurred to cause the Premises to comply with the ADA, which may include, but is not limited to, restroom facilities, emergency strobe lights and horns, and building access).  If it is determined that for any reason Landlord shall have failed to cause the physical structure of the Premises to be brought into compliance with the ADA as of the Commencement Date (to at least the minimum extent required under applicable regulations then in effect), then Landlord, as its sole obligation, will take the action(s) necessary to cause the physical structure of the Premises to so comply, and Tenant acknowledges and agrees that Landlord has and shall have no other obligation or liability whatsoever to Tenant, or to anyone claiming by or through Tenant, regarding any failure of the Premises or the activities therein to comply with the applicable requirements of the ADA.  Landlord and Tenant agree, however, that if any actions is necessary in order to comply with any of the above requirements during the last two (2) years of the Lease and such action to comply with any of the above requirements would cost Landlord in excess of one (1) year’s rent, then Landlord may terminate this Lease by giving written notice of termination to Tenant, which termination shall become effective sixty (60) days after receipt of such notice, and which notice shall eliminate the necessity of compliance with such requirement by Landlord, unless Tenant shall elect, before termination becomes effective, to pay to Landlord all costs for the necessary compliance.

15.           MUTUAL WAIVER OF SUBROGATION.  For the purpose of waiver of subrogation, the parties mutually release and waive unto the other all rights to claim damages, costs or expenses for any injury to property of Landlord or Tenant caused by a casualty of any type whatsoever in, on or about the Premises  All insurance policies carried with respect to this Lease, if permitted under applicable law, shall contain a provision whereby the insurer waives, prior to loss, all rights of subrogation against either Landlord or Tenant.

16.           SIGNS AND ADVERTISING.

(a)           Tenant may install one (1) tenant identification sign in accordance with Building standards and subject to Landlord's prior written approval (not to be unreasonably withheld, delayed or conditioned), such sign to be located at or near the Tenant’s front entrance to the Premises within the Building.  Tenant shall submit sign drawings to Landlord for approval prior to fabrication and installation.  The following submission requirements, in duplicate, constitute the minimum data required: (i) layout, size, location and color of test; (ii) layout of additional symbols or logo; (iii) installation details; and (iv) lighting details, if applicable. In the event Tenant desires any changes to its initial sign, Tenant shall reimburse Landlord for its actual legal fees for Landlord’s review and approval of a new sign.  If at any time during the term of this Lease (as same may be extended) Landlord provides signage on a monument to other tenants in the Building, Landlord shall at Tenant’s cost provide Tenant with similar signage on such monument.

(b)           In order to provide architectural control for the Building, Tenant shall, without Landlord’s prior written approval, install no other exterior signs, marquees, billboards, outside lighting fixtures and/or other decorations on the Premises or the Building.  Landlord shall have the right to remove any such sign or other decoration and restore fully the Premises at the cost and expense of Tenant if any such exterior work is done without Landlord’s prior written approval, which approval Landlord shall be entitled to withhold or deny in its reasonable discretion.  Tenant shall not permit, allow or cause to be used in, on or about the Premises any sound production devices, mechanical or moving display devices, bright lights, or other advertising media, the effect of which would be visible or audible from the exterior of the Premises, unless previously approved by the Landlord.

17.           INDEMNIFICATION AND LIABILITY INSURANCE.

(a)           Tenant shall indemnify and save Landlord harmless against any and all claims, suits, demands, actions, fines, damages, and liabilities, and all costs and expenses thereof (including without limitation reasonable attorneys’ fees) arising out of injury to persons (including death) or property occurring in, on or about, or arising out of the Premises or other areas in the Building if caused or occasioned wholly or in part by any act(s) or omission(s) of Tenant, its agent(s), contractor(s), employee(s), invitee(s), licensee(s), servant(s), subcontractor(s) or subtenant(s), except if caused by any act(s) or omission(s) on the part of Landlord, its agent(s), contractor(s),  employee(s), invitee(s), licensee(s), servant(s) or subcontractor(s).  Tenant shall give Landlord immediate notice of any such happening causing injury to persons or property.

(b)           Landlord shall indemnify and save Tenant harmless against any and all claims, suits, demands, actions, fines, damages, and liabilities, and all costs and expenses thereof (including without limitation reasonable attorneys’ fees) arising out of injury to persons (including death) or property occurring in, on or about, or arising out of the Premises or other areas in the Building if caused or occasioned wholly or in part by any act(s) or omission(s) of Landlord, its agent(s), employee(s), contractor(s), invitee(s), licensee(s), servant(s) or subcontractor(s), except if caused by any act(s) or omission(s) on the part of Tenant, its agent(s), contractor(s), employee(s), invitee(s), licensee(s), servant(s), subcontractor(s) or subtenant(s).  Provided, however, Landlord shall not be liable for any damage caused or occasioned by or from water, snow or ice being upon or coming through the roof, trapdoor, walls, windows, doors, or otherwise in, upon or about the Premises or the Building or from any damage arising from acts or omissions of tenants or other occupants of the Building, unless due to negligence of Landlord, its agent(s), contractor(s), or employee(s), invitee(s), licensee(s), servant(s) or subcontractor(s).

(c)           (i) At all times during the term of this Lease, Tenant shall at its own expense keep in force adequate public liability insurance under the terms of a commercial general liability policy (occurrence coverage) in the amount of not less than $2,000,000.00 coverage and with such company(ies) licensed to do business in the state in which the Premises is located as shall from time to time be reasonably acceptable to Landlord (and to any lender having a mortgage interest in the Premises) and naming Landlord as an additional insured (and, if requested by Landlord from time to time, naming Landlord’s mortgagee as an additional insured).  Such insurance shall include, without limitation, personal injury and contractual liability coverage for the performance by Tenant of the indemnity agreements set forth in this Lease.  Tenant shall first furnish to Landlord copies of policies or certificates of insurance evidencing the required coverage prior to the Commencement Date and thereafter prior to each policy renewal date.  All policies required of Tenant hereunder shall contain a provision whereby the insurer is not allowed to cancel or change materially the coverage without first giving thirty (30) days’ written notice to Landlord, and (ii) at all times during the term of this Lease, Landlord shall at its own expense keep in force adequate public liability insurance under the terms of a commercial general liability policy (occurrence coverage) in the amount of not less than $2,000,000.00 coverage and with such company(ies) licensed to do business in the state in which the Premises is located.  Such insurance shall include, without limitation, personal injury and contractual liability coverage for the performance by Landlord of the indemnity agreements set forth in this Lease.  Landlord shall first furnish to Tenant copies of policies or certificates of insurance evidencing the required coverage upon request.

(d)           The non-prevailing party shall also pay all costs, expenses and reasonable attorneys’ fees that may be incurred by the prevailing party in enforcing the agreements of this Lease, whether incurred as a result of litigation or otherwise.

18.           LANDLORD’S RIGHT OF ENTRY.  Provided that Landlord uses reasonable efforts to minimize interference with Tenant’s use and occupancy of the Premises, Landlord, and those persons authorized by it, shall have the right to enter the Premises at all reasonable times and upon  24 hours prior notice (except in the case of emergency) for the purposes of making repairs, making connections, installing utilities, providing services to the Premises or for any other tenant, making inspections or showing the same to prospective purchasers and/or lenders, as well as at any time in the event of emergency involving possible injury to property or persons in or around the Premises or the Building.  Further, during the last three (3) months of the initial or of any extended term, Landlord and those persons authorized by it shall have the right at reasonable times and upon reasonable notice to show the Premises to prospective tenants.

19.           EMINENT DOMAIN.  If any substantial portion of the Premises is taken under the power of eminent domain (including any conveyance made in lieu thereof) or if such taking shall materially impair the normal operation of Tenant’s business, then either party shall have the right to terminate this Lease by giving written notice of such termination within thirty (30) days after such taking.  If neither party elects to terminate this Lease, Landlord shall repair and restore the Premises (to the extent possible) to substantially the same condition as the Premises existed immediately prior to such taking and the Annual Rental shall be proportionately and equitably reduced.  All compensation awarded for any taking (or the proceeds of a private sale in lieu thereof) shall be the property of Landlord whether such award is for compensation for damages to the Landlord’s or Tenant’s interest in the Premises, and Tenant hereby assigns all of its interest in any such award to Landlord; provided, however, Landlord shall not have any interest in any separate award made to Tenant for Tenant’s Alterations, loss of business, moving expense or the taking of Tenant’s trade fixtures or equipment if a separate award for such items is made to Tenant and if such separate award does not reduce the award to Landlord.

20.           EVENTS OF DEFAULT AND REMEDIES.

(a)           Upon the occurrence of any one or more of the following events (the “Events of Default,” any one an “Event of Default”), the party not in default shall have the right to exercise any rights or remedies available in this Lease, at law or in equity provided same are exercised in accordance with applicable Legal Requirements.  Events of Default shall be:

(i)           Tenant’s failure to pay when due any rental or other sum of money payable hereunder and such failure is not cured within ten (10) days after written notice thereof;

(ii)           Failure by either party to perform any other of the terms, covenants or conditions contained in this Lease if not remedied within thirty (30) days after receipt of written notice thereof, or if such default cannot be remedied within such period, such party does not within thirty (30) days after written notice thereof commence such act or acts as shall be necessary to remedy the default and shall not thereafter complete such act or acts within a reasonable time;

(iii)          Tenant shall become bankrupt or insolvent, or file any debtor proceedings, or file pursuant to any statute a petition in bankruptcy or insolvency or for reorganization, or file a petition for the appointment of a receiver or trustee for all or substantially all of Tenant’s assets and such petition or appointment shall not have been set aside within ninety (90) days from the date of such petition or appointment, or if Tenant makes an assignment for the benefit of creditors, or petitions for or enters into an arrangement; or

(iv)         Tenant allows its leasehold estate to be taken under any writ of execution and such writ is not vacated or set aside within ninety (90) days.

(b)           In addition to its other remedies, Landlord, upon an Event of Default by Tenant, shall have the immediate right, after any applicable grace period expressed herein (but in no event upon less than five (5) days prior written notice), to terminate and cancel this Lease and/or to reenter and remove all persons and properties from the Premises and dispose of such property as it deems fit, all without being guilty of trespass or being liable for any damages caused thereby.  If Landlord reenters the Premises, it may either terminate this Lease or from time to time without terminating this Lease, Landlord shall make such alterations and repairs as may be necessary or appropriate to relet the Premises and relet the Premises upon such terms and conditions as Landlord deems advisable without any responsibility on Landlord whatsoever to account to Tenant for any surplus rents collected.  No retaking of possession of the Premises by Landlord shall be deemed as an election to terminate this Lease unless a written notice of such intention is given by Landlord to Tenant at the time of reentry; but, notwithstanding any such reentry or reletting without termination, Landlord may at any time thereafter elect to terminate for such previous default.  In the event of an elected termination by Landlord, whether before or after reentry, Landlord may recover from Tenant damages, including the costs of recovering the Premises, and Tenant shall remain liable to Landlord for the total Annual Rental as would have been payable by Tenant hereunder for the remainder of the term (which may at Landlord’s election be accelerated to be due and payable in full as of the Event of Default and recoverable as damages equal to the net present value of future rent, discounted at the greater of (i) eight percent (8%) or (ii) the then applicable “discount rate” of the Federal Reserve Bank of Charlotte, North Carolina plus one percent (1.0%) per annum, less the Market Rate (as defined in Exhibit “E” hereof) of the Premises for the remainder of the Term) less the rents actually received from any reletting.  In determining the Annual Rental which would be payable by Tenant subsequent to default, the Annual Rental for the unexpired portion of the term shall be equal (on a monthly basis) to the Annual Rental payable by Tenant immediately prior to the default.  If any rent owing under this Lease is collected by or through an attorney, Tenant agrees to pay Landlord’s reasonable attorneys’ fees to the extent allowed by applicable law.

(c)           In the case of Tenant's default as contemplated herein, Landlord shall have a duty to mitigate its damages.

21.           SUBORDINATION.  This Lease is subject and subordinate to any and all mortgages or deeds of trust now or hereafter placed on the property of which the Premises are a part, and this clause shall be self-operative without any further instrument necessary to effect such subordination; however, if requested by Landlord, Tenant shall promptly execute and deliver to Landlord any such certificate(s) as Landlord may reasonably request evidencing subordination of this Lease to or the assignment of this Lease as additional security for such mortgages or deeds of trust.  Provided, however, in each case the holder of the mortgage or deed of trust shall (which in the case of an existing holder of a mortgage or deed of trust, prior to the Commencement Date) agree that this Lease shall not be divested by foreclosure or other default proceedings thereunder so long as Tenant shall not be in default under the terms of this Lease beyond any applicable cure period set forth herein.  Tenant shall continue its obligations under this Lease in full force and effect notwithstanding any such default proceedings under a mortgage or deed of trust and shall attorn to the mortgagee, trustee or beneficiary of such mortgage or deed of trust, and their successors or assigns, and to the transferee under any foreclosure or default proceedings.  Tenant will, upon request by Landlord, execute and deliver to Landlord or to any other person designated by Landlord, any instrument or instruments required to give effect to the provisions of this paragraph.

 22.           ASSIGNING AND SUBLETTING.  Tenant shall not assign, sublet, mortgage, pledge or encumber this Lease, the Premises, or any interest in the whole or in any portion thereof, directly or indirectly, without the prior written consent of Landlord, which consent shall not be unreasonably withheld, delayed or conditioned.  If Tenant makes any such assignment, sublease, mortgage, pledge or encumbrance with Landlord’s written consent, Tenant will still remain primarily liable for the performance of all terms of this Lease and one-half (1/2) of any rental or any net fees or charges received by Tenant (after deduction by Tenant of  Tenant’s third-party brokerage fees, legal fees, architectural fees, advertising costs and the reasonable costs of refitting or improving the Premises for the proposed assignee or subtenant, and free rent and improvement allowances granted, in connection with such transaction)  in excess of the Annual Rental payable to Landlord hereunder shall be also paid to Landlord as further rental under this Lease.  Landlord’s consent to one assignment or sublease will not waive the requirement of its consent to any subsequent assignment or sublease as required herein.  Notwithstanding the foregoing, Tenant shall have the absolute right to assign this Lease and/or sublet any part or all of the Premises, without the Landlord's consent, to any of Tenant's subsidiary(s), joint venture partner(s), partnership(s), or other affiliated or related entity(s), and/or to a successor(s) in interest to any part and/or all of Tenant's business including, without limitation, a sale of assets ("Permitted Transfer").  A Permitted Transfer shall include a merger or consolidation with another entity and/or an assignment or subletting to another entity which is controlled by Tenant or is under common control of Tenant and other entity.  Regardless of Landlord's consent, no assignment or sublease shall release Tenant of Tenant's obligations hereunder.

23.           TRANSFER OF LANDLORD’S INTEREST.  If Landlord shall sell, assign or transfer all or any part of its interest in the Premises or in this Lease to a successor in interest which expressly assumes the obligations of Landlord hereunder, then Landlord shall thereupon be released or discharged from all covenants and obligations hereunder which accrue after such sale, assignment or transfer, and Tenant shall look solely to such successor in interest for performance of all of Landlord’s obligations which accrue after such sale, assignment or transfer.  Tenant’s obligations under this Lease shall in no manner be affected by Landlord’s sale, assignment, or transfer of all or any part of such interest(s) of Landlord, and Tenant shall thereafter attorn and look solely to such successor in interest as the Landlord hereunder.

24.           COVENANT OF QUIET ENJOYMENT.  Landlord represents that it has full right and authority to lease the Premises and Tenant shall peacefully and quietly hold and enjoy the Premises for the full term hereof so long as Tenant does not default in the performance of any of the terms hereof beyond the expiration of any applicable cure period.

25.           ESTOPPEL CERTIFICATES.  Within ten (10) business days after a request by Landlord, Tenant shall deliver a written estoppel certificate, in form supplied by or acceptable to Landlord, certifying any facts that are then true with respect to this Lease, including without limitation that this Lease is in full force and effect, that no default exists on the part of Landlord or Tenant (or listing such default in case any exists), that Tenant is in possession, that Tenant has commenced the payment of rent, and that Tenant claims no defenses or offsets (or listing such defenses or offsets in case any exists) with respect to payment of rentals under this Lease.  Likewise, within ten (10) business days after a request by Tenant, Landlord shall deliver to Tenant a similar estoppel certificate covering such matters as are reasonably required by Tenant.  Landlord and Tenant shall each agree not to make such request more than 2 times per calendar year.

26.           LIENS.  

 (a) Tenant shall do all things necessary to prevent the filing of any mechanics’, materialmen’s or other types of liens whatsoever, against all or any part of the Premises by reason of any claims made by, against, through or under Tenant.  If any such lien is filed against the Premises, Tenant shall either cause the same to be discharged of record within thirty (30) days after filing or, if Tenant in its discretion and in good faith determines that such lien should be contested, it shall furnish such security as may be necessary to prevent any foreclosure proceedings against the Premises during the pendency of such contest.  If Tenant shall fail to discharge such lien within said time period or fail to furnish such security, then Landlord may at its election, in addition to any other right or remedy available to it, discharge the lien by paying the amount claimed to be due or by procuring the discharge by giving security or in such other manner as may be allowed by law.  If Landlord acts to discharge or secure the lien then Tenant shall immediately reimburse Landlord for all sums paid and all costs and expenses (including reasonable attorneys’ fees) incurred by Landlord involving such lien together with interest on the total expenses and costs at the maximum lawful rate.  It is specifically agreed to by the parties that Tenant is not acting as an agent for Landlord and that Landlord shall not be liable for the contracts or liabilities of Tenant.

(b)           Landlord hereby waives any and all liens Landlord may otherwise be entitled to against any and all of Tenant’s personal property, equipment and other assets.

27.           MEMORANDUM OF LEASE.  If requested by Tenant, Landlord shall execute a recordable Memorandum or Short Form Lease, prepared at Tenant’s expense, specifying the exact term of this Lease and such other terms as the parties shall mutually determine.

28.           FORCE MAJEURE.  In the event Landlord or Tenant shall be delayed, hindered or prevented from the performance of any act required hereunder, by reason of governmental restrictions, scarcity of labor or materials, strikes, fire, or any other reasons beyond its reasonable control, the performance of such act shall be excused for the period of delay, and the period for performance of any such act shall be extended as necessary to complete performance after the delay period, provided, however, that Landlord’s or Tenant’s performance of its obligations  under this Lease shall not otherwise be  affected or diminished .  However, the provisions of this paragraph shall in no way be applicable to Tenant’s obligations to pay Annual Rental or Landlord’s or Tenant’s obligations to pay any other sums, monies, costs, charges or expenses required by this Lease.

29.           REMEDIES CUMULATIVE -- NONWAIVER.  Unless otherwise specified in this Lease, no remedy of Landlord or Tenant shall be considered exclusive of any other remedy, but each shall be distinct, separate and cumulative with other available remedies.  Each remedy available under this Lease or at law or in equity may be exercised by Landlord or Tenant from time to time as often as the need may arise.  No course of dealing between Landlord and Tenant or any delay or omission of Landlord or Tenant in exercising any right arising from the other party’s default shall impair such right or be construed to be a waiver of a default.

30.           HOLDING OVER.  Tenant shall have the right to holdover in possession of the Premises for up to six (6) months under the same terms and conditions of this Lease, with the exception that  Tenant shall be allowed to vacate the Premises at any time during such six (6) month period after giving Landlord 30 days prior written notice.  After such six (6) month period, if Tenant continues to remain in possession of the Premises or any part thereof, whether with or without Landlord’s acquiescence, (i) Tenant shall be deemed only a tenant at will and there shall be no renewal of this Lease without a written agreement signed by both parties specifying such renewal, (ii) the “monthly” rental payable by Tenant during any such tenancy at will period shall be one hundred twenty-five percent (125%) of the monthly installments of Annual Rental payable during the final year immediately preceding such expiration, and (iii)  Tenant shall also remain liable for any and all direct damages suffered by Landlord as a result of any holdover without Landlord’s unequivocal written acquiescence.

31.           NOTICES.  Any notice allowed or required by this Lease shall be deemed to have been sufficiently served if the same shall be in writing and (i) placed in the United States mail, via certified mail or registered mail, return receipt requested, with proper postage prepaid or (ii) delivered to any nationally recognized overnight courier, and addressed as follows:

AS TO LANDLORD: Shopton Ridge Business Park Limited Partnership

c/o American Asset Corporation

3700 Arco Corporate Drive, Suite 350

Charlotte, North Carolina 28273

Attention:                           President with a copy to General Counsel

AS TO TENANT:                         Shutterfly, Inc.

2800 Bridge Parkway

Redwood City, CA 94065

Attention:                           Chief Financial Officer with a copy to Vice President, Legal

The addresses of Landlord and Tenant and the party, if any, to whose attention a notice or copy of same shall be directed may be changed or added from time to time by either party giving notice to the other in the prescribed manner.

32.           LEASING COMMISSION.  Landlord and Tenant represent and warrant each to the other that they have not dealt with any broker(s) or any other person claiming any entitlement to any commission in connection with this transaction except American Asset Corporation and Trammel Crow Services, Inc. (the “Broker”).  Landlord and Tenant agree to indemnify and save each other harmless from and against any and all claims, suits, liabilities, costs, judgments and expenses, including reasonable attorneys’ fees, for any leasing commissions or other commissions, fees, charges or payments resulting from or arising out of their respective actions in connection with this Lease except as to Broker.  Landlord agrees to be responsible for the leasing commission due Broker pursuant to a separate written agreement between Landlord and Broker, and to hold Tenant harmless respecting same.

33.           MISCELLANEOUS.

(a)           Rules and Regulations.  Landlord shall have the right from time to time to prescribe reasonable rules and regulations  (the “Rules and Regulations”) for Tenant’s use of the Premises and the Building, provided same do not materially adversely affect Tenant’s use or occupancy of the Premises or the operation of Tenant’s business.  A copy of Landlord’s current Rules and Regulations respecting the Premises and the Building is attached hereto as Exhibit ”D”.  Subject to paragraph 9 of Exhibit “D” and to paragraph 6 of Exhibit “E” attached hereto, Tenant shall abide by and use reasonable efforts to actively enforce on all its employees, agents, invitees and licensees such regulations including without limitation rules governing parking of vehicles in designated portions of the Building.

(b)           Evidence of Authority.  If requested by Landlord, Tenant shall furnish appropriate legal documentation evidencing the valid existence and good standing of Tenant and the authority of any parties signing this Lease to act for Tenant.

(c)           Limitation of Landlord’s Liability.  If Landlord shall fail to perform any covenant, term or condition of this Lease upon Landlord’s part to be performed, and, as a consequence of such default, Tenant shall recover a money judgment against Landlord, such judgment shall be satisfied solely out of the proceeds of sale received upon execution of such judgment levied thereon against the right, title and interest of Landlord in the Building as the same may then be encumbered; and neither Landlord nor, if Landlord be a partnership, any of the partners comprising Landlord shall have any personal liability for any deficiency.  It is understood and agreed that in no event shall Tenant or any person claiming by or through Tenant have the right to levy execution against any property of Landlord other than its interest in the Building as hereinbefore expressly provided.

(d)           Nature and Extent of Agreement.  This Lease, together with all exhibits hereto, contains the complete agreement of the parties concerning the subject matter, and there are no oral or written understandings, representations, or agreements pertaining thereto which have not been incorporated herein.  This Lease creates only the relationship of Landlord and Tenant between the parties, and nothing herein shall impose upon either party any powers, obligations or restrictions not expressed herein.  This Lease shall be construed and governed by the laws of the state in which the Premises are located.

(e)           Binding Effect.  This Lease shall be binding upon and shall inure to the benefit of the parties hereto and their respective heirs, successors and assigns.  This Lease shall not be binding on Landlord until executed by an authorized representative of Landlord and delivered to Tenant.  No amendment or modification to this Lease shall be binding upon Landlord unless same is in writing and executed by an authorized representative of Landlord.

(f)           Captions and Headings.  The captions and headings in this Lease are for convenience and reference only, and they shall in no way be held to explain, modify, or construe the meaning of the terms of this Lease.

(g)           Intentionally Deleted.

(h)           Intentionally Deleted.

(i)           Lease Review.  The submission of this Lease to Tenant for review does not constitute a reservation of or option for the Premises, and this Lease shall become effective as a contract only upon execution and delivery by Landlord and Tenant.

34.           SEVERABILITY.  If any term or provision of this Lease or the application thereof to any person or circumstance shall, to any extent, be invalid or unenforceable, the remainder of this Lease, or the application of such term or provision to persons or circumstances other than those as to which it is held invalid or unenforceable, shall not be affected thereby, and each term and provision of this Lease shall be valid and enforced to the fullest extent permitted by law notwithstanding the invalidity of any other term or provision hereof.

35.           REVIEW OF DOCUMENTS.  If, following the execution of this Lease, either party hereto requests that the other party execute any document or instrument that is other than (i) a document or instrument the form of which is attached hereto as an exhibit, or (ii) a document that solely sets forth facts or circumstances that are then existing and reasonably ascertainable by the requested party with respect to this Lease (e.g., an estoppel certificate), then the party making such request shall be responsible for paying the out-of-pocket costs and expenses, including without limitation, the attorneys fees, incurred by the requested party in connection with the review (and, if applicable, the negotiations) related to such document(s) or instrument(s), regardless of whether such document(s) or instrument(s) is (are) ever executed by the requested party.  In the event the requesting party is Tenant, all such costs and expenses incurred by Landlord in connection with its review and negotiation of any such document(s) or instrument(s) shall be deemed to be Additional Rental due hereunder and shall be payable by Tenant promptly upon demand.

36.           SPECIAL STIPULATIONS.  (Special stipulations shall control if in conflict with any of the foregoing provisions of this Lease.)  See Exhibit ”E” attached hereto and made a part hereof by this reference.

IN WITNESS WHEREOF, the parties have caused this Lease to be duly executed and sealed pursuant to authority duly given as of the day and year first above written.

“LANDLORD”

3915 SHOPTON ROAD, LLC,

a North Carolina limited liability company

By:  /s/ Paul L. Herndon

Name: Paul L. Herndon

Title: Vice President

“TENANT”

SHUTTERFLY, INC., a Delaware corporation

By: /s/Stephen E. Recht

Name:  Stephen E. Recht

Title: Chief Financial Officer

EXHIBIT “A”

LEGAL DESCRIPTION OF BUILDING SITE

3915 Shopton Road, LLC

 Lot 4, Shopton Ridge Business Park, Phase 1 Map 2

6.3152 Acres

Being a parcel or tract of land located in the City of Charlotte, Mecklenburg County, North Carolina, and being more particularly described as follows:

BEGINNING at an existing iron rod in the center of a 60’ ingress and egress easement and at the southwestern corner of Lot 3 Shopton Ridge, LLC property as recorded in DB. 17877, Pg. 944 at the Mecklenburg County Register of Deeds said iron being furthermore located South 80° 34' 16" East 4,696.40 feet (ground distance) from North Carolina Geodetic Survey control monument “Shopton” (State Plane Grid Coordinates: N: 523,015.0629, E: 1,413,721.9954) thence from said POINT OF BEGINNING and with the northern line of Lots 6 and 7 Shopton Ridge Business Park, Phase 1, Map 2 as recorded in MB. 42, Pg. 915 at the Mecklenburg County Register of Deeds; Thence, N 88° 53' 05" W for a distance of 674.08 feet to an existing iron pin at the southeastern corner of  Lot 5 Shopton Ridge Business Park, Phase 1, Map 2 as recorded in MB. 42, Pg. 915 at the Mecklenburg County Register of Deeds, thence with the eastern line of the aforesaid property N 01° 06' 55" E for a distance of 408.27 feet to an existing iron pin on the southern right of way line of Shopton Road (variable public right of way), thence with the aforesaid right of way line the following five (5) courses: 1) S 89° 04' 13" E for a distance of 100.97 feet to a point, 2) S 88° 36' 45" E for a distance of 196.31 feet to a point, 3) S 89° 01' 10" E for a distance of 196.85 feet to a point, 4)S 88° 49' 27" E for a distance of 107.74 feet to a point, 5) S 88° 55' 16" E for a distance of 72.22 feet to an existing iron rod at the northwestern corner of  Lot 3 Shopton Ridge, LLC property as recorded in DB. 17877, Pg. 944 at the Mecklenburg County Register of Deeds, thence with the western line of the aforesaid property S 01° 06' 55" W a distance of 408.07 feet to the POINT OF BEGINNING; containing 275,090 square feet or 6.3152 acres as shown on a survey by R. B. Pharr & Associates, P.A., dated May 3, 2006 (Map File W-3325).

EXHIBIT “B”

INTENTIONALLY DELETED

EXHIBIT “C”

UPFIT OF PREMISES

1.           LANDLORD’S WORK

Landlord, at Tenant’s sole cost and expense (except as provided in paragraph 2 of this Exhibit ”C”) shall construct all improvements to the Premises which constitute a part of Landlord’s Work (collectively, the “Improvements”) in a good and workmanlike manner and in accordance with the Final Plans and Specifications (as hereinafter defined) and all applicable Legal Requirements.  “Landlord’s Work” shall mean that certain work related to Tenant’s occupancy of the Premises which shall be mutually agreed upon by Landlord and Tenant.   Tenant shall submit to Landlord the proposed floor plan (including description of Landlord’s Work) on or before December 26, 2006.   Landlord shall within five (5) business days from receipt deliver to Tenant, in writing, either approval of the floor plan or detailed comments on any changes reasonably necessary.   If Landlord responds within such five (5) business day period, Tenant shall be responsible for obtaining such changes to the floor plan  as may be agreed upon by the parties and resubmitting for written approval.    If Landlord fails to respond during such five (5) business day period (the “Initial Floor Plan Response Period”), Landlord shall automatically be deemed to have approved the initial floor plan.   The final floor plan, as approved (or deemed approved) by both Landlord and Tenant, is herein referred to as the “Initial Floor Plan”.   If Landlord and Tenant cannot mutually agree upon the Initial Floor Plan on or before January 15, 2007 (the “Initial Floor Plan Approval Deadline Date”), Landlord or Tenant shall have the option, to terminate the Lease.

For purposes of this Lease, Landlord’s Work shall be deemed “substantially complete” when (i) Landlord has completed Landlord’s Work except for punchlist items which do not prevent or materially impair Tenant’s use or occupancy of the Premises, (ii) Tenant can occupy the Premises for the purpose of carrying on its intended business therein,  and (iii) Landlord has procured a temporary or permanent certificate of occupancy for the Premises, which shall allow Tenant to operate its business within the Premises.  Landlord represents and warrants that the Building has been constructed in (i) a good and workmanlike manner, (ii) in accordance with applicable Legal Requirements, and (iii) in accordance with Landlord’s base building shell specifications per the architectural drawings dated February 21, 2006 prepared by Merriman Schmitt which have been approved by both Tenant and Landlord (the “Base Building”).

Notwithstanding anything contained herein to the contrary, Tenant (and not Landlord) shall be solely responsible for any increases in the cost of Landlord’s Work which are attributable to (i) any change orders requested by Tenant to the Final Plans and Specifications which are agreed to between Landlord and Tenant and/or (ii) any Tenant Delay Factors (as described in Paragraph 4 of the Lease).  Such cost increases (subject to application of the Improvements Allowance and Additional Tenant Improvement Allowance, each as hereinafter defined)  shall be payable by Tenant to Landlord  within 30 days of Landlord’s written demand therefor.

Landlord shall have the final plans and specifications (the “Final Plans and Specifications”) for Landlord’s Work prepared, based upon the Initial Floor Plan, and delivered to Tenant for its review and approval (which approval shall not be unreasonably withheld) on or before January 22, 2007.  Such review and approval by Tenant of the Final Plans and Specifications shall be limited solely to those specific items that do not materially conform to the Initial Floor Plan.  Tenant, acting reasonably and in good faith, shall have seven (7) days from Landlord’s delivery of the Final Plans and Specifications to advise Landlord, in writing, as to whether or not Tenant desires any changes to the Final Plans and Specifications.  If Tenant fails to respond during such seven (7) day period (the “Response Period”), Tenant shall automatically be deemed to have approved the Final Plans and Specifications.  If Landlord and Tenant cannot mutually agree upon the Final Plans and Specifications on or before January 30, 2007 (the “Final Plans Approval Deadline Date”), Landlord or Tenant shall have the option, to terminate the Lease.

Within seven (7) business days after the Final Plans and Specifications have been finally approved (or deemed approved) by Tenant, Landlord shall submit the Final Plans and Specifications to the contractors for bidding purposes in accordance with the provisions set forth below.  In the essence of time, Landlord shall hire DSS Corporation as the general contract for Landlord Work.  DSS Corporation agrees to competitively bid the work to all subcontractors and open-book all bids for Tenant and Landlord review and selection.  DSS Corporation shall receive a “cost plus 5%” fee.  Tenant shall have the opportunity to review and provide input concerning the subcontractor bids, which Tenant agrees to do in a timely and good faith manner.

Tenant acknowledges and agrees that Tenant Delay Factors, as defined in paragraph 4 of the Lease, shall include, without limitation, any delays resulting from (i) change orders to the Final Plans and Specifications requested by Tenant or by those acting for or under the direction of Tenant; (ii) the performance or completion by Tenant, or any entity or person employed by Tenant, of any work in or about the Premises or (iii) the failure of Landlord and Tenant to agree on the Final Plans and Specifications on or before the Final Plans Approval Deadline Date, provided that in each such instance Landlord first gives Tenant two (2) business days notice that if Tenant does not  so cure its act or omission  the same will thereafter be considered a Tenant Delay Factor.

.

Except to the extent expressly provided in the Lease, Landlord shall have no liability or obligation whatsoever to remedy, replace or correct any alleged defects and deficiencies in Landlord’s Work; provided, however, that Landlord specifically warrants that  (i) all loading doors will be properly operational for three (3) months after the Commencement Date, absent any negligence of Tenant, and (ii) Landlord shall throughout the term of this Lease (as same may be extended) be responsible for repairing any latent defects in the Improvements at Landlord’s sole cost.  Landlord shall, to the extent permitted by law, assign all warranties associated with the Premises to, and cooperate with, Tenant in the enforcement of any express warranties or guarantees of workmanship or materials given by any contractors, subcontractors, architects, draftsmen, or materialmen relative to Landlord’s Work, the roof or any relevant Building systems.  Notwithstanding anything to the contrary contained herein or in the Lease, Landlord shall not be responsible, to any extent whatsoever, for the repair, remediation or correction of any alleged deficiencies or defects in any materials and workmanship in and concerning Landlord’s Work to the extent that the existence or occurrence of such defects or deficiencies are the result of, or due to, any negligent, willful or intentional or other acts or omissions of Tenant, its agents, employees, contractors, subcontractors, representatives or invitees.  Tenant may not conduct any activities on the Premises that would have the effect of rendering any relevant warranties related to the performance of Landlord’s Work void (unless previously approved by the Landlord), and if Tenant does conduct any such activities and renders any relevant warranty void, Landlord will no longer have any obligations under the terms of the Lease with respect to the component, element or feature of the Improvements that the warranty voided by Tenant’s activities had previously covered.  Except as otherwise provided in this Lease, at no time during the Lease term (as same may be extended pursuant to any renewal option, if any) shall Tenant have any right, of any nature whatsoever, to withhold the timely payment of any rental due under the Lease as a result of, or due to, or because of, any alleged breaches by Landlord under the Lease or the alleged existence of any defects or deficiencies in the Improvements.

Landlord shall obtain all applicable licenses, permits and approvals to complete the Tenant Improvements in accordance with all applicable laws.

Landlord shall give Tenant estimates of the schedule for completion of the Improvements and thirty (30) days prior written notice of the anticipated date the Premises will be ready for occupancy.  Within thirty (30) days following the Commencement Date, Landlord and Tenant shall mutually conduct a walk-through of the Premises and compile a punch list which sets forth any corrective work to be performed by Landlord with respect to the Improvements which Landlord, upon receipt, shall diligently pursue to correct.

Landlord represents and warrants to Tenant that as of the Commencement Date:

(i)           the Premises, including the HVAC, electrical, mechanical, plumbing, sewer and other systems serving the Premises, shall be in good working order;

(ii)          the Improvements and the Building shall not violate any covenants or restrictions of record (if any), or any applicable Legal Requirements having jurisdiction over the Project, and

(iii)         Landlord shall deliver the Premises to Tenant clean and free of debris.

Except as provided in Section 5(c) of the Lease, Tenant shall have no obligation to restore the Premises to their original condition as of the Commencement Date upon lease termination or expiration of the Lease.

Landlord agrees that there shall be no construction management fee payable by Tenant to Landlord to oversee the construction of the Improvements.

2.           IMPROVEMENTS ALLOWANCE

Notwithstanding anything to the contrary herein, Landlord shall contribute an amount (such amount being the “Improvements Allowance”) not to exceed $16.00 per rentable square foot of the Premises ($1,638,400.00 based on the rentable square footage of 102,400) towards the costs incurred by Landlord and/or Tenant in designing, planning and constructing the Improvements.  In the event the costs incurred in connection with designing, planning and constructing the Improvements exceed the Improvements Allowance (subject to application of the Additional Tenant Improvement Allowance, as hereinafter defined), Tenant shall be solely responsible for bearing and paying any such excess costs within thirty (30) days of Landlord’s written demand therefor.  In the event the costs incurred by Landlord and/or Tenant in connection with designing, planning and constructing the Improvements are less than the Improvements Allowance, Tenant shall provide Landlord with written notice prior to August 31, 2007 which may direct Landlord to pay such excess amounts directly to Tenant’s contractor/vendors for additional improvements to the Premises conducted by or for Tenant, or apply such excess amounts against the Minimum Rental payment(s) next due from Tenant until such excess amounts have been exhausted.  Without limiting the foregoing, Landlord acknowledges that “the costs incurred by Landlord and/or Tenant in designing, planning and construction the Improvements” shall be deemed to include the cost to obtain any and all (i) operating permit(s) that Tenant may be required to obtain (if any) in order for Tenant to operate for Tenant’s permitted use as described in Article 6(a) of this Lease; (ii) construction permits (including costs associated with any “express review” process); (iii) space planning; (iv) construction documents; (v) upfit costs; and (vi) any additional costs associated with the upfit.

3.           ADDITIONAL TENANT IMPROVEMENT ALLOWANCE

Upon written request to Landlord, Landlord agrees to provide Tenant with an additional improvement allowance up to a maximum of $250,000.00 (the “Additional Tenant Improvement Allowance”) to be used by Tenant for additional improvements to the Premises, and/or furniture, fixtures or equipment for the Premises.  Any such elected Additional Tenant Improvement Allowance shall be amortized over the entire eighty-nine (89) month term at an annual interest rate of ten percent (10%) and paid by Tenant as part of the Minimum Rent due under the Lease.  Landlord and Tenant shall amend this Lease as necessary to reflect such increased rent obligation.

EXHIBIT “D”

RULES AND REGULATIONS

1. Restricted Uses.  Neither the Premises nor any part of the common areas of the Building or the Business Park shall be used by Tenant for any one or more of the following uses:

(a) Agriculture or any related use, including any roadside stand for the display and sale of agricultural products and any use which involves the raising, breeding, or keeping of any animals or poultry;

(b) Processing or slaughter of livestock, swine, poultry or other animals;

(c) Manufacture of leather goods;

(d) Manufacture of explosives or explosive agents;

(e) Manufacture, sale, rental, repair or storage of heavy equipment, buses, trucks, trailers, automobiles, recreational vehicles and mobile or trailer homes;

(f) Unscreened outdoor storage, outdoor fabrication or outdoor handling of any machinery, parts, material, supplies or products;

(g) Residential uses;

(h) Overnight parking of campers, mobile homes, boats, trailers or motor homes;

(i) Erecting and maintaining structures of a temporary nature, except that during the period of construction of improvements to the Premises, Tenant’s contractors or subcontractors may be permitted to erect or maintain such temporary structures upon Landlord’s prior written approval;

(j) Jails, prisons, labor camps, penal, detention or correction facilities or farms;

(k) Cemeteries or mausoleums;

(l)           Mining, including the extraction, processing and removal of sand, gravel, stone, minerals or clay, except for substances used in connection with Tenant’s photo-developing and merchandising processes and services provided such chemicals and other substances are brought into the Premises, used, stored and disposed of in accordance with all Legal Requirements and Environmental Laws;

    (m) Any land fills, any hazardous waste disposal or storage facilities and any incinerators;

(n) Racetracks, raceways and drag strips; and

(o) Massage parlors, topless night clubs or similar business operations.

(p) Fast food restaurants;

(q) Airports, heliports or helistops, bus or train terminals;

(r) Hotels or motels;

(s) Rest stops, rest stations or service stations;

(t) Flea markets;

(u) Stadiums;

(v) Adult care centers;

(x) Cinemas or movie theaters;

(y) Night Clubs or bars; and

(z) Amusement parks, amusement galleries, arcades or turkey shoots.

2. Nuisances.  Tenant shall not cause any unclean, unhealthy, unsightly or unkempt condition to exist in the Premises or in the common areas of the Building or the Business Park.  Tenant shall not use the Premises or any portion of the common areas of the Building or the Business Park, in whole or in part, for the deposit, storage or burial of any property or thing that will cause the above-mentioned areas to appear to be in an unclean or untidy condition or that will be obnoxious to the eye; nor shall Tenant allow any substance, thing, or material to be kept, utilized or carried out in the Premises or the common areas of the Building or the Business Park that will emit foul or obnoxious odors, fumes, smoke or dust or that will cause any vibration or noise or other condition that will or might disturb the peace, quiet, safety, comfort, or serenity of the occupants of the Building or the Business Park in excess of what is commercially reasonable .  No noxious, offensive or illegal trade or activity shall be carried out in the Premises or in the common areas of the Building or the Business Park.

3. Restricted Actions on Common Areas of the Building and the Business Park.  Tenant shall not cause or allow any cutting of vegetation, dumping, digging, filling, destruction or other waste to be committed on the common areas of the Building or the Business Park. Tenant shall not cause any obstruction of, or allow or cause anything to be kept or stored on, altered, constructed or planted in, or removed from the common areas of the Building or the Business Park, without Landlord’s prior written consent.

4. Sign Display.  Subject to the provisions set forth in Article 16 of the Lease, (i) all signage will be coordinated by Landlord throughout the Business Park for uniformity and attractiveness, (ii) the size, shape, design, lighting, materials and location of all signs shall conform to the uniform signage plan for the Business Park, and (iii)  Tenant shall not cause any sign, tag, label, picture, advertisement or notice to be displayed, distributed, inscribed, painted or affixed by Tenant on any part of the Building, the Business Park or the Premises without the prior written consent of Landlord, which consent shall not be unreasonably withheld, delayed or conditioned.

5. Drives and Parking Areas.  Subject to the provisions set forth in paragraph 6 of Exhibit E to this Lease, (i) all parking shall be within marked parking spaces, (ii)  there shall be no on-street parking and at no time shall Tenant obstruct drives and loading areas intended for the joint use of all tenants of the Building, (iii) the drives and parking areas in the Business Park are for the joint use of all tenants of the Business Park unless specifically marked, (iv) Truck traffic and parking will be restricted to areas designated by Landlord, (v)  Tenant, its employees, agents and invitees shall comply with reasonable parking rules and regulations as they may be posed and distributed from time to time, and (vi)  Tenant is responsible for controlling all of its truck traffic in accordance with the restrictions and regulations imposed by Landlord.

6. Storage and Trash Disposal.  No materials, supplies or equipment belonging to Tenant shall be stored in any area of the Building or the Business Park, except inside the Premises.  Trash disposal is confined to the receptacles provided by Tenant in a location approved by Landlord and no trash receptacles may be placed in any other location in the Premises, in the Building or in the Business Park

7. Locks.  No additional locks shall be placed on the doors of the Premises by Tenant.  If Tenant changes any existing locks, Tenant shall immediately furnish Landlord with two keys to such new locks.  Landlord will, without charge, furnish Tenant with two keys for each lock existing upon the entrance door when Tenant assumes possession of the Premises, with the understanding that, at the termination of the Lease, the keys shall be returned.

8. Improvements, Contractors and Service Maintenance.  Subject to the provisions set forth in Article 5 of the Lease, (i) Tenant shall not make any improvements to the exterior of the Building or the Business Park and Tenant shall not make any structural changes or other material alterations, additions or improvements to the Premises without the prior written consent of Landlord, which such approval shall not be unreasonably withheld, (ii)   Tenant will refer all of Tenant’s contractors, contractors’ representatives and installation technicians rendering any service on or to the Premises to Landlord for Landlord’s approval and supervision before performance of any service, and (iii) this provision shall apply to all work performed in the Premises, including installation of electrical devices and attachments and installations of any nature affecting floors, walls, woodwork, trim, windows, ceilings, equipment or any other physical portion of the Premises, the Building or the Business Park

9. Regulations for Operation and Use.  Except as permitted in this Lease, Tenant shall not place, install or operate in the Premises or in any part of the Building or the Business Park any engine, stove or machinery, nor shall Tenant conduct any mechanical or cooking operations therein, nor place or use in or about the Premises or any part of the Building or the Business Park any explosives, gasoline, kerosene, oil, acids, caustics or any other flammable, explosive or hazardous material, without the prior written consent of Landlord.

10. Window Coverings.  Windows facing the Building exterior shall at all times be wholly clear and uncovered (except for such blinds or curtains or other window coverings as Landlord may provide or approve) so that a full unobstructed view of the interior of the Premises may be had from the exterior of the Building.

11. No Violations of Fire Laws or Health Code.  Tenant shall not do or permit anything to be done in the Premises, or bring or keep anything therein, which will obstruct or interfere with the rights of other tenants in the Building or the Business Park or in any other way injure them or conflict with any laws relating to fires, or with any regulations of the Fire Department or with any insurance policy upon the Building or the Business Park, or any part thereof, or conflict with any of the rules and ordinances of the Board of Health.

12. No Violations of Laws.  Tenant shall promptly and at its expense execute and comply with all laws, rules, orders, ordinances, including all applicable zoning ordinances, and regulations of the City, County, State or Federal Government, and of any department or bureau of any of them and of any other governmental authority having jurisdiction over the Premises,  to the extent necessary by reason of Tenant’s particular  use or occupancy of the Premises or Tenant’s business conducted therein.    Landlord hereby represents and warrants that Tenant’s intended use of the Premises (as set forth in  Section 6(a) of the Lease) is permitted as of right under the applicable zoning code.

13. No Use of Roof.  Neither Tenant, nor Tenant’s servants, employees or agents shall go upon the roof of the Building without the written consent of Landlord unless necessary for Tenant to exercise any of its rights under Section 9(b) of the Lease.

14. No Canvassing.  Canvassing, soliciting and peddling in and about the Building and the Business Park is prohibited.

15. No Loud Musical Devices.  Tenant shall not operate or permit to be operated any musical or sound producing instrument or device inside or outside the Premises which may be heard outside the Premises or by other tenants in the Building or the Business Park in excess of what is commercially reasonable.

16. Use of Washrooms.  Tenant shall not use the washrooms, restrooms, and plumbing fixtures of the Premises or the Building, and appurtenances thereto, for any purposes other than the purposes for which they were constructed, and Tenant shall not deposit any sweepings, rubbish, rags, or other improper substances therein.  If Tenant or Tenant’s servants, employees, agents, contractors, jobbers, licensees, invitees, guests or visitors cause any damage to such washrooms, restrooms, plumbing fixtures or appurtenances, such damage shall be repaired, at Tenant’s expense, and Landlord shall not be responsible therefor.

17. No Unpleasant Odors.  Tenant shall not cause or permit any unpleasant odors to emanate from the Premises, or otherwise interfere, injure or annoy in any way other tenants in the Building or the Business Park, or persons conducting business with them in excess of what is commercially reasonable.

18. Disposal of Crates.  When conditions are such that Tenant must dispose of crates, boxes, etc. on the sidewalk or parking areas on the Land, it will be the responsibility of Tenant to dispose of same only between the hours of 5:45 p.m. until 7:15 a.m unless other times are approved by the Landlord.

19. No Food Distribution.  No prepared food and/or beverages shall be distributed from the Premises, but, notwithstanding the provisions of Paragraph 9 hereof or this Paragraph 19, Tenant may prepare coffee and similar beverages and warm typical luncheon items for the consumption of Tenant’s employees and invitees.

20. Location of Improvements.  Tenant will not locate furnishings or cabinets adjacent to mechanical or electrical access panels or over air conditioning outlets in the Premises so as to prevent operating personnel from servicing such units as routine or emergency access may require.  Tenant shall be responsible for any cost associated with moving such furnishings for Landlord’s access to such mechanical or electrical access panels or air conditioning outlets.

21. Modifications.  Landlord shall have the right from time to time to make any and all such reasonable modifications and additions to these Rules and Regulations as may be necessary for the safety, care, quiet enjoyment and cleanliness of the Building and the Business Park.  Tenant agrees to abide by these Rules and Regulations and any reasonable modifications and additions as are hereafter adopted by Landlord, including, but not limited to, modifications made by Landlord as a result of any changes in the city zoning ordinance, provided same do not materially adversely affect Tenant’s use or occupancy of the Premises or operation of Tenant’s business

EXHIBIT “E”

SPECIAL PROVISIONS

1.           Moving Allowance.  Landlord agrees to provide Tenant with a moving allowance of $0.50 per rentable square foot (“Moving Allowance”) to be paid to Tenant upon receipt of paid moving expenses in connection with Tenant moving its personal property from its existing leased space to the Premises.  This Moving Allowance may also be used for the Improvements, cabling and furnishing the Premises.  Any unused Moving Allowance shall be credited to Tenant’s  monthly Minimum Rental payments next due until such unused Moving Allowance has been exhausted.

2.           Renewal Option.  So long as Tenant is not in default under this Lease beyond any applicable cure period, Tenant is hereby granted the option to renew the term of the Lease as to the entire Premises for three (3) additional periods (“Renewal Term”) of either three (3) or five (5) years in length, as Tenant may elect, to commence at the expiration of the initial Term or each then current Renewal Term.  Any such renewal of this Lease shall be upon the same terms and conditions of this Lease, except there shall be one less renewal option  in each Term and the annual Minimum Rental during the Renewal Term shall be at the then prevailing Market  Rate (as defined below) for comparable buildings in Charlotte, North Carolina.

The “Market Rate” means the rental rate which Landlord and a third party tenant would agree upon for a new lease, as of the commencement date of such Renewal Term, taking into consideration the uses permitted under the Lease, the quality, size, design and location of the Premises, which shall exclude any specialized improvements added by the Tenant, and the rental for a new lease for comparable space located in the vicinity.  The Market Rate shall include any tenant improvements, moving allowances, tenant improvement allowances, abatement of rentals, leasing commissions or other concessions that are then being offered by Landlord or other property owners for space comparable to the Premises.

Tenant shall notify Landlord of its intent to renew by delivering written notice to Landlord at least ten (10) months prior to the expiration of the initial Term, or then current Renewal Term, with Tenant’s election of the length of each such Renewal Term.  Landlord and Tenant shall then mutually determine the applicable Minimum Rental which will apply to such Renewal Term within thirty (30) days after Tenant’s intent notification or such additional time as necessary.  Tenant shall then exercise its option to renew, if at all, by delivering written notice to Landlord six (6) months prior to the expiration of the initial Term, or then current Renewal Term (provided, however, that in no event shall Tenant be given less than thirty (30) days after the Minimum Rental has been agreed upon in which to exercise said option), which such renewal shall be for the length time stated in Tenant’s intent notice and for the Minimum Rental mutually determined by Landlord and Tenant during the preceding month.

3.           Termination Option.  Tenant shall have the right to terminate this lease (“Termination Right”) with at least six (6) months’ prior written notice to Landlord at the end of the fifth (5th) year of the term.  Tenant must exercise this Termination Right, if at all, within thirty (30) days after the last day of the fifth lease year.  Prior to the effective date of such termination, Tenant shall pay to Landlord an amount equal to Landlord’s unamortized costs for this transaction (including, but not limited to, Tenant Improvement Allowance, Additional Tenant Improvement Allowance, moving allowance, brokers fees, and attorney’s fee) plus all amounts needed to cure then existing monetary defaults, if any.

4.           Rights of First Refusal.  So long as Tenant is not in default of this Lease beyond applicable cure periods and Tenant has not exercised its option set forth in paragraph 5 of this Exhibit  “E”, and subject to any and all prior rights of first refusal granted for space in the Building as of the date of this Lease, in the event  any premises in the  to-be-built adjacent Shopton 18-C building (“Building 18-C”) which is owned by an affiliate of Landlord becomes available for rent, Landlord shall so notify Tenant.  Thereupon, Tenant shall, for a period of ten (10) business days following receipt of such notice, have a right and option to lease such premises at Market Rent and terms for the intended use for the remainder of the term of this Lease (as may be extended).  Upon addition of space to the Premises pursuant to the exercise by Tenant of its option hereunder, Landlord and Tenant shall execute and deliver an amendment to this Lease confirming the same (or, at Tenant’s option, enter into a separate lease for such premises).  Notwithstanding anything in this Lease to the contrary, the right of first refusal granted to Tenant pursuant to this paragraph (i) is not applicable during the final twelve (12) months of the initial Term or any Renewal Term, unless Tenant has exercised its next Renewal Term, if any, in accordance with this Lease, and (ii) shall have no impact on Tenant’s right to exercise its Termination Right for the Premises in accordance with paragraph 3 of this Exhibit “E” (it being understood and agreed that Tenant shall also terminate the lease for Building 18-C at the same time as the Premises, if at all, by reimbursing Landlord for all unamortized costs for the Building 18-C transaction (as described in paragraph 3 of this Exhibit “E”).

5.           Right of First Refusal on Building 18-C (50,000 square feet minimum).  So long as Tenant is not in default of this Lease beyond applicable cure periods, Tenant shall have the option of leasing a minimum of 50,000 square feet in Building 18-C from its owner, which is an affiliate of Landlord.  Tenant must exercise such right, if at all, by providing written notice to Landlord on or before the date which is three (3) months from the date that Tenant receives notice from Landlord of the completion of the Building 18-C shell.  The terms and conditions of any lease in Building18-C shall be on the same terms and conditions as this Lease (including, without limitation, eight (8) months free Annual Rental), as may be adjusted based on the actual square footage leased (i.e. the rental rate and improvement allowance shall be the same per square foot, but will be adjusted if the lease for Building 18-C is not for 102,400 square feet).  In the event any such lease is executed for space in Building 18-C (the “18-C Lease”), the Term of this Lease shall be amended to be a full eighty-nine (89) months from the commencement date of the new 18-C Lease (at the same 3% annual increases in Minimum Rent) such that both leases are coterminous. Notwithstanding anything in this Lease to the contrary, the right of first refusal granted to Tenant pursuant to this paragraph (i) is not applicable during the final twelve (12) months of the initial Term or any Renewal Term, unless Tenant has exercised its next Renewal Term, if any, in accordance with this Lease, and (ii) shall have no impact on Tenant’s right to exercise its Termination Right for the Premises in accordance with paragraph 3 of this Exhibit “E” (it being understood and agreed that Tenant shall also have the right to terminate the lease for Building 18-C at the same time as the Premises by reimbursing Landlord for all unamortized costs for the Building 18-C transaction (as described in paragraph 3 of this Exhibit “E”).

6.           Right of First Refusal on Building 18-D (25,000 square feet minimum).  So long as Tenant is not in default of this Lease beyond applicable cure periods and subject to any and all prior rights of first refusal granted for space in the Building as of the date of this Lease, in the event any premises containing at least 25,000 square feet in the to-be-built Shopton 18-D building (“Building 18-D”) which is owned by an affiliate of Landlord becomes available for rent, Landlord shall so notify Tenant.  Thereupon, Tenant shall, for a period of ten (10) business days following receipt of such notice, have a right and option to lease such premises at Market Rent and terms for the intended use for the remainder of the term of this Lease (as may be extended).  Upon addition of space to the Premises pursuant to the exercise by Tenant of its option hereunder, Landlord and Tenant shall execute and deliver an amendment to this Lease confirming the same (or,  at  Tenant’s option, enter into a separate lease for such premises) .  Notwithstanding anything in this Lease to the contrary, the right of first refusal granted to Tenant pursuant to this paragraph (i) is applicable at all times during the initial Term (and any Renewal Term), but is not applicable during the final twelve (12) months of the initial Term or any Renewal Term unless Tenant has exercised its next Renewal Term, if any, in accordance with this Lease, and (ii) shall have no impact on Tenant’s right to exercise its Termination Right for the Premises in accordance with paragraph 3 of this Exhibit “E” (it being understood and agreed that Tenant shall also have the right to terminate the lease for Building 18-D at the same time as the Premises by reimbursing Landlord for all unamortized costs for the Building 18-D transaction (as described in paragraph 3 of this Exhibit “E”).

7.           Parking.   During the term of this Lease (as same may be extended), Tenant shall have the right to park vehicles in a minimum of 390 unreserved parking stalls on the property known as Shopton 18B, as reflected on Exhibit “E-1”, which Exhibit “E-1” shall subsequently be attached hereto after agreed to by Landlord and Tenant.  Landlord acknowledges that it will work with Tenant to provide extra parking areas in the rear of the Premises, or work with Tenant to find a suitable solution such as cross-parking with the adjacent buildings, in the event there are any parking problems during the term of the Lease to ensure that Tenant has a minimum of 390 parking stalls in the event Tenant uses some of the above referenced 390 parking spaces as a truck court.

8.           Contingency.  Tenant’s obligations under this Lease are contingent upon Tenant  obtaining a Charlotte-Mecklenburg Business Investment Grant (the “Grant”) from the City of Charlotte and County of Mecklenburg in an amount of at least $450,000 within thirty (30) days from the date of this Lease (the “Contingency”).  If Tenant does not receive the Grant within such thirty (30) day period, Tenant shall have the right to terminate this Lease by written notice to Landlord, in which event this Lease shall be null and void, and neither party shall have any further rights or obligations to the other.

9.           Access.  Tenant shall have access to the Premises and Building 24 hours per day, 7 days per week, 365 days per year.

10.           Street Name.  Upon written request from Tenant, and subject to all necessary approvals from the City of Charlotte and County of Mecklenburg, Landlord agrees to promptly (re)name the interior street immediately abutting the Building to be “Shutterfly Road”, “Shutterfly Street” or other similar name (containing the word “Shutterfly”) to be agreed upon by Landlord and Tenant.

11.           Environmental Matters.

(a)  Definitions.  For purposes of this Lease:

(1)  The term "Environmental Law" shall mean and refer to the Comprehensive Environmental Response, Compensation and Liability Act of 1980 ("CERCLA"), 42 U.S.C. §9601, et seq.; the Federal Resource Conservation and Recovery Act of 1976 ("RCRA"), 42 U.S.C. §6901, et seq.; the Federal Water Pollution Control Act, 33 U.S.C. §1251, et seq.; the Clean Air Act, 42 U.S.C. §7401, et seq.; all as the same may be from time to time amended, and any other federal, state, county, municipal, local or other statute, law, ordinance or regulation which relates to or deals with human health or the environment, including, without limitation, all regulations promulgated by a regulatory body pursuant to any such statute, law, ordinance or regulation.

(2)  The terms "Hazardous Substance" and "Hazardous Substances" shall mean and refer to asbestos, radon, urea-formaldehyde, polychlorinated biphenyls ("PCBs"), or substances containing PCBs, nuclear fuel or materials, radioactive materials, explosives, known carcinogens, petroleum products and bi-products, and any substance defined as hazardous or toxic or as a contaminant or pollutant in, or the release or disposal of which is regulated by any Environmental Law.

(b)  Landlord's Representations and Warranties.  Landlord represents that, except as set forth in that certain “Report of Phase I Environmental Site Assessment Update” dated May 15, 2006 prepared for Landlord by MACTEC:

(1)  no Hazardous Substances are now or have ever been located, produced, treated, stored, transported, incorporated, discharged, emitted, released, deposited or disposed of in, upon, under, over or from the Building in violation of any Environmental Law;

(2)  no threats exist of a discharge, release or emission of Hazardous Substances in, upon, under, over or from the Building into the environment in violation of any Environmental Law;

(3)  the Building has not ever been used as or for a mine, a landfill, a dump or other disposal facility, industrial or manufacturing purposes, auto repair, a dry cleaner, or a gasoline service station;

(4)  neither the Building nor any part thereof is in violation of any Environmental Law, no notice of any such violation or any alleged violation thereof has ever been issued or given by any governmental entity or agency, and there is not now nor has there ever been any investigation or report involving the Building by any governmental entity or agency which is in any way related to Hazardous Substances;

(5)  no person, party or private or governmental agency or entity has given any notice of or asserted any claim, cause of action, penalty, cost or demand for payment or compensation, directly or indirectly, resulting from or allegedly resulting from any activity or event described in (1), (2) or (4) above;

(6)  there are not now, nor have there ever been, any actions, suits, proceedings or damage settlements relating in any way to Hazardous Substances in, upon, under, over or from the Building;

(7)  the Building is not listed in the United States Environmental Protection Agency's National Priorities List of Hazardous Waste Sites, CERCLIS, or any other list of hazardous sites maintained by any federal, state or local governmental agency;

(8)  the Building is subject to no lien or claim for lien in favor of any governmental entity or agency as a result of any release or threatened release of any Hazardous Substances.

EXHIBIT “E-1”

Parking

[TO BE ATTACHED AFTER LEASE EXECUTION ONCE AGREED TO BY PARTIES]

EXHIBIT “F”

TENANT:                                _________________________

PROJECT:                                _________________________

To:           Landlord

Re:           Lease Pertaining to ________________________ (the "Project")

Ladies and Gentlemen:

The undersigned, as tenant ("Tenant"), hereby states and declares as follows:

1.           Tenant is the lessee under that certain lease (the "Lease") pertaining to the Project which is dated _______.

2.           The Lease is for the following portion of the Project ______________________________(the "Demised Premises") (if the entire Project, so state):

3.           The Lease has not been modified or amended except by the following documents (if none, so state): _________

4.           The initial term of the Lease commenced on _________, 2____ and shall expire on ______, 2_____, unless sooner terminated in accordance with the terms of the Lease.

Very truly yours,

TENANT:

Shutterfly, Inc.,

a Delaware corporation

By ___________________________

Name: ________________________

Its: ___________________________

AGREED TO THIS ___ DAY OF ___, 200_:

LANDLORD:

3915 SHOPTON ROAD, LLC

By: ________________________

Name: _____________________

Its: ________________________

FIRST AMENDMENT TO LEASE

THIS FIRST AMENDMENT TO LEASE (this “First Amendment”) is made and entered into as of this 26th day of February 2007, by and between 3915 SHOPTON ROAD, LLC, a North Carolina limited liability company (hereinafter referred to as "Landlord"), and SHUTTERFLY, INC., a Delaware corporation (hereinafter referred to as "Tenant").

RECITALS:

A.  Landlord and Tenant have previously entered into that certain Lease Agreement dated December 22, 2006 (the “Lease”) for the occupancy of approximately 102,400 rentable square feet of space (the “Premises”) known as building Shopton 18-B, in the Shopton Ridge Business Park, Charlotte, North Carolina (the “Building”).

B.  Landlord and Tenant desire to amend the Lease as hereinafter set forth.

NOW, THEREFORE, for good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, Landlord and Tenant do hereby enter into this First Amendment and amend the Lease as set forth below.  All terms used but not defined herein shall have the meanings set forth in the Lease.

1. Commencement Date.  The Commencement Date, which is defined in the first sentence of Section 2 of the Lease, is hereby amended to mean “the later of May 30, 2007 or upon substantial completion of Phase I of Landlord’s Work, as defined in Exhibit “C” attached to this First Amendment and made a part hereof.”

2. Delivery of Possession.  Section 4 of the Lease is hereby deleted in its entirety and the following is substituted in lieu thereof:

“Landlord will deliver the Premises to Tenant in phases beginning with Phase I delivered on the Commencement Date, with Landlord’s Work for each Phase (as defined in Paragraph 1 of Exhibit ”C” attached hereto) substantially completed in accordance with the Final Plans and Specifications (as defined in paragraph 1 of said Exhibit ”C”), subject to revisions as mutually agreed to in writing by Landlord and Tenant, as evidenced, if requested by Tenant, by the certification of Landlord’s architect or other designated engineering  representative.  Tenant shall be given access to the Premises upon written request to Landlord not more than sixty (60) days prior to the Commencement Date, for the purposes of preparing the Premises for Tenant’s use.  With the exception of any Annual Rental payments due, all terms and conditions of this Lease shall apply to Tenant upon such occupancy.  Tenant shall coordinate such occupancy with Landlord and shall not interfere with Landlord’s completion of Landlord’s Work.  If Landlord for any reason whatsoever cannot substantially complete Landlord’s Work and deliver possession of Phase I to Tenant on the Commencement Date as above specified, this Lease shall not be void or voidable nor shall Landlord be liable to Tenant for any loss or damage resulting therefrom; but in that event  (except to the extent that any such delay(s) has been caused by Tenant or its agent(s), employee(s), contractor(s) or subcontractor(s) (collectively, “Tenant Delay Factors”), and provided that in each such instance Landlord first gives Tenant written notice that if Tenant does not so cure its act or omission within two (2) business days the same will thereafter be considered a Tenant Delay Factor, the Commencement Date shall be adjusted to be the date when Landlord does in fact substantially complete Landlord’s Work and deliver possession of Phase I to Tenant.  Notwithstanding anything herein to the contrary, in the event Landlord’s Work for Phase I is not complete by the date (such date referred to herein as the “Delivery Date”) which is one hundred twenty (120) days after approval (or deemed approval) by Landlord and Tenant of the Final Phase I Plans and Specification (as hereinafter defined), except for reasons of Tenant Delay Factors or force majeure (which force majeure delays shall only be extended by up to 90 days), Tenant shall be granted three (3) days of free Minimal Rental for every day beyond the Delivery Date until Landlord’s Work for Phase I has been complete, and the Rent Commencement Date shall be adjusted accordingly.  In the event Landlord is unable to deliver the Premises by September 30, 2007, Tenant may terminate this Lease with no further obligation by providing Landlord written notice on or before October 10, 2007.”

3. Upfit of the Premises.  Exhibit “C” to the Lease, Upfit of the Premises, is hereby deleted in its entirety and the revised Exhibit “C” attached hereto is substituted in lieu thereof.

4. Exhibit “E” to the Lease.

a.Section 5 of Exhibit “E” to the Lease is hereby deleted in its entirety and the following substituted therefor:

“5.           Right of First Refusal on Building 18-C (50,000 square feet minimum).  So long as Tenant is not in default of this Lease beyond applicable cure periods, Tenant shall have the option of leasing a minimum of 50,000 square feet in Building 18-C from its owner, which is an affiliate of Landlord (“Landlord’s Affiliate”).  Tenant must exercise such right, if at all, by providing written notice to Landlord on or before the date which is three (3) months from the date that Tenant receives notice from Landlord of the completion of the Building 18-C shell.  The terms and conditions of any lease in Building 18-C shall (i) be on the same terms and conditions as this Lease (including, without limitation, eight (8) months free Annual Rental), as may be adjusted based on the actual square footage leased (i.e. the rental rate and improvement allowance shall be the same per square foot, but will be adjusted if the lease for Building 18-C is not for 102,400 square feet), and (ii) (subject to approval by Landlord, Landlord’s Affiliate, the applicable lenders for Landlord and Landlord’s Affiliate and further subject to applicable Legal Requirements) give Tenant the right, at Tenant’s sole cost and expense (subject to application of the Improvements Allowance and the Additional Tenant Improvement Allowance, each as hereinafter defined), to (a) block-off the back side of the driveway between Building 18-C and Building 18-B and create an enclosed walkway between such buildings as shown on Exhibit “E-2” attached hereto (the “Walkway”), and (b) lay conduit between such buildings.  Tenant acknowledges that it will be solely responsible for all maintenance and repair of the Walkway and upon written demand from Landlord must remove the same at the expiration or earlier termination of the Lease and restore the parking lot to its condition prior to installation of the Walkway.  In the event any such lease is executed for space in Building 18-C (the “18-C Lease”), the Term of this Lease shall be amended to be a full eighty-nine (89) months from the commencement date of the new 18-C Lease (at the same 3% annual increases in Minimum Rent) such that both leases are coterminous. Notwithstanding anything in this Lease to the contrary, the right of first refusal granted to Tenant pursuant to this paragraph (i) is not applicable during the final twelve (12) months of the initial Term or any Renewal Term, unless Tenant has exercised its next Renewal Term, if any, in accordance with this Lease, and (ii) shall have no impact on Tenant’s right to exercise its Termination Right for the Premises in accordance with paragraph 3 of this Exhibit “E” (it being understood and agreed that Tenant shall also have the right to terminate the lease for Building 18-C at the same time as the Premises by reimbursing Landlord for all unamortized costs for the Building 18-C transaction (as described in paragraph 3 of this Exhibit “E”).”

b.           Section 7 of Exhibit “E” to the Lease is hereby deleted in its entirety and the following substituted therefor:

“7.           Parking.   During the term of this Lease (as same may be extended), Tenant shall have the right to park vehicles in a minimum of 275 unreserved parking stalls on the property known as Shopton 18B, as reflected on Exhibit “E-1” attached hereto.  Landlord acknowledges that it will work with Tenant to provide extra parking areas in the rear of the Premises, or work with Tenant to find a suitable solution such as cross-parking with the adjacent buildings, in the event that (i) there are any parking problems during the term of the Lease, or (ii) Tenant anticipates a short-term increase in the number of parking stalls required to support peak production periods, or (iii) Tenant determines that it needs more than 275 parking spaces.  Tenant acknowledges that such 275 parking stalls will be available only until Tenant constructs the Walkway, if at all, and subsequent to such Walkway construction, Tenant’s parking stalls will be reduced beyond 275 stalls by the number lost for Tenant’s Walkway.”

c.           Section 8 (Contingency) of Exhibit “E” to the Lease is hereby deleted in its entirety.

5. Ratification.  Except as modified and amended by this First Amendment, all terms and conditions of the Lease shall remain in full force and effect.

IN WITNESS WHEREOF, Landlord and Tenant have executed this Second Amendment as of the date set forth above.

LANDLORD:

3915 SHOPTON ROAD, LLC,

a North Carolina limited liability company

By:  /s/Paul Herndon                                         

         Name: Paul Herndon

         Title: Vice President

TENANT:

SHUTTERFLY, INC.,

a Delaware corporation

By: /s/Stephen E. Recht      

Name: Stephen E. Recht                                 

Title: Chief Financial Officer                                         

EXHIBIT “C”

Upfit of Premises

1.           LANDLORD’S WORK

Landlord, at Tenant’s sole cost and expense (except as provided in paragraph 2 of this Exhibit ”C”) shall construct all improvements to the Premises which constitute a part of Landlord’s Work (collectively, the “Improvements”) in a good and workmanlike manner and in accordance with the Final Plans and Specifications (as hereinafter defined) and all applicable Legal Requirements.  “Landlord’s Work” shall mean that certain work related to Tenant’s occupancy of the Premises which shall be mutually agreed upon by Landlord and Tenant.   Tenant acknowledges that Landlord’s Work shall proceed in multiple phases (each a “Phase”).  Tenant has not yet completed final design plans for all Phases. Landlord and Tenant shall mutually decide upon the scope and completion date(s) for each of the Phases.

For purposes of this Lease, Landlord’s Work for each Phase shall be deemed “substantially complete” when (i) Landlord has completed Landlord’s Work for such Phase except for punchlist items which do not prevent or materially impair Tenant’s use or occupancy of such Phase, (ii) Tenant can occupy the completed Phase for the purpose of carrying on its intended business therein,  and (iii) Landlord has procured a temporary or permanent certificate of occupancy for such Phase, which shall allow Tenant to operate its business within the Phase.  Landlord represents and warrants that the Building has been constructed in (a) a good and workmanlike manner, (b) in accordance with applicable Legal Requirements, and (c) in accordance with Landlord’s base building shell specifications per the architectural drawings dated February 21, 2006 prepared by Merriman Schmitt which have been approved by both Tenant and Landlord (the “Base Building”).

Notwithstanding anything contained herein to the contrary, Tenant (and not Landlord) shall be solely responsible for any increases in the cost of Landlord’s Work which are attributable to (i) any change orders requested by Tenant to the Final Plans and Specifications which are agreed to between Landlord and Tenant and/or (ii) any Tenant Delay Factors (as described in Paragraph 4 of the Lease).  Such cost increases (subject to application of the Improvements Allowance and Additional Tenant Improvement Allowance, each as hereinafter defined) shall be payable by Tenant to Landlord within 30 days of Landlord’s written demand therefor.

Landlord shall have the final plans and specifications prepared for Phase I of Landlord’s Work (the “Final Phase I Plans and Specifications”) and delivered to Tenant for its review and approval (which approval shall not be unreasonably withheld) on or before March 13, 2007.    Tenant, acting reasonably and in good faith, shall have seven (7) days from Landlord’s delivery of the Final Phase I Plans and Specifications to advise Landlord, in writing, as to whether or not Tenant desires any changes to the Final Phase I Plans and Specifications.  If Tenant fails to respond during such seven (7) day period, Tenant shall automatically be deemed to have approved the Final Phase I Plans and Specifications.  Landlord, acting reasonably and in good faith, shall have four (4) business days from Tenant’s delivery of Tenant’s response to advise Tenant, in writing, as to whether or not Landlord desires any changes to Tenant’s proposed changes to the Final Phase I Plans and Specifications.  If Landlord fails to respond during such four (4) day period, Landlord shall automatically be deemed to have approved Tenant’s proposed changes to the Final Phase I Plans and Specifications.

Landlord, acting reasonably and in good faith, shall have seven (7) days from Tenant’s delivery of the final plans and specifications for the Phases (other than Phase I) of Landlord’s Work (the “Final Remaining Phases Plans and Specifications”) to advise Tenant, in writing, as to whether or not Landlord desires any changes to the Final Remaining Phases Plans and Specifications.  If Landlord fails to respond during such seven (7) day period, Landlord shall automatically be deemed to have approved the Final Remaining Phases Plans and Specifications.  Tenant, acting reasonably and in good faith, shall have four (4) business days from Landlord’s delivery of Landlord’s response to advise Landlord, in writing, as to whether or not Tenant desires any changes to Landlord’s proposed changes to the Final Remaining Phases Plans and Specifications.  If Tenant fails to respond during such four (4) business day period, Tenant shall automatically be deemed to have approved Landlord’s proposed changes to the Final Remaining Phases Plans and Specifications.  Within seven (7) business days after the Final Remaining Phases Plans and Specifications have been finally approved (or deemed approved) by Landlord and Tenant, Landlord shall submit such Final Remaining Phases Plans and Specifications to the contractors for bidding purposes in accordance with the provisions set forth below.

The Final Phase I Plans and Specifications and the Final Remaining Phases Plans and Specifications, shall sometimes collectively be referred to as the “Final Plans and Specifications.”

In the essence of time, Landlord shall hire DSS Corporation as the general contract for Landlord Work.  DSS Corporation agrees to competitively bid the work to all subcontractors and open-book all bids for Tenant and Landlord review and selection.  DSS Corporation shall receive a “cost plus 5%” fee.  Tenant shall have the opportunity to review and provide input concerning the subcontractor bids, which Tenant agrees to do in a timely and good faith manner.

Tenant acknowledges and agrees that Tenant Delay Factors, as defined in paragraph 4 of the Lease, shall include, without limitation, any delays resulting from (i) change orders to the Final Phase I Plans and Specifications or subsequent approved plans and specifications for the remaining phases of construction, requested by Tenant or by those acting for or under the direction of Tenant; (ii) the performance or completion by Tenant, or any entity or person employed by Tenant, of any work in or about the Premises; (iii) the failure of Tenant to supply adequate information to Landlord to prepare the Final Phase I Plans and Specifications by March 13, 2007; or (iv) the failure of Landlord and Tenant to mutually agree on the Final Phase I Plans and Specifications or subsequent plans and specifications for the remaining phases of construction in a timely manner, provided that in each such instance Landlord first gives Tenant two (2) business days notice that if Tenant does not  so cure its act or omission  the same will thereafter be considered a Tenant Delay Factor.

Except to the extent expressly provided in the Lease, Landlord shall have no liability or obligation whatsoever to remedy, replace or correct any alleged defects and deficiencies in Landlord’s Work; provided, however, that Landlord specifically warrants that  (i) all loading doors will be properly operational for three (3) months after the Commencement Date, absent any negligence of Tenant, and (ii) Landlord shall throughout the term of this Lease (as same may be extended) be responsible for repairing any latent defects in the Improvements at Landlord’s sole cost.  Landlord shall, to the extent permitted by law, assign all warranties associated with the Premises to, and cooperate with, Tenant in the enforcement of any express warranties or guarantees of workmanship or materials given by any contractors, subcontractors, architects, draftsmen, or materialmen relative to Landlord’s Work, the roof or any relevant Building systems.  Notwithstanding anything to the contrary contained herein or in the Lease, Landlord shall not be responsible, to any extent whatsoever, for the repair, remediation or correction of any alleged deficiencies or defects in any materials and workmanship in and concerning Landlord’s Work to the extent that the existence or occurrence of such defects or deficiencies are the result of, or due to, any negligent, willful or intentional or other acts or omissions of Tenant, its agents, employees, contractors, subcontractors, representatives or invitees.  Tenant may not conduct any activities on the Premises that would have the effect of rendering any relevant warranties related to the performance of Landlord’s Work void (unless previously approved by the Landlord), and if Tenant does conduct any such activities and renders any relevant warranty void, Landlord will no longer have any obligations under the terms of the Lease with respect to the component, element or feature of the Improvements that the warranty voided by Tenant’s activities had previously covered.  Except as otherwise provided in this Lease, at no time during the Lease term (as same may be extended pursuant to any renewal option, if any) shall Tenant have any right, of any nature whatsoever, to withhold the timely payment of any rental due under the Lease as a result of, or due to, or because of, any alleged breaches by Landlord under the Lease or the alleged existence of any defects or deficiencies in the Improvements.

Landlord shall obtain all applicable licenses, permits and approvals to complete the Tenant Improvements in accordance with all applicable laws.

Landlord shall give Tenant estimates of the schedule for completion of each Phase of the Improvements and thirty (30) days prior written notice of the anticipated date each Phase of the Premises will be ready for occupancy.  Within thirty (30) days following the Commencement Date, and thereafter within thirty (30) days following the completion of each remaining Phase, Landlord and Tenant shall mutually conduct a walk-through of the Premises and compile a punch list which sets forth any corrective work to be performed by Landlord with respect to the Improvements which Landlord, upon receipt, shall diligently pursue to correct.

Landlord represents and warrants to Tenant with respect to each completed Phase, that as of the date each Phase is delivered to Tenant:

(i)           such Phase, including the HVAC, electrical, mechanical, plumbing, sewer and other systems serving that Phase within the Building, shall be in good working order;

(ii)           the Improvements within such completed Phase, and the Building upon completion of all Phases, shall not violate any covenants or restrictions of record (if any), or any applicable Legal Requirements having jurisdiction over the Project, and

(iii)          Landlord shall deliver each Phase to Tenant clean and free of debris.

Except as provided in Section 5(c) of the Lease, Tenant shall have no obligation to restore the Premises to their original condition as of the Commencement Date upon lease termination or expiration of the Lease.

Landlord agrees that there shall be no construction management fee payable by Tenant to Landlord to oversee the construction of the Improvements.

2.           IMPROVEMENTS ALLOWANCE

Notwithstanding anything to the contrary herein, Landlord shall contribute an amount (such amount being the “Improvements Allowance”) not to exceed $16.00 per rentable square foot of the Premises ($1,638,400.00 based on the rentable square footage of 102,400) towards the costs incurred by Landlord and/or Tenant in designing, planning and constructing the Improvements.  In the event the costs incurred in connection with designing, planning and constructing the Improvements exceed the Improvements Allowance (subject to application of the Additional Tenant Improvement Allowance, as hereinafter defined), Tenant shall be solely responsible for bearing and paying any such excess costs within thirty (30) days of Landlord’s written demand therefor.  In the event the costs incurred by Landlord and/or Tenant in connection with designing, planning and constructing the Improvements are less than the Improvements Allowance, Tenant shall provide Landlord with written notice prior to August 31, 2007 which may direct Landlord to pay such excess amounts directly to Tenant’s contractor/vendors for additional improvements to the Premises conducted by or for Tenant, or apply such excess amounts against the Minimum Rental payment(s) next due from Tenant until such excess amounts have been exhausted.  Without limiting the foregoing, Landlord acknowledges that “the costs incurred by Landlord and/or Tenant in designing, planning and construction the Improvements” shall be deemed to include the cost to obtain any and all (i) operating permit(s) that Tenant may be required to obtain (if any) in order for Tenant to operate for Tenant’s permitted use as described in Article 6(a) of this Lease; (ii) construction permits (including costs associated with any “express review” process); (iii) space planning; (iv) construction documents; (v) upfit costs; and (vi) any additional costs associated with the upfit.

3.           ADDITIONAL TENANT IMPROVEMENT ALLOWANCE

Upon written request to Landlord, Landlord agrees to provide Tenant with an additional improvement allowance up to a maximum of $250,000.00 (the “Additional Tenant Improvement Allowance”) to be used by Tenant for additional improvements to the Premises, and/or furniture, fixtures or equipment for the Premises.  Any such elected Additional Tenant Improvement Allowance shall be amortized over the entire eighty-nine (89) month term at an annual interest rate of ten percent (10%) and paid by Tenant as part of the Minimum Rent due under the Lease.  Landlord and Tenant shall amend this Lease as necessary to reflect such increased rent obligation.

EXHIBIT “E-1”

Parking

EXHIBIT “E-2”

Enclosed Walkway

SECOND AMENDMENT TO LEASE

THIS SECOND AMENDMENT TO LEASE (this “Second Amendment”) is made and entered into this 31st day of October, 2007, by and between 3915 SHOPTON ROAD, LLC, a North Carolina limited liability company (hereinafter referred to as "Landlord"), 4015 SHOPTON ROAD, LLC, a North Carolina limited liability company (“Temporary Landlord”) and SHUTTERFLY, INC., a Delaware corporation (hereinafter referred to as "Tenant").

RECITALS:

A.  Landlord and Tenant have previously entered into that certain Lease Agreement dated December 22, 2006; as amended by that certain First Amendment to Lease dated February 26, 2006, (as amended, the “Lease”) for the occupancy of approximately 102,400 rentable square feet of space (the “Premises”) known as building Shopton 18-B, in the Shopton Ridge Business Park, Charlotte, North Carolina (the “Building”).

B.  Temporary Landlord owns that certain building adjacent to the Premises known as Shopton 18-C (the “Temporary Building”).  Tenant desires to lease temporary storage space from Temporary Landlord upon the same terms and conditions as the Lease, except as set forth herein.

C.  Landlord and Tenant desire to amend the Lease as hereinafter set forth and Temporary Landlord executes this Second Amendment evidencing its consent and acknowledgement of the terms and conditions of lease of the Temporary Premises.

NOW, THEREFORE, for good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, Landlord and Tenant do hereby enter into this Second Amendment and amend the Lease as set forth below.  All terms used but not defined herein shall have the meanings set forth in the Lease.  All Recitals are incorporated herein as if fully set forth below.

1.Signage.  Landlord hereby approves the signage proposal as defined in Exhibit “A” attached to this Second Amendment and made a part hereof. Tenant agrees to remove said signage from the Building upon Lease expiration or earlier termination and return any portion of the Building façade affected by such signage removal to its original condition, ordinary wear and tear excepted.

2.           Temporary Premises.  Landlord hereby leases to Tenant, and Tenant hereby accepts and rents from Landlord, for the period of November 1, 2007 (“Temporary Premises Commencement Date”) through and including January 31, 2008 (the “Temporary Premises Term”, that certain office/warehouse space (the “Temporary Premises”) containing approximately 19,200 rentable square feet as shown on the attached Exhibit B in the Temporary Building.  Tenant acknowledges that Landlord shall be permitted to show the Temporary Premises to prospective tenants upon reasonable notice to Tenant.  Landlord shall use commercially reasonable efforts not to interfere with Tenant’s use of the Temporary Premises during such showings.

3.           Temporary Premises Rent.  During the Temporary Premises Term, Tenant shall pay to Landlord, without notice, demand, reduction, setoff or any defense, and in addition to all payments due under the Lease for the Premises: (i) a monthly rental of $3,200.00; and (ii) Tenant’s prorate share of all taxes, insurance and common area maintenance costs for the Temporary Space, in advance, on or before the first day of each month of the Temporary Premises Term.

4.           Temporary Premises Improvements.  Tenant agrees to accept the Premises in its “AS-IS”, “WHERE-IS” condition.  Notwithstanding anything in the Lease regarding approval to the contrary, Tenant may, without any further approval or notice to Landlord, at Tenant’s sole cost and expense, including all permits, if any, in a good and workmanlike manner, perform the following improvements in the Temporary Premises: (i) erect an interior chain-link fence dividing the Temporary Premises from the remaining premises in the Building, provided, however, that Tenant shall be responsible for removing the fence upon expiration of the Temporary Premises Term; (ii) erect an exterior, temporary ramp to the rear door of the Temporary Premises; and (iii) install floor lamps.

5.           Lease.  With the exception of anything noted in this Second Amendment, the terms and conditions of Sections 5 through 35 the Lease shall govern the lease of the Temporary Premises and both Temporary Landlord and Tenant hereby agree to be bound by all such terms and conditions, except, with respect to the Temporary Premises as follows:

a.   All references in the Lease to the “Premises” shall be deemed to mean the Temporary Premises;

b.   All references in the Lease to the “Building” shall be deemed to mean the Temporary Building;

c.   The last sentence of Section 14 (Governmental Orders) is hereby deleted in its entirety.

d.   Notwithstanding anything in the Lease to the contrary, Tenant shall only be obligated to insure its personal property stored within the Premises.

e.   The first sentence of Section 9(a) is hereby deleted in its entirety and the following substituted therefor:

“Except as provided in Article 10 (Tenant’s Covenant to Repair), Landlord, at Landlord's sole cost and expense, shall keep the entire Building in good repair and maintenance (including replacements) at all times, for the proper operation of the Building in a manner generally consistent with the maintenance and repair (including replacements) of comparable properties, including, without limitation, the Temporary Premises, the common areas, the Building's windows, roof, foundation, structure and walls, and mechanical and electrical systems, which include, but are not limited to, the heating, electrical, air conditioning, ventilation and plumbing systems.”

f. Section 10 (Tenant’s Covenant to Repair) is hereby deleted in its entirety and the following substituted therefor.

“Except as provided in Article 9 (Landlord's Covenant to Repair and  Replace), 13 (Damage or Destruction of Premises), 19 (Eminent Domain), and reasonable wear and tear, Tenant shall at all times repair all damage to the Temporary Premises caused by Tenants or it employees, contractors, agents and invitees, and return any portion of the Premises affected by such damage to its original condition.”

6.            This Second Amendment may be executed in counterparts, which when taken together, shall constitute the entire agreement.  Temporary Landlord, Landlord and Tenant agree that the delivery of an executed copy of this Second Amendment by facsimile or by email of a *.pdf file with an original to follow shall be legal and binding and shall have the same force and effect as if an original executed copy of this Second Amendment had been delivered.

7.            Ratification.  Except as modified and amended by this Second Amendment, all terms and conditions of the Lease shall remain in full force and effect.

[REMAINDER OF PAGE LEFT INTENTIONALLY BLANK]

IN WITNESS WHEREOF, Landlord and Tenant have executed this Second Amendment as of the date set forth above.

LANDLORD:

3915 SHOPTON ROAD, LLC,

a North Carolina limited liability company

By:   /s/ Paul Herndon                                        

         Name: Paul Herndon

         Title: Vice President

TENANT:

SHUTTERFLY, INC.,

a Delaware corporation

By:   /s/ Stephen E. Recht        

Name: Stephen E. Recht                                                        

Title:   Chief Financial Officer                                                                        

TEMPORARY LANDLORD:

4015 SHOPTON ROAD, LLC,

a North Carolina limited liability company

By:    /s/ Paul Herndon                                       

         Name: Paul Herndon

         Title: Vice President

EXHIBIT “A”

Tenant’s Signage Proposal

EXHIBIT “B”

Temporary Premises Floor Plan

ADDENDUM TO SECOND AMENDMENT TO LEASE

THIS ADDENDUM TO SECOND AMENDMENT TO LEASE (this “Addendum”) is made and entered into this 3rd day of January, 2008, by and between 3915 SHOPTON ROAD, LLC, a North Carolina limited liability company (hereinafter referred to as "Landlord"), 4015 SHOPTON ROAD, LLC, a North Carolina limited liability company (“Temporary Landlord”) and SHUTTERFLY, INC., a Delaware corporation (hereinafter referred to as "Tenant").

RECITALS:

A.  Landlord, Temporary Landlord and Tenant have previously entered into that certain temporary lease arrangement more particularly described in the Second Amendment to Lease dated October 31, 2007; (the “Second Amendment”) between Temporary Landlord, Tenant and Landlord for the temporary occupancy of approximately 19,200 rentable square feet of space (the “Temporary Premises”) in the building commonly known as Shopton 18-C, in the Shopton Ridge Business Park, Charlotte, North Carolina (the “Building”).

B.  Landlord, Temporary Landlord and Tenant desire to amend Second Amendment to allow Tenant to remain in the Premises until March 31, 2008.

NOW, THEREFORE, for good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, Landlord, Temporary Landlord and Tenant do hereby enter into this Addendum and amend the Lease as set forth below.  All terms used but not defined herein shall have the meanings set forth in the Second Amendment.  All Recitals are incorporated herein as if fully set forth below.

1.           Temporary Premises.  Landlord, Temporary Landlord and Tenant hereby amend the Second Amendment such that the Temporary Premises Term shall expire on March 31, 2008.

2.            Counterpart Execution.  This Amendment may be executed in counterparts, which when taken together, shall constitute the entire agreement.  Landlord, Temporary Landlord and Tenant agree that the delivery of an executed copy of this Addendum by facsimile or by email of a *.pdf file with an original to follow shall be legal and binding and shall have the same force and effect as if an original executed copy of this Addendum had been delivered.

3.            Ratification.  Except as modified and amended by this Addendum, all terms and conditions of the Second Amendment shall remain in full force and effect.

IN WITNESS WHEREOF, Landlord, Temporary Landlord and Tenant have executed this Addendum as of the date set forth above.

LANDLORD:

3915 SHOPTON ROAD, LLC,

a North Carolina limited liability company

By:   /s/Paul Herndon                                        

         Name: Paul Herndon

         Title: Vice President

TENANT:

SHUTTERFLY, INC.,

a Delaware corporation

By: /s/Douglas Appleton          

Name: Douglas S. Appleton                                                               

Title:   VP, Legal                                                                        

TEMPORARY LANDLORD:

4015 SHOPTON ROAD, LLC,

a North Carolina limited liability company

By:   /s/Paul Herndon                                        

         Name: Paul Herndon

         Title: Vice President

EX-10.23

Exhibit 10.23

FIRST AMENDMENT TO LEASE

(EXPANSION)

This First Amendment to Lease (the “Agreement”) is entered into as of April 30, 2007, by and between WESTPORT OFFICE PARK, LLC, a California limited liability company (“Landlord”), and SHUTTERFLY, INC., a Delaware corporation ("Tenant"), with respect to the following facts and circumstances:

A.  Landlord and Tenant are parties to that certain Lease Agreement dated July 5, 1999 (the “Initial Lease Agreement), as amended by the Commencement Letter dated September 8, 1999, a letter agreement dated December 28, 1999, Amendment No. 1 dated January 11, 2000, Amendment No. 2 dated May 21, 2001, Amendment No. 3 dated July 6, 2004, and Amendment No. 4 (“Amendment No. 4”) dated April 28, 2005 (collectively, the “Original Lease”), of certain premises (the “Existing Premises”) within the building commonly known as 2800 Bridge Parkway, Redwood City, California, and more particularly described in the Original Lease.  Capitalized terms used and not otherwise defined herein shall have the meanings given those terms in the Original Lease.

B.  Landlord and Tenant desire to amend the Original Lease to add additional space on the terms and conditions provided herein.

IT IS THEREFORE, agreed as follows:

1.   As used in this Agreement, the following terms have the following meanings:

“3000 Bridge Building” means the commercial office building located at 3000 Bridge Parkway, Redwood City, California.

“Expansion Space” means a portion of the 3000 Bridge Building, containing approximately 12,036 square feet of rentable area, commonly known as Suites 102 and 103 and more particularly shows on Exhibit “A-1” attached hereto.  For purposes of this Agreement, “rentable area” shall be calculated pursuant to the Standard Method for Measuring Floor Area in Office Buildings (ANSI/BOMA Z65.1, 1996).  Notwithstanding anything to the contrary in this Agreement, the recital of the rentable area herein above set forth is for descriptive purposes only.  Tenant shall have no right to terminate the Lease or receive any adjustment or rebate of any Basic Rent or Additional Rent payable hereunder if said recital is incorrect.  The Tenant has inspected the Expansion and is fully familiar with the scope and size thereof and agrees to pay the full Basic Rent and Additional Rent set forth herein in consideration for the use and occupancy of said space, regardless of the actual number of squire feet contained therein.

“Expansion Space Commencement Date” shall mean June 1, 2007.

2.Effective on the Expansion Space Commencement Date, the Premises shall be expanded to include the Expansion Space.  Accordingly, effective on the Expansion Space Commencement Date, the following terms of the Original Lease are amended as follows:

2.1           The Expansion Space is added to the Premises such that the Premises shall be comprised of the Existing Premises and the Expansion Space, and Exhibit “A-1” attached hereto is hereby added to Exhibit “A” to the Original Lease.

2.2           Landlord and Tenant acknowledge that the provisions of Amendment No. 4 with respect to management fee, tenant maintenance, expenses of operation, management and maintenance of Common Areas in Buildings, utilities, and taxes that currently apply in the Original Lease to the Existing Premises are based on Tenant occupying the entire building in which the Existing Premises is located.  Accordingly, with respect to the Expansion Space the following provisions of the Initial Lease Agreement shall apply to the Expansion Space and the amendments of those sections made after the Initial Lease Agreement shall not be taken into account in determining Tenant’s obligations with respect to the Expansion Space: Paragraphs 4D, 4E, 7, 10, 11, and 12.  To the extent any costs are not generally applicable to the Building and the 3000 Bridge Building or to Common Areas, the amounts of those costs payable by Tenant shall be determined independently for the Existing Premises and the Expansion Space.

2.3           Tenant agrees to pay Landlord a Basic Rent for the Expansion Space in accordance with the following schedule:

Period	Annual Basic Rent	Monthly Basic Rent
June 1, 2007 – June 30, 2007	N/A	Abated
July 1, 2007 – June 30, 2008	$281,642.40	$23,470.20
July 1, 2008 – June 30, 2009	$303,357.20	$25,275.60
July 1, 2009 – May 31, 2010	N/A	$27,081.00

The Monthly Basic Rent for the second month and estimated Additional Rent for the first month after the Expansion Space Commencement Date shall be payable upon the execution of this Agreement.  The Monthly Basic Rent for the Expansion Space shall be payable in the manner provided for in the Original Lease.

2.4           Paragraph 6 is amended to increase Tenant’s non-exclusive parking spaces by thirty-nine (39) spaces, or from one hundred sixty-one (161) spaces to two hundred (200) spaces.

2.5           The Term with respect to the Expansion Space shall be coterminous with the Existing Premises.  In the event that Tenant exercises its extension option or a termination right under the Original Lease, such extension or termination shall apply to the entire Premises then subject to the Original Lease (including the Expansion Space).

3.Tenant may take possession of the Expansion Space upon the full execution and delivery of this Agreement.  Tenant’s possession of the Expansion Space prior to the Expansion Space Commencement Date shall be on all the terms and conditions of the Original Lease, as amended hereby, except that Tenant shall not be obligated to pay Basic Rent or Additional Rent.  After the Expansion Space Commencement Date, Tenant’s obligation with respect to Basic Rent and Additional Rent shall be provided in the Original Lease, as amended by this Agreement.

4.Except as provided in Section 5, below, Tenant shall accept the Expansion Space in its “AS IS” condition.  Tenant agrees that Landlord has no obligation and has made no promise to alter, remodel, improve, or repair the Expansion Space, or any part thereof, or to repair, bring into compliance with applicable laws, or improve any condition existing in the Expansion Space as of the Expansion Space Commencement Date.  The taking of possession of the Expansion Space by Tenant shall be conclusive evidence that the Expansion Space and the Building were in good and satisfactory condition at the time possession was taken by Tenant.  Neither Landlord nor Landlord’s agents have made any representations or promises with respect to the condition of the 3000 Bridge Building, the Expansion Space, the land upon which the 3000 Bridge Building is constructed, the present or future suitability or fitness of the Expansion Space or the 3000 Bridge Building for the conduct of Tenant’s particular business, or any other matter or thing affecting or related to the 3000 Bridge Building or the Expansion Space, and no rights, easements or licenses are acquired by Tenant by implication or otherwise except as expressly set forth in this Original Lease.  Any improvements or personal property located in the Expansion Space are delivered without any representation or warranty from Landlord, either express or implied, of any kind, including without limitation, title, merchantability, or suitability for a particular purpose.  Tenant shall deliver to Landlord any modifications to Tenant’s insurance required under the Original Lease to reflect the addition of the Expansion Space and Tenant’s entry into the Expansion Space prior to the delivery of possession to Tenant.

5.Notwithstanding Section 4, above, Landlord warrants that the roof, structural components of the Building, HVAC system, electrical and plumbing systems, doors, elevator, parking lot or site lighting (the “Covered Items”), other than those constructed by Tenant, shall be in good operating condition on the date possession of the Premises is delivered to Tenant.  If a non-compliance with such warranty exists as of the delivery of possession, or if one of such Covered Items should malfunction or fail within sixty (60) days after the delivery of possession to Tenant, Landlord shall, as Landlord’s sole obligation with respect to such matter, promptly after receipt of written notice from Tenant setting forth in reasonable detail the nature and extent of such non-compliance, malfunction or failure, rectify the same at Landlord’s expense.  If Tenant does not give Landlord the required notice within sixty (60) days after the delivery of possession to Tenant, Landlord shall have no obligation with respect to that warranty other than obligations regarding the Covered Items set forth elsewhere in the Lease.

6.Landlord and Tenant acknowledge that Tenant may desire to make certain Alterations to the Expansion Space in accordance with Article 9 of the Lease (“Tenant’s Work”).  So long as no default shall be declared and existing under the Original Lease (as amended by this Agreement) as of the date Tenant requests reimbursement of the Allowance (as defined below), Landlord agrees to reimburse Tenant up to, and not to exceed the sum of One Hundred Eight Thousand Five Hundred Forty Dollars ($180,540.00) (the “Allowance”) (based on a $15.00 prsf of the Premises).  Landlord shall pay the Allowance to Tenant upon delivery to Landlord of “Tenant’s Completion Notice” (as defined below) according to the terms and conditions of this Section 6.   The Allowance shall be used to reimburse Tenant for hard and/or soft costs incurred in connection with Tenant’s Work (“Tenant’s Work Costs”); provided, however, in no event shall the Allowance be used to pay for any of Tenant’s trade fixtures, equipment or inventory.  Upon the completion of Tenant’s Work, Tenant shall submit to Landlord a written notice indicating that Tenant has completed the construction and performance of Tenant’s work in accordance with the provisions of Article 9 of the Original Lease, as amended by this Agreement, which notice shall be accompanied by all of the following (collectively, “Tenant’s Completion Notice”): (i) copies of paid invoices and final, unconditional lien waivers from Tenant’s general contractor and all subcontractors and material suppliers, showing that full payment has been received for the construction of Tenant’s Work; (ii) certification from Tenant’s architect that all of Tenant’s Work has been completed substantially in accordance with the plans and specifications therefor (approved by Landlord, to the extent Landlord’s approval of such plans and specifications was required under Article 9 of the Original Lease, as amended by this Agreement) and all local governmental and quasi-governmental authorities with jurisdiction; and (iii) a copy of the building permit for Tenant’s Work has been finally approved.  The Allowance shall be available for a single reimbursement to Tenant during the period from June 1, 2007 through December 31, 2007 (the “Window”).  Any portion of the Allowance not requested by Tenant within the Window shall be deemed forfeited by Tenant and shall no longer be available for disbursement to or for the account of Tenant.  The parties understand and agree that under no circumstances shall Landlord, either by this Agreement or otherwise, have any responsibility for the space planning design.  In approving of any space planning or construction plans and specifications, Landlord is doing so only for its own benefit and does not thereby accept any responsibility that such design and construction has been completed in conformance with all applicable laws, is free from any errors or omissions by the professionals completing such work, is suitable for the purpose for which it is designed or constructed or is otherwise in conformance with recognized industry standards and requirements for such work.

7.The following new Paragraph 54 is added to the Lease:

 54.           TENANT’S RIGHT OF FIRST OFFER

54.1           As used herein, “Offer Space” means any space in the 3000 Bridge Building.  Landlord shall give Tenant a written notice (the “Availability Notice”) identifying the particular Offer Space (the “Specific Offer Space”) that is Available (as defined below).  Landlord shall not be obligated to given an Availability Notice until Landlord determines that Landlord shall commence the marketing of any of the Offer Space because such space shall become Available for lease to third parties.  As used herein, “Available” means that the space (i) is not part of the Premises, (ii) is not then subject to a lease, (iii) is not then subject to any rights of tenant to renew their lease or expand their premises as set forth in their lease, and (iv) is not then subject to any negotiations between Landlord and an existing tenant.  Without limiting the foregoing, Offer Space shall not be Available if it is subject to a renewal or extension right of a tenant, whether or not such right or extension is pursuant to an express written provision in its lease, regardless of whether any such renewal or extension is consummated pursuant to a lease amendment or a new lease.

54.2           The location and configuration of the Specific Offer Space shall be determined by Landlord in its reasonable discretion; provided that Landlord shall have no obligations to designate Specific Offer Space that would result in any space not included in the Specific Offer Space being not Configured for Leasing (as defined below).  For purposes of this Lease, “Configured for Leasing” means the applicable space must have convenient access to the central corridor on the applicable floor and must have a size and configuration that complies with all applicable building codes and other laws and is such that Landlord judges, in its reasonable discretion, that Landlord will be able to lease such space to a third party.  The Availability Notice shall:

(a) Describe the particular Specific Offer Space (including rentable area, useable area and location);  

(b) Include an attached floor plan identifying such space;  

(c) State the date (the “Specific Offer Space Delivery Date”) the space will be available for delivery to Tenant; and  

(d) Specify the Base Rent for the Specific Offer Space.

54.3           If Tenant wishes to exercise Tenant’s rights set forth in this Article 54 with respect to the Specific Offer Space, then within five (5) business days of delivery of the Availability Notice to Tenant, Tenant shall deliver irrevocable notice to Landlord (the “First Offer Exercise Notice”) offering to lease the Specific Offer Space on the terms and conditions as may be specified by Landlord in the Availability Notice.

54.4           In the event Tenant fails to give a First Offer Exercise Notice in response to any Availability Notice, Tenant shall have no further rights to receive an Availability Notice and Tenant’s rights under this Article 54 shall terminate and Landlord shall be free to lease the Offer Space to anyone on any terms at any time during the Term, without any obligation to provide Tenant with any further right to lease that space.

54.5           If Tenant timely and validly gives the First Offer Exercise Notice in response to any Availability Notice, Tenant shall have no further rights to receive an Availability Notice and Tenant’s rights under this Article 54 shall terminate and Landlord shall be free to lease the Offer Space to anyone on any terms at any time during the Term, without any obligation to provide Tenant with any further right to lease that space.

(a) The Specific Offer Space shall be part of the Premises under this Lease (so that the term “Premises” in this Lease shall refer to the space in the Premises immediately before the Specific Offer Space Delivery Date plus the Specific Offer Space);  

(b) Base Rent for the Specific Offer Space shall be specified in the Availability Notice.  

(c) Tenant’s lease of the Specific Offer Space shall be on the same terms and conditions as affect the original Premises from time to time, except as otherwise provided in this section.  Tenant’s obligation to pay Rent with respect to the Specific Offer Space shall begin on the Offer Space Delivery Date.  The Offer Space shall be leased to Tenant in its “as-is” condition and Landlord shall not be required to construct improvements in, or contribute any tenant improvement allowance for, the Offer Space.  Tenant’s construction of any improvements in the Specific Offer Space shall comply with the terms of this Lease concerning alterations.  

(d)  If requested by Landlord, Landlord and Tenant shall confirm in writing the addition of the Specific Offer Space to the Premises on the terms and conditions set forth in this section, but Tenant’s failure to execute or delivery such written confirmation shall not affect the enforceability of the First Offer Exercise Notice.

54.7           Tenant’s rights and Landlord’s obligations under this Article 54 are expressly subject to and conditioned upon there not existing a default by Tenant under this Lease, either at the time of delivery of the First Offer Exercise Notice or at the time the Specific Offer Space is to be added to the Premises.

54.8           It is understood and agreed that Tenant’s rights under this Article 54 are personal to Tenant and not transferable.  In the event of any assignment or subletting of the Premises or any part thereof, this expansion right shall automatically terminate and shall thereafter be null and void.

 8.Except as otherwise provided herein, all of the terms and conditions of the Original Lease shall continue to apply during the Extension Term; provided, however, that there shall be no rent credit, and that there shall be no improvement allowance, Landlord construction obligations or other initial concessions with respect to the Extension Term, except as provided in Paragraph 6 of this Agreement, and Tenant shall have no further option to extend the term.

  9.Landlord hereby represents and warrants to Tenant that it has dealt with no broker, finder or similar person in connection with this Agreement, and Tenant hereby represents and warrants to Landlord that it has dealt with no broker, finder or similar person in connection with this Agreement, other than NAI BT Commercial (“Landlord’s Broker”) and Studley, Inc. (“Tenant’s Broker”).  Landlord and Tenant shall each defend and indemnify and hold the other harmless with respect to all claims, causes of action, liabilities, losses, costs and expenses (including without limitation attorneys’ fees) arising from a breach of the foregoing representation and warranty.  The commission with respect to this Agreement shall be paid to Landlord’s Broker by Landlord pursuant to a separate agreement.  Landlord’s Broker will pay Tenant’s Broker a commission pursuant to a separate agreement.  Nothing in this Agreement shall impose any obligation on Landlord to pay a commission or fee to any party other than Landlord’s Broker.

 10.Time is of the essence of this Agreement and the provisions contained herein.

 11.As additional consideration for this Agreement, Tenant hereby certifies that:

(a) The Original Lease (as amended hereby) is in full force and effect.  

(b) Tenant is in possession of the Premises.  

(c) Rent has been paid through April 30, 3007.  

(d) To Tenant’s knowledge, there are no uncured defaults on the part of Landlord or Tenant under the Original Lease.  

(e) All of Landlord’s obligations with respect to construction of tenant improvements in the Premises and payment of Tenant improvement allowance have been satisfied, except those provided for in Paragraph 6 of this Agreement.  

(f) There are no existing offsets or defenses which Tenant has against the enforcement of the Original Lease (as amended hereby) by Landlord.  

(g) All of the representations and warranties of Tenant in the Original Lease are hereby remade.

 12.Except as specifically provided herein, the terms and conditions of the Original Lease as amended hereby are confirmed and continue in full force and effect.  This Agreement shall be binding on the heirs, administrators, successors and assigns (as the case may be) of the parties hereto.  This Agreement and the attached exhibits, which are hereby incorporated into and made a part of this Agreement, set forth the entire agreement between the parties with respect to the matters set forth herein.  There have been no additional oral or written representations or agreements.  Under no circumstances shall Tenant be entitled to any Rent abatement, improvement allowance, leasehold improvements, or other work to the Premises, or any similar economic incentives that may have been provided to Tenant in connection with entering into the Original Lease, unless specifically set forth in this Agreement.  Tenant agrees that neither Tenant nor its agents or any other parties acting on behalf of Tenant shall disclose any matters set forth in this Agreement or disseminate or distribute any information concerning the terms, details or conditions hereof to any person, firm or entity without obtaining the express written consent of Landlord.  In the case of any inconsistency between the provisions of the Original Lease and this Agreement, the provisions of this Agreement shall govern and control.  Submission of this Agreement by Landlord is not an offer to enter into this Agreement but rather is a solicitation for such an offer by Tenant.  Landlord shall not be bound by this Agreement until Landlord has executed and delivered the same to Tenant.

 13.Effective as of the date hereof, all references to the “Lease” shall refer to the Original Lease, as amended by this Agreement.

 14.To satisfy compliance with the Employee Retirement Income Security Act of 1974, as amended, Tenant represents and warrants to Landlord and The Prudential Insurance Company of America, a New Jersey corporation (“Prudential”), that:

  (a)Tenant is not an “employee benefit plan” (as that term is defined in Section 3(3) of ERISA); and

  (b)Tenant is not acquiring the Property as a plan asset subject to ERISA but for Tenant’s own investment account; and

  (c)Tenant is not an “affiliate” of Prudential as defined in Section IV(b) or PTE 90-1;

  (d)Tenant is not a “part in interest” (as that term is defined in Section 3(14) of ERISA) to the Virginia Retirement System; and

  (e)Tenant agrees to keep the identity of the Virginia Retirement System confidential, except to the extent that Tenant may be required to disclose such information as a result of (i) legal process, or (ii) compliance with ERISA or other Laws governing Tenant’s operations.

IN WITNESS WHEREOF, this Agreement was executed as of the date first above written.

Landlord:

WESTPORT OFFICE PARK LLC

a California limited liability company

By:           THE PRUDENTIAL INSURANCE

COMPANY OF AMERICA, a

New Jersey corporation, its member

By:           /s/ JoLynn Chow Miller

Director & Second Vice President

        Tenant:

        SHUTTERFLY, INC.,

 a Delaware corporation

       By:           /s/ Stephen E. Recht

  Its:           Secretary & CFO

EXHIBIT A-1

EXPANSION SPACE

EX-21.01

Exhibit 21.01

SUBSIDIARIES OF SHUTTERFLY, INC.

     None.

EX-23.01

Exhibit 23.01

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We hereby consent to the incorporation by reference in the Registration Statement on Form No. S−8 (Nos. 333-148487, 333−137676) of Shutterfly Inc. of our report dated March 6, 2008 relating to the consolidated financial statements, financial statement schedule and the effectiveness of internal control over financial reporting, which appears in this Form 10−K.

San Jose, CA

March 6, 2008

EX-31.01

Exhibit 31.01

CERTIFICATION OF CHIEF EXECUTIVE OFFICER

PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, Jeffrey T. Housenbold, President and Chief Executive Officer of Shutterfly, Inc., certify that:

1. I have reviewed this annual report on Form 10-K of Shutterfly, 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 (the registrant’s fourth fiscal quarter in the case of an annual report) 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 (or persons performing the equivalent functions):

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.

  By: /s/  Jeffrey T. Housenbold

               Jeffrey T. Housenbold

             President and Chief Executive Officer

Date: March 10, 2008

EX-31.02

Exhibit 31.02

CERTIFICATION OF CHIEF FINANCIAL OFFICER

PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, Mark J. Rubash, Chief Financial Officer of Shutterfly, Inc., certify that:

1. I have reviewed this annual report on Form 10-K of Shutterfly, 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 (the registrant’s fourth fiscal quarter in the case of an annual report) 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 (or persons performing the equivalent functions):

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.

By: /s/  Mark J. Rubash

 Mark J. Rubash

 Sr. Vice President and Chief Financial Officer

Date: March 10, 2008

EX-32.01

Exhibit 32.01

CERTIFICATION OF CHIEF EXECUTIVE OFFICER

PURSUANT TO

18 U.S.C. SECTION 1350

The undersigned, Jeffrey T. Housenbold, the President and Chief Executive Officer of Shutterfly, Inc. (the “Company”), pursuant to 18 U.S.C. §1350, hereby certifies that:

(i) the Annual Report on Form 10-K for the period ended December 31, 2007 of the Company (the “Report”) fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(ii) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/  Jeffrey T. Housenbold                                                                                       

Jeffrey T. Housenbold

President and Chief Executive Officer

Date: March 10, 2008

EX-32.02

Exhibit 32.02

CERTIFICATION OF CHIEF FINANCIAL OFFICER

PURSUANT TO

18 U.S.C. SECTION 1350

The undersigned, Mark J. Rubash, Chief Financial Officer of Shutterfly, Inc. (the “Company”), pursuant to 18 U.S.C. §1350, hereby certifies:

(i) the Annual Report on Form 10-K for the period ended December 31, 2007 of the Company (the “Report”) fully complies with the requirements of Section 13(a) and 15(d) of the Securities Exchange Act of 1934; and

(ii) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/  Mark J. Rubash                                                                  

Mark J. Rubash

Sr. Vice President and Chief Financial Officer

Date: March 10, 2008