UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

(Mark One)

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

For the fiscal year ended December 31, 2010

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

For the transition period from                      to                     

MakeMusic, Inc.

(Exact name of Registrant as specified in its charter)

Minnesota		41-1716250
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

7615 Golden Triangle Drive, Suite M, Eden Prairie, MN 55344
(Address of principal executive offices)

(952) 937-9611
(Registrant’s telephone number, including area code)

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

Common Stock $.01 par value		NASDAQ Capital Market
(Title of each class)		(Name of each exchange on which registered)

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

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

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

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 þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) 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. o

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

Large accelerated filer o		Accelerated filer o		Non-accelerated filer o		Smaller Reporting Company þ
				(Do not check if smaller reporting company)

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

The aggregate market value of the Common Stock held by non-affiliates of the Registrant as of June 30, 2010 was approximately $10,652,330 based upon the closing price of the Registrant’s Common Stock on such date.

There were 4,890,191 shares of Common Stock outstanding as of February 28, 2011.

None.

Transitional Small Business Disclosure Format (check one). Yes o No þ

 

 

TABLE OF CONTENTS

		Page No.
PART I
Item 1. Business			2
Item 2. Properties			14
Item 3. Legal Proceedings			14
Item 4. (Removed and Reserved)			14
PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities			15
Item 6. Selected Financial Data			15
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations			16
Item 8. Financial Statements and Supplementary Data			26
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure			44
Item 9A.Controls and Procedures			45
Item 9B. Other Information			46
PART III
Item 10. Directors, Executive Officers and Corporate Governance			47
Item 11. Executive Compensation			50
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters			58
Item 13. Certain Relationships and Related Transactions and Director Independence			59
Item 14. Principal Accounting Fees and Services			60
PART IV
Item 15. Exhibits, Financial Statement Schedules			61
EX-10.4
EX-10.8
EX-10.17
EX-10.18
EX-23.1
EX-31.1
EX-31.2
EX-32.1
EX-32.2

Important Factors Regarding Future Results

     Information provided by MakeMusic, Inc. (hereafter the “Company” or “MakeMusic”), in this Annual Report on Form 10-K, may contain forward-looking statements concerning such matters as projected financial performance, market and industry segment growth, product development and commercialization, acquisitions or other aspects of future operations. Such statements, made pursuant to the safe harbor established by the securities laws, are based on the assumptions and expectations of the Company’s management at the time such statements are made. The Company cautions investors that its performance (and, therefore, any forward-looking statement) is subject to risks and uncertainties. Various important factors including, but not limited to, those discussed in Item 1 “Cautionary Statements,” may cause the Company’s future results to differ materially from those projected in any forward-looking statement. All information presented is as of December 31, 2010, unless otherwise indicated.

PART I

ITEM 1. BUSINESS

Introduction

          MakeMusic, Inc., a Minnesota corporation (referred to herein as “we,” “us,” the “Company” or “MakeMusic”), is a world leader in music education technology whose mission is to develop and market solutions that transform how music is composed, taught, learned and performed. MakeMusic’s predecessor corporations, which were merged to form the current entity in 1992, were incorporated in Minnesota in 1990. We currently have approximately one hundred employees and are based in Eden Prairie, Minnesota.

          MakeMusic develops and markets two product lines that reinforce each other’s features and competitiveness. The well-established Finale^® family of music notation software products provides a solid base business that serves a large customer base, and generates consistent revenue through sales of new products, annual upgrades and trade-up campaigns.

          SmartMusic^® is a subscription-based product directed toward the very large and constantly renewing market of music students and their teachers. SmartMusic combines a software application, a library of thousands of music titles and skill-development exercises, and a web service to provide students with a compelling experience and teachers with the realistic means to document student achievement and growth.

SmartMusic

Market Need

          Many students naturally desire to learn to sing or play a musical instrument. The primary obstacle for them is practicing, which is necessary if they are to develop the skills and expertise music performance requires. The challenge is to find ways to make practice time more engaging and rewarding in order to encourage students to practice longer and more effectively, which leads to positive results. There is also an increasing demand for music teachers to document individual student achievement and growth, something that is far easier for classroom teachers who routinely give spelling tests, math quizzes, and science exams. It is impractical, however, for music teachers to audition every student on a weekly basis to document their skill-development and their proficiency with the music. The demand for measuring student performance and teacher effectiveness is readily apparent. While the initial focus on accountability rarely included music instruction, assessment standards are increasingly being applied to all subject areas. Administrators and music educators seem to have a growing desire to measure the progress of music students to validate the effectiveness of their programs and defend program funding. Accountability within the public schools has gained prominence as evidenced by federal legislative activity including the No Child Left Behind Act (NCLB) and Race to the Top (RttT).

          In addition, music teachers are very sensitive to how well their student ensembles perform. Each concert, musical and marching band performance puts their teaching effectiveness on display for all in the community to evaluate. They are keenly interested in solutions that help them be more effective and inspiring, so that they can produce noticeably better performances.

The SmartMusic Solution

          SmartMusic software is an interactive music teaching and learning solution for band, orchestra, and vocal students to use at school and, more importantly, at home. SmartMusic enhances and transforms the hours spent practicing by putting students inside a professional band or orchestra, so that they can hear how the music is supposed to be performed and how their part fits in. This makes practicing much more engaging, causing students to practice longer and more often. SmartMusic also offers a rich variety of effective practice tools that make practice time more efficient and productive. The combination of making practice time more engaging and productive leads to rapid student skill-development, increased student confidence, higher student retention, and stronger music programs.

          Teachers use SmartMusic Gradebook^™, the web-based grade book that comes with each teacher subscription, to post assignments to students, receive completed assignments from students, assess student achievement, and manage student records. The grade book process works as follows:

	1.		Teachers log in to SmartMusic Gradebook via a web browser, select a title the students are preparing for concert, and select a pre-defined assignment for that title. Teachers then set a due date, how many points the assignment is worth, and finally post the assignment to all students in the band or orchestra. This process takes the teacher about one minute.
	2.		Students log in to SmartMusic at home or at a school practice room and are immediately greeted by a list of assignments that are due. When students click on an assignment, it is automatically loaded for them and practice instructions are displayed. Students can then practice the assignment with SmartMusic’s practice tools: slow down the tempo, hear how their part is performed, set practice loops, use the tuner, etc. Students can even record their performance so that they can listen to themselves and better detect problems they need to correct. As students practice, they see notes and rhythms that were performed incorrectly turn red and those that were performed correctly turn green. In this manner, SmartMusic automatically assesses student performances, giving each student a score.
	3.		Once a student achieves a desired score, they click the Submit button so that the assignment and its final score are automatically sent to the teacher’s SmartMusic Gradebook. Although the student needs an Internet connection to do this, no browser or e-mail program is required.
	4.		Teachers can now see in their SmartMusic Gradebook which students have submitted assessment assignments and what grades were automatically given by SmartMusic. If the teacher required students to submit recordings of an assignment, the recordings are also in the Gradebook. Teachers can listen to recordings with a single click, which facilitates an efficient grading process.

SmartMusic Assignments

          With SmartMusic and SmartMusic Gradebook, teachers finally have a practical way to influence students’ home practice time and measure individual student achievement. They are able to use student records in SmartMusic Gradebook to explain semester grades to students and their parents. SmartMusic Gradebook also makes it easy for a teacher to e-mail parents a recording of their child’s performance with a note, “Listen to how great your child sounds!” This encourages parents to be more actively involved in their child’s musical education.

          Students understand that their teachers know, because of SmartMusic assignments, whether they practice and whether they master their concert music. At the same time SmartMusic holds students accountable, it makes their practice time more rewarding and inspiring. We believe students prefer to work on assignments at home with SmartMusic and submit them via the Gradebook instead of performing in front of their teacher and peers.

          An administrator can audit their teachers’ SmartMusic Gradebook to verify that student achievement is consistently being measured and that students are developing skills. This helps them justify the music program, which is generally acknowledged as very important to the school district.

How Does SmartMusic Develop Skills and Motivate Students?

          SmartMusic provides a rich combination of features that helps students focus their practice time and master specific skills, contributing to a more engaging and rewarding practice. These features include the following:

	•		Assessment. SmartMusic assesses student performance. Wrong notes and rhythms turn red while correct notes turn green. SmartMusic scores each attempt by the students, giving practice time a video game-like appeal.
	•		Practice with professional accompaniment. SmartMusic puts the student into an ensemble of professionals. The music comes alive for them as they hear how professionals create the drama, excitement, and beauty of the music.
	•		Practice at slower tempos. Students need to slow music down in order to master the technical challenges. SmartMusic allows students to set any tempo and then gradually build up speed.
	•		Hear how their part is performed. SmartMusic will play each student’s part so that they can hear how a professional would perform it.
	•		Record. Students often cannot hear what they are doing wrong as they sing or play. SmartMusic allows them to record themselves so that they can instantly hear what needs to be corrected.
	•		Follow me feature. When practicing solo literature that requires expressive interpretation, SmartMusic listens to the students as they speed up or slow down and the accompaniment follows their tempo changes. Students are free to experiment with phrasing, learning to project their personalities into the music and make it their own.
	•		Practice performing in tune. The SmartMusic tuner is built in and helps students hear where the pitch should be.
	•		Fingering charts. When students do not know how to finger a note, they can just click on it to see its fingering chart. SmartMusic automatically provides the right chart for the instrument that the student is playing. (primarily for wind instruments)
	•		Practice loops. Students can isolate difficult measures for concentrated practice.
	•		Skill-development exercises in all keys. SmartMusic includes a large library of exercises that foster skills related to scales, intervals, arpeggios, rhythms, playing by ear, and jazz improvisation.
	•		Wide range of repertoire. The SmartMusic accompaniment library includes classical, jazz, opera, worship, musical theater, classic rock, pop, and other genres. The accompaniments, made by professionals, are stylistic, authentic, and fun to practice with. Many of the jazz accompaniments, for example, are created by Wynton Marsalis’s musicians.

Licensing, Publisher Relations and Content Development

          Content is critical to SmartMusic’s success. Determining what titles teachers want is accomplished by studying published lists of titles such as 1) state contest approved lists, 2) most often performed lists, 3) best-selling lists, 4) basic library lists, and 5) most teacher-requested lists. Additionally, publisher requests, input from subscribers, and information from JW Pepper, the largest sheet music retailer, are factors considered to determine content. The repertoire is currently being extended to include popular instrumental solos where each student is able to “be the star” and play the melody with rich accompaniment.

          While the SmartMusic library contains many titles and exercises that are either in the public domain or copyrighted by MakeMusic, the vast majority of SmartMusic content is licensed. Licenses for band, orchestra, and vocal titles typically cover three usages: 1) the right to include the title in SmartMusic, 2) the right to display the music notation (and lyrics if applicable) on-screen, and 3) the right to use an audio recording of the title.

          These rights are licensed from a wide range of music publishers, including industry leaders such as Hal Leonard Corporation, Alfred Publishing, and Music Sales, Ltd. MakeMusic has been successful at licensing titles for use within SmartMusic and believes it has good relations with the publishing community at large. However, there is no guarantee that licensing efforts will continue to be successful in the future.

          The content development process for SmartMusic includes the following: 1) editing Finale notation files supplied by publishers or engraving the files with Finale, and modeling the result on the published music, 2) synchronizing the audio recording file with the Finale notation file, 3) marking the audio file as needed for use within SmartMusic, 4) defining assignments for all large ensemble titles, and 5) testing the final file. Once this process is complete, the file is added to the library database and posted for available download to subscribers. The development

costs for each title added into SmartMusic are capitalized and when added to the library database, amortized over a five-year period.

          In 2010, developing a typical band title that did not require engraving cost approximately $620 per title and the typical orchestra title was approximately $325. If engraving was required, the cost was approximately $2,730 per band title and $1,705 per orchestra title. The average cost per title has declined from prior years due to department efficiencies and by moving some of the external engraving work in house. Engraving is the process of taking hand written music notation and converting it into publishable format. We expect the costs for band titles to continue to be more than voice and orchestra titles due to their complexity and number of parts required. Development costs will vary depending upon the complexity of each title.

          As of December 31, 2010, SmartMusic had 1,688 titles available for band, 160 for jazz ensemble, and 624 titles available for orchestra and during 2010 capitalized costs totaling approximately $511,000. These band and orchestra titles are in addition to the thousands of titles in SmartMusic of solo literature, numerous beginning methods, and skill-development exercises.

SmartMusic Application Development

          The SmartMusic application is developed by an internal team of software programmers and testers. Certain technologies are licensed from third parties and then adapted for use within SmartMusic. Development priorities are set by researching how teachers and students use SmartMusic, noting what improvements and additions are required.

          The SmartMusic application coordinates a complex web of interacting technologies that include 1) playback of music, either synthesized or audio, 2) display of music notation on-screen with Finale technology, 3) use of a microphone attachment to record a student’s performance, 4) recognition of notes and rhythms and comparison of a student’s performance to what is notated, 5) communication of errors and correction techniques to students, and 6) the support of a growing selection of skill-development features that accelerate student learning. In addition, the application has patented features, such as the “Follow Me” feature which allow students to develop their skills of expression for solo literature.

          Most importantly, the SmartMusic application communicates directly with the SmartMusic Gradebook, making the posting and submitting of assignments automatic and problem-free. It also manages aspects of the subscription service as well as content updates.

Licensed Technology

          Certain pitch recognition software incorporated into SmartMusic for purposes of music performance assessment is licensed from Institut de Recherche et Coordination Acoustique/Musique (IRCAM) which is based in Paris, France. The license agreement continues in perpetuity and was exclusive to SmartMusic through November 24, 2009. In light of the constantly changing environment of music technology, coupled with an increase in alternative technology sources, we do not believe the expiration of this license exclusivity has had a material impact on SmartMusic.

SmartMusic Patents

          We licensed, from Carnegie Mellon University (“CMU”) on a worldwide basis for the life of the patent, the use of the U.S. patent that covers the automated accompaniment developed by MakeMusic that listens to and follows tempo changes from a live performance. Although this patent expired in 2005, we have further developed this technology and patented additional features. We have obtained five additional patents that protect improvements to the user control of the software and that contain certain aspects of the repertoire file that enhance the software’s algorithms, accompaniment controls, and repertoire data file capabilities and expand miscellaneous interface features of the product. As a result of the additional patented features we have developed, strong synergy with our Finale notation product, and continuing development of an extensive library of licensed repertoire, we do not believe that SmartMusic has been or will be materially affected by the expiration in 2005 of the CMU patent.

SmartMusic Website and Back Office Development

           The SmartMusic Gradebook is the most visible aspect of the web support provided to the SmartMusic application. We use another layer of interacting technologies, databases, and services to support the Gradebook. This

ensures that the SmartMusic solution is comprehensive and that the SmartMusic experience is logical, efficient and enjoyable.

          The website and back-office services are also developed by an internal team of programmers and testers. Certain aspects of this development are sometimes handled by external contractors with any development remaining the property of MakeMusic.

SmartMusic Accessories

          The primary SmartMusic accessories are the instrumental microphone and the vocal microphone headset. These microphones are inserted into the microphone input of the computer and their audio signal is routed to the SmartMusic software for recording and assessment analysis. The instrumental microphone has a plastic-coated tip that allows it to be clipped onto a musical instrument or the student’s clothing. We outsource the microphone manufacturing to suppliers who can meet the specifications at competitive pricing. During 2010, the suggested retail price of the SmartMusic microphones was $19.95. In 2009, we also introduced a USB microphone that retails for $29.95 and lowers the entry cost for Macintosh users.

SmartMusic Subscription Business

          SmartMusic is sold as an annual subscription. Currently, teacher subscriptions, which include the SmartMusic Gradebook, are priced at $140. Additional subscriptions for school computers and student home subscriptions are priced at $36. Multi-year subscriptions are also available. We evaluate our pricing on an annual basis and changes may occur in the future.

          As teachers come to rely on SmartMusic to prepare concert music and develop student skills, we believe they will post more and more SmartMusic assignments to their students. Because teachers are able to quickly post assignments and SmartMusic assesses and grades automatically, teachers can easily post assignments related to scales, intervals, arpeggios, rhythms, and solo repertoire as well as their concert music. We expect that as teachers post a greater number of SmartMusic assignments, more students will be motivated to have SmartMusic at home and our student subscription rates will increase.

          Among the statistics by which investors can evaluate SmartMusic growth are the following:

	•		Number of SmartMusic educator accounts
	•		Number of SmartMusic Gradebook teachers (those having issued assignments to 50+ students)
	•		Total number of SmartMusic subscriptions
	•		Subscription renewal rates

          SmartMusic subscriptions are sold directly to teachers, parents, and students. Marketing communications consist primarily of presentations, clinics, and exhibits at music educator state conferences, e-mail, and direct mail. Direct sales efforts are typically aimed at the 17,000 schools who match our ideal demographic profile. We are focusing such efforts on twenty-four key music education states including Texas, Florida, New York, Illinois, and Minnesota and the Race to the Top fund winners.

SmartMusic Site Agreements

          SmartMusic site agreements are intended to encourage large deployments of SmartMusic student subscriptions. The site agreements provide schools with coterminous subscriptions for all students and teachers and discounted pricing is available. The special site agreement pricing reduces all prices by 15% for 100 or more subscriptions. We offer reasonably priced teacher training to support these larger installations and offer a training workbook and DVD as well. As of December 31, 2010, there were 485 site agreements for SmartMusic. We expect the number of site agreements to increase in the future due to our recently expanded direct sales force and focused marketing initiatives.

SmartMusic Sales and Marketing

          The market for SmartMusic is large, with student use being the largest potential market. It is estimated that approximately 55,000 school buildings offer instrumental programs, and over 17,000 of these schools match our ideal demographic profile. Recent independent research suggests that an estimated 6,000,000 students participate in instrumental programs with additional students participating in school choral programs. We believe the key to

expanding the number of subscriptions for students is producing a compelling reason for educators to make SmartMusic an integral part of their curriculum and the basis for how they deliver and grade regular student assignments. Further, we believe that the majority of students will prefer the convenience and enhanced practice experience of completing SmartMusic assignments at home and it is this dynamic that will drive subscription growth.

          As of December 31, 2010, MakeMusic had more than 9,400 teacher accounts with active SmartMusic subscriptions. Since these teachers are already using SmartMusic, they will likely be the first to adopt SmartMusic Gradebook and embrace the concept of requiring students to submit frequent SmartMusic assignments. Therefore, this group of users represents one of our most important target segments. We are able to track when each teacher creates a SmartMusic Gradebook account, when they set up a class and the number of students enrolled. As a result, we have the ability to tailor our direct marketing messages.

          For the first time, the SmartMusic solution provides administrators with the ability to easily measure individual student achievement and growth, create and deliver district-wide curriculum, and provide parents with secure on-line access to student assignments and grades. Based on this solution, MakeMusic has established a direct sales organization. The field sales representatives have an objective of calling on district decision-makers and selling a higher number of subscriptions for each installation.

          Prospecting efforts are largely based on ranking school districts in target states based on student population, average household income, and geography. Priorities are established by identifying current users in target districts and requesting their assistance in setting up a meeting and presentation with district decision-makers and other music educators within the district and in neighboring districts.

          Our SmartMusic marketing efforts are exclusively focused on the U.S. and Canadian markets and directed primarily at public and private school music administrators, instrumental music educators, and their students. In addition to aggressive direct marketing programs, MakeMusic participates in more than 40 annual music educator conventions and presents SmartMusic clinics in a variety of settings to cultivate demand.

          The primary distribution for SmartMusic subscriptions is via our direct sales organization and the www.smartmusic.com website (linked with www.makemusic.com and www.finalemusic.com). School orders are normally processed directly through the MakeMusic customer support department.

SmartMusic Competition

          SmartMusic is a revolutionary concept that created a new product category for teaching and learning music. As such, it entered the market with no direct competitors and no major competitors exist today.

          At this time, no competitor has a library of content comparable to SmartMusic. Nor does any competitor have SmartMusic Gradebook functionality, the follow me feature, or the ability to utilize Finale files for user-created content. We believe these features, as well as our long-standing relationships with major industry partners, comprehensive repertoire, and our competitive pricing strategies, represent significant competitive barriers, but we can make no assurances that SmartMusic will not face challenging competition in the future.

Finale family of notation products

          We are a market leader in music notation software with our Finale family of products for use with Macintosh^® and Windows^® PC operating systems. Music notation software enables a musician to enter musical data into a computer using either the computer keyboard, a MIDI- (Musical Instrument Digital Interface) equipped electronic music keyboard or other MIDI-equipped instruments, and contemporaneously display the data on a computer screen as a musical score. The dramatic improvements in speed and flexibility provided by software programs like Finale have made such software the dominant method for composers, arrangers, publishers, and music teachers to create printed music. With the growth in portable computer display technologies, Finale also makes it possible for customers to share digital scores for review and performance.

          The Finale product is a powerful and comprehensive notation software product which is sold worldwide. Finale music notation software has a suggested retail price of $600. Finale software is differentiated from other

music notation software by its breadth and depth of features, including capabilities such as its “hyperscribe” feature, its high quality printing required for professional use, customizable music education worksheets, and inclusion of world class sounds.

          We also produce an Academic/Theological Edition of the Finale product that is sold exclusively to schools, teachers, college students, and religious organizations at a suggested retail price of $350. This edition has been a key source of revenue and registered user-base growth. In addition, it reaches a market that is continuously replenished with new student users.

          The Finale product is currently translated into German, French, Italian, Swedish, and Japanese. We believe the international market is a key growth opportunity as computer penetration increases worldwide. All transactions with our international customers are completed in US currency.

          The Finale Allegro^® product, a value-priced version of the powerful Finale music notation software product, was introduced in 1993. The Allegro music notation software product currently retails for $199 and contains a subset of the notation tools contained in the Finale product.

          Finale PrintMusic^® and Finale SongWriter^® are entry-level music notation software products, retailing for $119.95 and $49.95, respectively. Each contains a subset of the notation tools contained in the Finale product. These products allow us to offer entry-level products to the retail customer, thereby expanding the base of registered users and increasing the potential for sales of notation software upgrades. These products are targeted to a broad audience in the education and general consumer marketplace. They are both available though our reseller network as well via download directly from MakeMusic. In addition they are also sold internationally and available in German, French, Dutch, Italian, and Japanese.

          Finale NotePad^® is sold as an introduction to the Finale notation family and provides a quick and easy method to transform musical ideas into printed music. Finale NotePad is available via download for $9.95. Finale Reader^™ was introduced in 2008 and is a free download to view, play and print Finale files.

Finale Sales and Marketing

          As of December 31, 2010, Finale notation products were sold through approximately 50 distributors serving countries world-wide. In the United States and Canada, the Finale family of notation products is sold by channel-specific distributors and retailers in the musical instrument, educational, and consumer electronic channels, as well as directly from our website. Our products are merchandised through a combination of websites, catalogs, and in-store displays. We support these efforts with a modest co-op advertising program. We have a domestic distribution agreement with Hal Leonard Corporation, the largest music publisher in the world, to provide our products to U.S. and Canadian musical instrument and print music retailers.

          Upgrades and trade-ups are marketed and sold exclusively by MakeMusic in North America. MakeMusic requires all notation products sold in North America to be registered, and we regularly market upgrades and trade-ups to the registered user database. Each campaign is evaluated based on the return on investment and against original projections. Finale upgrades were introduced on both the Windows platform and Macintosh platform in each of the last several years and we intend to continue this annual upgrade cycle. All Finale products operate on both the Windows and Macintosh platforms.

          Internationally, Finale notation products are represented by key distributors in many overseas territories. Finale is translated into German, French, Japanese, Swedish, and Italian. MakeMusic markets a variety of Finale notation education offerings to schools, students, and other qualified institutions including the Finale Academic edition, the Finale lab pack, and the Finale site license. The Finale lab pack and Finale site license provide educational discounts for volume purchases. Education sales have steadily increased, although the mix is shifting towards site licenses indicating wider acceptance and use of Finale notation software. We believe that this trend will increase based on the synergistic relationship between Finale and SmartMusic along with the direct sales team’s focus on the education market.

          Customers can also utilize Finale software to create accompaniments for use with SmartMusic. A Finale file is saved as a SmartMusic accompaniment and becomes part of the SmartMusic solution. This interplay provides MakeMusic with cross-marketing opportunities between Finale and SmartMusic users and products, and also provides a unique differentiator in the marketplace.

          We believe, based on current economic conditions, that Finale notation software revenue will be relatively stable in 2011. We expect to see a continued shift towards direct notation sales and lower sales through our distribution channel. Additionally, we will begin offering Finale as a download starting with the release of our next upgrade which may further accelerate the shift to direct sales. All other products have previously been available by download. We anticipate holding our notation development spending on our Finale products generally comparable to historical levels as a result. We intend to steadily build on our core notation business by continually expanding the installed base of users, regularly providing them with upgrades, expanding our educational offerings, increasing the synergy with SmartMusic, and establishing the products as a means for electronic transmission of music. In addition, we are exploring strategies to expand our reach outside of the market that we have traditionally served. As a result of this work, we are currently evaluating additional investments for our notation business.

Finale Competition

          The notation market is highly competitive and includes competitors such as, Avid/Sibelius Software, NOTION Music, Inc., Gvox/Encore, MusScore, and Capella Software. Competitive factors in marketing Finale products include product features, quality, brand recognition, ease of use, customer support, merchandising, distribution channels, retail shelf space, and price. We believe we compete effectively through regular upgrades and marketing initiatives and continue to maintain dominant market share.

Synergies between SmartMusic and Finale products

          From a technology perspective, there are considerable synergies between the SmartMusic business and the Finale notation business because the products benefit from shared technologies. The Finale notation technology, for example, is used within SmartMusic to display, among other things, sheet music, exercises, and beginning band method songs. It is this technology that puts red and green notes on the screen to show SmartMusic students what they played incorrectly and how to correct their mistakes. The synergistic integration between SmartMusic and Finale notation products represents a differentiator for our notation products and provides a barrier to entry into the marketplace. Likewise, the ability to create SmartMusic repertoire using the Finale product is a major benefit for SmartMusic customers.

General Information

Customer Support

          As of December 31, 2010, customer support for all products is handled by 22 employees and as of December 31, 2009, our customer support staff totaled 19. They are supported by knowledge-based software that allows customers to ask questions on-line at www.finalemusic.com and www.smartmusic.com and then presents them with answers. As new questions are asked by customers, the database of questions and answers is expanded. This software reduces the number of contacts reaching customer support employees and thus enhances efficiency, reduces cost, and provides a better experience for customers.

Principal Sources and Suppliers

          Printing of user manuals, packaging, and the manufacture of related materials are performed to our specifications by outside subcontractors. We currently use one subcontractor to perform standard copying and assembling services, including copying software DVD and CD-ROM discs, and assembling the product manuals, discs, and other product literature into packages. If this subcontractor is unable to perform, there are alternative vendors that we could use for this service. Our instrumental and vocal microphones are each currently provided by two separate vendors that are sole source suppliers. We believe there are alternative vendors available if our subcontractors are unable to supply microphones.

Dependence on Major Customers

          As of December 31, 2010 no distributor or direct customer for either our SmartMusic or Finale products represented more than 10% of total revenue.

Product Development

          At December 31, 2010 and 2009, there were 51 and 54 employees, respectively involved in product development for SmartMusic and Finale products at MakeMusic. This staff engages in research and development of new products, enhancements to existing products, business systems support, repertoire development, and quality assurance testing.

          MakeMusic’s non-capitalized expenditures for product development were $5,524,000 and $5,081,000 in 2010 and 2009, representing 32.2% and 30.9% of gross revenues, respectively. These expenses include the costs for our annual notation upgrades, product maintenance releases and support for our business systems. We expect these costs to moderately increase in 2011 due to enhancements in our technology infrastructure required to support our expanding SmartMusic customer base, development investments to increase the business model flexibility in SmartMusic, and potential additional investments in notation products aimed at expanding our reach outside of the market we have traditionally served.

Trademarks

          We own the registered trademarks in the United States for Allegro^®, Coda^®, Finale^®, Finale Allegro^®, Finale NotePad^®, Finale Performance Assessment^®, Finale PrintMusic^®, Finale SongWriter^®, Finale Viewer ^®, FinaleScript^®, FPA^®, HumanPlayback^®, HyperScribe^®, Intelligent Accompaniment^®, Intonation Trainer^®, M!^®, MakeMusic^®, MicNotator^®, SmartMusic^®, SmartMusic Impact^®, StudioView^®, SmartFind and Paint^®, and TempoTap^®. In addition, the names Finale^®, Finale NotePad^®, Finale PrintMusic^®, Finale SongWriter^®, Finale Viewer ^®, Intelligent Accompaniment^®, MakeMusic^®, SmartMusic^®, and The Art of Music Notation^® have been protected in some foreign countries. We have applied for trademark registration in the United States for Finale Reader^™. In addition to our own registered trademarks listed above, this report also contains references to trademarks owned by third parties.

Technology Infrastructure

          The MakeMusic data center is comprised of both on and offsite facilities. During 2010, we also expanded the MakeMusic data center to the “cloud” by utilizing Microsoft’s Azure platform. Data centers are operated internally and offer extensive uptime and connectivity to the Internet backbone via fiber-optic connections. Storage Area Networks and servers utilizing redundant arrays of independent discs for information backup as well as redundant power provide our foundation for simplified storage administration, server consolidation and virtualization. Websites and services are run on Microsoft IIS^® and our databases are run on Microsoft SQL Server^®. MakeMusic utilizes a VoIP phone system that provides unified messaging and is deeply integrated with Microsoft Active Directory and Microsoft Exchange. Our network is monitored twenty-four hours a day, seven days a week, and is scalable and upgradeable for future growth

          The extension of our data center into the “cloud” using Microsoft’s Azure platform has allowed us to take advantage of Microsoft’s SaaS (Software as a Service) model. We are able to provide rapid scalability to meet our customer needs, as well as familiar tools and a development environment that works seamlessly with our existing data centers.

MakeMusic Websites:

          www.smartmusic.com. The SmartMusic website promotes our SmartMusic subscriptions and SmartMusic accessories.

          www.finalemusic.com. The Finale website promotes notation products and e-commerce with mail-order fulfillment, as well as downloads of Finale NotePad.

          www.makemusic.com. The MakeMusic website includes information on the Company and our products. It also provides links to www.smartmusic.com and www.finalemusic.com for people wanting to make purchases of our products.

Available Information

          All reports filed electronically by MakeMusic with the Securities and Exchange Commission (“SEC”), including its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy and information statements, other information and amendments to those reports filed (if applicable), are accessible at no cost by contacting the Investor Relations department at MakeMusic. These filings are also accessible on the SEC’s website at www.sec.gov. The public may read and copy any materials filed by MakeMusic with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may also obtain information from the Public Reference Room by calling the SEC at 1-800-SEC-0330.

Cautionary Statements

          The Private Securities Litigation Reform Act of 1995 (the “Reform Act”) provides a safe harbor for forward-looking statements made by us or on our behalf. We have made, and may continue to make, various written or verbal forward-looking statements with respect to business and financial matters, including statements contained in this document, other filings with the SEC and reports to shareholders. Forward-looking statements provide current expectations or forecasts of future events and can be identified by the use of terminology such as “believe,” “estimate,” “expect,” “intend,” “may,” “could,” “will” and similar words or expressions. Forward-looking statements speak only as of the date on which they are made.

          Our forward-looking statements generally relate to the following: expectations regarding an extension of the lease for our headquarters facility; beliefs about our ability to compete in the music software industry; expectations and beliefs relating to our vendors, contractors and suppliers; beliefs about the impact of intellectual property and licensing rights and our ability to develop, license and maintain intellectual property rights in the future; expectations relating to our business model and strategy; expectations relating to development, production, marketing and other expenses; intentions and expectations relating to growth initiatives for our notation and SmartMusic product lines, improvements to our technological infrastructure, and the effects these improvements will have on our financial results; expectations regarding our method of selling and delivering our product; beliefs relating to the market penetration of our products, including expectations in regard to subscription rates, site agreements, international sales, synergies between our products lines, and sales; expectations regarding our results of operations; beliefs with respect to realization of deferred tax assets and our intent to retain earnings for use in operations. Forward-looking statements cannot be guaranteed and actual results may vary materially due to the uncertainties and risks, known and unknown, associated with such statements. We do not intend to update any forward-looking statements unless required by law. We wish to caution investors that the following important factors, among others, in some cases have affected and in the future could affect our actual results of operations and cause such results to differ materially from those anticipated in forward-looking statements made in this document and elsewhere by us or on our behalf. It is not possible to foresee or identify all factors that could cause actual results to differ from expected or historic results. As such, investors should not consider any list of such factors to be an exhaustive statement of all risks, uncertainties, or potentially inaccurate assumptions.

          We currently believe that we have sufficient capital, but we may have other future capital needs. We again achieved positive operating cash flow in 2010 and expect it to continue to be positive in the future, provided we continue to increase revenue and manage expenses. We believe our cash reserves are sufficient to execute our strategies. If we do not maintain positive cash flow, we may need additional capital in the form of debt or equity financing to continue to operate the business. Additional capital may be needed if there is a significant change in our business plan or operating results. There is no assurance that additional debt or equity financing will be available to us on favorable terms or at all.

          We are dependent upon our new product development efforts. Additional development work is required to increase the breadth of and provide periodic upgrades to our SmartMusic and Finale products and expand the accompaniment repertoire for SmartMusic. There can be no assurance that our timetable for any of our development plans will be achieved, that sufficient development resources will be available, or that development efforts will be successful.

          We are dependent upon the Internet in our business. We are dependent on the Internet to activate our SmartMusic subscriptions and secure our licensed content. We also utilize the Internet as one of our order-processing

channels. Critical issues concerning the commercial use of the Internet, including security, cost, ease of use and access, intellectual property ownership, and other legal liability issues, remain unresolved and could materially and adversely affect both the growth of Internet usage generally and our business in particular. If we experience problems developing and maintaining our Internet operations, our sales, operating results, and financial condition could be adversely affected.

          We are dependent upon obtaining and maintaining license agreements with music publishers, of which there are a limited number. The world market for music license rights is highly concentrated among a limited number of publishers. We have entered into license agreements with leading music publishers that provide access to certain musical titles for accompaniment development. Many of our contracts with major publishers are not exclusive, which means that similar agreements may be made with competitors or that the publishers themselves may sell the same titles. While we believe that our relationships with these publishers are good, there can be no assurance that we will be able to maintain or expand these relationships. The lack of a sufficient number and variety of musical arrangements would greatly limit the ability to market our products and services.

          Certain of our products have limited and fluctuating sales. Sales of our SmartMusic subscription products have not achieved, and may not achieve, significant levels. Further, internet sales have fluctuated, as have sales of Finale products, which are historically higher following the release of product upgrades. We believe that results of operations may fluctuate as a result of, among other things, the purchasing cycle of the education market and the timing of releases of new products and product upgrades. Certain states have had significant budget deficits and education funding cuts, which could negatively impact sales of products to the education market. Additionally, we have rapidly expanded our direct educational sales organization. There is no guarantee that our sales strategy will result in increased SmartMusic subscriptions. We may also have limited success retaining sales personnel.

          The uncertainty in worldwide economic conditions may divert consumer spending from our products. The spending habits of our target group of students and their families are often impacted by general economic conditions. If the improvement of economic conditions remains uncertain in the United States or internationally, our target customers’ discretionary income and purchasing decisions may change. This could negatively impact Notation sales, SmartMusic subscription rates and accessory sales.

          We have incurred operating losses in the past and may incur losses in the future. While we have been profitable for the past six years, we have incurred losses from operations in the past and may incur such losses in the future. In order to continue to develop our business and planned product and service offerings, we will be required to continue to devote capital to, among other things, marketing and development efforts, including, potential, new notation product offerings. There can be no assurance that we will operate profitably or provide an economic return to investors.

          We face intense competition. While competition for SmartMusic is relatively limited, there can be no assurance, in spite of significant barriers to entry, that others, such as large electronic and musical instrument manufacturers, will not enter this market. Competition for our notation products could potentially adversely impact future sales levels. Our ability to continue to compete effectively will be substantially dependent upon our ability to continue to improve our product offerings, Internet resources along with our sales and marketing initiatives. If such improvements and development efforts do not materialize as intended, we may lose our ability to differentiate our products from those of our competitors. In addition, increasing competition in the music software market could cause prices to fall and the volume of transactions to decline, either of which could adversely affect our business, operating results, and financial condition.

          Rapid technological changes and obsolescence may adversely affect our business. We operate in an industry greatly affected by technological changes. While we are not currently aware of any significant technological changes that may affect our current technology base, continued advancements in computer software, hardware, and network designs and formats may impact our ability to effectively maintain our Internet-based sales efforts in a workable and user-friendly format. The proprietary technology we use to protect access to our licensed files may be effective for only a limited period by reason of technological change. We must, therefore, devote new resources to improve or modify this security system, which is a critical aspect of our ability to establish and maintain relationships with music publishers. While we currently believe that we have sufficient resources to address technological changes

that may affect our business, there can be no assurance that any such technological changes will not prove too much for us to overcome in a cost-effective manner.

          The success of our web-based products and services is dependent upon our ability to protect user information and comply with data protection laws and regulations. In connection with the use of our web-based products, users provide us with certain personal information. The collection, use, disclosure or security of personal information or other privacy-related matters are regulated by applicable data protection laws. While we strive to comply with all applicable data protection laws and regulations, as well as our own posted privacy policies, any failure or perceived failure to comply may result in proceedings or actions against us by government entities, individuals or others, which could potentially have an adverse effect on our business. Further, federal, state, and international regulations regarding privacy and data protection may become more stringent in the future, which could increase our cost of compliance,

          In addition, as our SmartMusic Gradebook product is web-based, the amount of data we store for our users on our servers (including personal information) has been increasing. Any systems failure or compromise of our security that results in the release of our users’ data could seriously limit the adoption of our products as well as harm our reputation and brand and, therefore, our business. We may also need to expend significant resources to protect against system failure or security breaches. The risk that these types of events could seriously harm our business is likely to increase as we expand the number of subscribers to our products.

          We are dependent upon key personnel. Our performance is closely linked to the performance of our management and key personnel. Recently, we have made significant changes among our executives and key personnel. Such changes, and the time and costs associated with locating and integrating replacements, could affect our ability to execute our strategic plans.

          We are dependent upon proprietary technology and cannot assure protection of such technology. There can be no assurance that our proprietary technology will provide us with significant competitive advantages, that other companies will not develop substantially equivalent technology, or that we will be able to protect our technologies. We could incur substantial costs in seeking enforcement of our patents or in defending ourselves against patent infringement claims by others. Further, there can be no assurance that we will be able to obtain or maintain patent protection in the markets in which we intend to offer products.

          International development plans are subject to numerous risks. There can be no guarantee that our international expansion efforts will be successful or that we will be able to offset the cost of the resources allocated to such efforts. Moreover, we could be faced with the risks inherent in any international development, such as unpredictable changes in export restrictions, barriers, and customs rates; currency risks; the difficulty of managing foreign operations; the differences in technological standards, payment terms and labor laws and practices among countries; collection problems; political instabilities; seasonal reductions in business; and unforeseen taxes. Such risk factors could harm our international operations and, therefore, our business, operating results, and financial condition.

          The market price of our stock may experience volatility. We cannot speculate as to the future market price of our common stock. Our common stock has experienced, and may continue to experience, significant price volatility due to a number of factors, including fluctuations in operating results, changes in market perspectives for our products, developments in our industry, and general market conditions that may be unrelated to our performance.

          We will be exposed to risks relating to evaluations of controls required by Section 404 of the Sarbanes-Oxley Act. Changing laws, regulations, and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act and related regulations implemented by the SEC, are creating uncertainty for public companies, increasing legal and financial compliance costs, and making some activities more time consuming. We will continue to evaluate our internal controls systems to allow management to report on our internal controls. We have performed the system and process evaluation and testing (and any necessary remediation) required to comply with the management certification requirements of Section 404 of the Sarbanes-Oxley Act. If we fail to maintain effective controls and procedures, we may be unable to provide the required financial information in a timely and reliable manner. Further, if we acquire any business in the future, we may incur substantial additional costs to bring the acquired business systems into compliance with Section 404.

          Significant management judgment is required for certain financial statement entries. As explained in more detail in Item 7 below under the heading “Critical Accounting Policies,” the preparation of our financial statements requires management to make significant estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. For example, during 2009, based upon our operating results in recent years and through December 31, 2009 as well as an assessment of our expected future results of operations, we determined that it had become more likely than not that we would realize a portion of our net deferred tax assets. As a result, during the fourth quarter of 2009, we released $2,564,000 of our valuation allowance. If management’s assumptions were inaccurate or management’s judgment was otherwise erroneous, we may be required to adjust the valuation allowance in subsequent financial reporting periods. In addition, future utilization of NOL carry-forwards is subject to certain limitations under Section 382 of the Internal Revenue Code, and our ability to use NOL’s in the future will be limited.

ITEM 2. PROPERTIES

          Our corporate facility is leased under an operating lease arrangement and consists of approximately 22,000 square feet of office and warehouse space at 7615 Golden Triangle Drive, Suite M, Eden Prairie, Minnesota, 55344. Rent and maintenance over the remaining lease term are approximately $250,000 on an annual basis and the lease expires March 31, 2011. We are currently negotiating an extension of our existing lease, which we expect to provide approximately 3,000 additional square feet to our current corporate facility. We expect the term of the lease extension to be five years and to be on terms and rates generally comparable to our existing lease. We anticipate that we will finalize these negotiations by the end of March 2011. We believe our leased space will be adequate for the foreseeable future.

ITEM 3. LEGAL PROCEEDINGS

          As previously disclosed in our Form 10-Q for the quarter ended September 30, 2010, on September 14, 2010, a complaint was filed against us by Uniloc USA, Inc. and Uniloc Singapore Private Limited (collectively “Uniloc”) in the United States District Court for the Eastern District of Texas. The complaint alleges infringement of Uniloc’s patent for securely registering software and other digital media to prevent illicit copying and software piracy and seeks a permanent injunction. In addition, Uniloc is seeking compensatory damages in an unspecified amount, and interest, costs and expenses associated with the litigation. We are one of approximately 60 companies that have been similarly sued by Uniloc. Further, the United States Patent and Trademark Office recently issued an initial rejection for all of the claims of the Uniloc patent at issue in the litigation. Management believes that the claims involved in the suit are without merit and does not expect the litigation to have a material adverse effect on our business, financial condition, or results of operations. We will, however, incur costs and diversion of management resources in defending the infringement claim. Moreover, because litigation is inherently uncertain, we cannot guarantee that the outcome of this litigation will be favorable to us or that material damages will not be awarded against us.

          In the ordinary course of business, we may be party to additional legal actions, proceedings, or claims. Corresponding costs are accrued when it is reasonably possible that loss will be incurred and the amount can be precisely or reasonably estimated. We are not aware of any actual or threatened litigation that would have a material adverse effect on its financial condition or results of operations.

ITEM 4. (REMOVED AND RESERVED)

PART II

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

Market Information

          Our common stock trades on The NASDAQ Capital Market under the symbol MMUS. The following table sets forth the high and low sales prices of our common stock for the periods set forth:

						2010								2009
						High				Low				High				Low
		First Quarter				$	6.82			$	4.06			$	4.50			$	1.86
Common Stock		Second Quarter					6.28				5.06				3.90				2.31
		Third Quarter					6.16				4.82				4.05				2.61
		Fourth Quarter					7.00				4.64				5.00				3.06

          As of December 31, 2010, we had 111 registered shareholders.

Dividends

          We have never paid cash dividends on any of our securities. We do not currently anticipate paying cash dividends in the foreseeable future.

Recent Sales of Unregistered Equity Securities

          There were no sales of unregistered securities during the quarter or year ended December 31, 2010 that have not been previously reported.

          For information on our equity compensation plans, refer to Item 12, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”

ITEM 6.		SELECTED FINANCIAL DATA

          As a smaller reporting company, we are not required to provide the information required by this Item.

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

Executive Overview

          MakeMusic’s mission is to develop and market solutions that transform how music is composed, taught, learned and performed. This is accomplished by:

	•		Providing integrated technology, content and web services to enhance and expand how music is taught, learned and prepared for performance.
	•		Providing music education content developers with a technology-enriched publishing platform that leverages their copyrighted assets while simultaneously increasing the content and value of the SmartMusic library.
	•		Offering software solutions for engraving and electronically distributing sheet music.

          MakeMusic develops and markets two product lines, SmartMusic^® learning software for band, jazz ensemble, orchestra and voice and Finale^® music notation software. We believe these innovative products reinforce each other’s features and competitiveness and will allow us to continue to achieve positive operating results. The well-established Finale family of music notation software products provides a solid base business that serves a large customer base and generates consistent revenue through sales of new products, annual upgrades and trade-up campaigns.

          While our existing notation products enjoy leading market positions, in the fourth quarter of 2010, we began the process of evaluating the potential to expand our reach outside of the market we have traditionally served with the assistance of an outside strategic consulting firm. As a result of this work, we are currently evaluating additional investments for our notation business.

          Our fiscal year 2010 resulted in continued sales growth for MakeMusic and, overall, a 4% increase over 2009 net revenue was achieved. SmartMusic revenue grew 20% due to our year over year subscription growth from 133,782 to 162,189 and price increases implemented in the third quarter of 2010, from $130 to $140 for teacher subscriptions and from $30 to $36 for student subscriptions. Notation revenue decreased 3% overall, which we attribute primarily to reductions in our sales to distribution partners, offset by stronger direct sales of our Finale products and downloads. Gross margin percentages were comparable at 83% in 2010 and 84% in 2009. Operating expenses increased in 2010, due to increased selling and marketing expenses as a result of the planned growth of marketing staff and expansion of our direct sales force. Development expenses also increased primarily due to consulting expenses incurred to support the release of SmartMusic 2011 and for the review of future notation product direction. Our net income before taxes in 2010 was $551,000 compared to $959,000 in 2009. Additionally, we reported a significant tax benefit in 2009. This tax benefit resulted primarily from reducing our valuation allowance against our deferred tax assets by $2,564,000 that represented management’s estimate of the realizability of our deferred tax assets. During 2010, we have maintained our policy established in the fourth quarter of 2009 of recording a deferred tax asset representing tax on three years of forecasted income, there continues to be enough uncertainty around our ability to forecast beyond three years that this policy is prudent. The primary uncertainties relate to technological changes beyond three years potentially impacting our Notation products. The tax benefit in 2010 was $461,000. As a result of the factors mentioned, we reported net income of approximately $1,012,000 in 2010 compared to net income of $3,453,000 in 2009.

          We believe our greatest growth potential lies with SmartMusic, a subscription-based product directed toward the very large and constantly renewing market of music students and their teachers. SmartMusic combines a software application, a library of thousands of music titles, skill-development exercises and a web service to provide students with a compelling experience and teachers with the realistic means to document the progress of every student.

          SmartMusic software enhances and transforms the hours spent practicing by putting students inside a professional band or orchestra so that they can hear how the music is supposed to be performed and how their part fits in. This makes practicing much more engaging, causing students to practice longer and more often. SmartMusic

provides access to an ever-increasing library of band, jazz ensemble and orchestra literature. Each title includes individual part assignments authored by respected educators, thereby providing music teachers with a time-saving solution for preparing selections for their next performance. SmartMusic also offers a rich variety of effective practice tools that make practice time more efficient and productive. The combination of making practice time more engaging and productive leads to rapid student skill-development, increased student confidence, higher student retention, and stronger music programs.

          SmartMusic Gradebook is a web-based grade book that is included with each teacher subscription designed to manage student assignments, grades, and recordings while documenting the progress of each student and assessing student achievement. This provides music educators (and students) with exciting new possibilities to assist in developing strong music programs and complying with accountability requirements. SmartMusic Gradebook enables teachers to easily send assignments to each of their students. Students complete the assignment on their home computer, provided that they have a SmartMusic subscription, or on a school computer equipped with SmartMusic. Submitted assignments are automatically graded and posted in the teacher’s SmartMusic Gradebook thereby providing teachers with the visible means for measuring student achievement.

          Our educational sales organization focuses on direct school district sales aimed at the 17,000 schools who match our ideal demographic profile. We sell site agreements that provide discounts for volume purchases. The SmartMusic quarterly site agreement totals are shown in the SmartMusic metrics table below.

          In addition to tracking the total number of subscriptions, we track the number of teachers who use SmartMusic Gradebook and the number of those teachers who are using SmartMusic Gradebook to deliver and manage student assignments to fifty students or more. As of December 31, 2010, we reported 1,019 Gradebook teachers compared to 886 Gradebook teachers as of December 31, 2009.

The following table illustrates our quarterly SmartMusic metrics:

		Dec-09				Mar-10				Jun-10				Sep-10				Dec-10
Total Subscriptions			133,782				139,363				143,095				158,574				162,189
Educator Accounts			9,269				9,368				9,073				9,312				9,402
Educators who have issued assignments*			1,857				2,340				2,379				1,085				2,040
Gradebook Teachers*			886				1,156				1,172				415				1,019
Site Agreements			322				356				372				466				485
Site Agreement Educator Subscriptions			2,181				2,458				2,532				3,403				3,343

          The SmartMusic target business model is to have music educators increase their use of SmartMusic Gradebook to set up their classes, enroll students and issue assignments, which we believe would result in an increase in student subscriptions. As stated above, 2,040, or 22%, of the teachers who have purchased SmartMusic have utilized SmartMusic Gradebook, and those teachers have 130,424 students receiving SmartMusic assignments.

          We increased the size of our educational sales force from 5 to 7 and our marketing staff from 8 to 9 in 2010 to strengthen our strategic sales and marketing initiatives. We expect to continue to aggressively invest in expanding our sales force to increase the penetration level of our target market. In addition, our development efforts have focused on improving and simplifying the SmartMusic purchase process, Gradebook class set-up, student enrollment and SmartMusic assignments. The overall objective is to make these processes easy and intuitive for both teachers and students. As a result of the increased focus of our direct sales force and product enhancements, site agreement educator subscriptions increased 53%, from 2,181 at December 31, 2009, to 3,343 at December 31, 2010.

          We believe that our technological investments in SmartMusic have created a digital pipeline between our growing subscriber base of more than 160,000 and the music publishers who provide SmartMusic content. This growing platform is a strategic asset for MakeMusic and we are focusing on finding additional ways to monetize it. As a result, we expect to make additional investments in development to leverage the SmartMusic platform and to increase our business model flexibility.

          The following table illustrates the net new SmartMusic subscriptions for each quarter for the years ended December 31, 2009 and 2010:

																										Quarterly
Quarter End		Beginning				New				Renewed				Renewal				Subscriptions				Quarter End				Net New
Date		Subscriptions				Subscriptions				Subscriptions				Rate				Ended				Subscriptions				Subscriptions
3/31/2009			106,584				10,609				12,241				64	%			19,116				110,318				3,734
6/30/2009			110,318				5,256				11,350				72	%			15,865				111,059				741
9/30/2009			111,059				24,456				29,585				70	%			42,523				122,577				11,518
12/31/2009			122,577				20,122				26,402				75	%			35,319				133,782				11,205
3/31/2010			133,782				11,590				15,330				72	%			21,339				139,363				5,581
6/30/2010			139,363				5,391				14,069				89	%			15,728				143,095				3,732
9/30/2010			143,095				23,826				47,383				85	%			55,730				158,574				15,479
12/31/2010			158,574				20,453				29,065				63	%			45,903				162,189				3,615

          We define renewed subscriptions as those subscriptions that customers purchase within the two-month period after their prior subscription ended. Because of changes to the start of school from year to year as well as fluctuations in the date that music teachers implement their curriculum, we commonly see subscribers that have a delay of up to two months in renewing their subscription. As a result, we believe that using the above definition of a renewal more accurately reflects the renewal rate for SmartMusic subscriptions. In the fourth quarter of 2010, the SmartMusic renewal rate declined from prior quarters. We believe this can be attributed to the price increase that was implemented during the third quarter that resulted in early renewals and purchases prior to the increase. The renewal rate during the last six months of 2010 was 75% compared to 72% during the last six months of 2009. Additionally, there were some educators who delayed adoption of SmartMusic due to the late release and product functionality delays in SmartMusic 2011 Gradebook.

          We have achieved positive cash flow from operations for the last six years, including the most recent year ended December 31, 2010. Our quarterly results will fluctuate as a result of the seasonality of the education market. Due to current economic conditions and concerns over school budgets, we remain cautious regarding our future financial projections. However, with increased revenues and, in particular, the growth in SmartMusic subscriptions, plus improvements in operational efficiency over the last few years and the establishment of contingency plans to be implemented if our revenue and cash flow objectives are not met, we feel that we can continue to achieve positive operating cash flow for the next twelve months.

Critical Accounting Estimates

          Our financial statements are prepared in conformity with U.S. generally accepted accounting principles. The preparation of these financial statements requires management to make significant estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. We believe that the following are some of the more critical judgment areas in the application of our accounting policies that currently affect our financial position and results of operations.

          Allowance for doubtful accounts. Our distribution of notation products in domestic and international markets through independent dealers and distributors concentrates relatively large amounts of receivables in relatively few customer accounts; however, none are greater than 10% of the total revenue. Some international customers pay for the product prior to shipment; domestic dealers and distributors who do not prepay are granted payment terms and credit limits based on credit checks and account history. We have successfully done business with most of our dealers and distributors for many years. There were no significant uncollectible accounts in 2010 or 2009.

          Any sales directly to home users are prepaid and schools submit purchase orders for purchases. MakeMusic records an accrual for potential non-payments, which has historically been sufficient to cover uncollected accounts. Financial conditions in international markets and economic conditions can change quickly and our allowance for doubtful accounts cannot anticipate all potential changes.

          Sales returns and allowance reserves. SmartMusic teacher subscriptions automatically renew at the end of their subscription period. Notices of renewal are sent to the teacher in advance and an invoice is sent upon the renewal date. A reserve is booked for those subscriptions that automatically renew and are subsequently cancelled due to teacher relocation, teacher cancellation, or non-payment of accounts. The reserve is then evaluated quarterly to determine if any adjustments are necessary.

          When a new version of Finale is released, dealers and distributors retain the right to return any unsold versions of the prior release (normally 10% of total prior year sales) in exchange for an equal number of units of the updated version of the product that is returned. The history of these returns is tracked and revenue is deferred based on the expected return rate until the new product is released, at which time the product may be returned for credit provided the customer places an equivalent (number of units) order for the new version.

          Inventory valuation. Inventories consisting of packaged product, materials and accessories are stated at the lower of cost or market, with cost being determined on a weighted average cost method. We record a provision to adjust slow-moving and obsolete inventories to the lower of cost or market based on historical experience and current product demand. The carrying value of inventory is evaluated at least quarterly and adjusted as needed. Inventory is reviewed for obsolescence when the inventory is no longer used in products in their most current released version.

          Stock based compensation. Accounting Standards Codification (ASC) 718, Compensation — Stock Compensation, (formerly known as SFAS 123R) requires us to measure and recognize in our Statements of Income the expense associated with all share-based payment awards made to employees and directors based on estimated fair values. We utilize the Black-Scholes option valuation model to measure the amount of compensation expense we recognize for each option award. There are several assumptions that we must make when using the Black-Scholes model such as the expected term of each option, the expected volatility of the stock price during the expected term of the option, the expected dividends payable, and the risk free interest rate expected during the option term. Of these assumptions, the expected term of the options and expected volatility of our common stock are the most difficult to estimate since they are based on the exercise behavior of employees and the expected future performance of our stock.

          Capitalized software costs. Costs incurred in the development of software products are capitalized in accordance with ASC 985-20, Software — Costs of Software to be Sold, Leased or Marketed, (formerly known as FAS 86) which requires the capitalization of certain software development costs incurred after technological feasibility is established. Technological feasibility is established when the detailed program design and all planning and testing activities are completed. Capitalization of computer software costs shall cease when a product is available for general release to customers. We capitalize the costs of producing any new software product, which includes individual song titles to be included as repertoire with the SmartMusic product. The estimated economic life of SmartMusic Gradebook, whose capitalization and market introduction was completed in 2007, has been established as five years. This five-year amortization period is consistent with the initial licensing term for the large ensemble titles available in SmartMusic that have pre-authored assignments for use by teachers within SmartMusic Gradebook. Similarly, upon release of a large ensemble song title into SmartMusic, we amortize the related capitalized software costs over the estimated life of the song, not to exceed the five-year licensing period. A reserve is recorded for an estimate of song titles that will not be released. Annual development of notation products consists of maintenance costs that are expensed as incurred. We will continue to review our amortization period for capitalized software costs as considered necessary based upon any new information and information gained in our review of the net realizable value of unamortized costs.

          Post contract support. We account for software maintenance offered on our Notation products in accordance with ASC 985-605, Software — Software Revenue Recognition, (formerly AICPA SOP 97-2) which states that revenue for post-contract support (PCS) may be recognized upon the initial sale when PCS is included with the initial license, the cost of providing PCS during the arrangement is insignificant, there are no unspecified upgrades, and only minor bug fixes are offered to licensed users. However, the estimated related costs are accrued in the same period that the sales price is recognized. We provide unlimited, free telephone, e-mail, and on-line technical support to our customers and, therefore, accrue an estimated cost of future support for our notation products in the period of sale.

          Impairment of goodwill. We review goodwill for potential impairment at least annually or when events or changes in circumstances indicate the carrying value of goodwill may be impaired. We have assigned all of our goodwill to the Notation reporting unit and compare the fair value of this reporting unit (effective January 2009), as computed primarily by applying a combination of income and market valuation approaches, to its book carrying value, including goodwill (step 1). If the fair value exceeds the carrying value, no further work is required and no impairment loss is recognized. If the carrying value exceeds the fair value, the goodwill of the reporting unit is potentially impaired and we would then complete step 2 to arrive at an implied fair value of the goodwill, by deducting the fair value of all tangible and intangible net assets (including unrecognized intangible assets) and liabilities of the reporting unit from the fair value of the reporting unit. If the implied fair value of the goodwill is less than the reported value of goodwill, we would recognize an impairment loss equal to the difference. The assessment of potential impairment requires certain judgments and estimates by us, including the determination of an event indicating impairment, the future cash flows to be generated by reporting units, the risks associated with those cash flows, and the discount rate to be utilized.

          Income taxes. We account for income taxes using the asset and liability method provided by ASC 740, Income taxes (formerly FAS 109). We estimate our income taxes in each of the jurisdictions in which we operate and account for income taxes payable as part of the preparation of our financial statements. This process involves estimating our actual current tax expense as well as assessing temporary differences resulting from differing treatment of items, such as depreciation and amortization, for financial and tax reporting purposes. These differences result in deferred tax assets and liabilities, which are included in our balance sheet to the extent deemed realizable. We assess the likelihood that, and the extent to which, our deferred tax assets will be realized and establish a valuation allowance to reduce deferred tax assets to an amount for which realization is more likely than not. If we increase or decrease a valuation allowance in a given period, then we must increase or decrease the tax provision in our statements of income.

          As of December 31, 2010, we had U.S. net operating loss carry-forwards of approximately $15,771,000, Minnesota net operating loss carry-forwards of $5,946,000, and research and development tax credits of $1,164,000 and Minnesota research and development tax credits of $490,000. The losses and tax credits are carried forward for federal and state corporate income taxes and may be used to reduce future taxes.

          Significant management judgment is required in determining any valuation allowance recorded against our net deferred tax assets. Prior to the fourth quarter of 2009, we remained uncertain on how economic conditions would impact our back to school selling cycle and annual financial results. Based upon our strong performance in the fourth quarter of 2009, our operating results in recent years and an assessment of our expected future results of operations, we determined in 2009 that it had become more likely than not that we would realize a portion of our net deferred tax assets. As a result, during the fourth quarter of 2009, we reduced our valuation allowance by $2,564,000, representing the approximate estimated tax on three years of forecasted net income. During 2010, we have maintained our policy established in the fourth quarter of 2009 of recording a deferred tax asset representing tax on three years of forecasted income. There continues to be enough uncertainty around our ability to forecast beyond three years that this policy is prudent. The primary uncertainties relate to technological changes beyond three years potentially impacting our notation products. Due to uncertainties related to our ability to utilize the balance of our deferred tax assets, as of December 31, 2010 we have maintained a valuation allowance of $5,690,000. Should the remaining $5,690,000 valuation allowance be reversed in the future, a liability of $3,175,000 would have to be established for uncertain tax positions.

          As required by ASC 740, Income taxes, we recognize the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the more-likely-than-not threshold, the amount recognized in the financial statements is the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the relevant tax authority.

          In addition, future utilization of NOL carry-forwards is subject to certain limitations under Section 382 of the Internal Revenue Code. This section generally relates to a 50 percent change in ownership of a company over a three-year period. The acquisition of additional shares by a greater than 5% shareholder in January 2007 resulted in an “ownership change” under Section 382. Accordingly, our ability to use NOL’s in the future will be limited.

Results of Operations

Comparison of the year ended December 31, 2010 to the year ended December 31, 2009

Net Revenue ($ in thousands)

		Year Ended December 31,
		2010				2009				Incr (Decr)				%
Notation		$	10,712			$	11,060				($348	)			-3	%
SmartMusic			6,436				5,382				1,054				20	%
Total		$	17,148			$	16,442			$	706				4	%

          Net revenue increased 4% from $16,442,000 in 2009 to $17,148,000 in 2010.

          Notation revenue decreased $348,000 from $11,060,000 for the year ended December 31, 2009 to $10,712,000 for the year ended December 31, 2010. Notation revenue decreased in 2010 due to reductions in our sales to our distribution partners, offset by stronger direct sales of our Finale products and downloads.

          SmartMusic revenue increased by $1,054,000 from $5,382,000 for the year ended December 31, 2009 to $6,436,000 for the year ended December 31, 2010. The increase in revenue reflects the continued growth of the SmartMusic product that was originally launched in 2001 and the SmartMusic Gradebook product that was released in 2007. It also reflects the expansion of our SmartMusic site agreement program which encourages school district deployment of SmartMusic student subscriptions and our direct sales force which focuses on district level sales. As of December 31, 2010, there were 485 site agreements for SmartMusic compared to 322 site agreements as of December 31, 2009.

          SmartMusic is sold to schools, students and music organization members on a subscription basis. Revenue for these subscriptions is recognized over the life of the subscription which is typically 12 months. Total earned SmartMusic subscription revenue for the year ended December 31, 2010 was $4,970,000, an increase of $1,025,000, or 26%, over the year ended December 31, 2009. This increase is due to the increase in the total number of subscriptions as well as a price increase in the third quarter of 2010 when teacher subscriptions increased from $130 to $140 and student subscriptions increased from $30 to $36. Total unearned SmartMusic subscription revenue (deferred revenue) was $3,633,000 as of December 31, 2010, an increase of $799,000, or 28%, over the balance at December 31, 2009. Deferred SmartMusic revenue represents the future revenue to be recorded on current subscriptions.

          SmartMusic has shown sustained growth since its launch. As of December 31, 2010, 9,402 schools have purchased SmartMusic, an increase of 1% over the 9,269 schools that had purchased it as of December 31, 2009. Total SmartMusic subscriptions as of December 31, 2010 numbered 162,189, representing a net gain of 28,407, or 21%, over the December 31, 2009 subscription count of 133,782.

          SmartMusic Gradebook is a web-based service that is designed to manage student assignments, recordings and grades while documenting the progress of each student and assessing student achievement. We track the number of teachers who use SmartMusic Gradebook and the number of those teachers who are using SmartMusic Gradebook to deliver and manage student assignments to 50 or more students (Gradebook teachers). As of December 31, 2010, we had 1,019 Gradebook teachers compared to 886 Gradebook teachers as of December 31, 2009. This is an annual statistic, counting only teachers who have issued assignments to 50 or more students during a school fiscal year. The number of Gradebook teachers restarts at zero on July 1 of each year to correspond with the start of the school year.

          Many SmartMusic customers, especially new customers, also purchase accessories (primarily microphones and foot pedals) that are used with the software. Revenue for the sales of accessories, included in the SmartMusic revenue category, for the year ended December 31, 2010 was $1,000,000, which was comparable to revenue of $953,000 for SmartMusic accessories for the year ended December 31, 2009.

Gross Profit ($ in thousands)

		Year Ended December 31,
		2010				2009				Incr (Decr)				%
Notation		$	9,874			$	10,120				($246	)			-2	%
SmartMusic			4,441				3,724				717				19	%
Total		$	14,315			$	13,844			$	471				3	%

          Gross profit increased by $471,000 from $13,844,000 for the year ended December 31, 2009, to $14,315,000 for the year ended December 31, 2010. Notation gross profit declined due to the decline in revenue through our distribution partners. SmartMusic gross profit increased due to the increase in SmartMusic revenue, which resulted from an increased number of subscribers and subscription price increases. Cost of revenue includes product costs, royalties paid to publishers, amortization of capitalized software development costs for repertoire and SmartMusic Gradebook software development costs, shipping, and credit card fees. Gross margin as a percentage of revenue was 83% and 84%, respectively, for the years ended December 31, 2010 and 2009.

Development expense ($ in thousands)

		Year Ended December 31,
		2010				2009				Incr (Decr)				%
Notation		$	2,531			$	1,898			$	633				33	%
SmartMusic			1,957				1,937				20				1	%
Other			1,036				1,246				(210	)			-17	%
Total		$	5,524			$	5,081			$	443				9	%

          Development expenses increased $443,000 from $5,081,000 in 2009 to $5,524,000 in 2010. Development expenses consist primarily of internal payroll, payments to independent contractors and related expenses for the development and maintenance of our Finale notation, SmartMusic and SmartMusic Gradebook products as well as non-capitalized SmartMusic repertoire development, business systems and quality assurance. Other development expenses are unallocated expenses not directly attributable to a particular segment and include IT infrastructure and website support costs.

          Notation development expenses increased primarily due to increased quality assurance costs for automated testing enhancements and consulting expenses relating to the engagement of an interactive design and strategic consulting company that assessed future notation product direction.

          SmartMusic development expenses increased primarily due to contractor labor used to support the release of SmartMusic 2011, which included enhancements to SmartMusic Gradebook functionality, as well as an increase of non-capitalized SmartMusic repertoire development. During the year ended December 31, 2010, numerous method books and 176 new SmartMusic large ensemble band, jazz ensemble, and orchestra titles with pre-authored assignments were released, compared to 759 new titles in the year ended December 31, 2009. Net content development expenditures of $511,000 in 2010 and $570,000 in 2009 related to this additional SmartMusic repertoire have been capitalized and are being amortized over their estimated useful life of 5 years.

          Other development expenses declined as resources were assigned to SmartMusic to support the enhancements to SmartMusic 2011 and Gradebook functionality.

Selling and marketing expense ($ in thousands)

		Year Ended December 31,
		2010				2009				Incr (Decr)				%
Notation		$	1,778			$	1,816				($38	)			-2	%
SmartMusic			1,728				1,607				121				8	%
Other			1,068				716				352				49	%
Total		$	4,574			$	4,139			$	435				11	%

          Selling and marketing expenses primarily consist of marketing, advertising and promotion expenses, business development and customer service activities, and payroll. Selling and marketing expenses increased from $4,139,000 in 2009 to $4,574,000 in 2010. This increase of $435,000, or 11%, is primarily due to an increase in SmartMusic expenses of $121,000 relating to personnel increases in educational sales and an increase in Other selling and marketing expenses of $352,000 due to increased personnel relating to our company-wide strategic sales and marketing initiatives and expanded focus on company-wide e-commerce efforts.

General and administrative expense ($ in thousands)

		Year Ended December 31,
		2010				2009				Incr (Decr)				%
Notation		$	81			$	77			$	4				5	%
SmartMusic			71				70				1				1	%
Other			3,589				3,589				0				0	%
Total		$	3,741			$	3,736			$	5				0	%

          General and administrative expenses consist primarily of payroll and related expenses for executive and administrative personnel, professional services, facility costs, bad debt, and other general corporate expenses. General and administrative expenses increased by $5,000 from $3,736,000 in 2009 to $3,741,000 in 2010. General and administrative costs increased primarily as a result of legal and professional fees relating to the engagement of a national investment banking firm to pursue strategic alternatives and expenses relating to the departure of our former Chief Executive Officer in the fourth quarter of 2010, offset by a decrease in consulting expenses and voluntary disclosure sales tax payments.

Income from operations ($ in thousands)

		Year Ended December 31,
		2010				2009				Incr (Decr)				%
Notation		$	5,484			$	6,329				($845	)			-13	%
SmartMusic			685				110				575				523	%
Other			(5,693	)			(5,551	)			(142	)			3	%
Total		$	476			$	888				($412	)			-46	%

          Net income from operations decreased from $888,000 in 2009 to $476,000 in 2010. The decline in operating performance was primarily due to the overall increase in operating expenses noted above, when compared to the same period last year.

          The notation segment net income decreased from $6,329,000 in 2009 to $5,484,000 in 2010 due primarily to a decrease in revenue and increased development expenses. SmartMusic income from operations improved

$575,000 to $685,000 in 2010 due to increased SmartMusic revenue, which was partially offset by increased operating expenses, related primarily to development.

Interest income and expense, net

          Net interest income was $58,000 for the year ended December 31, 2010, compared to $56,000 in net interest income for the year ended December 31, 2009. The increase in net interest income was due to a larger cash balance during the year.

Income tax

          We recorded a net income tax benefit of $461,000 for the year ended December 31, 2010, compared to an income tax benefit of $2,494,000 for the year ended December 31, 2009.

          In evaluating our ability to utilize our deferred tax assets, we consider all available positive and negative evidence, including our past operating results in the most recent fiscal years and our assessment of expected future profitability and the overall prospects for our business. Based on all the available evidence, in the fourth quarter of 2009, we determined that it had become more likely than not that we would realize a portion of our net deferred tax assets. As a result, we reduced our valuation allowance by approximately $2,564,000. During 2010, we have maintained our policy established in the fourth quarter of 2009 of recording a deferred tax asset representing tax on three years of forecasted income. There continues to be enough uncertainty around our ability to forecast beyond three years that this policy is prudent. The primary uncertainties relate to technological changes beyond three years potentially impacting our notation products. As of December 31, 2010 and 2009 we have a remaining valuation allowance of approximately $5,690,000 against net deferred tax assets. In the event the valuation allowance on the net operating losses expiring in 2023 is reversed we will need to recognize a reserve for uncertain tax positions of $3,175,000. Significant management judgment is required to determine when, in the future, the realization of our net deferred tax assets will become more likely than not. We will continue to assess the realizability of the tax benefit available based on actual and forecasted operating results.

Liquidity and capital resources

          Cash flow from operating activities was $3,128,000 in the year ended December 31, 2010 compared to $3,233,000 in the year ended December 31, 2009, a decrease of $105,000. Included in the cash flow from operating activities are deferred income taxes of $2,564,000 in 2009 and $436,000 in 2010. The reduction in cash provided by operating activities was primarily due to the reduction in net income for fiscal 2010. Actual cash used in operations is typically highest in the first and second quarter, with the third and fourth quarters normally producing positive operating cash flow. These quarterly fluctuations are created by the notation product release cycle and the seasonality impact of sales to schools related to the school year fiscal calendar. Management expects to continue to achieve positive annual cash flow in the foreseeable future but not necessarily in each quarter. If we do not meet our anticipated revenue levels due to economic conditions, a significantly later-than-anticipated product release, or a decrease in demand for our products, management is committed to expense reductions as necessary to ensure adequate cash levels.

          Our primary liquidity and capital requirements have been for investment in product development primarily relating to the additional titles and method books being added into SmartMusic. Cash used in investing activities was $653,000 in the year ended December 31, 2010, compared to $788,000 in the year ended December 31, 2009. This $135,000 reduction was due to our decrease in property and equipment purchases and repertoire development spending. Current year expenditures were $143,000 for purchases of property and equipment and $511,000 for capitalization of repertoire development. We expect to incur higher levels of development spending in the future as our growth initiatives in both the notation and SmartMusic segments.

          Cash provided by financing activities was $114,000 in the year ended December 31, 2010, compared to cash used of $94,000 in the year ended December 31, 2009. This change is primarily due to stock option exercise activity. During 2010, $181,000 was received for the exercise of stock options and warrants, versus $86,000 received in 2009.

During 2010, one individual exercised stock options under a cashless exercise and, as a result, cash proceeds of $6,000 from the redemption were used to pay taxes withheld. During 2009, one individual exercised stock options under multiple cashless exercises and, as a result, cash proceeds of $121,000 from the redemption were used to pay taxes withheld. We do not expect any significant cash to be provided by the exercise of stock options or warrants in 2011 due to our current stock price and options outstanding.

          As of December 31, 2010, we had cash and cash equivalents of $11,532,000 and as of December 31, 2009, the balance was $8,943,000.

Contractual Obligations and Commitments

          As of December 31, 2010, our contractual cash obligations consist of future minimum lease payments due under non-cancelable capital and operating leases as follows:

		Capital Lease				Operating Lease				Total Lease
		Obligations				Obligations				Obligations
		(in thousands)
2011		$	26			$	48			$	74
2012			5				0				5
Thereafter			0				0				0
		$	31			$	48			$	79

          We expect to continue to incur operating lease obligations generally comparable to our existing lease payments following our anticipated lease renewal in March 2011. However, we have not yet executed a binding agreement regarding such amounts.

          From time to time we enter into purchase commitments with our suppliers under customary purchase order terms. Any significant losses implicit in these contracts would be recognized in accordance with generally accepted accounting principles. At December 31, 2010 no such losses existed.

Off-Balance Sheet Arrangements

          None.

New accounting pronouncements. Refer to Note 3 in our financial statements.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders
MakeMusic, Inc.

          We have audited the accompanying balance sheets of MakeMusic, Inc. as of December 31, 2010 and 2009, and the related statements of income, stockholders’ equity and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

          We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

          In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of MakeMusic, Inc. as of December 31, 2010 and 2009, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.

/s/ McGladrey & Pullen, LLP

Minneapolis, Minnesota
March 4, 2011

MakeMusic, Inc.
Balance Sheets
(In thousands of U.S. dollars, except share and per share data)

		December 31,
		2010				2009
Assets
Current assets:
Cash and cash equivalents		$	11,532			$	8,943
Accounts receivable (net of allowance of $20 and $33 in 2010 and 2009, respectively)			1,238				1,277
Inventories			201				386
Deferred income taxes, net			2,786				2,070
Prepaid expenses and other current assets			252				294
Total current assets			16,009				12,970
Property and equipment, net			342				533
Capitalized software products, net			2,424				2,645
Goodwill			3,630				3,630
Long term deferred income taxes, net			214				494
Other non-current assets			2				6
Total assets		$	22,621			$	20,278
Liabilities and Shareholders’ Equity
Current liabilities:
Current portion of capital lease obligations		$	25			$	61
Accounts payable			489				726
Accrued compensation			1,372				1,167
Other accrued liabilities			307				297
Post contract support			150				132
Reserve for product returns			380				414
Current portion of deferred revenue			3,603				2,913
Total current liabilities			6,326				5,710
Capital lease obligations, net of current portion			4				30
Deferred revenue, net of current portion			96				0
Other long term liabilities			0				8
Shareholders’ equity:
Common stock, $0.01 par value:
Authorized shares — 10,000,000
Issued and outstanding shares — 4,895,983 and 4,756,891 in 2010 and 2009, respectively			49				48
Additional paid-in capital			66,632				65,980
Accumulated deficit			(50,486	)			(51,498	)
Total shareholders’ equity			16,195				14,530
Total liabilities and shareholders’ equity		$	22,621			$	20,278

See accompanying notes.

MakeMusic, Inc.
Statements of Income
(In thousands of U.S. dollars, except share and per share data)

		Year
		Ended December 31,
		2010				2009
Notation revenue		$	10,712			$	11,060
SmartMusic revenue			6,436				5,382
NET REVENUE			17,148				16,442
COST OF REVENUES			2,833				2,598
GROSS PROFIT			14,315				13,844
OPERATING EXPENSES:
Development expenses			5,524				5,081
Selling and marketing expenses			4,574				4,139
General and administrative expenses			3,741				3,736
Total operating expenses			13,839				12,956
INCOME FROM OPERATIONS			476				888
Other, net			75				71
Net income before income tax			551				959
Income tax benefit			(461	)			(2,494	)
Net Income		$	1,012			$	3,453
Income per common share:
Basic		$	0.21			$	0.74
Diluted		$	0.21			$	0.72
Weighted average common shares outstanding:
Basic			4,835,478				4,685,480
Diluted			4,913,887				4,771,734

See accompanying notes.

MakeMusic, Inc.
Statement of Shareholders’ Equity
(In thousands of U.S. dollars, except shares)

										Additional
		Common Stock								Paid-In				Accumulated				Shareholders’
		Shares				Amount				Capital				Deficit				Equity
BALANCE AT DECEMBER 31, 2008			4,635,529			$	46			$	65,716			$	(54,951	)		$	10,811
Exercise of stock options and warrants			37,800				1				85				—				86
Redemption of stock, net of cashless option exercise			59,446				1				(121	)							(120	)
Issuance of restricted shares, net of forfeiture			24,116				—				—				—				—
Share based compensation			—				—				300				—				300
Net income			—				—								3,453				3,453
BALANCE AT DECEMBER 31, 2009			4,756,891				48				65,980				(51,498	)			14,530
Exercise of stock options			76,179				1				180				—				181
Redemption of stock, net of cashless option exercise			6,980				—				(18	)			—				(18	)
Issuance of restricted shares			55,933				—				52				—				52
Share based compensation			—				—				438				—				438
Net income			—				—				—				1,012				1,012
BALANCE AT DECEMBER 31, 2010			4,895,983			$	49			$	66,632			$	(50,486	)		$	16,195

                See accompanying notes.

MakeMusic, Inc.
Statements of Cash Flows
(In thousands of U.S. dollars)

		Year
		Ended December 31,
		2010				2009
Cash flows from operating activities
Net income		$	1,012			$	3,453
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			1,069				943
Gain on disposal of assets			(1	)			(7	)
Deferred income taxes, net			(436	)			(2,564	)
Share based compensation			438				300
Net changes in operating assets and liabilities:
Accounts receivable			39				121
Inventories			185				79
Prepaid expenses and other current assets			42				(1	)
Accounts payable			(237	)			353
Accrued liabilities and product returns			231				(21	)
Deferred revenue			786				577
Net cash provided by operating activities			3,128				3,233
Cash flows from investing activities
Purchases of property and equipment			(143	)			(227	)
Proceeds from disposal of property and equipment			1				9
Capitalized development			(511	)			(570	)
Net cash used in investing activities			(653	)			(788	)
Cash flows from financing activities
Proceeds from stock options exercised			181				86
Payments for redemption of stock			(6	)			(121	)
Payments on capital leases			(61	)			(59	)
Net cash provided by (used in) financing activities			114				(94	)
Net increase in cash and cash equivalents			2,589				2,351
Cash and cash equivalents, beginning of year			8,943				6,592
Cash and cash equivalents, end of year		$	11,532			$	8,943
Supplemental disclosure of cash flow information
Interest paid		$	6			$	10
Income taxes paid			136				5
Other non-cash investment and financing activities
Equipment acquired under capital lease			0				18

See accompanying notes.

Notes to Financial Statements

1. Description of Business

          MakeMusic develops and markets proprietary music technology solutions under the Finale^® and SmartMusic^® brands that enhance music learning and composition, increase productivity and make practicing and performing music engaging. Our innovative products provide easy-to-use, efficient alternatives to traditional practice, education, and composition techniques. Software product sales are made through traditional distribution channels and MakeMusic’s websites.

2. Summary of Significant Accounting Policies

Revenue Recognition

          Notation revenue is primarily derived from the sale of perpetual license agreements to end users and a dealer network for “off the shelf” products which are easily installed and used by the customer. Post contract support revenue is recognized at the time of sale, the cost associated with the support is accrued. SmartMusic subscription revenue is generated from the sale of term license agreements with a subscription to our current repertoire of songs and access to all future titles released during the subscription period. SmartMusic revenue is recognized over the lives of the term license agreements. Software revenue is recognized in accordance with ASC 985-605, Software — Software Revenue Recognition, (formerly AICPA SOP 97-2) when all of the following conditions are met: there is evidence of an agreement with the customer (normally a purchase order), delivery has occurred, the total sales price is fixed and determinable, collection is probable, and any uncertainties with regard to customer acceptance are insignificant. We recognize revenue from the sale of SmartMusic accessories based on the fair value of the individual components based on standalone sales.

          When a new version of Finale is released, dealers retain the right to return any unsold versions of the prior release (normally 10% of total prior year sales) in exchange for an equal number of units of the updated version of the product that is returned. The history of these returns is tracked and revenue is deferred based on the expected return rate until the new product is released, at which time the product may be returned for credit provided the customer places an equivalent (number of units) order for the new version.

          Shipping and handling charges are accounted for in accordance with ASC 605-45, Revenue Recognition — Principal Agent Considerations, (formerly EITF No. 00-10) with all charges to customers for shipping and handling included in revenues and all costs in cost of revenues. Net revenue for the years ended December 31, 2010, and 2009 includes $746,000 and $779,000 of shipping and handling revenue, respectively. Cost of revenue for the years ended December 31, 2010 and 2009 includes $444,000 and $439,000 of shipping expense, respectively.

          We record revenue net of any sales tax, use tax and value added tax. Sales taxes collected from our customers are included in accounts payable until remitted to the appropriate taxing jurisdiction.

Net Income Per Common Share

          For years ended December 31, 2010, and 2009 diluted net income per common share was computed by dividing net income by the weighted average number of common shares outstanding during the year, including potentially dilutive shares such as options and warrants to purchase shares of common stock at various amounts per share (Note 5). The dilutive effect of the additional shares for the years ended December 31, 2010 and 2009 was to increase the weighted average common shares outstanding by 78,409 and 86,254 respectively.

2. Summary of Significant Accounting Policies (Continued)

Fair Value of Financial Instruments

          At December 31, 2010, and 2009 the carrying values of financial instruments such as cash and cash equivalents, accounts receivable, and accounts payable approximated their market values based on the short-term maturities of these instruments.

Cash and Cash Equivalents

          Cash equivalents consist of money market instruments with original maturities of 90 days or less. Cash equivalents are recorded at cost, which approximates fair value. Cash balances at December 31, 2010 and 2009 exceed FDIC insurance limits. The Company has not experienced any losses in such accounts.

Accounts Receivable

          Accounts receivable are recorded for all credit sales at the time the products are shipped to the customers. Credit terms for dealers and distributors are generally net 30 days and are granted on the basis of credit references and payment history. Certain large volume dealers and distributors are granted payment terms of greater than 30 days. Schools submit purchase orders for shipments with payment due in 30 days. Sales to individuals are paid prior to shipment with a credit card or prepayment with the order. Payments not received within the agreed-upon terms are considered past due.

          The Company maintains an allowance for doubtful accounts based on bad debt history and analysis of specific past due accounts. Analysis of the customers’ ability to pay includes contact through statements, e-mail, and telephone as well as consideration of the customers’ payment history. If the analysis indicates any customers are unlikely to pay, the accounts are written off against the allowance for doubtful accounts, and if significant, sent to collections.

Inventories

          Inventories are stated at the lower of weighted average cost or market, using the first-in first-out (FIFO) method, and consist of finished products and components, net of a reserve for obsolescence. An analysis of obsolescence reserves is conducted quarterly.

Property and Equipment

          Property and equipment are stated at their acquisition costs net of accumulated depreciation. Depreciation is computed by using the straight-line method over the estimated useful lives of the purchased software (three years), computer equipment (three years), and furniture (five years).

          Property and equipment held under capital leases are capitalized and depreciated over the useful lives of the assets, in case of a contractual option to buy, or over the residual lives of the lease contracts.

Capitalized Software Products

          Capitalized software products consist of expenditures to develop software products for sale, including repertoire software.

2. Summary of Significant Accounting Policies (Continued)

Product development

          Costs incurred in the development of software products are capitalized in accordance with ASC 985-20, Software — Costs of Software to be Sold, Leased or Marketed, (formerly FAS 86). The Company evaluates the unamortized capitalized costs compared to the estimated net realizable value of the product to determine if the capitalized costs are recoverable. Costs incurred on notation products relating to the annual development of upgrades are expensed as incurred.

          Costs capitalized in accordance with ASC 985-20 for the development of SmartMusic Gradebook application as of December 31, 2010 and 2009, net of amortization and reserves were $128,000 and $230,000 respectively. The capitalized amount represents costs of developing the SmartMusic Gradebook interface to the SmartMusic application as technological feasibility had been established through the successful selling of the core SmartMusic application. The capitalized costs are being amortized over a five-year period. The Company evaluates the unamortized capitalized costs compared to the estimated net realizable value of the product to determine if the capitalized costs are recoverable.

          As of December 31, 2010, and 2009, costs capitalized for the development of repertoire software, net of amortization and reserves, were $2,296,000 and $2,415,000, respectively. The capitalized amount represents costs of producing product masters for new songs as technological feasibility had been established by the inclusion of solo repertoire in earlier SmartMusic versions. When a title is available for release, expenditures related to that title are no longer capitalized and the capitalized cost of the title is amortized over a five-year period using the straight-line method. The Company evaluates the unamortized capitalized costs compared to the estimated net realizable value of the product to determine if the capitalized costs are recoverable. For the years ended December 31, 2010 and 2009, amortization expense was $735,000 and $449,000, respectively.

Goodwill

          Goodwill represents the cost in excess of fair value of the tangible and identified intangible assets of businesses acquired. In accordance with ASC 350, Intangibles — Goodwill and Other, (formerly SFAS 142) goodwill is not amortized but rather is reviewed for impairment annually in the fourth quarter of MakeMusic’s fiscal year, or more often if indicators of impairment exist (see Note 4).

Impairment of Long-Lived Assets

          Long-lived assets, excluding goodwill, are reviewed for impairment when events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If impairment indicators are present and the estimated undiscounted cash flows are less than the carrying value of the assets, the carrying value of the assets may require a reduction to their estimated fair value as measured by discounted cash flows or appraised values.

2. Summary of Significant Accounting Policies (Continued)

Income Taxes

          Deferred taxes are provided on a liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss or tax credit carry-forwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the amounts of assets and liabilities recorded for income tax and financial reporting purposes. Deferred tax assets are reduced by a valuation allowance when management determines that it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and tax rates on the date of enactment.

          In the fourth quarter of 2009, we determined that it had become more likely than not that we would realize a portion of our net deferred tax assets. As a result, based on the estimated tax on three years of forecasted net income, we reversed approximately $2,564,000 of our valuation allowance in fiscal year 2009 which was recorded as a one-time income tax benefit. As of December 31, 2010, we have a remaining valuation allowance of approximately $5,690,000 against net deferred tax assets. The additional future potential decrease of the valuation allowance is dependent on our future ability to realize the deferred tax assets that are affected by the future profitability of MakeMusic.

          The following table illustrates the change in our reserve for uncertain tax positions during the year ended December 31, 2010. These amounts represent unrecorded tax net operating loss carry forwards and therefore they are not reflected as a liability on our balance sheet ($ in thousands):

Balance at January 1, 2010		$	3,133
Additions based on tax positions related to the current year			99
Net reductions for tax provisions of prior years			(57	)
Settlements			—
Balance at December 31, 2010		$	3,175

          In the event that we utilize the unrecorded tax net operating losses prior to its expiration in 2023 we will need to recognize a reserve for uncertain tax positions of $3,175,000.

          Interest and penalties related to any uncertain tax positions would be accounted for as a long-term liability with the corresponding expense being charged to current period non-operating expenses. As of December 31, 2010 and December 31, 2009, we have recognized no liability related to interest and penalties. The total amount of unrecognized tax benefits that, if recognized, would affect our effective tax rate is zero based on the fact that we currently have a full reserve against our unrecognized tax benefits.

          As of December 31, 2010, there are no open positions for which the unrecognized tax benefits will significantly increase or decrease during the next twelve months. Additionally, tax years still open for examination by federal and state agencies as of December 31, 2010, are 2005 to 2010.

2. Summary of Significant Accounting Policies (Continued)

Stock-Based Compensation

          A stock-based compensation plan is currently offered to MakeMusic employees, board members, and consultants. This plan is administered by the compensation committee of the Board of Directors, which recommends to the Board those persons eligible to receive awards and the number of shares and/or options subject to each award, the terms, conditions, performance measures, and other provisions of the award. Readers should refer to Note 5 for additional information related to our stock-based compensation plans.

          Compensation cost recognized in 2010 and 2009 includes compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the standards then in effect, and compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated.

          Stock based compensation expense for the year ended December 31, 2010 was $438,000, plus an additional $63,000 accrued until restricted shares are issued in 2011. Stock compensation for the year ended December 31, 2009 was $300,000.

          During 2010 and 2009 we used the Black-Scholes option pricing model to estimate the fair value of stock-based awards with the weighted average assumptions noted in the following table:

		2010				2009
Risk-free interest rate			1.45	%			1.27	%
Expected life, in years			3.8				4.2
Expected volatility			79.71	%			76.61	%
Dividend yield			0.00	%			0.00	%

          Expected volatility is based on the historical volatility of our share price for the period prior to option grant equivalent to the expected life of the options. The expected term is based on management’s estimate of when the option will be exercised which is generally the midpoint between the vesting period and the contractual life. The risk-free interest rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.

Advertising and Promotion

          Product costs for promotional samples are classified in the statement of income as sales and marketing expense. Costs associated with the purchase of tradeshow booths and equipment are included in capitalized property and equipment and depreciated over their estimated useful lives. All other advertising costs are expensed as incurred. Sales and marketing expenses include advertising expense of $872,000 and $905,000 for the years ended December 31, 2010 and 2009, respectively.

Use of Estimates

          Preparation of the financial statements requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and related revenues and expenses. Actual results could differ from those estimates.

Reclassification

          Certain amounts have been reclassified in the 2009 balance sheet to be consistent with the 2010 balance sheet presentation. This reclassification resulted in an increase in the current asset for deferred income taxes of $483,000 and corresponding decrease in the long term asset for deferred income taxes.

3. New Accounting Pronouncements

          In September 2009, the FASB issued new accounting guidance related to revenue recognition of multiple element arrangements. The new guidance states that if vendor-specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, companies will be required to develop a best estimate of the selling price to separate deliverables and allocate arrangement consideration using the relative selling price method. The accounting guidance will be applied prospectively and will become effective during the first quarter of 2011. We are currently evaluating the impact of this accounting guidance, but do not expect adoption will have any impact on our consolidated financial statements.

          In September 2009, the FASB issued new accounting guidance related to certain revenue arrangements that include software elements. Previously, companies that sold tangible products with “more than incidental” software were required to apply software revenue recognition guidance. This guidance often delayed revenue recognition for the delivery of the tangible product. Under the new guidance, tangible products that have software components that are “essential to the functionality” of the tangible product will be excluded from the software revenue recognition guidance. The new guidance includes factors to help determine what is “essential to the functionality.” Software-enabled products will not be subject to other revenue recognition guidance and will likely follow the guidance for multiple deliverable arrangements issued by the FASB in September 2009, noted above. We must apply the new guidance on a prospective basis for revenue arrangements entered into or materially modified beginning January 1, 2011. We are currently evaluating the impact of this accounting guidance, but do not expect adoption will have any impact on our consolidated financial statements.

4. Supplemental Balance Sheet Information

Inventories

Inventories consist of the following:

		December 31,
		2010				2009
		(In thousands)
Components		$	152			$	317
Finished goods			80				138
Reserve for obsolescence			(31	)			(69	)
		$	201			$	386

Property and Equipment

Property and equipment consists of the following:

		December 31,
		2010				2009
		(In thousands)
Computer equipment and software		$	2,453			$	2,551
Office furniture and other			483				482
			2,936				3,033
Less accumulated depreciation			(2,594	)			(2,500	)
		$	342			$	533

     Depreciation expense for years ended December 31, 2010 and 2009 was $334,000 and $383,000, respectively.

4. Supplemental Balance Sheet Information (Continued)

     Certain equipment has been financed through capital lease contracts. Leased property and equipment includes $222,000 of gross assets held as capital leases during 2010 and 2009 which had accumulated depreciation of $204,000 and $138,000 as of December 31, 2010 and 2009, respectively.

Capitalized Software Products

Capitalized software products are as follows:

		December 31,
		2010				2009
		(In thousands)
Repertoire development		$	4,491			$	4,032
Software translation			125				125
SmartMusic website			461				461
SmartMusic Gradebook development			511				511
			5,588				5,129
Less accumulated depreciation and amortization			(3,164	)			(2,484	)
		$	2,424			$	2,645

          Amortization expense related to the capitalized software was $735,000 and $556,000 for the years ended December 31, 2010, and 2009, respectively. Of the $2,424,000 in capitalized software as of December 31, 2010, $423,000 is for repertoire development in progress that has not yet been released into a current product. Of the $2,645,000 in capitalized software as of December 31, 2009, $566,000 is for repertoire development in progress that had not been released. When the content that is currently in development is released into current product, these additional amounts will also be amortized over five years on a straight-line basis. The estimated future amortization expense for existing capitalized software is as follows:

		(In thousands)
2011		$	818
2012			699
2013			501
2014			268
2015			138
		$	2,424

Goodwill

          Goodwill of $3,630,000 resulted from a reverse merger in 2000. MakeMusic has two reporting units and assigned all goodwill to the Notation reporting unit. On an annual basis, or more often if indicators of impairment exist, we evaluate goodwill to determine whether any impairment may have occurred. Our impairment analyses for years ended December 31, 2010, and 2009 indicated no impairment had occurred.

4. Supplemental Balance Sheet Information (Continued)

Deferred Revenue

          Deferred revenue is primarily composed of the unearned portion of SmartMusic subscriptions lasting more than one month, deferrals of Finale notation revenue for free upgrades granted to customers purchasing Finale immediately prior to release of a new version, and other deferred revenue and deposits, as follows:

		December 31,
		2010				2009
		(In thousands)
Deferred SmartMusic subscription revenue, current		$	3,537			$	2,834
Deferred notation revenue			28				42
Deposits			38				37
Current Deferred Revenue			3,603				2,913
Deferred SmartMusic subscription revenue, long-term			96				0
		$	3,699			$	2,913

Other Accrued Liabilities

          Other accrued liabilities are composed of accrued royalties and other miscellaneous accrued expenses as follows:

		December 31,
		2010				2009
		(In thousands)
Accrued royalties		$	119			$	82
Other			188				223
		$	307			$	305

5. Shareholders’ Equity

Stock Options and Warrants

          MakeMusic has a Stock Option Plan (the 2003 Plan) pursuant to which options for up to 1,500,000 shares of its common stock may be issued to its key employees and directors. Under the 2003 Plan, the options generally may not exceed 10 years and are granted at prices that must be equal to or more than the stock’s fair market value at the grant date. There were 504,536 options outstanding under the 2003 plan as of December 31, 2010.

5. Shareholders’ Equity (Continued)

          The following table represents stock option and restricted stock activity for the year ended December 31, 2010:

														Weighted Average				Weighted Average
		Shares Reserved				2003 Plan								Option Exercise				Remaining Contract
		for Future Grant				Restricted Shares				Plan Option Shares				Price				Life
At December 31, 2009			586,047				24,116				445,755			$	5.09
Authorized			—				—				—
Granted			(309,433	)			55,933				253,500			$	4.79
Expired			1,250				—				(1,250	)		$	2.35
Cancelled			83,239				—				(83,239	)		$	4.72
Exercised			—				—				(110,230	)		$	2.77
At December 31, 2010			361,103				80,049				504,536			$	5.51			3.7 Years
Outstanding Exercisable Options at December 31, 2010											259,201			$	6.2			1.8 Years

          The weighted-average fair value of options granted during 2010 and 2009 (computed using the Black-Scholes method) was $2.67 and $2.05, respectively.

          The following summarizes information about stock options outstanding at December 31, 2010:

														Options Outstanding
Range of Exercise Prices														Weighted Remaining								Options Exercisable
														Contractual Life				Weighted Exercise								Weighted Exercise
From						to				Number Outstanding				(in Years)				Price				Number Outstanding				Price
$0.00		to				$	3.50				60,392				4.24			$	3.21				27,750			$	2.92
$3.51		to				$	6.00				329,313				3.88			$	5.12				129,995			$	5.64
$6.01		to				$	10.00				84,833				2.68			$	6.96				76,458			$	7.02
$10.01		to				$	11.00				29,998				3.37			$	10.21				24,998			$	10.22
						Total					504,536				3.69			$	5.51				259,201			$	6.20

          At December 31, 2010, the aggregate intrinsic value of options outstanding was $248,000 and the aggregate intrinsic value of options exercisable was $88,000. Total intrinsic value of options exercised during 2010 was $289,000. At December 31, 2010, there was $316,000 of unrecognized compensation cost related to nonvested share-based payments which is expected to be recognized over a weighted-average period of 1.8 years. At December 31, 2010, there was $39,000 of unrecognized compensation cost related to the issuance of restricted stock which is expected to be recognized over a weighted-average period of 1.5 years.

          There were no new warrants issued during 2010 or 2009. Total warrants of 15,000 at an exercise price of $6.60 were outstanding at December 31, 2010, all of which are exercisable. There were 15,083 warrants that expired during the fiscal year ended December 31, 2010 and no warrants that expired during the fiscal year ended December 31, 2009. The 15,000 remaining warrants will expire in 2011.

6. Commitments

Capital Lease Obligations

          Future minimum lease payments under capital lease obligations due for the years ending December 31 are as follows (in thousands):

2011		$	26
2012			5
Total minimum lease payments			31
Less amount representing interest			(2	)
Present value of net minimum lease payments			29
Less current portion			(25	)
Long-term portion		$	4

Operating Leases

          The Company leases office and warehouse space and certain equipment under operating leases. Total future minimum lease payments, excluding common area charges, under these leases as of December 31, 2010, are as follows (in thousands):

2011		$	48
Total		$	48

          Rent expense, including common area maintenance expense for the years ended December 31, 2010, and 2009 was $247,000 and $251,000, respectively.

7. 401(k) Savings Plan

          The Company has a 401(k) savings plan for the benefit of qualified employees. Under the plan, qualified employees may elect to defer up to 80% of their compensation, subject to a limit determined by the Internal Revenue Service. The Company, at the discretion of the Board of Directors, may elect to make additional discretionary contributions. The Company made no contributions to the plan in 2010 or 2009.

8. Income Taxes

          The tax effects of temporary differences for 2010 and 2009 at assumed effective annual rates of 37.4% and 37.8%, respectively (combined federal rate and state tax rate) for both years are shown in the following table:

		December 31,
		2010				2009
		(In thousands)
Deferred tax assets:
Loss carry-forwards		$	5,747			$	6,474
Research and development credits			1,164				1,069
Alternative minimum tax credit			36				0
Minnesota research and development credits			490				0
Inventory			16				26
Depreciation and amortization			131				114
Deferred revenue			1,370				1,087
Software development and prepaid royalties			69				55
Accrued expenses			586				420
Accounts receivable			7				13
Valuation allowance for deferred tax assets			(5,690	)			(5,690	)
Deferred tax assets		$	3,926			$	3,568
Deferred tax liability:
Software development costs			926				1,004
Net deferred tax assets		$	3,000			$	2,564

          The components giving rise to the net deferred income tax assets described above have been included in the accompanying balance sheets as follows:

		December 31,
		2010				2009
		(In thousands)
Current assets		$	2,786			$	2,070
Long-term assets			214				494
Net deferred tax assets		$	3,000			$	2,564

          The components of income tax benefit are as follows:

		December 31,
		2010				2009
		(In thousands)
Current tax expense (benefit)		$	(25	)		$	70
Deferred tax benefit			(436	)			(2,564	)
Total tax benefit			($461	)			($2,494	)

8. Income Taxes (continued)

          Realization of deferred tax assets is dependent upon the generation of sufficient future taxable income. Management has determined that sufficient uncertainty exists regarding realizability of the net deferred tax assets and has provided a valuation allowance of $5,690,000 in 2010 and 2009.

          A reconciliation of the income tax expense computed using the U.S. statutory rate (34%) to the effective income tax expense (benefit) included in the statements of income is as follows:

		December 31,
		2010				2009
		(In thousands)
Income tax expense computed at the statutory rate		$	187			$	326
State tax expense, net of calculated federal income tax effects			19				37
R&D Credits			(140	)			(10	)
Change in Valuation Allowance			(621	)			(2,922	)
Permanent differences			77				80
Other			17				(5	)
Income tax benefit		$	(461	)		$	(2,494	)

Net Operating Losses

          At December 31, 2010, we had federal net operating loss carry-forwards (NOLs) and research and development credit carry-forwards which may be used to offset otherwise future taxable income with the following expiration dates:

		Federal				Research and
		Net Operating Loss				Development Credits
		(In thousands)
2011		$	910			$	43
2012			1,736				38
2018			770				46
2019			491				36
2020			—				—
2021			1,474				72
2022			1,275				116
2023			9,115				72
2024			—				91
2025			—				68
2026			—				72
2027			—				168
2028			—				101
2029			—				100
2030			—				141
		$	15,771			$	1,164

          Section 382 of the Internal Revenue Code restricts the annual utilization of NOL’s incurred prior to a change in ownership. Such a change in ownership occurred in connection with the Coda reverse merger, thereby potentially restricting the NOLs available. In 2009 we completed a further Section 382 analysis for the time period since the reverse merger and determined that there are limitations relating to ownership changes. The acquisition of additional shares by a greater than 5% shareholder in January 2007 resulted in an “ownership change” under Section 382 over a three year period resulting in potential future limitations on the utilization of our NOL’s.

9. Litigation

          On September 14, 2010, a complaint was filed against us by Uniloc USA, Inc. and Uniloc Singapore Private Limited (collectively “Uniloc”) in the United States District Court for the Eastern District of Texas. The complaint alleges infringement of Uniloc’s patent for securely registering software and other digital media to prevent illicit copying and software piracy and seeks a permanent injunction. In addition, Uniloc is seeking compensatory damages in an unspecified amount, and interest, costs and expenses associated with the litigation. We are one of approximately 60 companies that have been similarly sued by Uniloc. Further, the United States Patent and Trademark Office recently issued an initial rejection for all of the claims of the Uniloc patent at issue in the litigation. Management believes that the claims involved in the suit are without merit and does not expect the litigation to have a material adverse effect on our business, financial condition, or results of operations. We will, however, incur costs and diversion of management resources in defending the infringement claim. Moreover, because litigation is inherently uncertain, we cannot guarantee that the outcome of this litigation will be favorable to us or that material damages will not be awarded against us.

          In the ordinary course of business, we may be party to additional legal actions, proceedings, or claims. Corresponding costs are accrued when it is probable that a loss will be incurred and the amount can be precisely or reasonably estimated. Other than the litigation described above, we are currently not aware of any threatened or actual litigation that would have a material effect on its financial condition or results of operations.

10. Segment and Geographic Data

          MakeMusic reports results of operations by two unique reportable segments, Notation and SmartMusic.

          The Notation segment includes the design, development, and sales and marketing for the Finale family of music notation software products.

          The SmartMusic segment includes the design, development, amortization of capitalized song title development, and sales and marketing of the subscription-based SmartMusic product line, and related accessories.

          The costs included in each of the reportable segments’ operating results include the direct costs of the products sold to customers and operating expenses managed by each of the reportable segments.

          The remaining activities are included in “Other.” These are unallocated expenses which include costs related to selling and corporate functions, including general and administrative and business systems functions that are not directly attributable to a particular segment. Unallocated expenses are reported in the reconciliation of the segment totals to consolidated totals as “Other” items. As a result, reportable segment results of operations are not representative of the operating profit of the products in these reportable segments.

10. Segment and Geographic Data (Continued)

          MakeMusic does not allocate its balance sheet assets by segment because such information is not available nor is it used by the chief operating decision maker. Therefore, information relating to segment assets is not presented. The following table presents results of operations by reportable segment (in thousands):

		For the Year Ended December 31, 2010																For the Year Ended December 31, 2009
		Notation				SmartMusic				Other				Total				Notation				SmartMusic				Other			Total
NET REVENUE		$	10,712			$	6,436			$	0			$	17,148			$	11,060			$	5,382			$	0			$	16,442
COST OF REVENUES			838				1,995				0				2,833				940				1,658				0				2,598
GROSS PROFIT			9,874				4,441				0				14,315				10,120				3,724				0				13,844
Percentage of Net Revenue			92	%			69	%			0	%			83	%			92	%			69	%			0	%			84	%
OPERATING EXPENSES:
Development expenses			2,531				1,957				1,036				5,524				1,898				1,937				1,246				5,081
Selling and marketing expenses			1,778				1,728				1,068				4,574				1,816				1,607				716				4,139
General and administrative expenses			81				71				3,589				3,741				77				70				3,589				3,736
Total Operating Expenses			4,390				3,756				5,693				13,839				3,791				3,614				5,551				12,956
Income/(Loss) from Operations			5,484				685				(5,693	)			476				6,329				110				(5,551	)			888
Other Expense			0				0				536				536				0				0				2,565				2,565
NET INCOME/(LOSS)		$	5,484			$	685				($5,157	)		$	1,012			$	6,329			$	110				($2,986)				$3,453