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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

For the fiscal year ended

MARCH 31, 2005

or

Napster, Inc.

(Exact name of registrant as specified in its charter)

9044 Melrose Ave.

Los Angeles, CA 90069

(Address of principal executive offices)

Registrant’s telephone number, including area code: (310) 281-5000

N/A

(Former name or former address, if changed since last report.)

Securities registered pursuant to Section 12(b) of the Act: None

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

Common Stock, $0.001 par value per share

Series A Participating Preferred Stock, $0.001 par value per share

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

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2.)    Yes x  No ¨

As of June 3, 2005, the aggregate market value of voting and non-voting common equity held by non-affiliates of the registrant was approximately $188.9 million. For this computation, Napster has excluded the market value of all common stock beneficially owned by all executive officers and directors of Napster as a group. As of June 3, 2005, the number of outstanding shares of common stock of the registrant was approximately 43,816,190.

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NAPSTER, INC.

INDEX TO ANNUAL REPORT ON FORM 10-K

FOR THE FISCAL YEAR ENDED MARCH 31, 2005

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INTRODUCTION AND NOTE ON FORWARD LOOKING STATEMENTS

We are a Delaware corporation, and our principal executive offices are located at 9044 Melrose Avenue, Los Angeles, California 90069.

You should not rely on forward-looking statements in this annual report. This annual report contains forward-looking statements that involve risks and uncertainties. We use words such as “anticipates,” “plans,” “expects,” “future,” “intends,” “may,” “will,” “should,” “estimates,” “predicts,” “potential,” “continue” and similar expressions to identify such forward-looking statements. This annual report also contains forward-looking statements attributed to certain third parties relating to their estimates regarding the growth of certain markets. Forward-looking statements are subject to known and unknown risks, uncertainties and other facts that may cause our actual results to be materially different from those expressed or implied by such forward-looking statements. These risks, uncertainties and other factors include, among others, those identified under “Risk Factors” and elsewhere in this annual report.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of these statements, and we assume no obligation to update any such statements.

The name “Napster”, our tagline, Napster Light and Napster To Go are trademarks of Napster, Inc. or its subsidiaries in the United States and/or other countries. Other trademarks and tradenames appearing in this annual report are the property of their respective holders.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of our definitive proxy statement for the 2005 annual meeting of stockholders, to be held on October 13, 2005, have been incorporated by reference into Part III of this annual report.

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PART I

ITEM 1.    BUSINESS

Napster, among the most recognized brands in digital music, is a leading provider of online music for the consumer market. Our subscription services and our “a la carte” single track download service enable fans to sample one of the world’s largest and most diverse online music catalogues and to experience a feature rich service, utilizing a secure and legal platform. Napster users have access to songs from all major labels and hundreds of independent labels and have many ways to discover, share and acquire new music and old favorites. Napster subscribers also enjoy community features, such as the ability to email songs to friends and browse other members’ collections. For consumers who want to purchase songs and albums a la carte, rather than through a subscription, we also offer Napster Light, a “lighter” version of our Napster service that does not include the ability to stream or download unlimited tracks or enjoy other premium community features. Napster is currently available in the United States, Canada and the U.K. and is headquartered in Los Angeles with offices in London, New York, San Diego and San Jose.

Until December 17, 2004, Napster was known as “Roxio, Inc.” and we operated our business in two divisions, the consumer software division (“CSD”) and the online music distribution division, also known as the Napster division.

On December 17, 2004, we completed the sale of substantially all of the assets and liabilities of CSD to Sonic Solutions, a California corporation (“Sonic”), including all of the capital stock of certain international subsidiaries. Sonic paid us a total of $72.3 million in cash and 653,837 shares of Sonic common stock, valued at approximately $13.6 million as of the closing date. We intend to retain the proceeds and use them for general working capital purposes and to operate and expand our Napster business.

Since the sale of our consumer software division, we have focused exclusively on our online music distribution business under the Napster brand and, since January 3, 2005, have been traded on the Nasdaq Stock Market under the symbol “NAPS.”

Napster was incorporated in Delaware in August 2000. We maintain executive offices and principal facilities at 9044 Melrose Avenue, Los Angeles, California 90069. Our telephone number is 310-281-5000. We maintain a Web site at www.napster.com. Investors can obtain copies of our SEC filings from this site free of charge, as well as from the SEC Web site at www.sec.gov.

Industry Background

Consumers are fundamentally changing the way that they interact with content, as traditional methods of delivery are being rapidly replaced by newer digital technologies that offer a much greater degree of freedom and flexibility. This trend has been fueled by the rapid growth of Internet usage by consumers, particularly as a result of broadband connections that enable content to be transferred securely at much higher speeds, and a number of powerful new technologies for compressing and sharing digital content using a personal computer. The playback and enjoyment of content obtained over the Internet is not limited to the PC. Content can be “burned” to CDs simply, easily and affordably, or transferred to a growing number of portable consumer devices called “MP3 players,” as well as digital media devices for the living room and car stereo. The increasing adoption of portable MP3 players further increases the demand for content as consumers look to “fill up” their players with music, personal photos and even videos. Consumers are embracing technologies and services that allow them to conveniently obtain, manage and move digital content in an easy and affordable manner.

The growth of consumer Internet connectivity, particularly broadband, has increased consumer access to digital media.

Broadband refers to a range of high-speed Internet connections that are always available, meaning that if a PC is on, it is connected to the Internet. Broadband connections enable consumers to transfer data more

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quickly than on traditional dial-up connections. Data transfer speed becomes increasingly important as the size of the information being transferred grows, such as with rich digital media. In their report entitled “US Broadband and Online Household Forecast, 2005 to 2010”, JupiterResearch forecasts swift broadband adoption over the next few years, reaching nearly 80 percent of U.S. online households by 2010. We believe that this trend, along with other new technologies, will improve consumers’ access to rich digital media. As this flow of digital media to consumers’ PCs via the Internet increases, we believe that consumers will continue to seek products and services that help them quickly and easily find and access content, manage their own collection of digital assets, and help them move their personal collection from their PCs to other media such as CDs and DVDs and to digital entertainment devices, including portable MP3 players.

MP3 players have proliferated and their use has increased.

Many users are playing back digital music, spoken word and video content via consumer electronics devices such as portable MP3 players. This market for portable MP3 players is rapidly expanding according to the JupiterResearch US Portable Music Device Forecast dated April 2005. For example, in the United States, this market is expected to grow from a 15.2 million installed base in 2004 to a projected base of 35.3 million players in 2005. Since fall 2004, a number of device manufacturers have incorporated, or announced that they plan to incorporate, Microsoft’s Windows Media Digital Rights Management 10 technology (“WMDRM10”) into portable MP3 players. WMDRM10 technology allows users to extend their online music subscriptions to their portable MP3 players, providing them greater flexibility in the use of their music collections.

The use of these devices has created demand for services that can provide permanent or limited access to content to “fill” these devices.

The growth in broadband penetration and MP3 player usage is driving growth in the online music industry.

Consumer demand for downloadable digital content, such as compressed audio files, has given rise to independent music web sites and subscription services. Forrester Research estimates that United States purchases of downloadable digital music will exceed $1.9 billion by 2007. In addition, Forrester Research projects that revenues from online music subscription services will exceed $800 million by 2007.

In addition to music, Internet sites exist and are being established which allow for distribution of other downloaded content including spoken word literature and commercial movies.

Our Solution and Products

Our online music subscription services, Napster and Napster To Go, provide consumers with unlimited access to over 1,000,000 songs for monthly fees of $9.95 and $14.95, respectively, in the United States. Fees in other geographies are based on the local currency and vary accordingly. With all of our products, consumers can discover, access and acquire their favorite songs by searching or browsing our catalogue, or accessing preprogrammed content through radio stations or custom compilations. Napster subscribers also have access to community features, such as sharing songs with other members and searching their collections. With a Napster subscription, for as long as consumers maintain their subscription, they can enjoy unlimited on-demand streaming and unlimited tethered downloading of songs to the hard drives of three PCs. With a Napster To Go subscription, users can enjoy all the benefits of a Napster subscription, as well as unlimited transfers of tethered downloads to a compatible MP3 player without paying an additional fee per song. In other words, a Napster To Go subscriber enjoys unlimited music on up to three PCs and “on the go” with up to two compatible MP3 players. In addition to our Napster and Napster To Go offerings, we provide a separate download music store, called Napster Light, where customers who are not subscribers can purchase individual tracks for $0.99 each or albums starting at $6.95. These tracks can be downloaded or “burned” to a CD, or transferred to an MP3 player. Napster’s catalogue of available music exceeds one million tracks and all content is licensed from major music companies, including EMI Recorded Music, Sony BMG, Universal Music Group and Warner Music Group, as well as numerous independent labels, on a non-exclusive basis.

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Our Strategy

Our objective is to become the leading global provider of consumer digital music services. We intend to pursue the following key strategic initiatives to accomplish our objective:

Continue to Build Our Consumer Brand

We have embarked on a fully integrated marketing program and communication strategy with the goal of strengthening our position in the digital music sector. The combination of our strategic focus on subscription and the popularity of the Napster brand has driven our subscriber growth, and we expect this growth to continue. We continue to see strong evidence of consumer adoption of a Napster subscription service and believe that more and more consumers will want to experience, share and discover music. We believe we further demonstrated our leadership in the digital music industry by launching Napster To Go, the world’s first portable subscription service. Our successful launch highlighted the value and rich music experience that a Napster To Go subscription provides.

Continue to Innovate by Investing in New Services and Technologies

We plan to continue to innovate by investing in product development to improve our service, expand the breadth of our service offerings, and maintain compatibility with popular technology standards. A significant focus of our future development efforts will continue to relate to portable subscription and enabling subscribers to enjoy their subscriptions wherever they are located: the office, home, living room, automobile or “on the go”. These development efforts will include efforts on platforms such as the mobile platform. In addition, we intend to leverage our core service offerings and brand to related products and services that support our core service offerings, add to the richness of the consumer experience and provide additional revenue.

Continue to Pursue and Execute Strategic Partnerships

We intend to enter into additional strategic partnerships with the goal of delivering the best experience for consumers. Strategic partnerships allow us to enhance, expand upon and complement our product offerings and increase our distribution by joining with companies that have significantly greater resources and specific expertise than we do. To date, we have entered into strategic partnerships with technology companies (Microsoft, Intel, Dwango), hardware companies (iRiver, Dell, Creative, Samsung, Gateway, eMachines, Toshiba, IBM), retailers (Best Buy, Blockbuster, Radio Shack, Dixons Group, The Link, PC World, Currys, Target), and others (Molson, Miller, Energizer, Nestle).

Continue to Pursue Strategic Acquisitions and Complementary Technologies

When appropriate, we have acquired companies or their products and technologies to expand upon and complement our product offerings. In order to expand our service offerings and take advantage of new market opportunities, we may acquire or invest in other complementary businesses, products and technologies in the future. We have not entered into any agreements or understandings regarding any future acquisitions and cannot ensure that we will be able to identify or complete any acquisition in the future.

Customers

Our online music services are sold directly to end users by us through our website, affiliate network and universities that have procured site licenses. We also sell prepaid cards through our retail partners and bundle our services with OEM partners, such as iRiver, Dell, Creative Labs, Gateway and Samsung. We have licensed certain merchandising rights to select third parties and expect to continue to do so in the future.

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Competition

The markets we are targeting are highly competitive, and we expect competition to increase in the future. Increased competition may result in price reductions and loss of market share, which could reduce our future revenues and otherwise harm our business. Primary competitors for online music services include Apple Computer’s iTunes Music Store, RealNetworks, Inc.’s Rhapsody, Yahoo! Unlimited, Sony Connect, AOL Music, MusicNet and MusicNow. In addition, we expect MTV Networks to enter the market soon. Other competitors include online and offline retailers such as Amazon.com and WalMart, as well as satellite radio providers such as XM and Sirius. Finally, our online music distribution services also compete against “free” peer-to-peer services, as well as traditional retail music distributors.

We believe that the principal competitive factors affecting the market for our services include programming and features, price and performance, quality of customer support, compatibility with popular hardware devices and brand. We believe that we compete more favorably than many of our current competitors with respect to some or all of these factors. However, we may not be able to maintain our competitive position against current and potential competitors, especially those with significantly greater resources. For example, many of our competitors in the online music distribution industry have significantly more resources than we do, including exclusive access to music content, and some of these competitors may be able to leverage their experience in providing online music distribution services or similar services to their customers in other businesses. Some of these competitors have offered and will likely continue to offer services at a lower price than we do.

Intellectual Property

Our success and ability to compete depend substantially upon our intellectual property. To date, we have 26 pending United States and foreign patent applications. These applications cover online music distribution functionality and peer-to-peer technology. We currently have five United States and foreign patents issued, with terms ending in 2017 through 2025.

We may be unsuccessful in prosecuting our patent applications or patents may not be issued from our patent applications. Even if patents are issued and maintained, these patents may not be of adequate scope to benefit us or may be held invalid and unenforceable against third parties.

While we rely on patent, copyright, trade secret and trademark law to protect our technology, we also believe that factors such as the technological and creative skills of our personnel, new product developments, frequent product enhancements and reliable product maintenance are essential to establishing and maintaining a technology leadership position. We cannot assure you that others will not develop technologies that are similar or superior to our technology.

Product Development

With the acquisition of Napster, LLC (formerly known as Pressplay) in May 2003, we acquired considerable in-house engineering skill in the areas of digital media delivery, content management, and digital rights management. Along with skilled additional engineering resources, we now have (i) a distribution system tailored to manage digital media files and the associated metadata and associated usage rights; (ii) a scalable e-commerce and media delivery infrastructure, which can support a range of business models for the delivery of digital music including a la carte and subscription services; and (iii) a digital rights management platform, which provides persistent robust security around the digital media assets as well as the ability to tailor usage rights and offerings to end consumers. The digital rights management capability has recently been extended to support portable subscriptions—the ability to download an unlimited amount of content to a set number of portable devices, and to continue to allow users access to that content as long as they continue to pay their subscription fee.

Research and development expenses for our Napster business totaled $12.1 million in the year ended March 31, 2005 (“fiscal 2005”) and $11.9 million in the year ended March 31, 2004 (“fiscal 2004”.)

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Sales, Marketing and Support

We market our Napster service directly to consumers through an integrated offline and online marketing program consistent with the existing strong awareness and perception of the Napster brand. The marketing message is focused on our subscription service, which differentiates our offering from those of many of our competitors. Offline marketing channels include television (including direct response TV), radio and print advertising. Our online marketing program includes advertising placements on a number of web sites (including affiliate partners) and search engines.

We also have a number of key strategic alliances with the direct-to-consumer retail channel. We have strategic relationships with large electronics retail chains, such as Best Buy, Radio Shack and Target in the United States and Dixons in the United Kingdom. These relationships include a number of components, such as store placement via permanent displays, inclusion in the retail chain’s own advertising efforts (such as Sunday circulars), salespeople training, and sales of Napster retail products such as prepaid download cards, subscription CDs and free trial offers.

We also enter into partner programs directly with PC and MP3 player manufacturers, whereby Napster service or service and software comes either preloaded on the desktop (in the case of PCs), or in the device box (in the case of MP3 players.)

Our advertising and promotional efforts will continue to focus on building the Napster brand and aggressively supporting our new product launches, such as Napster To Go.

Employees

As of March 31, 2005, Napster had 135 employees, of which 10 directly supported the online music service (maintaining content and providing customer care), 25 were in sales and marketing, 63 were in engineering and product development and 37 were in finance, administration and operations.

Our future performance depends, in significant part, upon our ability to attract new personnel and retain existing personnel in key areas including engineering, technical support and sales. None of our employees is represented by a collective bargaining agreement. We have not experienced any work stoppages, and we consider our relations with our employees to be good.

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RISK FACTORS

Investing in our common stock involves a high degree of risk. You should carefully consider the risks described below and the other information in this annual report. If any of the following risks occur, our business could be materially harmed, and our financial condition and results of operations could be materially and adversely affected. As a result, the price of our common stock could decline, and you could lose all or part of your investment.

Risks Relating to the Sale of Our Consumer Software Products Business

Selling our consumer software products business constituted a sale of a significant portion of our historical operating assets and a change in our business focus.

On December 17, 2004, we completed the sale of our consumer software division to Sonic Solutions and have subsequently focused exclusively on our online music distribution business, under the Napster brand. From May 19, 2003 to December 2004, our consumer software products business accounted for substantially all of our revenues, and prior to that, our consumer software products business accounted for all of our revenues. As a result of the sale of our consumer software products business, all of our revenues are now generated by our online music distribution business. We have limited experience in the highly competitive online music distribution business and cannot assure you that we will be successful in operating and growing such business. If we are not successful in operating and growing our online music distribution business, our business, results of operations and financial condition will be adversely affected.

The asset purchase agreement with Sonic Solutions exposes us to contingent liabilities.

Under the asset purchase agreement with Sonic Solutions, we have retained various liabilities relating to the consumer software products business and have agreed to indemnify Sonic Solutions under certain circumstances, if we have breached our representations and warranties contained in the asset purchase agreement and for other matters, including all liabilities retained by us under that agreement. For example, an indemnification claim by Sonic Solutions might result if we breach or default on any of our representations about the assets comprising our consumer software products business. Under the terms of the asset purchase agreement, if claims are made by Sonic Solutions, we may be required to expend significant cash resources in defense and settlement of such claims, which may adversely affect our business, results of operations and financial condition.

Management could spend or invest the proceeds from the sale of our consumer software products business in ways with which our stockholders may not agree.

Our management could spend or invest the proceeds from the sale of our consumer software products business in ways with which our stockholders may not agree. We currently intend to invest the proceeds from the sale of our consumer software products business into our online music distribution business. The investment of these proceeds may not yield a favorable return. Furthermore, because our online music distribution business is evolving, in the future we may discover new opportunities that are more attractive. As a result, we may commit resources to these alternative market opportunities. If we change our business focus, we may face risks that are different from the risks currently associated with our online music distribution business.

Risks Relating to Our Napster Service

Our online music services initiatives have a limited operating history and a history of losses and may not be successful.

On May 19, 2003 we acquired substantially all of the ownership interests of Napster, LLC (f/k/a Pressplay.) We used the Pressplay-branded service as a technology platform to roll-out our online music services division in October 2003. The business models, technologies and market for online music services are new and

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unproven. Prior to our acquisition of Napster, LLC, consumer adoption and usage of the Pressplay-branded service had not been significant. On December 17, 2004, we completed the sale of our consumer software division to Sonic Solutions and have subsequently focused our business exclusively on our online music distribution business, under the Napster brand. You should consider the online music distribution business and prospects in light of the risks, expenses and difficulties encountered by companies in their early stage of development.

Our Napster business has experienced significant net losses since its inception and, given the significant operating and capital expenditures associated with our business plan, we expect to incur net losses for at least the next twelve months and likely continue to experience net losses thereafter. No assurance can be made that our Napster business will ever contribute net income to our statement of operations. If our Napster business is not successful, our business and business prospects could be harmed. Since April 1, 2003, just prior to our acquisition of Pressplay in May 2003, we have incurred approximately $97.8 million of after tax losses from continuing operations.

The success of our Napster service depends upon our ability to add new subscribers and reduce churn.

We cannot assure you that we will be able to attract new subscribers to the Napster service or that existing subscribers will continue to subscribe. Existing subscribers may cancel their subscriptions to the Napster service for many reasons, including a perception that they do not use the services enough to justify the expense, that the service does not provide enough value or availability of content relative to our competition. If we do not continue to increase the total number of subscribers each quarter, our operating results will be adversely impacted.

Our online music distribution business has lower margins than our former consumer software products business.

Costs of our online music distribution business as a percentage of the revenue generated by that business are higher than those of our former consumer software products business. The cost of third party content, in particular, is a substantial portion of revenues we receive from subscribers and end users and is unlikely to decrease significantly over time as a percentage of revenue. We expect this trend will continue to negatively impact our overall gross margins as our online music distribution business is our primary source of revenue, and this may affect our ability to regain profitability.

We rely on the value of the Napster brand, and our revenues could suffer if we are not able to maintain its high level of recognition in the digital music sector.

We believe that maintaining and expanding the Napster brand is an important aspect of our efforts to attract and expand our user and advertiser base. We have embarked on a broad branding program to ensure that our position in the digital music sector continues to be strongly associated with the Napster name. Promotion and enhancement of the Napster brand will depend in part on our ability to provide consistently high-quality products and services. If we are not able to successfully maintain or enhance consumer awareness of the Napster brand or, even if we are successful in our branding efforts, if we are unable to maintain or enhance customer awareness of the Napster brand in a cost effective manner, our business, operating results and financial condition would be harmed.

We face significant competition from traditional retail music distributors, from emerging paid online music services delivered electronically such as ours, and from “free” peer-to-peer services.

Our Napster service faces significant competition from traditional retail music distributors such as Tower Records as well as online retailers such as Amazon.com. These retailers may include regional and national

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mall-based music chains, international chains, deep-discount retailers, mass merchandisers, consumer electronics outlets, mail order, record clubs, independent operators and online physical retail music distributors, some of which have greater financial and other resources than we do. To the extent that consumers choose to purchase media in non-electronic formats, it may reduce our sales, reduce our gross margins, increase our operating expenses and decrease our profit margins in specific markets.

Our online music services competitors include Apple Computer’s iTunes Music Store, Yahoo! Unlimited, Listen.com, the provider of the Rhapsody service and a subsidiary of RealNetworks, Inc., Sony Connect, Walmart.com, FYE, Microsoft’s MSN Music service and online music services powered by MusicNet such as AOL Music and Virgin. Internationally we currently compete with OD2 and Puretracks as well as with a number of the other competitors described above.

Our online music services also face significant competition from “free” peer-to-peer services, such as KaZaA, Morpheus, Grokster and a variety of similar services that allow computer users to connect with each other and to copy many types of program files, including music and other media, from one another’s hard drives, all without securing licenses from content providers. The legal status of these “free” services is uncertain, because although some courts have found that these services violate copyright laws, other courts have found that these same services do not violate any copyright laws, particularly in the case of Grokster. Additionally, enforcement efforts against those in violation have not effectively shut down these services, and there can be no assurance that these services will ever be shut down. The ongoing presence of these “free” services substantially impairs the marketability of legitimate services, regardless of the ultimate resolution of their legal status.

Many of our competitors have significantly more resources than we do, and some of our competitors may be able to leverage their experience in providing online music distribution services or similar services to their customers in other businesses. We or our competitors may be able to secure limited exclusive rights to content from time to time. If our competitors secure significant exclusive content, it could harm the ability of our online music services to compete effectively in the marketplace.

In particular, some of these competitors offer other goods and services and may be willing and able to offer music services at a lower price than we can in order to promote the sale of these goods and services. Yahoo!, for example, recently announced that it will offer a competing service at a significant discount to our current prices. If we lower our prices, our gross margins and operating results will be adversely affected. If we do not lower our prices, we may be unable to compete with discount services. This could harm the ability of our online music services to compete effectively in the marketplace.

Online music distribution services in general are new and rapidly evolving and may not prove to be a profitable or even viable business model.

Online music distribution services are a relatively new business model for delivering digital media over the Internet. It is too early to predict whether consumers will accept, in significant numbers, online music services and accordingly whether the services will be financially viable. If online music distribution services do not prove to be popular with consumers, or if these services cannot sustain any such popularity, our business and prospects would be harmed.

We rely on content provided by third parties, which may not be available to us on commercially reasonable terms or at all.

We rely on third-party content providers, including music publishers and music labels, to offer music online content that can be delivered to users of our service. Rights to provide this content to our customers, particularly publishing rights, are difficult to obtain and require significant time and expense. In some cases, we pay substantial fees to obtain this third party content. In order to provide a compelling service, we must be able

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to continue to license a wide variety of music content to our customers with attractive usage rights such as CD recording, output to MP3 Players, portable subscription rights and other rights. In addition, if we do not have sufficient breadth and depth of the titles necessary to satisfy increased demand arising from growth in our subscriber base, our subscriber satisfaction will be affected adversely. We cannot guarantee that we will be able to secure licenses to music content or that such licenses will be available on commercially reasonable terms. Recently, we have begun to offer the Napster service outside of the United States. The expansion of the service abroad requires that additional publishing and sound recording licenses be obtained for music currently offered in the United States as well as for music that is available only in foreign markets. We cannot assure you that we will be able to obtain such licenses on favorable terms or at all. Failure to obtain these licenses will harm our business in existing and potential foreign markets and our revenues.

Under copyright law, we may be required to pay licensing fees for compositions embodied in digital sound recordings we deliver in our Napster service. Copyright law generally does not specify the rate and terms of the licenses, which are determined by voluntary negotiations among the parties or, for certain compulsory licenses where voluntary negotiations are unsuccessful, by arbitration proceedings known as CARP proceedings which are subject to approval by the United States Copyright Office. Past CARP proceedings have resulted in proposed rates for statutory web casting that were significantly in excess of rates requested by web casters. We cannot predict the outcome of any negotiations or CARP proceedings and may elect instead to attempt to directly license music content for our subscription and/or non-subscription services, either alone or in concert with other affected companies. Such licenses may only apply to music performed in the United States, and the availability of corresponding licenses for international performances is unclear. Therefore, our ability to find rights holders and negotiate appropriate licenses is uncertain. There are other negotiations and CARP proceedings in process which will set rates for subscription music services and services that deliver digital downloads of music, and the outcome of these negotiations and CARP proceedings will also likely affect our business in ways that we cannot predict. Voluntarily negotiated rates for mechanical licenses with respect to streaming and conditional digital downloads with the Harry Fox Agency and National Music Publishers Association have not been agreed to, and we are currently operating under a standstill agreement until such rates are negotiated. No agreement has been reached with performing rights societies such as ASCAP or BMI regarding whether digital downloads constitute public performances of copyrighted works that would trigger payment of public performance royalties. Depending on the rates and terms adopted for these voluntary and/or statutory licenses, our business could be harmed by increasing our own cost of doing business, as well as by increasing the cost of doing business for our customers. We anticipate future CARP proceedings relating to music subscription delivery services, which may also adversely affect the online distribution of music.

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

We must provide digital rights management solutions and other security mechanisms in our online music distribution services in order to address concerns of content providers and artists, and we cannot be certain that we can develop, license or acquire such solutions, or that content licensors or consumers will accept them. Content providers may be unwilling to continue to support portable subscription services. Consumers may be unwilling to accept the use of digital rights management technologies that limit their use of content, especially with large amounts of free content readily available. Third-party providers of digital rights management software, such as Microsoft, may be unwilling to continue to provide such software to us upon reasonable or any terms. If we are unable to acquire these solutions on reasonable or any terms, or if customers are unwilling to accept these solutions, our business and prospects could be harmed.

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

Our business is affected by the release of “hit” music titles, which can create cyclical trends in sales distinctive to the music industry. It is not possible to determine the timing of these cycles or the future availability of hit titles. Hit products are important because they generate customer interest. We depend upon

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the music content providers to continue to produce hit products. To the extent that new hits are not available, or not available at prices attractive to consumers, our sales and margins may be adversely affected.

Our success depends on our music service’s interoperability with our customer’s music playback hardware.

In order for our Napster service to be successful we must design our service to interoperate effectively with a variety of hardware products, including home stereos, car stereos, portable MP3 players, and PCs. We depend on significant cooperation with manufacturers of these products and with software manufacturers that create the operating systems for such hardware devices to achieve our design objectives and to offer a service that is attractive to our customers. Currently, there are a limited number of devices that offer the portable subscription functionality that is required to carry our services. Our software is not compatible with the iPod music player, the current equipment market leader. If we cannot successfully design our service to interoperate with the music playback devices that our customers own, our business will be harmed.

We may not successfully develop new products and services.

The success of the Napster service will depend on our ability to develop leading-edge media and digital distribution products and services. Our business and operating results will be harmed if we fail to develop products and services that achieve widespread market acceptance or that fail to generate significant revenues or gross profits to offset our development and operating costs. We may not timely and successfully identify, develop and market new product and service opportunities. We may not be able to add new content such as video, spoken word or other content as quickly or as efficiently as our competitors or at all. If we introduce new products and services, they may not attain broad market acceptance or contribute meaningfully to our revenues or profitability. Competitive or technological developments may require us to make substantial, unanticipated investments in new products and technologies, and we may not have sufficient resources to make these investments.

Because the markets for our products and services are changing rapidly, we must develop new offerings quickly. Delays and cost overruns could affect our ability to respond to technological changes, evolving industry standards, competitive developments or customer requirements. Our products also may contain undetected errors that could cause increased development costs, loss of revenues, adverse publicity, reduced market acceptance of our products or services or lawsuits by customers.

We must maintain and add to our strategic marketing relationships in order to be successful.

We depend on a number of strategic relationships with third parties to co-market our services. We often enter into co-marketing agreements with infrastructure providers, retailers and other large companies to broaden the distribution of our brand and our services. There is no guarantee that we will be able to renew existing agreements or enter into new agreements on acceptable terms, or at all. If we cannot maintain existing strategic relationships or enter into new relationships, our ability to market our services will be harmed.

In addition, because of the rapidly evolving nature of online music distribution and our short history of operations, we often enter into strategic agreements that have uncertain financial impact on our business and operations. We cannot guarantee that any of these agreements will result in the desired benefits to our business or result in significant additional revenue.

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

The growth of our business depends on the continued growth of the Internet as a medium for media consumption, communications, electronic commerce and advertising. Our business will be harmed if Internet

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usage does not continue to grow, particularly as a source of media information and entertainment and as a vehicle for commerce in goods and services. Our success also depends on the efforts of third parties to develop the infrastructure and complementary products and services necessary to maintain and expand the Internet as a viable commercial medium. We believe that other Internet-related issues, such as security, privacy, reliability, cost, speed, ease of use and access, quality of service and necessary increases in bandwidth availability, remain largely unresolved and may affect the amount and type of business that is conducted over the Internet, and may impact our ability to sell our products and services and ultimately impact our business results and prospects.

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

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

We believe that increased Internet use and especially the increased use of media over the Internet may depend on the availability of greater bandwidth or data transmission speeds (also known as broadband transmission.) If broadband technologies do not become widely available or widely adopted, our online music distribution services may not achieve broad market acceptance and our business and prospects could be harmed.

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

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

Our network is subject to security and stability risks that could harm our business and reputation and expose us to litigation or liability.

Online commerce and communications depend on the ability to transmit confidential information and licensed intellectual property securely over private and public networks. Any compromise of our ability to transmit such information and data securely or reliably, and any costs associated with preventing or eliminating such problems, could harm our business. Online transmissions are subject to a number of security and stability risks, including:

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

Risks Relating to Our Business in General

We experience fluctuations in our quarterly operating results, which may cause our stock price to decline.

Our quarterly operating results may fluctuate from quarter to quarter. We cannot reliably predict future revenue and margin trends and such trends may cause us to adjust our operations. Other factors that could affect our quarterly operating results include:

We depend on key personnel who may not continue to work for us.

Our success substantially depends on the continued employment of certain executive officers and key employees, particularly Christopher Gorog. The loss of the services of these or other key officers, employees or third parties could harm our business. If any of these individuals were to leave our company, we could face substantial difficulty in hiring qualified successors and could experience a loss in productivity while any such successor obtains the necessary training and experience.

If we fail to manage expansion effectively, we may not be able to successfully manage our business, which could cause us to fail to meet our customer demand or to attract new customers, which would adversely affect our revenue.

Our ability to successfully offer our products and services and implement our business plan in a rapidly evolving market requires an effective planning and management process. We plan to continue to increase the

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scope of our online music distribution operations domestically and internationally. In addition, we plan to continue to hire a significant number of employees in fiscal 2006 for our online music distribution service. This anticipated growth in future operations will place a significant strain on our management resources.

In the future we plan to continue to develop and improve our financial and managerial controls, reporting systems and procedures. In addition, we plan to continue to expand, train and manage our work force worldwide.

We may need to make additional future acquisitions to remain competitive. The process of identifying, acquiring and integrating future acquisitions may constrain valuable management resources, and our failure to effectively integrate future acquisitions may result in the loss of key employees and the dilution of stockholder value and have an adverse effect on our operating results.

We have completed several acquisitions and expect to continue to pursue strategic acquisitions in the future. Completing any potential future acquisitions could cause significant diversions of management time and resources. Financing for future acquisitions may not be available on favorable terms, or at all. If we identify an appropriate acquisition candidate for any of our businesses, we may not be able to negotiate the terms of the acquisition successfully, finance the acquisition or integrate the acquired business, products, technologies or employees into our existing business and operations. Future acquisitions may not be well-received by the investment community, which may cause our stock price to fall. We have not entered into any agreements or understanding regarding any future acquisitions and cannot ensure that we will be able to identify or complete any acquisition in the future.

If we acquire businesses, new products or technologies in the future, we may be required to amortize significant amounts of identifiable intangible assets, and we may record significant amounts of goodwill that will be subject to annual testing for impairment. If we consummate one or more significant future acquisitions in which the consideration consists of stock or other securities, our existing stockholders’ ownership could be significantly diluted. If we were to proceed with one or more significant future acquisitions in which the consideration included cash, we could be required to use a substantial portion of our available cash.

Acquisition-related costs can cause significant fluctuation in our net income.

Previous acquisitions have resulted in significant expenses, including amortization of purchased technology, charges for in-process research and development and amortization of acquired identifiable intangible assets, which are reflected in operating expenses. Total amortization of acquired intangible and purchased technology assets in ongoing operations was $2.1 million in the fiscal year ended March 31, 2005. Additional acquisitions and any additional impairment of the value of purchased assets could have a significant negative impact on future operating results.

A significant portion of the revenues from our Napster service is derived from international revenues. Economic, political, regulatory and other risks associated with international revenues and operations could have an adverse effect on our revenues.

Because we operate worldwide, our business is subject to risks associated with doing business internationally. International net revenues did not account for a significant percentage of our net revenues prior to the sale of our consumer software products division; however, we anticipate that revenues from international operations will represent a substantial portion of our total net revenues as we expand our Napster service abroad. Accordingly, our future revenues could decrease based on a variety of factors, including:

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To grow our business, we must be able to hire and retain sufficient qualified technical, sales, marketing and administrative personnel.

Our future success depends in part on our ability to attract and retain engineering, sales, marketing, finance and customer support personnel. If we fail to retain and hire a sufficient number of these employees, we will not be able to maintain and expand our business. We cannot assure you that we will be able to hire and retain a sufficient number of qualified personnel to meet our business objectives.

We may be unable to adequately protect our proprietary rights.

Our inability to protect our proprietary rights, and the costs of failing to do so, could harm our business. Our success and ability to compete partly depend on the superiority, uniqueness or value of our technology, including both internally developed technology and technology licensed from third parties. To protect our proprietary rights, we rely on a combination of patent, trademark, copyright and trade secret laws, confidentiality agreements with our employees and third parties, and protective contractual provisions. These efforts to protect our intellectual property rights may not be effective in preventing misappropriation of our technology. These efforts also may not prevent the development and design by others of products or technologies similar to, competitive with or superior to those we develop. Any of these results could reduce the value of our intellectual property. We may be forced to litigate to enforce or defend our intellectual property rights and to protect our trade secrets. Any such litigation could be very costly and could distract our management from focusing on operating our business.

We may be subject to intellectual property infringement claims, such as those claimed by SightSound Technologies, which are costly to defend and could limit our ability to use certain technologies in the future.

Many of our current and potential competitors dedicate substantially greater resources to protection and enforcement of their intellectual property rights, especially patents, than we do. Many parties are actively developing streaming media and digital distribution-related technologies, e-commerce and other Web-related technologies, as well as a variety of online business methods and models. We believe that these parties will continue to take steps to protect these technologies, including, but not limited to, seeking patent protection. As a result, disputes regarding the ownership of these technologies and rights associated with streaming media, digital distribution and online businesses are likely to arise in the future and may be very costly. In addition to existing patents and intellectual property rights, we anticipate that additional third-party patents related to our products and services will be issued in the future. If a blocking patent has been issued or is issued in the future, we would need to either obtain a license or design around the patent. We may not be able to obtain such a license on acceptable terms, if at all, or design around the patent, which could harm our business. For example, on October 8, 2004, SightSound Technologies, Inc. filed a lawsuit against us and Napster, LLC in U.S. District Court for the Western District of Pennsylvania, Case No. 04-1549 alleging infringement of certain of their patents by the Napster service. If they are ultimately able to prevail at trial, we may be unable to provide certain download or subscription features of the Napster service or may be forced to pay significant and costly license royalties, all of which will harm our business.

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Companies in the technology and content-related industries have frequently resorted to litigation regarding intellectual property rights. We may be forced to litigate to determine the validity and scope of other parties’ proprietary rights. Any such litigation could be very costly and could distract our management from focusing on operating our business. In addition, we believe these industries are experiencing an increased level of litigation to determine the applicability of current laws to, and impact of new technologies on, the use and distribution of content over the Internet and through new devices, especially in the music industry, and as we develop products and services that provide or enable the provision of content, in such ways, our litigation risk may increase. The existence and/or outcome of such litigation could harm our business.

From time to time we receive claims and inquiries from third parties alleging that our internally developed technology, or technology we license from third parties, may infringe the other third parties’ proprietary rights, especially patents. Third parties have also asserted and most likely will continue to assert claims against us alleging infringement of copyrights, trademark rights, or other proprietary rights, or alleging unfair competition or violations of privacy rights. We could be required to spend significant amounts of time and money to defend ourselves against such claims. If any of these claims were to prevail, we could be forced to pay damages, comply with injunctions, or stop distributing our products and services while we re-engineer them or seek licenses to necessary technology, which might not be available on reasonable terms, or at all. We could also be subject to claims for indemnification resulting from infringement claims made against our customers and strategic partners, which could increase our defense costs and potential damages. Any of these events could require us to change our business practices and could harm our business.

A decline in current levels of consumer spending could reduce our sales.

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

We may need additional capital, and we cannot be sure that additional financing will be available.

Although we currently anticipate that our available funds and expected cash flows from operations will be sufficient to meet our cash needs for at least the next twelve months, we may require additional financing. Our ability to obtain financing will depend, among other things, on our development efforts, business plans, operating performance and condition of the capital markets at the time we seek financing. We expect to spend significant amounts of cash in connection with the recent launch of our Napster To Go service and expect to experience operating losses from the Napster service in at least the short term. We cannot assure you that additional financing will be available to us on favorable terms when required, or at all. If we raise additional funds through the issuance of equity, equity-linked or debt securities, those securities may have rights, preferences or privileges senior to the rights of our common stock, and our stockholders may experience dilution.

Changes in stock option accounting rules may adversely impact our reported operating results prepared in accordance with generally accepted accounting principles, our stock price and our competitiveness in the employee marketplace.

Technology companies like ours have a history of using broad-based employee stock option programs to hire, provide incentives to and retain our workforce in a competitive marketplace. We have elected to apply Accounting Principles Board (“APB”) Opinion No. 25, “ Accounting for Stock Issued to Employees” (“APB 25”) to account for stock options. Accordingly we generally do not recognize any expense with respect to employee stock options as long as such options are granted at exercise prices equal to the fair value of our common stock on the date of grant.

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On December 16, 2004, the Financial Accounting Standards Board (“FASB”) adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment,” which revises the previously effective SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes APB No. 25. This statement addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for either equity instruments of the enterprise or liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The statement eliminates the ability to account for share-based compensation transactions using APB No. 25, and generally requires that such transactions be accounted for using a fair-value-based method and recognized as expenses in our consolidated statements of operations. The FASB originally stated a preference for a lattice model because it believed that a lattice model more fully captures the unique characteristics of employee stock options in the estimate of fair value, as compared to the Black-Scholes model which the Company currently uses for its footnote disclosure. The FASB decided to remove its explicit preference for a lattice model and not require a particular valuation methodology. The effective date of the standard for public companies is for the first annual reporting periods beginning after June 15, 2005. We are evaluating the requirements under SFAS 123(R) and expect the adoption to have a significant adverse impact on our consolidated statements of operations and net income (loss) per share.

We are subject to risks associated with governmental regulation and legal uncertainties.

Few existing laws or regulations specifically apply to the Internet, other than laws and regulations generally applicable to businesses. Certain United States export controls and import controls of other countries, including controls on the use of encryption technologies, may apply to our products. Many laws and regulations, however, are pending and may be adopted in the United States, individual states, and local jurisdictions and other countries with respect to the Internet. These laws may relate to many areas that impact our business, including content issues (such as obscenity, indecency and defamation), copyright and other intellectual property rights, digital rights management, encryption, caching of content by server products, personal privacy, taxation, e-mail, sweepstakes, promotions, network and information security and the convergence of traditional communication services with Internet communications, including the future availability of broadband transmission capability and wireless networks. These types of regulations are likely to differ between countries and other political and geographic divisions. Other countries and political organizations are likely to impose or favor more and/or different regulations than that which has been proposed in the United States, thus furthering the complexity of regulation. The United States, for example, has recently enacted an e-mail marketing law that, among other things, permits consumers to choose not to receive unsolicited e-mail from specified senders and subjects violators to certain civil penalties. As we have in the past utilized, and will likely continue in the future to utilize e-mail marketing, such laws will affect our future marketing efforts and, although we intend to comply with such laws, any inadvertent violation of such laws could subject us to penalties. In addition, state and local governments may impose regulations in addition to, inconsistent with, or stricter than federal regulations. The adoption of such laws or regulations, and uncertainties associated with their validity, interpretation, applicability and enforcement, may affect the available distribution channels for and costs associated with our products and services and may affect the growth of the Internet. Such laws or regulations may harm our business. Our products and services may also become subject to investigation and regulation of foreign data protection and e-commerce authorities, including those in the European Union. Such activities could result in additional product and distribution costs for us in order to comply with such regulations.

We do not know for certain how existing laws governing issues such as property ownership, copyright and other intellectual property issues, digital rights management, taxation, gambling, security, illegal or obscene content, retransmission of media, personal privacy and data protection apply to the Internet. The vast majority of such laws were adopted before the advent of the Internet and related technologies and do not address the unique issues associated with the Internet and related technologies. Most of the laws that relate to the Internet have not yet been interpreted. In addition to potential legislation from local, state and federal governments, labor guild agreements and other laws and regulations that impose fees, royalties or unanticipated payments regarding the distribution of media over the Internet may directly or indirectly affect our business. While we

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and our customers may be directly affected by such agreements, we are not a party to such agreements and have little ability to influence the degree such agreements favor or disfavor Internet distribution or our business models. Changes to or the interpretation of these laws and the entry into such industry agreements could:

The Child Online Protection Act and the Child Online Privacy Protection Act impose civil and criminal penalties on persons distributing material harmful to minors (e.g., obscene material) over the Internet to persons under the age of 17, or collecting personal information from children under the age of 13. We do not knowingly distribute harmful materials to minors or collect personal information from children under the age of 13. The manner in which these Acts may be interpreted and enforced cannot be fully determined, and future legislation similar to these Acts could subject us to potential liability if we were deemed to be non-compliant with such rules and regulations, which in turn could harm our business.

There are a large number of legislative proposals before the United States Congress and various state legislatures regarding intellectual property, digital rights management, copy protection requirements, privacy, email marketing and security 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 materially and adversely affect our business through a decrease in user registration and revenue, and influence how and whether we can communicate with our customers.

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

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

If, in the future, we conclude that our internal controls over financial reporting is not adequate, or if our auditors conclude that our evaluation of internal controls over financial reporting is not adequate, investors could lose confidence in the reliability of our financial statements, which could result in a decrease in the value of our common stock.

As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commission adopted rules requiring public companies to include a report of management on the company’s internal control over financial reporting in their annual reports on Form 10-K. This report is required to contain an assessment by management of the effectiveness of such company’s internal controls over financial reporting. In addition, the

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independent registered public accounting firm auditing a public company’s financial statements must attest to and report on management’s assessment of the effectiveness of the company’s internal controls over financial reporting. There is a risk that in the future we may identify internal control deficiencies that suggest that our controls are no longer effective. This could result in an adverse reaction in the financial markets due to a loss of confidence in the reliability of our financial statements, which could cause the market price of our common stock to decline and make it more difficult for us to finance its operations.

The effectiveness of our disclosure and internal controls may be limited.

Our disclosure controls and procedures and internal controls over financial reporting may not prevent all errors and intentional misrepresentations. In the event that there are errors or misrepresentations in our historical financial statements or the SEC disagrees with our accounting, we may need to restate our financial statements. For example, in November 2004 we restated our financials in order to correct the valuation of a previously issued warrant and to adjust the purchase accounting of our former subsidiary, MGI Software, and in May 2005 we restated our financial statements to reallocate the tax benefit of certain operating losses from our discontinued operation to our continuing operations. Any system of internal control can only provide reasonable assurance that all control objectives are met. Some of the potential risks involved could include but are not limited to management judgments, simple errors or mistakes, willful misconduct regarding controls or misinterpretation. There is no guarantee that existing controls will prevent or detect all material issues or be effective in future conditions, which could materially and adversely impact our financial results in the future.

We hold cash in foreign subsidiaries, which we intend to repatriate to the United States, and which may result in income taxes that could negatively impact our results of operations and financial position.

We are in the process of completing a corporate restructuring to close the overseas operations of certain dormant subsidiaries of our former consumer software division. We plan to repatriate our cash from these foreign subsidiaries to the United States. We are likely to incur additional income taxes from the repatriation, which could negatively affect our results of operations and financial position.

Risks Related to Securities Markets and Ownership of Our Common Stock

We cannot assure you that our stock price will not decline.

The market price of our common stock could be subject to significant fluctuations. Among the factors that could affect our stock price are:

The stock markets in general and the markets for technology stocks in particular, have experienced extreme volatility that has often been unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the trading price of our common stock.

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Provisions in our agreements, charter documents, stockholder rights plan and Delaware law may delay or prevent acquisition of us, which could decrease the value of our stock.

Our certificate of incorporation and bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us without the consent of our board of directors. These provisions include a classified board of directors and limitations on actions by our stockholders by written consent. In addition, our board of directors has the right to issue preferred stock without stockholder approval, which could be used to dilute the stock ownership of a potential hostile acquirer. Delaware law also imposes some restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding common stock. In addition, we have adopted a stockholder rights plan that makes it more difficult for a third party to acquire us without the approval of our board of directors. Although we believe these provisions provide for an opportunity to receive a higher bid by requiring potential acquirers to negotiate with our board of directors, these provisions apply even if the offer may be considered beneficial by some stockholders.

ITEM 2.    DESCRIPTION OF PROPERTIES

Our principal executive offices are located in Los Angeles, California. The table below lists our principal leased or licensed facilities as of June 3, 2005.

We believe that our leased facilities are adequate to meet our current needs and that additional facilities will be available to meet our development and expansion needs on commercially reasonable terms.

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ITEM 3.    LEGAL PROCEEDINGS

Napster and Pressplay have been notified by a number of companies that the Pressplay and Napster online music distribution services may infringe patents owned by those companies. Napster is investigating the nature of these claims and the extent to which royalties may be owed by Napster and Pressplay to these entities. The ultimate resolution of these claims cannot be determined at this time.

On October 8, 2004, SightSound Technologies, Inc. filed a lawsuit against Napster and Napster, LLC in U.S. District Court for the Western District of Pennsylvania, Case No. 04-1549, alleging infringement of certain of its patents by the Napster service. Napster was served with the complaint in the lawsuit on November 5, 2004. Napster has answered the complaint and filed an application with the United States Patent and Trademark Office for reexamination of the patents. In January 2005, SightSound moved for a preliminary injunction of the Napster service and Napster moved for a stay of the proceedings pending the outcome of Napster’s reexamination application. On February 28, 2005, the court granted Napster’s motion to stay and denied SightSound’s motion for preliminary injunction without prejudice. On March 3, 2005 SightSound filed a notice of appeal with the U.S. Court of Appeals for the Federal Circuit, appealing the district court’s order. On March 22, 2005, SightSound filed a Petition to Cancel certain trademark registrations owned by Napster before the Trademark Trial and Appeals Board, claiming that Napster did not acquire the rights to these trademarks when it purchased them through the bankruptcy estate. Napster believes that this petition is entirely without merit.

On May 19, 2005, Napster filed a motion with U.S. Bankruptcy Court for the District of Delaware to reopen the Napster bankruptcy case and enforce the order assigning all of the assets of the former Napster, Inc. (including trademarks and goodwill) to us. Management believes that it is not currently possible to estimate the impact, if any, that the ultimate resolution of these matters will have on the Company’s results of operations, financial position or cash flows.

On December 12, 2003, Optima Technology Corporation filed a lawsuit against us in U.S. District Court for the Central District of California, Case No. 03-1776-JVS-ANx, alleging infringement of certain of its patents by CSD’s Easy CD Creator line of products. Optima is seeking unspecified damages and injunctive relief. This matter and any other claims related to CSD and MGI Software Corp. have been assumed by Sonic in connection with the sale of CSD to Sonic. However, Napster is still a named party in the Optima litigation that was assumed by Sonic. Napster believes that the Optima claims are without merit and intends to defend itself vigorously. On February 20, 2004, Napster filed a countersuit against Optima Technology Corporation alleging infringement of certain patents owned by Napster at that time. Following that countersuit, Napster obtained a favorable ruling of the court on the definition of certain key terms in the claims of Optima’s patent.

Napster is a party to other litigation matters and claims that are normal in the course of its operations, and, while the results of such litigation and claims cannot be predicted with certainty, Napster believes that the final outcome of such matters will not have a material adverse impact on its business, financial position, cash flows or results of operations.

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

The most recent annual meeting of stockholders was held on February 10, 2005. Proposals I and II were approved. The results were as follows:

Proposal I

The following directors were elected at the meeting to serve a three-year term as directors:

Proposal II

Ratification of appointment of PricewaterhouseCoopers LLP as Napster’s registered public accounting firm for fiscal 2005.

The proposals above are described in detail in Napster’s definitive proxy statement dated January 12, 2005 for the annual meeting of stockholders held on February 10, 2005.

EXECUTIVE OFFICERS OF THE REGISTRANT

The following table sets forth certain information with respect to our executive officers:

Wm. Christopher Gorog has served as our chief executive officer and director since September 2000. From September 2000 through May 2003, Mr. Gorog also served as our president. In September 2001, Mr. Gorog was elected chairman of our Board of Directors. From February 1999 to September 2000, Mr. Gorog served as a consultant in the entertainment and media industry, including serving as advisor to J.H. Whitney, an asset management company, in HOB Entertainment, Inc.’s acquisition of Universal Concerts. From November 1995 to February 1999, Mr. Gorog served as president of new business development at Universal Studios, an entertainment company. From January 1995 to November 1995, Mr. Gorog served as executive vice president of group operations at Universal Studios. Mr. Gorog is a director of Guitar Center, Inc., a music instrument retail chain. Mr. Gorog earned a B.A.S. in Telecommunications and Film from San Diego State University.

Bradford D. Duea has served as our president since January 2004. Prior to that, Mr. Duea served as our vice president of business development from February 2001 through January 2004. From January 2000 to February 2001, Mr. Duea served as vice president, corporate development and corporate secretary of People Support, Inc., a provider of electronic customer relationship management solutions. From September 1996 to January 2000, Mr. Duea was an associate of O’Melveny & Myers LLP, a law firm. Mr. Duea holds a B.A. in Law and Society from the University of California at Santa Barbara, an M.B.A. in Finance and International Marketing from the University of Southern California, and a J.D. from the University of San Diego.

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Laura B. Goldberg has served as our chief operating officer since January 2004. Prior to that, Ms. Goldberg served as our Senior Vice President Operations from May 2003 to January 2004. From April 2001 to May 2003, Ms. Goldberg served as Senior Vice President Operations of Duet GP d/b/a Pressplay. From August 1999 to April 2001, Ms. Goldberg served as General Manager at Universal Music Group, an entertainment company. Ms. Goldberg holds a B.S. in Industrial Management from Carnegie Mellon University and an M.B.A. from the Harvard Business School.

Nand Gangwani has served as our vice president and chief financial officer since November 2003. Prior to that, Mr. Gangwani served as our Vice President of Strategic Planning and M&A from January 2002 to November 2003. From May 2000 to November 2001, Mr. Gangwani served as Vice President of Corporate and Business Development at Evolve Software, Inc., a software company. From November 1997 to April 2000, Mr. Gangwani served as Manager of Corporate Development at Intuit Inc., a software company. Mr. Gangwani holds a B.S. in Chemical Engineering from the Indian Institute of Technology and an M.B.A. in Finance from Bentley College.

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PART II

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

Dividend Policy

We have never declared or paid any cash dividends on our capital stock. We currently intend to retain all available funds and any future earnings for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. The terms of our line of credit agreement with Silicon Valley Bank restrict our ability to pay dividends.

Price Range of Common Stock

Our common stock is listed on the Nasdaq National Market under the symbol “NAPS.” The approximate number of holders of record of our common stock as of June 3, 2005 was 891.

Our common stock was first listed on the Nasdaq National Market on May 4, 2001. The range of high and low sales prices of our common stock, as reported by the Nasdaq National Market System, for fiscal 2004 and 2005 is as follows:

Recent Sales of Unregistered Securities

On January 24, 2005, Napster issued 7,100,000 shares of its common stock in a private placement to certain accredited investors. The shares were sold at a price of $7.35 per share with gross proceeds of $52.2 million. The gross proceeds were reduced by placement fees and legal and accounting fees of approximately $3.6 million. The sale and issuance of these securities were exempt from registration under the Securities Act of 1933, as amended, by virtue of Section 4(2) of the Securities Act.

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ITEM 6.    SELECTED HISTORICAL CONSOLIDATED FINANCIAL AND OTHER DATA

The following selected consolidated financial data of Napster reflect our historical operating results and balance sheet data. Our consolidated statement of operations data set forth below for the years ended March 31, 2005, 2004, 2003, 2002 and 2001 and the consolidated balance sheet data as of March 31, 2005, 2004, 2003, 2002 and 2001 are derived from consolidated financial statements. The audited consolidated statement of operations for the years ended March 31, 2005, 2004 and 2003 and the audited consolidated balance sheet as of March 31, 2005 and 2004 are included elsewhere in this annual report. This selected historical consolidated financial data should be read in conjunction with those financial statements and the notes thereto and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” also included elsewhere in this annual report.

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The following selected financial information has been derived from our consolidated financial statements, and reflects our online music division as a continuing operation and our previously owned consumer software division as a discontinued operation. The information set forth below is not necessarily indicative of our future performance and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operation” and the consolidated financial statements and related notes included elsewhere in this annual report on Form 10-K. In addition, the financial information for the fiscal year ended March 31, 2001 and part of the fiscal year ended March 31, 2002 was carved out from Adaptec’s consolidated financial statements and thus did not necessarily reflect what our financial position and operating results would have been had we operated as a separate, stand-alone entity during these fiscal years.

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

The following discussion should be read in conjunction with the financial statements and notes thereto included elsewhere in this annual report. The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from the results contemplated by these forward-looking statements due to certain factors, including those discussed below, in “Risk Factors” and elsewhere in this annual report.

As discussed further in the “Executive Summary” section below, we completed the sale of our Consumer Software Division (“CSD”) in December 2004. Unless otherwise indicated, the Management’s Discussion and Analysis of Financial Condition and Results of Operations relate to our continuing operations.

Overview

This overview provides our perspective on the following individual sections of MD&A:

Executive Summary

Napster, among the most recognized brands in digital music, is a leading provider of online music for the consumer market. Our subscription services and our “a la carte” single track download service enable fans to sample one of the world’s largest and most diverse online music catalogues and to experience the most feature rich service utilizing a secure and legal platform. Napster users have access to songs from all major labels and hundreds of independent labels and have many ways to discover, share and acquire new music and old favorites. Napster subscribers also enjoy community features, such as the ability to email songs to friends and to browse other members’ collections. For consumers who want to purchase songs and albums a la carte, rather than through a subscription, we also offer Napster Light, a “lighter” version of our Napster service that does not include the ability to stream or download unlimited tracks or enjoy other premium community features. Napster is currently available in the United States, Canada and the U.K. and is headquartered in Los Angeles with offices in London, New York, San Diego and San Jose.

Until December 17, 2004, Napster was known as “Roxio, Inc.” and we operated our business in two divisions, the consumer software division (“CSD”) and the online music distribution division, also known as the Napster division.

On December 17, 2004, we completed the sale of substantially all of the assets and liabilities of CSD to Sonic Solutions, a California corporation (“Sonic”), including all of the capital stock of certain international subsidiaries. Sonic Solutions paid a total of $72.3 million in cash, subject to certain future adjustments, and

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653,837 shares of Sonic Solutions common stock, valued at approximately $13.6 million as of the closing date. We intend to retain the proceeds and use them for general working capital purposes and to operate and expand our Napster business.

Since the sale of our consumer software division, we have focused exclusively on our online music distribution business under the Napster brand and, since January 3, 2005, have been traded on the Nasdaq Stock Market under the symbol “NAPS.”

The Napster service allows users to legally stream, download and copy, or “burn” a wide variety of digital music. Napster launched the Napster service in October 2003, following the May 2003 acquisition of Napster, LLC (f/k/a Pressplay.)

Napster derives its primary revenues from online subscriptions and permanent music downloads. The Napster service offers subscribers on-demand access to a wide variety of music that can be streamed or downloaded as well as the ability to purchase individual tracks or albums on an a la carte basis. Subscription and permanent download fees are paid by end user customers in advance either via credit card, online payment systems or redemption of pre-paid cards, gift certificates or promotional codes. Napster also periodically licenses merchandising rights and resells hardware that our end users may utilize to store and replay their digital music content.

The online music business was launched under the Napster brand in the United States in October 2003. Prior to this launch we had online music revenue from the acquisition of a business, Napster, LLC, formerly known as Pressplay. During May 2004, we expanded the service to be available in both the United Kingdom and Canada.

Our online music subscription services, Napster and Napster To Go, provide consumers with unlimited access to over 1,000,000 songs for monthly fees of $9.95 and $14.95, respectively in the United States. Fees in other geographies are based on the local currency and vary accordingly. With all of our products consumers can discover, access and acquire their favorite songs by searching or browsing our catalogue, or accessing preprogrammed content through radio stations or custom compilations. Napster subscribers also have access to community features, such as sharing songs with other members and searching their collections. With a Napster subscription, for as long as consumers maintain their subscription, they can enjoy unlimited on-demand streaming and unlimited tethered downloading of songs to the hard drives of three PCs. With a Napster To Go subscription users can enjoy all the benefits of a Napster subscription, as well as unlimited transfers of tethered downloads to a compatible MP3 player without paying an additional fee per song. In other words, a Napster To Go subscriber enjoys unlimited music on up to three PCs and “on the go” with up to two compatible MP3 players. In addition to our Napster and Napster To Go offerings, we provide a download music store, called Napster Light where customers who are not subscribers can purchase individual tracks for $0.99 each or albums starting at $6.95. These tracks can be downloaded or “burned” to a CD, or transferred to an MP3 player. Napster’s catalogue of available music exceeds one million tracks and all content is licensed from major music companies, including EMI Recorded Music, Sony BMG, Universal Music Group and Warner Music Group, as well as numerous independent labels, on a non-exclusive basis.

Consumers have a choice of MP3 players with which to enjoy Napster To Go. Currently, the Dell DJ20, Dell DJ30, Dell Pocket DJ, Creative Zen Micro, Creative Zen PMC, Gateway MP3 Photo Jukebox, iRiver H10, iRiver H320, iRiver PMC-120, Samsung YH999 and Audiovox SMT 5600 are all Napster To Go compatible. If the public availability of compatible MP3 players is delayed, or there are not enough compatible MP3 players, our planned revenue growth could be adversely impacted.

We sell our online music services directly to end users through our Napster.com website, but also use retail distribution channels to promote and bundle the Napster services with other products they sell. If we lost access to our retail distribution partners, our revenues could be adversely impacted.

The market for online music is rapidly growing and we expect our online music business to continue to grow as the industry expands. This market is highly competitive and we expect competition to continue to

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increase in the future as the market expands. We believe that our unique technology and feature set positions us ahead of many of our competitors. Our strategy is to drive increased demand, and stay ahead of our competition by continuing to expand the features of our Napster service and provide our customers the best user experience. Additionally, our strategic priorities include continuing to build our customer brand, pursuing strategic partnerships and pursuing strategic acquisitions and complementary technologies.

The Napster division continues to operate at a loss and net negative cash flow due to our significant investments to enhance service capabilities, market Napster To Go and grow worldwide.

Discontinued Operations

On December 17, 2004, Napster sold substantially all of the assets and liabilities of its consumer software division (“CSD”.) From the acquisition of Pressplay on May 19, 2003 though the divestiture of CSD on December 17, 2004, our consumer software products business accounted for substantially all of our revenues. Prior to the acquisition of Pressplay, CSD accounted for all of our revenues. We derived CSD revenue from distributors and direct sales to end users through the Company’s website and toll-free number. Distributors resold our consumer software products to retailers of computer software products. We also sold our software products to OEMs such as PC manufacturers and CD- and DVD-recordable drive manufacturers and integrators.

During fiscal 2004, we undertook a number of restructurings, particularly workforce reductions and real estate consolidations, to react to market conditions. CSD expenses were reduced through strong cost cutting measures and consolidating operations. These activities included the sale of our GoBack product line to Symantec, Inc. in a transaction accounted for as a sale of assets.

Significant Transactions

Issuance of Common Stock

On January 24, 2005, we issued 7,100,000 shares of common stock in a private placement to certain accredited investors. The shares were sold at a price of $7.35 per share with gross proceeds of $52.2 million. The gross proceeds were reduced by placement fees and legal fees totaling approximately $3.6 million.

Sale of Consumer Software Division

On December 17, 2004, we sold substantially all of the assets and liabilities of CSD, including all of the capital stock of certain international subsidiaries historically included in CSD, to Sonic. The remaining international subsidiaries historically included in CSD have been substantially liquidated as of December 17, 2004. The transaction was structured as an asset sale. The disposition is accounted for as a discontinued operation in accordance with SFAS No. 144 “Accounting for Impairment or Disposal of Long-Lived Assets”. Therefore, the results of operations of CSD have been reclassified to results of operations from discontinued operations for all periods presented.

Common Stock Purchase Agreement

On June 17, 2004, we entered into a Common Stock Purchase Agreement with Best Buy Co., Inc. (“Best Buy”.) Under the terms of a related multi-year agreement, Best Buy’s affiliate, Best Buy Stores, L.P., will promote Napster as its leading digital music service through comprehensive in-store marketing activities as well as extensive broadcast, print and online advertising. Best Buy Stores, L.P. will also market a co-branded version of Napster which will be made available to customers via retail and online through Bestbuy.com. On June 17, 2004, Napster issued approximately 1.1 million shares of common stock valued at approximately $5.0 million to Best Buy at a cash purchase price of $0.01 per share. The difference between the fair value of the shares and the cash purchase price was recorded as prepaid marketing expenses upon issuance of the shares in June 2004.

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Acquisition of Napster, LLC

In May 2003, we acquired substantially all of the ownership of Napster, LLC (formerly known as Pressplay), a provider of an online music service. Pressplay served as the foundation for Napster’s online music service, which was launched on October 29, 2003 under the Napster brand. In consideration of the acquisition, Napster exchanged $12.5 million in cash, issued 3.9 million shares of Napster’s common stock valued at $23.5 million and obligated itself to pay up to $12.4 million in contingent payments based on Napster’s future cash flows from the online music business. We incurred approximately $1.8 million in professional fees, including legal, valuation and accounting fees related to the acquisition, which were included as part of the purchase price of the transaction. This acquisition was accounted for as a purchase and Napster, LLC’s (f/k/a Pressplay) results of operations are included in our financial statements from the date of acquisition. Prior to the launch of the Napster branded online music services in October 2003, online music revenues were minimal.

Divestiture of GoBack product line

In April 2003, we sold our GoBack product line and related tangible and intangible assets to Symantec. Cash consideration of $10.2 million was due at the date of the sale with a further $2.8 million held in escrow. This escrow was subject to claims for certain potential contingencies and was paid to us after the one-year anniversary date of the close of the transaction. A total of $1.1 million of the escrow amount was recognized as consideration at the time of the transaction. The remainder was recognized in April 2004, on the one-year anniversary date of the close of the transaction after satisfaction of the conditions specified in the purchase agreement. In the fiscal year ended March 31, 2004, we recorded a total gain of $12.3 million from the sale of the GoBack product line, including $1.7 million recognized in the quarter ended June 30, 2004.

Acquisition of certain Napster assets

In November 2002, we acquired certain assets of Enco Recovery Corporation (f/k/a Napster, Inc.), an entity unrelated to the Company, an online music file-sharing service, for $5.7 million in cash and a warrant to purchase 100,000 shares of Napster’s common stock at a price of $3.12 per share. The transaction was accounted for as a purchase of assets. The purchase price, including the fair value of the warrants and certain acquisition expenses, was $6.1 million and was allocated to the acquired assets based on their fair market value. On November 29, 2004 the warrant was exercised in a cashless transaction for 66,227 shares of our common stock.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. On an ongoing basis, we evaluate significant estimates used in preparing our financial statements, including those related to revenue recognition, sales returns and allowances, bad debt allowances, valuation and amortization of long lived assets, restructuring provisions and deferred income taxes. Actual results could differ from these estimates. Certain of our critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the financial statements.

Note 1 to the Consolidated Financial Statements provides a summary of our significant accounting policies. Certain of these policies require substantial judgment on the part of management. These critical accounting policies and the effect that changes in management’s estimates could have on our consolidated financial statements are further described below.

Revenue Recognition

We recognize revenues in accordance with Staff Accounting Bulletin (“SAB”) 104, “Revenue Recognition in Financial Statements” (“SAB 104”,) Emerging Issues Task Force (“EITF”) 00-21 “Revenue Arrangements with

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Multiple Deliverables” and EITF 99-19 “Reporting Revenue Gross as a Principal versus Net as an Agent” (“EITF 99-19”.) In general, we recognize revenue when there is persuasive evidence of an arrangement, the fee is fixed or determinable, the product or services have been delivered and collectibility of the resulting receivable is reasonably assured.

Music subscriptions are paid in advance, typically for monthly or annual periods. Music subscription revenues are recognized on a daily basis over the subscription period. Revenues from sales of individual songs or albums by download are recognized at the time the music is delivered, digitally, to the end user. Revenues from pre-paid cards are deferred and then recognized as tracks are downloaded by the end users or, if redeemed for a subscription, over the subscription period. Revenues from licenses of Napster merchandising rights are recognized upon receipt of royalty reports from the licensee.

We have arrangements whereby customers pay one price for multiple products and services. In some cases, these arrangements involve a combination of hardware and services. In other cases, the customer pays a single price for multiple music downloads and months of music subscriptions. For arrangements with multiple deliverables, revenue is recognized upon the delivery of the separate units in accordance with EITF No. 00-21. Consideration from multiple element arrangements is allocated among the separate elements based on their relative fair values. In the event that there is no objective and reliable evidence of fair value, the revenue recognized upon delivery is the total arrangement consideration less the fair value of the undelivered items. The maximum revenue recognized on a delivered element is limited to the amount that is not contingent upon the delivery of additional items. Management applies significant judgment in establishing the fair value of multiple elements within revenue arrangements. Estimates of fair value represent our best estimate, but changes in circumstances relating to the products and services sold in these arrangements may result in one-time revenue charges as future elements of the arrangements are delivered.

We have arrangements with certain customers whereby the customer provides goods or services to Napster. Our revenue and the charges for the goods or services provided by a customer are accounted for in accordance with EITF No. 01-09, “Accounting for Consideration Given by a Vendor to a Customer,” including subsequent interpretations (“EITF 01-09”.) The costs of separately identifiable goods or services received from a customer are valued at the cost we would incur to procure the same goods or services from a non-customer third party. If the goods or services cannot be separated, the total consideration is recorded as a reduction of revenues. Consideration paid to customers under these arrangements that exceeds the separately identifiable value of the goods or services provided would be reflected as a reduction of the customer’s revenue. Management exercises significant judgment in determining the fair value of separately identified goods or services. Estimates of fair value represent our best estimate, but changes in circumstances relating to the products and services sold in these arrangements may result in one-time expense or revenue charges.

We recognize revenue gross or net in accordance with EITF 99-19. In most arrangements, we contract directly with our end user customers, are the primary obligor and carry all collectibility risk. Revenue in these arrangements is recorded on a gross basis. In some cases, we utilize third party distributors to sell products or services directly to end user customers and carry no collectibility risk. In those instances, in accordance with EITF 99-19, we report the revenue net of the amount paid to the distributor.

Discontinued operations

CSD recognized revenues in accordance with SAB 104, American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) No. 97-2, “Software Revenue Recognition” (“SOP 97-2”) and SFAS No. 48, “Revenue Recognition When Right of Return Exists” (“SFAS 48”.) In general, CSD recognized revenue when there was persuasive evidence of an arrangement, the fee was fixed or determinable, the product or services had been delivered and collectibility of the resulting receivable was reasonably assured.

CSD sold its consumer software products through original equipment manufacturers (“OEMs”), retail channels via distributors and direct to end users.

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For software product sales to OEMs, CSD recognized revenue based on reported product shipments from OEMs to their customers provided that all fees were fixed or determinable, evidence of an arrangement existed and collectibility was reasonably assured. For arrangements in which all elements were not delivered at the point of reported product shipment, revenues associated with the undelivered element were recognized when all revenue recognition criteria were met for the undelivered elements.

For software product sales to distributors, revenues were recognized upon product shipment to the distributors or receipt of the products by the distributor, depending on the shipping terms, provided that all fees were fixed or determinable, evidence of an arrangement existed and collectibility was reasonably assured. CSD’s distributor arrangements provided distributors with certain product rotation rights. Additionally, CSD permitted its distributors to return products in certain circumstances, generally during periods of product transition. CSD also utilized mail-in rebates (“MIRs”) as a marketing tool to promote its products and acquire new end users. Estimated redemption of MIRs was recorded as a direct reduction to revenues and was accrued at the date the related revenues were recognized. Estimates were based upon historical redemption rates and current market factors.

For direct software product sales to end users, revenues were recognized upon shipment by CSD to the end users provided all appropriate revenue recognition criteria were met. End users additionally had the right to return their product within 30 days of the purchase. CSD established allowances for expected product returns in accordance with SFAS No. 48 and SAB 104. These allowances were recorded as a direct reduction of revenues and as an accrued liability.

CSD had other programs whereby customers are reimbursed for promotional activities. In accordance with EITF 01-09, the costs of separately identifiable promotions were valued at the cost CSD would incur to obtain the same promotion from a non-customer third party and were charged to marketing expense. If the promotion could not be separated, the total consideration was recorded as a reduction of revenue.

Revenues from CSD licenses of technology were recognized upon delivery of the licenses, provided that all fees were fixed or determinable, evidence of an arrangement existed, and collectibility was reasonably assured and there were no undelivered elements in the arrangement.

In connection with the retail sale of CSD products, CSD provided to customers a limited amount of free technical support assistance including bug fixes, work-arounds, patches and compatibility updates that were downloadable from the CSD website. In accordance with SOP 97-2, CSD did not defer the recognition of any revenue associated with this free technical support assistance but accounted for this obligation by accruing the estimated cost of providing such assistance as the associated revenue was recognized.

Management exercised significant judgment in determining whether revenues were collectable, estimating MIR redemption, return reserve allowances, fair value of separately identified goods or services and estimating the cost of technical support assistance. These estimates represented our best estimate. All CSD product return, rebate and technical support obligations were assumed by Sonic as of December 17, 2004.

Fair-Value Hedge

On December 29, 2004, Napster entered into a forward contract to hedge exposures resulting from changes in fair market value of the 653,837 shares of Sonic common stock received in our sale of CSD to Sonic (the “Sonic Shares”.) This forward contract is accounted for as a fair value hedge under SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities.” SFAS No. 133 requires us to recognize the hedge as either an asset or liability on the balance sheet, measured at fair value. Additionally, pursuant to SFAS No. 133, changes in the intrinsic value of this fair-value hedge are recognized as gains or losses in current operations within other income (loss.) Effective December 29, 2004, when the hedge was put in place, gains or losses on fair value changes of the hedged Sonic Shares are also recognized in current operations in other

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income (loss), offsetting any gain or loss on the fair value hedge. Napster will record any ineffective portion of the hedging instruments as a gain or loss in current operations. Additionally, the hedge discount is recorded as an interest expense over the term of the hedge. Management exercised judgment in determining the nature of this hedge.

Prepaid Content Advances and Marketing Expenses

We recognize up front advance payments for digital content and marketing expenses in Prepaid and Other Current Assets. Prepaid Content Advances are expensed based on usage. Prepaid Marketing Expenses are charged to operations as we receive separately identifiable marketing services from our strategic marketing partners. Advances that are not recovered by the end of their contractual terms may be non-refundable. The recoverability of these balances is subject to regular review by management considering expected future content fees and marketing services. The estimates of expected future benefits include judgments about growth in demand for our products, performance by our strategic partners and fair values for related services. Changes in these estimates could require us to write down the carrying value of these advances and could materially impact our financial position and results of operations.

Capitalized software development costs

Internal use software.    We comply with AICPA SOP No. 98-1 “Accounting For Cost of Computer Software Developed or Obtained for Internal Use” and EITF Issue 00-2 “Accounting for Website Development Costs.” In accordance with SOP 98-1, software development costs incurred as part of an approved project plan that result in additional functionality to internal use software are capitalized and amortized on a straight-line basis over the estimated useful life of the software, generally three years.

Software held for sale.    In accordance with SFAS No. 86, “Computer Software to be Sold, Leased, or Otherwise Marketed,” development costs of computer software to be sold, leased or otherwise marketed are subject to capitalization beginning when a product’s technological feasibility has been established and ending when a product is available for general release to customers. We have not capitalized any software development costs as technological feasibility is generally not established until a working model is completed, at which time substantially all development is complete.

Management applies significant judgment when determining whether products under development are technologically feasible or whether it is probable that they will result in additional functionality. These judgments include assessments of our development progress and expected performance. Additionally, the future realizability of capitalized software costs is subject to regular review by management, who consider expected future benefits. The estimates of expected future benefits include judgments about growth in demand for our products, performance by our strategic partners and fair values for related services. Changes in these estimates could require us to write down the carrying value of these capitalized amounts and could materially impact our financial position and results of operations.

Goodwill and other intangible assets

We account for goodwill and other intangible assets in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” which we adopted effective April 1, 2001. We ceased to amortize goodwill effective April 1, 2001 and evaluate the carrying value of goodwill on an annual basis. We will adjust the carrying value if the asset’s value has been impaired. We amortize other intangible assets on the straight-line method over their estimated useful lives, generally three years.

During the fourth quarters of each of fiscal 2005, 2004 and 2003 we completed our annual impairment tests. The assessment of goodwill impairment was conducted by determining and comparing the fair value of

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our reporting units, as defined in SFAS 142, to the reporting unit’s carrying value as of each date. In fiscal 2005 we used the market value approach to determine the fair value. In fiscal 2004 and 2003 we used the discounted cash flow methodology because we had multiple business segments. Based on the results of these impairment tests, we determined that our goodwill and other intangible assets were not impaired during fiscal 2005, 2004 or 2003. We plan to conduct our annual impairment tests in the fourth quarter of every year, or sooner if impairment indicators exist. Screening for and assessing whether impairment indicators exist or if events or changes in circumstances, including changes in market conditions, operating fundamentals, competition and general economic conditions, have occurred requires significant judgment. Additionally, changes in the high-technology industry occur frequently and quickly. Therefore, there can be no assurance that a charge to operations will not occur as a result of future goodwill and purchased intangible impairment tests.

Restructuring Provisions

We have recorded restructuring provisions in accordance with SFAS No. 146, “Accounting for Exit Costs Associated with Exit or Disposal Activities.” In order to determine our restructuring liability, SFAS 146 requires us to make a number of assumptions. These assumptions include estimated wages and associated costs for employee terminations, sublease income over the remaining lease period, estimated term of subleases, estimated utility and real estate broker fees, as well as estimated discount rates for use in calculating the present value of our liability. We developed these assumptions based on our employee termination plans and understanding of the real estate market as well as market interest rates. The assumptions used were management’s best estimate at the time of the accrual, and adjustments are made on a periodic basis if better information is obtained. On December 17, 2004 Sonic assumed all liabilities on leases associated with our restructuring provisions. Following the CSD divestiture, in December 2004 and January 2005 all terminated employees received their separation pay. As such, there is no outstanding restructuring liability as of March 31, 2005.

Income Taxes

We account for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” As part of the process of preparing our consolidated financial statements we are required to determine our income taxes in each of the jurisdictions in which we operate. This process involves determining our current tax expense together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must assess the likelihood that our deferred tax assets will be recovered from various means including future taxable income and, to the extent we believe that recovery is not more likely than not, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the statement of operations. The above process is computed separately for each of continuing operations, the discontinued operation and elements of other comprehensive income.

Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We have recorded a full valuation allowance against our deferred tax assets, net of reversing deferred tax liabilities, as of March 31, 2005 due to uncertainties related to our ability to utilize our deferred tax assets, primarily consisting of net operating losses and accrued liabilities and other provisions not currently deductible for tax purposes. The timing of the reversal of the remaining deferred tax liability related to the election to step up the tax basis of the Pressplay goodwill is indefinite. The valuation allowance is based on our estimates of taxable income by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to establish an additional valuation allowance, which could materially impact our financial position and results of operations.

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Equity Instruments

Napster accounts for stock-based compensation in accordance with APB No. 25, “Accounting for Stock Issued to Employees,” and complies with the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” and with the disclosure provisions of SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure, Amendment of SFAS No. 123.” Under APB No. 25, compensation expense is recognized based on the difference, if any, on the measurement date between the fair value of Napster’s common stock and the amount an employee must pay to acquire the common stock. The compensation expense is recognized over the periods the employee performs the related services, generally the vesting period of four years.

Napster accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and EITF No. 96-18, “Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” which requires that such equity instruments are recorded at their fair value on the measurement date.

Management generally estimates the fair value of non-traded equity instruments using the Black-Scholes model. The Black-Scholes model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. This model requires the input of highly subjective assumptions including the expected stock price volatility. Changes in the subjective input assumptions can materially affect the fair value estimate, which could materially impact our financial position and results of operations.

Results of Operations

Fiscal 2005 as compared to fiscal 2004

The following table sets forth our results as a percentage of total net revenues for the periods indicated. These operating results are not necessarily indicative of the results for any future period.

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We began to generate online music revenues with the acquisition of Napster, LLC in May 2003. As a result, unless otherwise indicated, the following discussions and analysis of our results of operations from continuing operations relate only to the fiscal years ended March 31, 2005 and 2004.

Net Revenues

The following table sets forth, for the periods indicated, the summary of our revenues from continuing operations:

Content revenues increased approximately 284% to $44.7 million in fiscal 2005 from $11.7 million in fiscal 2004. This increase was primarily due to subscriber growth. The Napster service was launched in the United States during October 2003 and in the United Kingdom and Canada during May 2004. Since these launches, our subscriber base has increased steadily, reaching 412,000 as of March 31, 2005, comprised of 56,000 University subscribers and 356,000 full-paying subscribers. We anticipate that content revenues will continue to increase in the future as the overall online music market expands, and as a result of our continued marketing activities and initiatives to control customer cancellations (“churn”), increase customer growth and expand internationally.

Hardware and license revenues increased approximately $1.7 million to $2.0 million in fiscal 2005 from $307,000 in fiscal 2004, primarily due to increased hardware promotions in fiscal 2005. We anticipate that hardware and license revenues will fluctuate in the future depending on the hardware promotions and licenses that we enter into each period.

Geographic Revenues

The following table sets forth, for the periods indicated, the summary of our revenues from continuing operations:

The increase in revenues in both geographies is related to the launch of the online music service in the United States during October 2003 and the launches of the service in the United Kingdom and Canada in May 2004. We anticipate that the proportion of revenue outside of the United States will fluctuate as a result of continued marketing activities and initiatives focused on world-wide customer growth and international expansion.

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Gross Margin

The following table sets forth, for the periods indicated, our gross margin from continuing operations:

Content gross margin is the profit from revenues after deducting the cost of royalties to content providers and publishers, technical support, bandwidth and hosting costs, depreciation and amortization of infrastructure assets related to the delivery of our online services, and any other direct costs of the net revenues.

Gross margin on content revenue increased to 20% in fiscal 2005 from 12% in fiscal 2004, due primarily to the revenue mix which transitioned to a higher percentage of subscriptions during fiscal 2005. Additionally, our continuing operations have a relatively fixed cost base that was put in place in October 2003 as part of the launch of the online music service. Margins are improving steadily as revenues have grown in contrast to those fixed costs.

Hardware and license gross margins fluctuate based on the nature of the hardware promotions and the volume of trademark licenses in each period. During the year ended March 31, 2005, Napster sponsored hardware promotions at break-even and offered several product bundles. Revenue from product bundles is allocated between content revenues and hardware and license revenues on a pro-rata basis in accordance with EITF No. 00-21. Napster had immaterial license revenues in both fiscal 2004 and 2003.

Online service headcount dedicated to maintaining content and providing customer care was 10 at March 31, 2005 and 3 at March 31, 2004.

We expect online music gross margins to increase slightly as we expand revenues, transition the revenue mix to more subscribers and maintain our fixed infrastructure base.

Operating Expenses

We classify operating expenses as research and development, sales and marketing and general and administrative. Each category includes related expenses for salaries, employee benefits, incentive compensation, travel, telephone, communications, rent and allocated facilities and professional fees. Our sales and marketing expenses include additional expenditures specific to the marketing group, such as public relations and advertising, trade shows, and marketing collateral materials and expenditures specific to the sales group, such as commissions. In addition, we include restructuring charges, certain amortization of identifiable intangible assets and stock-based compensation charges associated with individuals in operating expense departments as operating expenses.

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The following table sets forth, for the periods indicated, our operating expenses from continuing operations:

Research and Development

Research and development expenses consist primarily of salary, benefits and contractors’ fees for our development and other costs associated with the minor enhancements of existing products and development of new features for the online service.

Research and development expenses increased $167,000 or 1% to $12.1 million in fiscal 2005 from $11.9 million in fiscal 2004. This net increase was primarily due to a $1.4 million increase in research and development in fiscal 2005, offset by $1.2 million of non-recurring expenses in the quarter ended December 31, 2003 for one-time costs associated with launching the Napster service in October 2003. The $1.4 million increase is primarily due to a full year of research and development activity in fiscal 2005 compared to ten months of activity in fiscal 2004 following the May 2003 Pressplay acquisition.

Research and development headcount for Napster was 63 at March 31, 2005 and 65 at March 31, 2004.

We anticipate that research and development expenses will increase in absolute dollars in the future as we continue to invest in online music features and services, but will remain flat or decrease as a percentage of total revenues.

Sales and Marketing

Sales and marketing expenses consist primarily of salary and benefits for sales and marketing personnel, and costs associated with advertising and promotions.

Sales and marketing expenses increased $23.6 million or 151% to $39.2 million in fiscal 2005 from $15.6 million in fiscal 2004. This increase was primarily due to $22.6 million of additional advertising and promotional spending during fiscal 2005 compared to the prior year, because the Napster service was not launched until the third quarter of fiscal 2004 and because we undertook an extensive marketing campaign during February and March 2005 related to the launch of Napster To Go. The increase was also due to $1.0 million of additional staff and overhead expenses because fiscal 2005 included a full year, whereas fiscal 2004 included only ten months from the date the acquisition of Pressplay in May 2003.

Sales and marketing headcount for Napster was 25 at March 31, 2005 and 15 at March 31, 2004.

We anticipate sales and marketing expenses to increase in the future as a result of continued marketing activities and a number of initiatives planned to drive customer growth and international expansion.

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General and Administrative

General and administrative expenses consist primarily of salary and benefit costs for executive and administrative personnel, professional services and other general corporate activities. General and administrative charges in continuing operations include all corporate overhead charges that are not directly attributable to CSD.

General and administrative expenses increased $2.1 million or 10% to $23.3 million in fiscal 2005 from $21.2 million in fiscal 2004. General and administrative expenses reflect $4.1 million of additional professional service fees related to the transaction with Sonic, compliance with the Sarbanes-Oxley Act and legal costs related to the SightSound litigation in fiscal 2005, and an additional $1.1 million of general and administrative expenses related to international expansion. These increased expenses were offset by a $3.1 million reduction in headcount and related expenses in corporate functions due to the fiscal 2004 restructurings and the divestiture of CSD in December 2004.

General and administrative headcount for Napster was 37 at March 31, 2005 and 14 at March 31, 2004. The general and administrative headcount at March 31, 2004 included all corporate general and administrative employees.

We expect general and administrative expenses to decrease in absolute dollars in future periods because CSD has been sold and we have reduced corporate finance, human resources and information technology headcount to support the smaller online music organization.

Restructuring Charges

During fiscal 2004, Napster recorded a restructuring charge in the continuing operations of approximately $1.1 million. The restructuring charge was primarily in connection with the reorganization of Napster’s domestic operations. This restructuring charge was primarily related to severance and benefits associated with involuntary terminations. As of March 31, 2005, no additional restructurings are anticipated.

Amortization of Intangible Assets

Amortization of other intangible assets consists of amortization expense related to the intangible assets recorded in connection with our acquisition of Napster’s name in December 2002 and Napster, LLC, formerly known as Pressplay, in May 2003.

Amortization of other intangible assets decreased $236,000 or 11% to $1.9 million in fiscal 2005 from $2.2 million in fiscal 2004. The decrease is primarily due to certain identifiable intangible assets that were fully amortized during the first half of fiscal 2005.

Provided that we do not acquire new intangible assets, amortization of intangible assets is anticipated to be $1.3 million for the fiscal year ending March 31, 2006.

Stock-Based Compensation Charges

Stock-based compensation charges relate to the amortization of costs associated with stock options issued to employees and the commitment of Napster stock options to Adaptec employees who became Napster employees and are part of continuing operations.

Stock-based compensation decreased $228,000 or 25% to $676,000 in fiscal 2005 from $904,000 in fiscal 2004, because most deferred charges have been fully amortized. We expect stock-based compensation charges will increase in the future because Napster plans to change it’s employee stock-based compensation from issuing employee stock options to issuing restricted stock rights in fiscal 2006. During fiscal 2006 we will report stock-based compensation equal to the fair value of stock rights granted to employees over the employee’s service period.

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Other Income, Net

Other income, net, consists primarily of interest income on our cash equivalents and short-term investments, realized gains (losses) on short-term investments, interest expense, change in the fair value of the hedge and other miscellaneous income. Other income, net increased $457,000 in fiscal 2005 to $1.1 million from $634,000 in fiscal 2004 primarily due to a $1.5 million increase in investment income offset by a $536,000 increase in interest expense, a $139,000 foreign currency loss and a $342,000 expense for the discount on the fair market value hedge. We had no foreign currency gains or losses and no hedges in fiscal 2004. We expect other income, net to increase in fiscal 2006 because we have more cash equivalents and short term investments as of March 31, 2005 and we have paid off the line of credit.

Income Tax Benefit

Income tax benefit primarily relates to the tax benefit of utilizing the operating losses from continuing operations to offset taxable gains in the discontinued operation. We have recorded a valuation allowance to reduce deferred tax assets to the amount we believe is more likely than not to be realized. Conversely, we have recognized a provision in continuing operations in each period that a valuation allowance was recorded against beginning of the period deferred tax assets.

During January 2005, following the divestiture of CSD, which utilized substantially all of our tax operating losses, Napster made a tax election to step up the basis in Pressplay goodwill for tax purposes. As a result, the Pressplay goodwill is deductible for tax purposes. In accordance with FAS 109, this tax deduction represents a tax timing difference that is shown as a provision for income taxes.

Income tax benefit increased $11.0 million or 244% to $15.5 million in fiscal 2005 from $4.5 million in fiscal 2004. The increase in fiscal 2005 is primarily due to the taxable gain on the divestiture of CSD during fiscal 2005, which was completely offset by operating losses from continuing operations. This benefit is offset by a $1.7 million tax provision for the deductibility of the Pressplay goodwill.

We do not expect to realize tax benefits on the continuing operations in fiscal 2006, because the discontinued operation (CSD) has been divested and continuing operations are expected to incur taxable losses in the foreseeable future. We expect to incur a tax provision of approximately $1 million during fiscal 2006 related to the deductible Pressplay goodwill. In the event that deferred tax assets are realizable in the future in excess of the net recorded valuation allowance, an adjustment to the deferred tax asset will increase the tax benefit in the period such determination is made.

Income (Loss) from Discontinued Operations

Income (loss) from discontinued operations increased $19.9 million or 995% to $21.9 million in fiscal 2005 from $2.0 million in fiscal 2004. The increase is primarily due to the $18 million after-tax gain on the sale of CSD in December 2004 and $1.9 million of after-tax profits from CSD prior to the divestiture.

Fiscal 2004 as compared to fiscal 2003

We had no online music revenues, costs of revenues, research and development expenses or sales and marketing expenses in fiscal 2003 or earlier because we had no online music operation until the acquisition of the Napster trademark in November 2002.

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The following table sets forth, for the periods indicated, our operating expenses from continuing operations:

General and Administrative.    General and administrative expenses consist primarily of salary and benefit costs for executive and administrative personnel, professional services and other general corporate activities. General and administrative charges for the continuing operations in fiscal 2003 represent corporate overhead charges that are not directly attributable to CSD. General and administrative expenses increased $3.4 million or 19% to $21.2 million in fiscal 2004 from $17.8 million in fiscal 2003. General and administrative expenses increased primarily as a result of the addition of the online music division during early fiscal 2004. General and administrative headcount for Napster was 14 at March 31, 2004 and 18 at March 31, 2003. General and administrative headcount in all periods includes all corporate general and administrative employees.

Amortization of Intangible Assets.    Amortization of other intangible assets consists of amortization expense related to the intangible assets recorded in connection with our acquisition of the Napster trademark in November 2002 and Napster, LLC, formerly known as Pressplay, in May 2003. Amortization of other intangible assets increased $1.5 million or 226% to $2.2 million in fiscal 2004 from $666,000 in fiscal 2003. The increase is because the Napster trademark was acquired during the third quarter of fiscal 2003, and was therefore only amortized for three months in fiscal 2003 compared to twelve months in fiscal 2004. Additionally, Presssplay was acquired in fiscal 2004, and therefore represented none of the fiscal 2003 amortization.

Stock-Based Compensation Charges.    Stock-based compensation charges relate to the amortization of costs associated with stock options issued to employees and the commitment of Napster stock options to Adaptec employees who became Napster employees and are part of continuing operations. Stock-based compensation increased $131,000 or 17% to $904,000 in fiscal 2004 from $773,000 in fiscal 2003, because additional stock based compensation was deferred in fiscal 2004 associated with stock option grants at strike prices below fair market value.

Other Income, Net.    Interest income and realized gains on investments decreased to $799,000 in fiscal 2004 from $956,000 in fiscal 2003 primarily due to fluctuations in interest rates on cash, cash equivalents and investments. Interest expense increased to $175,000 in fiscal 2004 from $42,000 in fiscal 2003 due to interest on the borrowings through our revolving line of credit.

Income Tax Benefit.    The $2.7 million decrease in the tax benefit to $4.5 million in fiscal 2004 from 7.2 million in fiscal 2003 was because fewer fiscal 2004 losses were expected to be realized as an offset to 2004 discontinued operation profits.

Income (Loss) from Discontinued Operations.    Income (loss) from discontinued operations increased by $2.5 million or 510% to $2.0 million income in fiscal 2004 from a $489,000 loss in fiscal 2003. The increase from fiscal 2003 to 2004 is primarily due to reduced spending following restructuring actions.

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Liquidity and Capital Resources

We ended fiscal 2005 with $167.8 million in cash, cash equivalents and short-term investments, including the $9.8 million fair value of the Sonic Shares. These amounts consist principally of commercial paper, corporate bonds, U.S. government securities and money market funds. This balance represents a $100.7 million increase as compared to March 31, 2004. Our primary ongoing source of cash is receipts from revenues and proceeds from private equity placements. The primary uses of cash are payroll (salaries and related benefits), general operating expenses (marketing, travel and office rent), payments to content providers, payments for products held for resale, and purchases of property and equipment. Our working capital was $131.5 million at March 31, 2005.

On January 24, 2005, we issued 7,100,000 shares of common stock in a private placement to certain accredited investors. The shares were sold at a price of $7.35 per share with gross proceeds of $52.2 million. The gross proceeds were reduced by placement fees and legal and accounting fees of in total approximately $3.6 million.

Line of Credit

In March 2004, we entered into an agreement with Silicon Valley Bank to provide a $15.0 million revolving line of credit, collateralized by substantially all of its assets. In June 2004, we amended the line of credit agreement to increase the available borrowings to $17.0 million. In December 2004, we amended the line to release the lender’s security in assets sold to Sonic and to extend the maturity date to December 2005. At March 31, 2005, we had borrowed $15.0 million under the line of credit. During May 2005, we repaid the $15.0 million line of credit balance, plus $73,000 of accrued interest.

As of June 3, 2005, $17.0 million is available for borrowing under the line. The line of credit bears interest at a variable rate of prime plus 0.5% per annum. The line of credit contains a material adverse conditions clause and covenants that require us to maintain certain financial ratios. The covenants require at the end of each month and throughout the term of the agreement (i) a minimum tangible net worth of $45.0 million, (ii) a ratio of unrestricted cash, cash equivalents and short-term investments, plus 10% of net accounts receivable, to total borrowings under the line of credit of not less than 2.00 to 1.00. At March 31, 2005, we were in compliance with all covenants under the line of credit.

Financial Position

We believe that the liquidity provided by existing cash, cash equivalents, and short-term investments will provide sufficient capital to meet our requirements for at least the next 12 months. Napster operates and will continue to operate in the near term at a loss and net negative cash flow due to significant investments required to expand its service capabilities and to expand internationally.

On December 29, 2004, we entered into a forward contract to hedge against changes in the fair market value of its 653,837 unregistered shares of Sonic common stock. This forward contract, carried at fair value, has a maturity between six and twelve months. As a result of the hedge agreement, Napster has eliminated its exposure to changes in the fair value of the shares until the forward contract expires in December 2005.

We do not currently hold any variable interest rate debt other than our revolving line of credit. Accordingly, we have not been exposed to near-term adverse changes in interest rates or other market prices. We may, however, experience such adverse changes if we incur debt or hold other derivative financial instruments in the future.

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Cash Flows

Operating Activities

The following table sets forth, for the periods indicated, the components of cash flows from operating activities (in thousands):