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EX-32.1 - SouthPeak Interactive CORPv211159_ex32-1.htm
EX-10.3 - SouthPeak Interactive CORPv208010_ex10-3.htm
EX-31.2 - SouthPeak Interactive CORPv211159_ex31-2.htm
EX-10.2 - SouthPeak Interactive CORPv208010_ex10-2.htm
EX-31.1 - SouthPeak Interactive CORPv211159_ex31-1.htm
EX-10.1 - SouthPeak Interactive CORPv208010_ex10-1.htm
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
(Mark One)

 
þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended December 31, 2010
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
Commission File Number 000-51869
SouthPeak Interactive Corporation
(Exact Name of Registrant as Specified in Its Charter)

Delaware
 
20-3290391
(State or Other Jurisdiction of
 
(I.R.S. Employer
Incorporation or Organization)
  
Identification No.)

2900 Polo Parkway
Midlothian, Virginia 23113
(804) 378-5100
(Address including zip code, and telephone number,
including area code, of principal executive offices)

Not applicable
(Former name, former address and former fiscal year, if changed since last report)

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  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, 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  ¨

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

Large accelerated filer  ¨
Accelerated filer  ¨
Non-accelerated filer  ¨
Smaller reporting company  þ
(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  ¨      No  þ

As of February 11, 2011, 60,799,538  shares of common stock, par value $0.0001 per share, of the registrant were outstanding.

 

 
 
 
     
Page
       
 
PART I — FINANCIAL INFORMATION
 
 
Item 1.
Financial Statements
 
3
 
Condensed Consolidated Financial Statements (unaudited)
 
3
 
Condensed Consolidated Balance Sheets as of December 31, 2010 (unaudited) and June 30, 2010
 
3
 
Condensed Consolidated Statements of Operations for the three months and six months ended December 31, 2010 and 2009 (unaudited)
 
4
 
Condensed Consolidated Statements of Cash Flows for the six months ended December 31, 2010 and 2009 (unaudited)
 
5
 
Notes to Condensed Consolidated Financial Statements
 
6
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
24
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
 
34
Item 4.
Controls and Procedures
 
35
     
 
 
PART II — OTHER INFORMATION
 
 
     
 
Item 1.
Legal Proceedings
 
36
Item 1A.
Risk Factors
 
37
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
38
Item 3.
Defaults Upon Senior Securities
 
38
Item 5.
Other Information
 
38
Item 6.
Exhibits
 
39
     
 
 
SIGNATURES
 
40

 
2

 
 

Item 1.   Condensed Consolidated Financial Statements

SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS

   
December 31, 2010
   
June 30, 2010
 
   
(Unaudited)
       
Assets
           
             
Current assets:
           
Cash and cash equivalents
 
$
78,631
   
$
92,893
 
Accounts receivable, net of allowances of $928,451 and $5,700,931 at December 31, 2010 and June 30, 2010, respectively
   
1,150,873
     
3,703,825
 
Inventories
   
1,131,915
     
1,211,301
 
Current portion of advances on royalties
   
11,911,559
     
12,322,926
 
Current portion of intellectual property licenses
   
353,571
     
383,571
 
Related party receivables
   
16,260
     
34,509
 
Prepaid expenses and other current assets
   
457,836
     
695,955
 
                 
Total current assets
   
15,100,645
     
18,444,980
 
                 
Property and equipment, net
   
2,559,579
     
2,667,992
 
Advances on royalties, net of current portion
   
1,920,978
     
1,511,419
 
Intellectual property licenses, net of current portion
   
1,237,500
     
1,534,286
 
Goodwill
   
7,911,800
     
7,911,800
 
Deferred debt issuance costs, net
   
532,681
     
-
 
Intangible assets, net
   
10,358
     
17,025
 
Other assets
   
10,955
     
11,280
 
                 
Total assets
 
$
29,284,496
   
$
32,098,782
 
                 
Liabilities and Shareholders’ Equity (Deficit)
               
                 
Current liabilities:
               
Line of credit
 
$
-
   
$
3,830,055
 
Due to factor
   
864,902
     
-
 
Secured convertible debt in default, net of discount
   
3,884,377
     
950,000
 
Warrant liability
   
1,276,102
     
-
 
Current portion of long-term debt
   
67,334
     
65,450
 
Production advance payable in default
   
3,755,104
     
3,755,104
 
Accounts payable
   
9,951,665
     
12,663,788
 
Accrued royalties
   
4,455,312
     
2,530,253
 
Accrued expenses and other current liabilities
   
4,877,623
     
3,781,711
 
Deferred revenues
   
77,312
     
325,301
 
Due to related parties
   
4,425
     
2,200
 
Accrued expenses - related parties
   
341,618
     
322,281
 
Total current liabilities
   
29,555,774
     
28,226,143
 
                 
Long-term debt, net of current portion
   
1,507,310
     
1,541,081
 
Total liabilities
 
$
31,063,084
   
$
29,767,224
 
                 
Commitments and contingencies
   
-
     
-
 
                 
Shareholders’ equity (deficit):
               
                 
Preferred stock, $0.0001 par value; 5,000,000 shares authorized; no shares issued and outstanding at December 31, 2010 and June 30, 2010
   
-
     
-
 
Series A convertible preferred stock, $0.0001 par value; 15,000,000 shares authorized; 5,503,833 shares issued and outstanding at December 31, 2010 and June 30, 2010, respectively; aggregate liquidation preference of $5,503,833 at December 31, 2010
   
550
     
550
 
Common stock, $0.0001 par value; 190,000,000 and 90,000,000 shares authorized at December 31, 2010 and June 30, 2010, respectively; 60,181,870 and 59,774,370 shares issued and outstanding at December 31, 2010 and June 30, 2010, respectively
   
6,018
     
5,976
 
Additional paid-in capital
   
30,559,705
     
31,154,835
 
Accumulated deficit
   
(32,257,094
)
   
(28,973,325
)
Accumulated other comprehensive income (loss)
   
(87,767
   
143,522
 
                 
Total shareholders’ equity (deficit)
   
(1,778,588
   
2,331,558
 
Total liabilities and shareholders’ equity (deficit)
 
$
29,284,496
   
$
32,098,782
 

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

 
3

 
 
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
 
   
For the three months ended
December 31,
   
For the six months ended
December 31,
 
   
2010
   
2009
   
2010
   
2009
 
                                 
Net revenues
 
$
7,470,053
   
$
10,063,952
   
$
8,901,912
   
$
26,773,601
 
                                 
Cost of goods sold:
                               
Product costs
   
3,097,437
     
5,149,597
     
3,858,719
     
8,696,283
 
Royalties, net
   
3,298,538
     
1,618,962
     
3,231,430
     
6,619,633
 
Intellectual property licenses
   
95,893
     
99,797
     
191,786
     
219,457
 
                                 
Total cost of goods sold
   
6,491,868
     
6,868,356
     
7,281,935
     
15,535,373
 
                                 
Gross profit
   
978,185
     
3,195,596
     
1,619,977
     
11,238,228 
 
                                 
Operating expenses (income):
                               
Warehousing and distribution
   
282,327
     
320,723
     
348,416
     
607,234
 
Sales and marketing
   
974,498
     
2,215,620
     
1,871,169
     
5,870,676
 
General and administrative
   
2,091,082
     
2,973,944
     
4,023,397
     
6,088,712
 
Litigation costs
   
-
     
3,075,206
     
-
     
3,075,206
 
Gain on settlement of trade payables
   
-
     
(3,256,489
 )
   
(585,122
)
   
(3,256,489
)
                                 
Total operating expenses
   
3,347,907
     
5,329,004
     
5,657,860
     
12,385,339
 
                                 
Loss from operations
   
(2,369,722
)
   
(2,133,408
 )
   
(4,037,883
)
   
(1,147,111
)
                                 
Other expenses (income):
                               
Change in fair value of warrant liability
   
(1,531,323
)
   
-
     
(3,062,646
)
   
-
 
Interest and financing costs, net
   
1,244,436
     
508,858
     
2,308,532
     
808,174
 
Net loss
 
 $
(2,082,835
 
 $
(2,642,266
 
 $
(3,283,769
 
 $
(1,955,285
                                 
Basic loss per share:
 
$
(0.04
)
 
$
(0.06
 )
 
$
(0.06
)
 
$
(0.04
)
Diluted loss per share:
 
$
(0.04
)
 
$
(0.06
 )
 
$
(0.06
)
 
$
 (0.04
)
                                 
Weighted average number of common shares outstanding - Basic
   
57,252,122
     
45,039,292
     
57,140,971
     
44,930,125
 
Weighted average number of common shares outstanding - Diluted
   
57,252,122
     
45,039,292
     
57,140,971
     
44,930,125
 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.

 
4

 
 
SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

   
For the six months ended
December 31,
 
   
2010
   
2009
 
Cash flows from operating activities:
           
Net loss
 
$
(3,283,769
)
 
$
(1,955,285
Adjustments to reconcile net loss to net cash (used in) provided by operating activities:
               
Depreciation and amortization
   
132,142
     
129,972
 
Allowances for price protection, returns, and defective merchandise
   
(2,463,231
)
   
(531,050
Bad debt expense, net of recoveries
   
(49,161
   
(35,321
Stock-based compensation expense
   
214,283
     
359,920
 
Common stock and warrants issued to vendor
   
-
     
104,500
 
Amortization of royalties and intellectual property licenses
   
960,543
     
5,443,825
 
Loss on disposal of fixed assets
   
-
     
4,839
 
Amortization of debt discount and issuance costs
   
924,403
     
-
 
Change in fair value of warrant liability
   
(3,062,646
)
   
-
 
Fair market value adjustment to common stock issued for advances on royalties
   
(2,112
)
   
-
 
Gain on settlement of trade payables
   
(585,122
   
(3,256,489
                 
Changes in operating assets and liabilities:
               
Due to/from factor, net
   
(1,395,186
)
   
-
 
Accounts receivable
   
7,325,432
     
(1,788,962
)
Inventories
   
79,386
     
749,689
 
Advances on royalties
   
(1,575,876
)
   
(3,651,309
)
Related party receivables
   
18,249
     
(27,635
Prepaid expenses and other current assets
   
238,119
     
42,696
 
Production advance payable
   
-
     
3,755,104
 
Accounts payable
   
(2,127,001
)
   
(4,318,114
Accrued royalties
   
1,925,059
     
1,279,109
 
Accrued expenses and other current liabilities
   
1,230,912
     
1,988,225
 
Accrued litigation costs
   
-
     
4,308,035
 
Deferred revenues
   
(247,989
)
   
(2,547,339
)
Accrued expenses - related parties
   
19,337
     
(47,478)
 
                 
Total adjustments
   
1,559,541
     
1,962,217
 
                 
Net cash (used in) provided by operating activities
   
(1,724,228
   
6,932
 
                 
Cash flows from investing activities:
               
Purchases of property and equipment
   
(16,737
)
   
(65,544
)
Change in restricted cash
   
-
     
395,982
 
Net cash (used in) provided by investing activities
   
(16,737
   
330,438
 
                 
Cash flows from financing activities:
               
Proceeds from line of credit
   
-
     
16,557,571
 
Repayments of line of credit
   
(3,830,055
)
   
(16,596,792
)
Proceeds from inventory financing
   
1,710,281
     
-
 
Repayments of inventory financing
   
(1,710,281
)
   
-
 
Repayments of long-term debt
   
(31,887
)
   
(25,013
)
Net proceeds from (repayments of) amounts due to shareholders
   
-
     
(232,440
Net proceeds from (repayments of) amounts due to related parties
   
2,225
     
(120,645
Proceeds from the issuance of subordinated convertible promissory notes
   
7,000,000
     
-
 
Payment of debt issuance costs
   
(733,959
)
   
-
 
Repayments of subordinated convertible promissory notes
   
(450,000
)
   
-
 
Proceeds from the exercise of common stock warrants
   
1,668
     
-
 
                 
Net cash provided by (used in) financing activities
   
1,957,992
     
(417,319
                 
Effect of exchange rate changes on cash and cash equivalents
   
(231,289
   
90,247
 
                 
Net (decrease) increase in cash and cash equivalents
   
(14,262
   
10,298
 
Cash and cash equivalents at beginning of the period
   
92,893
     
648,311
 
                 
Cash and cash equivalents at end of the period
 
$
78,631
   
$
658,609
 
                 
Supplemental cash flow information:
               
Cash paid during the period for interest
 
$
514, 642
   
$
243,011
 
                 
Supplemental disclosure of non-cash activities:
               
Fair value of common stock warrant liability at issuance date
 
$
4,338,748
   
$
-
 
Fair market value adjustment to common stock issued for advances on royalties
 
$
811,039
   
$
-
 
Conversion of junior secured subordinated convertible promissory note to senior secured convertible note
 
$
500,000
   
$
-
 
Issuance of vested restricted stock
 
$
40
   
$
-
 
Contingent purchase price payment obligation related to Gamecock acquisition
 
$
-
   
$
597,124
 
Decrease in goodwill with respect to finalizing purchase price allocation
 
$
-
   
$
55,423
 
Purchase of vehicle through the assumption of a note payable
 
$
-
   
$
73,459
 

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

 
5

 
 
SOUTHPEAK INTERACTIVE CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)

1.  Principal Business Activity and Summary of Significant Accounting Policies

Business

SouthPeak Interactive Corporation (the “Company”) is an independent developer and publisher of interactive entertainment software.  The Company develops, markets and publishes videogames for all leading gaming and entertainment hardware platforms, including home videogame consoles such as Microsoft Corporation’s (“Microsoft”) Xbox 360 (“Xbox360”), Nintendo Co. Ltd.’s (“Nintendo”) Wii (“Wii”), Sony Computer Entertainment’s (“Sony”) PlayStation 3 (“PS3”) and PlayStation 2 (“PS2”); handheld platforms such as Nintendo Dual Screen (“DS”), Nintendo DSi, Sony PlayStation Portable (“PSP”), Sony PSPgo, Apple Inc. (“Apple”) iPhone; game applications for the Next Generation NVIDIA® Tegra™ mobile processor used in Droid phones and tablets; and personal computers.  The Company’s titles span a wide range of categories and target a variety of consumer demographics, ranging from casual players to hardcore gaming enthusiasts.

The Company maintains its operations in the United States and the United Kingdom. The Company sells its games to retailers and distributors in North America and United Kingdom, and primarily to distributors in the rest of Europe, Australia and Asia.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements as of December 31, 2010 and for the three and six month periods ended December 31, 2010 and 2009 have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial reporting. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP. In the opinion of management, all adjustments (all of which are of a normal, recurring nature) considered for a fair presentation have been included. Operating results for the three and six month periods ended December 31, 2010 are not necessarily indicative of the results that may be expected for the fiscal year ending June 30, 2011.

The accounting policies followed by the Company with respect to unaudited interim financial statements are consistent with those stated in the Company’s annual report on Form 10-K. The accompanying June 30, 2010 financial statements were derived from the Company’s audited financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in the Company’s annual report on Form 10-K for the year ended June 30, 2010 filed with the SEC on October 13, 2010.

The accompanying unaudited condensed consolidated financial statements include the accounts of SouthPeak Interactive Corporation, and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of net revenues and expenses during the reporting periods. The most significant estimates and assumptions relate to the recoverability of advances on royalties, intellectual property licenses and intangibles, valuation of inventories, realization of deferred income taxes, the adequacy of allowances for sales returns, price protection and doubtful accounts, accrued and contingent liabilities, the valuation of stock-based transactions and assumptions used in the Company’s goodwill impairment test.  These estimates generally involve complex issues and require the Company to make judgments, involve analysis of historical and the prediction of future trends, and are subject to change from period to period. Actual amounts could differ significantly from these estimates.

Subsequent events have been evaluated through the filing date of these unaudited condensed consolidated financial statements.

 
6

 
 
1.  Principal Business Activity and Summary of Significant Accounting Policies, Cont.
 
Going Concern

The accompanying condensed consolidated financial statements have been prepared on a going-concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business.  The ability of the Company to continue as a going concern is predicated upon, among other things, generating positive cash flows from operations, curing the default on the production advance payable (see Note 5), and the resolution of various contingencies (see Note 11).

As of December 31, 2010, the Company had insufficient cash resources to satisfy its liabilities, many of which are past due. Further, the Company has various unresolved contingencies that could require future cash payments in excess of available funds (see Note 11).

On August 17, 2009, the Company entered into a unit production financing agreement with a producer relating to the production of certain games, of which the balance outstanding under this agreement was $3,755,104 at December 31, 2010 (see Note 5).  The Company has failed to make the required payments under this agreement.  As a result, the production advance payable is currently in default and is accruing additional production fees at $0.009 per unit (based upon 382,000 units) for each day after November 15, 2009 (approximately $1,298,000 through December 31, 2010). Given the manner in which the Company was required to enter into this agreement, the Company is contesting its liability for this obligation.

On December 31, 2010, the Company failed to make a timely payment of interest required pursuant to the secured convertible notes (the “Notes”).  Such failure triggered a default provision under the Notes following a seven day cure period.  On February 16, 2011, the Company entered into a Waiver and Forbearance Agreement (each, a “Waiver Agreement” and collectively, the “Waiver Agreements”) with the holders of the Notes (see Note 6).  Pursuant to the Waiver Agreements, the holders of the Notes waived their right of redemption and remedies regarding the Company’s failure to have paid the required interest and agreed to forbear from exercising all remedies available in connection with such failure until March 15, 2011. Pursuant to the Waiver Agreement, the Company is not required to pay the required interest until March 15, 2011 and the interest rates under the Notes increase to 15% and 29%, as applicable, from December 31, 2010 to March 15, 2011.
 
A failure to generate additional revenues, raise additional capital or manage discretionary spending could have a material adverse effect on the Company's ability to continue as a going concern and to achieve its intended business objectives. Accordingly, there is substantial doubt about the Company’s ability to continue as a going concern. A going concern uncertainty may limit the Company’s ability to access certain types of financing, or may prevent the Company from obtaining financing on acceptable terms. If the Company is unable to obtain additional financing, it may not be able to continue as a going concern after its funds have been exhausted and the Company could be required to significantly curtail or cease operations, file for bankruptcy, or liquidate and dissolve. The accompanying condensed consolidated financial statements have been prepared on the basis of the Company continuing as a going concern. No adjustments have been made to carrying value of the assets and liabilities that might result from the outcome of this uncertainty.

Management plans to maintain the Company’s viability as a going concern by:
 
 
attempting to expeditiously resolve its contingencies for amounts significantly less than currently accrued for in order to reduce aggregate liabilities on the Company’s condensed consolidated balance sheet and negotiate payment terms manageable by the Company;
     
 
reducing costs and expenses in order to reduce the Company’s ongoing working capital needs and monthly cash burn;
     
 
seeking to raise additional capital.
     
 
 
applying the anticipated profits from several key game releases towards payment of its outstanding obligations.

 
7

 
 

Concentrations of Major Customers and Major Vendors

The Company has four customers, Wal-Mart, GameStop, Atari, and Target, which accounted for 19%, 17%, 14%, and 10%, respectively, of consolidated gross revenues for the six months ended December 31, 2010.  GameStop, Solutions2Go, and Atari accounted for 29%, 16%, and 15%, respectively, of consolidated gross accounts receivable at December 31, 2010.  For the six months ended December 31, 2009, Wal-Mart, GameStop, PDQ Distribution Limited and Solutions 2 Go accounted for 20%, 15%, 11% and 10%, respectively, of consolidated gross revenues.  GameStop, Wal-Mart, and Atari accounted for 29%, 15% and 10%, respectively, of consolidated gross accounts receivable at June 30, 2010.

The Company publishes videogames for the proprietary console and hand-held platforms created by Microsoft, Sony and Nintendo, pursuant to the licenses they have granted to the Company. Should the Company’s licenses with any of such three platform developers not be renewed by the developer, it would cause a disruption in the Company’s operations. The Company expects that such contracts will be renewed in the normal course of business.

Amounts incurred related to these three vendors as of December 31, 2010 and June 30, 2010 and for the three-month and six-month periods ended December 31, 2010 and 2009 are as follows:

   
Cost of Goods Sold — Products
   
Accounts Payable
 
   
For the
three
months
ended
December
31, 2010
   
For the
three
months
ended
December
31, 2009
   
For the
six
months
ended
December
31, 2010
   
For the six
months
ended
December
31, 2009
   
As of
December
31, 2010
   
As of
June 30,
2010
 
                                     
Microsoft
 
$
503,087
   
$
214,598
   
$
702,423
   
$
2,952,440
   
$
424,710
   
$
158,592
 
Nintendo
 
$
1,109,701
   
$
3,194,743
   
$
1,276,385
   
$
4,026,539
   
$
-
   
$
-
 
Sony
 
$
300,123
   
$
81,265
   
$
889,985
   
$
108,787
   
$
18,121
   
$
449,042
 

Allowances for Returns, Price Protection, and Doubtful Accounts

Management closely monitors and analyzes the historical performance of the Company’s various games, the performance of games released by other publishers, and the anticipated timing of other releases in order to assess future demands of current and upcoming games. Initial volumes shipped upon title launch and subsequent reorders are evaluated to ensure that quantities are sufficient to meet the demands from the retail markets, but at the same time are controlled to prevent excess inventory in the channel.

The Company may permit product returns from, or grant price protection to, its customers under certain conditions. Price protection refers to the circumstances when the Company elects to decrease the wholesale price of a product based on the number of products in the retail channel and, when granted and taken, allows customers a credit against amounts owed by such customers to the Company with respect to open and/or future invoices. The criteria the Company’s customers must meet to be granted the right to return products or price protection include, among other things, compliance with applicable payment terms, and consistent delivery to the Company of inventory and sell-through reports.

Management must estimate the amount of potential future product returns and price protection related to current period revenues utilizing industry and historical Company experience, information regarding inventory levels, and the demand and acceptance of the Company’s games by end consumers. The Company regularly reviews its reserves and allowances for these items and assesses the adequacy of the amounts recorded. Similarly, management must make estimates of the uncollectibility of the Company’s accounts receivable.

 
8

 

1.  Principal Business Activity and Summary of Significant Accounting Policies, Cont.
 
At December 31, 2010 and June 30, 2010, accounts receivable allowances consisted of the following:
 
   
December
31, 2010
   
June 30,
2010
 
Sales returns
 
$
121,338
   
$
2,634,097
 
Price protection
   
297,544
     
2,257,171
 
Doubtful accounts
   
505,056
     
771,442
 
Defective items
   
4,513
     
38,221
 
                 
Total allowances
 
$
928,451
   
$
5,700,931
 

Assessment of Impairment of Assets

Current accounting standards require that the Company assess the recoverability of purchased intangible assets subject to amortization and other long-lived assets whenever events or changes in circumstances indicate the remaining value of the assets recorded on its condensed consolidated balance sheets is potentially impaired. In order to determine if a potential impairment has occurred, management must make various assumptions about the estimated fair value of the asset by evaluating future business prospects and estimated cash flows. For some assets, the Company’s estimated fair value is dependent upon predicting which of its products will be successful. This success is dependent upon several factors, which are beyond the Company’s control, such as which operating platforms will be successful in the marketplace, market acceptance of the Company’s products and competing products. Also, the Company’s revenues and earnings are dependent on the Company’s ability to meet its product release schedules.

Goodwill is considered to have an indefinite life, and is carried at cost. Goodwill is not amortized, but is subject to an impairment test annually and in between annual tests when events or circumstances indicate that the carrying value may not be recoverable. The Company performs its annual impairment testing at June 30.  Impairment of goodwill is tested at the reporting unit level.  The Company has one reporting unit, because none of the components of the Company constitute a business for which discrete financial information is available and for which Company management regularly reviews the results of operations.

To determine the fair value of the reporting unit used in the first step, the Company uses a combination of the market approach, which utilizes comparable companies’ data and/or the income approach, or discounted cash flows. Each step requires management to make judgments and involves the use of significant estimates and assumptions. These estimates and assumptions include long-term growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates based on the Company’s weighted average cost of capital, future economic and market conditions and determination of appropriate market comparables. These estimates and assumptions have to be made for each reporting unit evaluated for impairment. The Company’s estimates for market growth, its market share, and costs are based on historical data, various internal estimates, and certain external sources, and are based on assumptions that are consistent with the plans and estimates the Company is using to manage the underlying business. The Company’s business consists of publishing and distribution of interactive entertainment software and content using both established and emerging intellectual properties, and its forecasts for emerging intellectual properties are based upon internal estimates and external sources rather than historical information and have an inherently higher risk of accuracy. If future forecasts are revised, they may indicate or require future impairment charges. The Company bases its fair value estimates on assumptions it believes to be reasonable but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates.

The Company determined that current business conditions, and the resulting decrease in the Company’s projected cash flows, constituted a triggering event which required the Company to perform interim impairment tests related to its long-lived assets and goodwill during the quarter ended December 31, 2010. The Company’s interim test on its long-lived assets indicated that the carrying value of its long-lived assets was recoverable and that no impairment existed as of the testing date.  As of December 31, 2010, there was no impairment to goodwill.  The Company will continue to monitor its goodwill and indefinite-lived intangible and long-lived assets for possible future impairment.

 
9

 
 
1.  Principal Business Activity and Summary of Significant Accounting Policies, Cont.
 
Revenue Recognition

The Company recognizes revenue from the sale of video games upon the transfer of title and risk of loss to the customer. Accordingly, the Company recognizes revenue for software titles when (1) there is persuasive evidence that an arrangement with the customer exists, which is generally a purchase order, (2) the product is delivered, (3) the selling price is fixed or determinable and (4) collection of the customer receivable is deemed probable.  The Company’s payment arrangements with customers typically provide for net 30 and 60 day terms. Advances received for licensing and exclusivity arrangements are reported on the condensed consolidated balance sheets as deferred revenues until the Company meets its performance obligations, at which point the revenues are recognized. Revenue is recognized after deducting estimated reserves for returns, price protection and other allowances. In circumstances when the Company does not have a reliable basis to estimate returns and price protection or is unable to determine that collection of a receivable is probable, the Company defers the revenue until such time as it can reliably estimate any related returns and allowances and determine that collection of the receivable is probable.

The Company has an arrangement pursuant to which it distributes videogames co-published with another company for a fee based on the gross sales of the videogames.  Under the arrangement, the Company bears the inventory risk as the Company purchases and takes title to the inventory, warehouses the inventory in advance of orders, ships the inventory, and invoices its customers for videogame shipments.  Also under the arrangement, the Company bears the credit risk as the supplier does not guarantee returns for unsold videogames and the Company is not reimbursed by the supplier in the event of non-collection. The Company records the gross amount of revenue under the arrangement as it is not acting as an agent for the principal in the arrangement.

Foreign Currency Translation

Foreign exchange transaction gains (losses) included in general and administrative expenses in the accompanying condensed consolidated statements of operations for the three and six months ended December 31, 2010 amounted to $(14,884) and $(64,670), respectively. Foreign exchange transaction gains (losses) for the three and six months ended December 31, 2009 amounted to $10,535 and $(7,497), respectively.

Comprehensive (Loss) Income

For the three-month and six-month periods ended December 31, 2010 and 2009, the Company’s comprehensive loss was as follows:

   
Three months ended
   
Six months ended
 
   
December 31,
2010
   
December 31,
2009
   
December 31,
2010
   
December 31,
2009
 
                         
Net loss
 
$
(2,082,835
)
 
$
(2,642,266
 
$
(3,283,769
)
 
$
(1,955,285
)
Other comprehensive income (loss)
                               
Change in foreign currency translation adjustment
   
44,089
     
7,747
     
(231,289
   
90,247
 
Comprehensive loss
 
$
(2,038,746
)
 
$
(2,634,519
 
$
(3,515,058
)
 
$
(1,865,038
)

Fair Value Measurements

The following table summarizes the Company’s financial assets and liabilities that are measured at fair value on a recurring basis.

         
Fair Value Measurements at Reporting Date Using
 
         
Quoted Prices
in
             
         
Active Markets
   
Significant
       
         
for Identical
   
Other
   
Significant
 
   
As of
   
Financial
   
Observable
   
Unobservable
 
   
December
   
Instruments
   
Inputs
   
Inputs
 
   
31, 2010
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
Assets:
                       
Advances on royalties
 
$
389,667
   
$
389,667
   
$
-
   
$
-
 
                                 
Total assets at fair value
 
$
389,667
   
$
389,667
   
$
-
   
$
-
 
                                 
Liabilities:
                               
Warrant liability
 
$
1,276,102
   
$
-
   
$
-
   
$
1,276,102
 
                                 
Total liabilities at fair value
 
$
1,276,102
   
$
-
   
$
-
   
$
1,276,102
 

 
10

 
 
1.  Principal Business Activity and Summary of Significant Accounting Policies, Cont.
 
On February 23, 2010, the Company issued to a videogame publisher 3,000,000 shares of common stock as an advance on royalties, valued at $1,020,000 based on the fair market value of the Company’s common stock on the date the agreement was executed by the parties. The Company has capitalized such payment to the videogame publisher and the amount is marked-to-market on a quarterly basis. The fair value of the advances on royalties is based entirely upon quoted market prices, which is a level 1 input. The Company recorded an $811,039 decrease to the carrying amount of asset related to the periodic fair value remeasurement at December 31, 2010. During the six months ended December 31, 2010, 19,817 shares were earned and $8,521 was expensed to “cost of goods sold – royalties”, and $2,112 was expensed to “general and administrative” relating to the periodic fair value remeasurement. As of December 31, 2010, 2,783,337 shares of common stock, valued at $389,667, based on the fair market value of the Company’s common stock were included in advances on royalties.

On July 19, 2010, the Company issued Series A warrants in connection with the sale of $5,500,000 of senior secured convertible notes. The Series A warrants entitle the holders to purchase an aggregate of 12,761,021 shares of common stock. The Series A warrants have an exercise price of $0.375 per share and a term of five years, and became exercisable upon the issue date. The Company has accounted for the Series A warrants as a liability because the exercise price of the warrants will reset if the Company issues stock at a lower price. At inception, the fair value of the Series A warrants of $4,338,748 was separated from the debt liability and recorded as a derivative liability which resulted in a reduction of the initial notional carrying amount of the senior secured convertible notes. The fair value of the warrants was computed using the Black-Scholes option pricing model. The Company assumed a risk-free interest rate of 1.73%, no dividends, expected volatility of 148.24% and the contractual life of the warrants of 5 years.

In addition, the purchasers of the senior secured convertible notes received Series B warrants which will expire, if the warrants become exercisable, on the fifth year anniversary of the date the Company announces its 2011 operating results. The number of Series B warrants each purchaser received is equal to 75% of the Series A warrants they obtained. The Series B warrants can only be exercised if the EBITDA Test under the senior secured convertible notes is not achieved or if the Company fails to announce its 2011 operating results by September 28, 2011. The obligation to deliver the Series B warrants was determined to be an embedded derivative. The Company has approached the valuation of this embedded derivative based on the probability that the EBITDA Test under the senior secured convertible notes will be achieved. Because the probability at inception that the EBITDA Test will not be achieved is considered to be de minimis (less than 5%), the fair value of the derivative instrument is not considered to be material and no value has been assigned to it.

The Company measures the fair value of the warrants at each balance sheet date, and records the change in fair value as a non-cash charge or gain to earnings each period. The warrants were valued at $1,276,102 at December 31, 2010. The Company recorded a non-cash gain of $3,062,646 due to the change in fair value of warrants during the six months ended December 31, 2010. The fair value of the warrants at December 31, 2010 was computed using the Black-Sholes option pricing model. The Company assumed a risk-free interest rate of 2.01%, no dividends, expected volatility of 126.64% and the remaining contractual life of the warrants of 4.6 years.

The following table is a rollforward of the fair value of the warrants, as to which fair value is determined by Level 3 inputs:

   
Six Months
 
   
Ended
 
   
December 31,
 
Description
 
2010
 
Beginning balance
 
$
-
 
Purchases, issuances, and settlements
   
4,338,748
 
Total gain included in net loss
   
(3,062,646
)
Ending balance
 
$
1,276,102
 

11

 
1.  Principal Business Activity and Summary of Significant Accounting Policies, Cont.
 
Earnings (Loss) Per Common Share

Basic earnings (loss) per share is computed by dividing net income (loss) attributable to common shareholders by the weighted average number of common shares outstanding for all periods.  Diluted earnings per share is computed by dividing net income (loss) attributable to common shareholders by the weighted average number of shares outstanding, increased by common stock equivalents.  Common stock equivalents represent incremental shares issuable upon exercise of outstanding options and warrants, the conversion of preferred stock and the vesting of restricted stock. However, potential common shares are not included in the denominator of the diluted earnings (loss) per share calculation when inclusion of such shares would be anti-dilutive, such as in a period in which a net loss is recorded.  Potentially dilutive securities including outstanding options, warrants, restricted stock, and the conversion of preferred stock amounted to 11,168,697 and 11,109,787 for the three-month and six-month periods ended December 31, 2010, respectively.

2.  Inventories

Inventories consist of the following:
 
   
December 31,
2010
   
June 30,
2010
 
Finished goods
 
$
970,232
   
$
1,085,433
 
Purchased parts and components
   
161,683
     
125,868
 
Total
 
$
1,131,915
   
$
1,211,301
 
 
3.  Line of Credit

The Company had a $8.0 million revolving line of credit facility with SunTrust Banks, Inc. (“SunTrust”) that was scheduled to mature on November 30, 2010. The line of credit bore interest at prime plus 1½%, which was 4.75% at June 30, 2010. At June 30, 2010, the Company was not in compliance with certain financial and non-financial covenants and $3,830,055 was outstanding. For the three and six months ended December 31, 2010, interest expense relating to the line of credit was $-0- and $2,021, respectively. For the three and six months ended December 31, 2009, interest expense related to the line of credit was $65,211 and $116,970, respectively. There was $33,284 of accrued interest at June 30, 2010.

On July 12, 2010, the Company repaid in full the entire outstanding balance under the credit agreement as a result of entering into a factoring agreement with Rosenthal & Rosenthal, Inc. (see Note 4, Due to Factor for further discussion). As a result of such repayment, (i) the loan agreement has automatically terminated, (ii) SunTrust’s lien or security interest in the Company’s assets has been terminated, and (iii) all obligations of the Company under the loan agreement have been satisfied in full.

4.  Due to Factor

On July 7, 2010, the Company entered into a Factoring Agreement with Rosenthal & Rosenthal. Under the Factoring Agreement, the Company agreed to sell certain receivables to Rosenthal & Rosenthal arising from sales of inventory to customers. In connection with the execution of the Factoring Agreement, the Company, certain subsidiaries, and the chairman, Terry Phillips, have executed guarantees in favor of Rosenthal & Rosenthal. In addition, the Company and certain subsidiaries each granted to Rosenthal & Rosenthal a security interest against all their respective assets.

Under the terms of the Factoring Agreement, the Company is selling certain of its receivables to Rosenthal & Rosenthal. For the approved receivables, Rosenthal & Rosenthal will assume the risk of collection. The Company has agreed to pay Rosenthal & Rosenthal a commission of .60% of the amount payable under all of the Company’s invoices to most of the Company’s customers against a minimum commission of $30,000 multiplied by the number of months in a contract period, with the first period being 12 months and the second 7 months. All payments received by Rosenthal & Rosenthal are payable to the Company after amounts due to Rosenthal & Rosenthal are satisfied. Under the Factoring Agreement, the Company has the right to borrow against payments due the Company at the rate of 65% of credit approved receivables. The borrowing rate against non-credit approved receivables is subject to negotiation. The interest rate on borrowings is equal to the greater of prime plus 1.5% per annum or 6.5% per annum. A $10,000,000 loan cap applies against the Company’s borrowings, which is subject to an increase of up to $3,000,000 if shareholders’ equity increases. The initial term of the Factoring Agreement ends on February 28, 2012.

 
12

 
 
4.  Due to Factor, Cont.
 
Due (to) from factor consists of the following:

   
December 31,
2010
 
Outstanding accounts receivable sold to factor
 
$
5,200,626
 
Cash collateral
   
109,650
 
Less: allowances
   
(2,260,088
)
Less: advances from factor
   
(3,915,090
)
   
$
(864,902
)

Accounts receivable totaling $5,200,626 were sold to the factor at December 31, 2010, of which the Company assumed credit risk of $1,578,909. The following table sets forth adjustments to the price protection and other customer allowances included as a reduction of amounts due (to) from factor:

   
Six
months
ended
December 31,
2010
 
Beginning balance
 
$
-
 
Add: provision
   
(5,441,699
)
Less: amounts charged against allowance
   
3,181,611
 
Ending balance
 
$
(2,260,088
)

For the three-month and six-month periods ended December 31, 2010, interest and financing costs relating to the factoring agreement were $102,480 and $257,938, respectively.

 
13

 

5.  Production Advance Payable

On August 17, 2009, the Company entered into a euro-denominated unit production financing agreement with a producer relating to the production of certain games, of which the balance outstanding under this agreement was $3,755,104 at December 31, 2010.  Production fees relating to this production advance for the three-month and six-month periods ended December 31, 2010 totaled $294,018, and $572,878, respectively.  The production fees for the three-month and six-month periods ended December 31, 2010 related to the default status of the production advance, as described in the subsequent paragraph.  These amounts are included in interest and financing costs, net on the accompanying condensed consolidated statements of operations. As of December 31, 2010 and June 30, 2010, accrued and unpaid production fees totaled $1,658,914 and $1,000,392, respectively, and are included in accrued expenses and other current liabilities. The Company is obligated to pay approximately $99,000 of production fees for every month the full production advance is outstanding past its due date of November 15, 2009.  Pursuant to the agreement, the Company has assigned to the producer a portion of the net revenues related to the sale of certain games in Europe.

The Company has failed to make the required payments under this agreement.   Accordingly, the production advance payable is currently in default and is accruing production fees at $0.009 per unit (based upon 382,000 units) for each day after November 15, 2009 (approximately $1,298,000 through December 31, 2010).  Pursuant to the terms of the production financing agreement, the producer is free to exercise any rights in connection with the security interests granted. Because of several issues surrounding the facts associated with the production advance agreement, the Company is currently contesting its obligation to repay this advance.
 
6.  Secured Convertible Debt

On April 29 and 30, 2010, the Company entered into a note purchase agreement pursuant to which the Company could issue up to $5,000,000 of junior secured subordinated promissory notes (the “Junior Notes”) in one or more closings and each of the Company’s subsidiaries guaranteed the Company’s obligations under the Junior Notes. Pursuant to the note purchase agreement, the Company issued Junior Notes in the aggregate principal amount of $950,000 in private placements that closed on April 30, 2010 and May 6, 2010. Of the Junior Notes issued on April 29 and 30, 2010, the Company’s chairman, purchased $500,000.

The Junior Notes were due and payable in full on December 27, 2010 and bore interest at the rate of 10% per annum. The Junior Notes were secured by all of the assets of the Company and its subsidiaries and the indebtedness under the Junior Notes and the security interest granted by the Company and its subsidiaries in the note purchase agreement were junior to the Company’s indebtedness to SunTrust Banks the Company’s senior lender, and the indebtedness held by any future senior lender of the Company or its subsidiaries. The principal and accrued interest outstanding under each Junior Note was convertible, in whole or in part, at the option of its holder into shares of the Company’s common stock at a price per share of $0.45 per share.

The Company evaluated the conversion feature of the Junior Notes and determined that there was no beneficial conversion feature as the conversion price of $0.45 per share was greater than the fair value of the stock at the time of issuance.

On July 16, 2010, the Company repaid the $450,000 Junior Note plus accrued interest thereon with proceeds from the senior secured convertible notes. On July 16, 2010, the Company exchanged the $500,000 Junior Note issued to the Company’s chairman for a $500,000 senior secured convertible note (see discussion below). Interest expense for the three-month and six-month periods ended December 31, 2010 related to the Junior Notes was $5,411 and $5,411, respectively. There was $-0- and $15,548 of accrued interest outstanding at December 31, 2010 and June 30, 2010, respectively.

On July 16, 2010, the Company entered into a Securities Purchase Agreement with CNH Diversified Opportunities Master Account, L.P., CNH CA Master Account, L.P., AQR Diversified Arbitrage Fund and Terry Phillips, the Company’s chairman, for the sale of $5,500,000 of senior secured convertible notes (the “Initial Notes”) and warrants. Mr. Phillips’ Initial Note was issued in exchange for a Junior Note originally issued to him on April 30, 2010. The Company received $5,000,000 in cash for $5,000,000 of the Initial Note and exchanged a $500,000 prior Junior Note for $500,000 of the Initial Note. The Initial Notes are due and payable in full on July 19, 2013 and bear interest at the rate of 10.0% per annum. Interest is payable semi-annually commencing on December 31, 2010. The Company did not make its first interest payment of $252,083 on December 31, 2010 and was in default on the Notes with respect to which default the Company entered into a Waiver Agreement with each holder of the Initial Note (see discussion regarding the waiver and forbearance agreements below). Pursuant to their respective terms, in the event of a default, the interest rate of the Initial Notes increases to 15.0% per annum until the interest is paid. Once the interest is paid, the interest rate will return to the original 10.0% per annum. The Initial Notes are senior to all obligations of the Company with the exception of the indebtedness under the Company’s Factoring Agreement with Rosenthal & Rosenthal (see Note 4). Interest expense for the three-month and six-month periods ended December 31, 2010 was $140,556 and $252,083, respectively, and there was $252,083 of accrued interest outstanding at December 31, 2010.

 
14

 
 
6.  Secured Convertible Debt, Cont.
 
The principal and interest due under the Notes are convertible at a price of $0.431 per share at the option of the holders. The Company evaluated the conversion feature of the Notes and determined that there was no beneficial conversion feature as the conversion price of $0.431 per share was greater than the fair value of the stock at the time of issuance.

On August 31, 2010, the Company entered into an Amended and Restated Securities Purchase Agreement (the “Amended Purchase Agreement”), pursuant to which it sold an aggregate of $2,000,000 of a new series of senior secured convertible notes (the “Additional Notes”) to AQR Opportunistic Premium Offshore Fund, L.P., Advanced Series Trust, solely on behalf of the AST Academic Strategies Asset Allocation Portfolio, and Terry Phillips, the Company’s chairman. The Company received $2,000,000 in cash for $2,000,000 of the Additional Notes, of which $200,000 was paid by Terry Phillips, the Company’s chairman. The Additional Notes are due and payable in full on March 15, 2011 and bear interest at the rate of 24.0% per annum. Interest is payable on December 31, 2010 and on March 15, 2011, the maturity date. The Company did not make its first interest payment of $161,333 on December 31, 2010 and was in default on the Additional Notes as of December 31, 2010 with respect to which default the Company entered into a waiver and forbearance agreement with each holder of the Initial Note (see discussion regarding the waiver and forbearance agreements below).  Pursuant to their respective terms, in the event of a default, the interest rate of the Additional Notes increases to 29.0% per annum until the interest is paid. Once the interest is paid, the interest rate will return to the original 24.0% per annum. The Additional Notes are subject to the Pledge and Security Agreement and the Guaranty made by the Company’s subsidiaries. Interest expense for the three-month and six-month periods ended December 31, 2010 was $122,667 and $161,333, respectively, and there was $161,333 of accrued interest outstanding at December 31, 2010.

The principal and interest due under the Additional Notes are convertible at a price of $20.00 per share at the option of the holders. The Company evaluated the conversion feature of the Notes and determined that there was no beneficial conversion feature as the conversion price of $20.00 per share was greater than the fair value of the stock at the time of issuance.

As a part of the issuance of the Notes, the Company issued Series A warrants to the purchasers of the Notes giving them the right to purchase up to an aggregate of 12,761,021 shares of common stock at an exercise price of $0.375 per share. The Series A warrants expire on July 19, 2015, unless sooner exercised.

In addition, the purchasers of the Notes received Series B warrants which will expire, if the warrants become exercisable, on the fifth year anniversary of the date the Company announces its 2011 operating results. The number of Series B warrants each purchaser received is equal to 75% of the Series A warrants they obtained. The Series B warrants can only be exercised if the EBITDA Test, as defined under the Notes, is not achieved or if the Company fails to announce its 2011 operating results by September 28, 2011. The exercise price of the Series B warrants is equivalent to the weighted average price of the Company’s common stock for each of the 30 consecutive trading days following the earlier of the announcement of the Company’s 2011 operating results or September 28, 2011. The exercise price per share is also subject to full ratchet anti-dilution protection and limitations on exercise similar to the provisions for the Series A warrants.

The Company’s Notes and certain warrants have been accounted for in accordance with applicable authoritative guidance for derivative instruments which requires identification of certain embedded features to be bifurcated from debt instruments and accounted for as derivative assets or liabilities. The derivative assets and liabilities are initially recorded at fair value and then at each reporting date, the change in fair value is recorded in the condensed consolidated statements of operations.

The Company has accounted for the Series A warrants as a liability because the exercise price of the warrants will reset if the Company issues stock at a lower price. At inception, the fair value of the Series A warrants of $4,338,748 was separated from the Notes and recorded as a derivative liability which resulted in a reduction of the initial notional carrying amount of the Notes, and as unamortized discount, which is being accreted over the term of the Notes using the straight-line method. The fair value of the warrants was computed using the Black-Scholes option pricing model. The Company assumed a risk-free interest rate of 1.73%, no dividends, expected volatility of 148.24% and the contractual life of the warrants of 5 years.

The obligation to deliver the Series B warrants was determined to be an embedded derivative. The Company has determined the valuation of this embedded derivative based on the probability that the EBITDA Test, as defined under the Notes, will not be achieved. Because the probability at inception that the EBITDA Test will not be achieved is considered to be de minimis (less than 5%), the fair value of the derivative instrument is not considered to be material and no value has been assigned to it.

 
15

 
 
6.  Secured Convertible Debt, Cont.
 
As of December 31, 2010, the unamortized debt discount amounted to $3,615,623. Total amortization of the debt discount recorded as interest expense was $361,562 and $723,125 for the three-month and six-month periods ended December 31, 2010, respectively.

In connection with the sale of the Initial Notes and warrants, the Company executed a Registration Rights Agreement under which it agreed to register the shares of common stock underlying the Initial Notes and warrants. The Registration Rights Agreement has been amended and currently provides that the Company file a registration statement by November 19, 2010 and to have it declared effective by January 31, 2011, if it is not subject to full review by the SEC, and by March 15, 2011, if it is subject to full review. Failure to have the registration statement declared effective within 60 days from the prescribed effectiveness deadline constitutes a default under the Initial Notes.

On December 31, 2010, the Company failed to make a timely payment of interest required under the Notes.  Such failure triggered a default provision under the Notes following a seven day cure period.  On February 16, 2011, the Company entered into Waiver Agreements with each holder of the Notes.  Pursuant to the Waiver Agreements, the holders of the Notes waived their right of redemption and remedies regarding the Company’s failure to have paid the required interest and agreed to forbear from exercising all remedies available in connection with such failure until March 15, 2011. Pursuant to the Waiver Agreement, the Company is not required to pay the required interest until March 15, 2011 and the interest rates under the Notes increase to 15% and 29%, as applicable, from December 31, 2010 to March 15, 2011.

The purchasers of the senior secured convertible notes and warrants were introduced to the Company by an investment bank pursuant to an engagement letter agreement with the Company. Pursuant to the engagement letter, the investment bank received a cash fee that was approximately equal to 5.0% of the aggregate proceeds raised in the financing. The Company recorded the cash fee and other direct costs incurred for the issuance of the senior secured convertible notes in aggregate of $733,959 as deferred debt issuance costs. Debt issuance costs are amortized on the straight-line method over the terms of the senior secured convertible notes, with the amounts amortized being recognized as interest expense. Amortization of deferred debt issuance costs included in interest expense for the three-month and six-month periods ended December 31, 2010 totaled $135,186 and $201,278, respectively.

7.  Inventory Financing Payable

On September 20, 2010, the Company entered into a Master Purchase Order Assignment Agreement with Wells Fargo Bank, National Association (“Wells Fargo”). In connection with the execution of this Agreement, each of the Company, its subsidiaries, Gone Off Deep, LLC and Vid Sub, LLC, and the chairman, Terry Phillips (the “Guarantors”), have executed a Guaranty in favor of, and, along with the Company, have entered into a Security Agreement and Financing Statement with, Wells Fargo.

Under the terms of the agreement, the Company may request that Wells Fargo accept the assignment of customer purchase orders and request that Wells Fargo purchase the required materials to fulfill such purchase orders. If accepted, Wells Fargo, in turn, will retain the Company to manufacture, process, and ship the ordered goods. Wells Fargo’s aggregate outstanding funding under the agreement shall not exceed $2,000,000. As of December 31, 2010, no amounts were outstanding under the agreement. Interest expense for the three month and six month periods ended December 31, 2010 was $42,070 and $42,070, respectively.

Upon receipt of customer payments by Wells Fargo, the Company will be paid a fee for its services, with such fee calculated pursuant to the terms of the agreement. Also from such customer payments, Wells Fargo shall be entitled to receive the following: (1) a transaction initiation and set-up fee equal to 1.5% of the aggregate amount outstanding on all amounts (including letters of credit) advanced by Wells Fargo; (2) a daily maintenance fee equal to 0.05% of all amounts (including letters of credit) advanced by Wells Fargo which remain outstanding for more than 30 days; and (3) a product advance fee equal to (a) the prime rate plus 2%, divided by 360, multiplied by (b) (i) the aggregate amount outstanding on all amounts (including letters of credit) advanced by Wells Fargo on account of purchases of products or other advances made in connection with a customer purchase order, multiplied (ii) by the number of days from the earlier of (A) the date on which any such letter of credit or purchase order or financial accommodation is negotiated into cash, or (B) the date funds are advanced by other than issuing a letter of credit or purchase order.

In addition, Wells Fargo is entitled to a commitment fee of $120,000 to be paid on the earlier of (a) September 20, 2011 or (b) the date on which the Agreement is terminated. Wells Fargo is also entitled to additional commitment fees for each renewal of the Agreement, and such fees will be paid on the earlier of (a) the first anniversary of the beginning of each renewal term or (b) the date on which the Agreement is terminated.

 
16

 
 
7.  Inventory Financing Payable, Cont.
 
Subject to the rights of senior lenders, the Company and the Guarantors have granted security interests in their assets to Wells Fargo under the Security Agreement and Financing Statement to secure the LLC’s obligations under the Agreement and the Guarantors’ guarantees of such obligations.


For all periods presented, the Company had the following related party transactions.

Related Party Receivables

Related party receivables consist primarily of short-term advances to employees. No allowance has been provided due to the short-term nature and recoverability of such advances.

Also included in related party receivables at December 31 and June 30, 2010 is a receivable attributed to lease income. The Company leases certain office space to a company whose shareholders are also shareholders of the Company, one of whom is the Company's chairman.  At December 31, 2010 and June 30, 2010, $-0- and $7,815, respectively, was owed to the Company and is included in related party receivables.

Due to Related Parties

The Company incurred fees for broadband usage to an entity partially owned by two shareholders of the Company, one of whom is the Company’s chairman. Broadband usage fees for the three and six months ended December 31, 2010 were $6,625 and $13,225, respectively.  Broadband usage fees for the three and six months ended December 31, 2009 were $6,600 and $13,200, respectively. These amounts are included in general and administrative expenses in the accompanying condensed consolidated statements of operations. At December 31, 2010 and June 30, 2010, $4,425 and $2,200, respectively, remained as a payable to the affiliate and is included in due to related parties in the accompanying condensed consolidated balance sheets.

Accrued Expenses - Related Parties

Accrued expenses - related parties as of and for the six months ended December 31, 2010 and the year ended June 30, 2010 are as follows:
 
   
Six
months ended
December 31,
2010
   
Year ended
June 30,
2010
 
Balance at beginning of period
 
$
322,281
   
$
221,493
 
Expenses incurred:
               
Rent
   
55,000
     
110,000
 
Commissions
   
56,848
     
551,932
 
Cash in advance
   
210,623
     
-
 
Less: amounts paid
   
(303,134
)
   
(561,144
)
Balance at end of period
 
$
341,618
   
$
322,281
 

The Company incurred sales commissions for the marketing and sale of videogames with four affiliates of the Company’s chairman.  Sales commissions for the three and six months ended December 31, 2010 were $16,478 and $56,848, respectively.  Sales commissions for the three and six months ended December 31, 2009 were $172,231 and $265,297, respectively.  These amounts are included in sales and marketing in the accompanying condensed consolidated statements of operations.

 
17

 
 
 
Cash in Advance - Related Party

On December 30, 2010, the Company received $210,623 cash in advance for goods not yet delivered from an affiliate of the Company’s chairman.  At December 31, 2010, $210,623 was included in accrued expenses – related parties in the accompanying condensed consolidated balance sheets and will be recognized as revenue when the goods are delivered.

Lease - Related Parties

The Company leases certain office space from a company whose shareholders are also shareholders of the Company, one of whom is the Company’s chairman.  Related party lease expense was $27,500 and $55,000 for the three months and six months ended December 31, 2010, respectively.    Related party lease expense was $27,500 and $55,000 for the three and six months ended December 31, 2009, respectively.  These amounts are included in the general and administrative expense in the accompanying condensed consolidated statements of operations. The lease expires on December 31, 2013.

The Company leases certain office space to a company whose shareholders are also shareholders of the Company, one of whom is the Company’s chairman.  Related lease income was $3,907 and $7,815 for the three months and six months ended December 31, 2010, respectively.  Related lease income was $3,907 and $7,815 for the three and six months ended December 31, 2009, respectively.  These amounts are included in general and administrative expense in the accompanying condensed consolidated statements of operations.  The lease expires on January 31, 2014.

9.  Commitments

Total future minimum commitments are as follows:

   
Software
   
Office
       
   
Developers
   
Lease
   
Total
 
For the year ending June 30,
                 
                   
2011 (six months ended June 30, 2011)
 
2,506,000
   
 $
74,122
   
 $
2,580,122
 
2012
   
596,318
     
148,244
     
744,562
 
2013
   
-
     
125,935
     
125,935
 
2014
   
-
     
55,000
     
55,000
 
2015
   
-
     
-
     
-
 
Total
 
$
3,102,318
   
$
403,301
   
$
3,505,619
 

Total future commitments pursuant to vendor settlement agreements are as follows:

   
Vendor
 
   
Payments
 
For the year ending June 30,
     
       
2011 (six months ended June 30, 2011)
 
386,738
 
2012
   
-
 
2013
   
-
 
2014
   
-
 
2015
   
-
 
Total
 
$
386,738
 

10.  Stock-based Compensation

In May 2008, the Company’s board of directors and its shareholders approved the 2008 Equity Incentive Compensation Plan (the “2008 Plan”) for the grant of stock awards, including restricted stock and stock options, to officers, directors, employees and consultants.  The 2008 Plan expires in May 2018. Shares available for future grant as of December 31, 2010 and June 30, 2010 were 695,989 and 919,372, respectively, under the 2008 Plan.

 
18

 
 
10.  Stock-based Compensation, Cont.
 
Stock awards and shares are generally granted at prices which the Company’s board of directors believes approximate the fair market value of the awards or shares at the date of grant. Individual grants generally become exercisable ratably over a period of three years from the date of grant. The contractual terms of the options range from three to ten years from the date of grant.

The Company uses the Black-Scholes option pricing model to determine the fair value of stock-based compensation to employees and non-employees. The determination of fair value is affected by the Company’s stock price and volatility, employee exercise behavior, and the time for the shares to vest.

The assumptions used in the Black-Scholes option pricing model to value the Company’s option grants to employees and non-employees were as follow:

   
For the six
months ended
December 31, 2010
   
For the six
months ended
December 31, 2009
 
Risk-free interest rate
   
1.60 – 3.30%
   
2.20 – 3.85%
Weighted-average volatility
   
154 - 157%
   
160.78 – 166.29%
Expected term
   
5.5 – 8.7
     
5.5 - 9.4 years
 
Expected dividends
   
0.0%
   
0.0%

The following table summarizes the stock-based compensation expense resulting from stock options and restricted stock in the Company’s consolidated statements of operations:

   
For the three
months ended
December 31,
2010
   
For the three
months ended
December 31,
2009
   
For the six
months ended
December 31,
2010
   
For the six
months ended
December 31,
2009
 
Sales and marketing
 
$
(1,196
 
$
12,196
   
$
9,509
   
$
39,818
 
General and administrative
   
61,877
     
191,528
     
204,774
     
320,102
 
Total stock-based compensation expense
 
$
60,681
   
$
203,724
   
$
214,283
   
$
359,920
 

As of December 31, 2010, the Company’s unrecognized stock-based compensation for stock options issued to employees and non-employee directors was approximately $388,206 and will be recognized over a weighted average of 1.8 years.  The Company estimated a 5.0% forfeiture rate related to the stock-based compensation expense calculated for employees and non-employee directors.

The following table summarizes the Company’s stock option activity for employees, non-employee directors, and non-employees for the six months ended December 31, 2010:

   
 
Options
   
Weighted-
Average
Exercise
Price
   
Weighted-
Average
Remaining
Contractual
Term
(in years)
   
Aggregate
Intrinsic
Value
 
Outstanding as of June 30, 2010
   
2,882,128
   
$
1.16
     
-
   
$
-
 
Activity for the six months ended December 31, 2010
                               
Granted
   
696,500
     
0.30
     
-
     
-
 
Exercised
   
-
     
-
     
-
     
-
 
Forfeited, cancelled or expired
   
666,768
     
0.69
     
-
     
-
 
Outstanding as of December 31, 2010
   
2,911,860
   
$
0.93
     
8.51
   
$
-
 
Exercisable as of December 31, 2010
   
1,227,013
   
$
1.40
     
7.93
   
$
-
 
Exercisable and expected to be exercisable
   
2,764,994
   
$
0.96
     
8.47
   
$
-
 

 
19

 
 
10.  Stock-based Compensation, Cont.
 
The aggregate intrinsic value represents the total pre-tax intrinsic value based on the Company’s closing stock price ($0.14 per share) as of December 31, 2010, which would have been received by the option holders had all option holders exercised their options as of that date.

The following table summarizes the Company’s restricted stock activity for the six months ended December 31, 2010:

   
Shares
   
Weighted-
Average
Grant Date
Fair Value
 
Outstanding as of June 30, 2010
   
1,085,000
   
$
0.37
 
Activity for the nine months ended December 31, 2010
               
Granted
   
195,651
     
0.23
 
Vested
   
396,333
     
0.41
 
Forfeited, cancelled or expired
   
2,000
     
1.20
 
Outstanding as of December 31, 2010
   
882,318
   
$
0.32
 
Vested as of December 31, 2010
   
509,833
   
$
0.80
 

As of December 31, 2010, the Company’s unrecognized stock-based compensation for restricted stock issued to employees and non-employee directors was approximately $268,545 and will be recognized over a weighted average of 1.85 years.

11.  Contingencies

On October 27, 2008, Gamecock was served with a demand for arbitration by a developer alleging various breaches of contract related to a publishing agreement entered into between Gamecock and the developer on December 12, 2007. The developer is seeking an award of $4,910,000, termination of the agreement, exclusive control of the subject videogame, and discretionary interest and costs. Gamecock has responded stating that the developer’s attempts to terminate the publishing agreement constitute wrongful termination of the agreement and breach of the agreement. Gamecock has also filed a counterclaim against the developer seeking the return of approximately $5.9 million in advances on royalties in the event the publishing agreement is terminated.  The developer has filed a supplemental demand for arbitration concerning royalty payments due under a separate publishing agreement and is seeking an award of $41,084.  An arbitration scheduled for January 2010 has been put on hold pending possibility of settlement.  As of December 31, 2010, the Company believes it has accrued sufficient amounts to cover potential losses related to this matter.  The Company’s management currently believes that resolution of this matter will not have a material adverse effect on the Company’s consolidated financial position or results of operations. However, legal issues are subject to inherent uncertainties and there exists the possibility that the ultimate resolution of this matter could have a material adverse effect on the Company’s consolidated financial position and the results of operations in the period in which any such effect is recorded.

In February 2010, the Company, SouthPeak Interactive, L.L.C., and Gamecock were served with a complaint by TimeGate Studios, Inc., or TimeGate, alleging various breach of contract and other claims related to a publishing agreement, or the Publishing Agreement, entered into between Gamecock and TimeGate in June 2007.  TimeGate is seeking the return of all past and future revenue generated from the videogame related to the Publishing Agreement, an injunction against the Company and its subsidiaries, damages to be assessed, and discretionary interest and costs. Based upon the current status of this claim, the Company is of the opinion that it has limited or no exposure in connection with this claim.

On May 10, 2010, SouthPeak Interactive, L.L.C. and Melanie Mroz were served with a complaint by Spidermonk Entertainment, LLC or Spidermonk, alleging various breach of contract and other claims related to a publishing agreement, or the Publishing Agreement, entered into between Southpeak and Spidermonk in November 2007.  Spidermonk is seeking the unpaid milestone payments related to the development of the game “Roogoo” videogame as well as other highly speculative damages related to the poor sales performance of this game. The Company and its subsidiaries intend to vigorously defend all claims.

 
20

 
 
11.  Contingencies, Cont.
 
In September 2010, the Company instituted summary proceedings in the Lyon France Commercial Court against Nobilis Group in which the Company has alleged the Licensing and Distribution Agreements for the games the Company was to obtain and has obtained from Nobilis, including the My Baby games, were wrongfully terminated. The Company is seeking the reinstatement of the agreements and damages associated with the actions of Nobilis. Following a hearing on October 26, 2010, the court has rendered a temporary summary judgment reinstating the agreement for My Baby First Steps and ordered Nobilis to advise Nintendo to build all products pursuant to the My Baby First Steps contract, which includes the My Baby First Steps game and an additional fourteen games. On December 7, 2010, the Lyon France Commercial Court issued a judgment confirming that Nobilis's termination of the distribution agreement was null and void. The Court has ordered that Nobilis restore SouthPeak's ability to manufacture licensed games under the agreement with immediate effect.

In November 2010, in connection with the Circuit City Stores, Inc. (“Circuit City”) bankruptcy proceedings, Alfred H. Siegal, Trustee of the Circuit City Liquidating Trust, filed a lawsuit against the Company in United States Bankruptcy Court in the Eastern District of Virginia for the avoidance of payments totaling $1,155,300 as allegedly preferential transfers paid to the Company during the 90 days preceding the filing of the bankruptcy petition of Circuit City on November 10, 2008. The Company believes it has meritorious defenses to these avoidance actions, intends to vigorously defend against them and believes that the likelihood of the avoidance actions prevailing is remote. Accordingly, the Company has not accrued any loss reserve related to this claim.

In October 2010, BVT Games Fund IV Dynamic GmbH & Company (“Fund IV”), an investment fund based in Germany that finances the development of video games, sued the Company in the Regional Court in Munich, Germany to recover funds advanced to the Company to manufacture two titles which a sister fund, BVT Games Fund III Dynamic GmbH & Company (“Fund III”), had financed. A distribution agreement existed for these titles with Phillips Sales, Inc. and not the Company although the Company had guaranteed the obligations of Phillips Sales, Inc. In this litigation, Fund IV is seeking €3,115,341 (approximately USD $4.1 million) plus interest. The Company is actively contesting this litigation and has multiple defenses. The liability associated with the production advance is reflected in the Company’s condensed consolidated financial statements.

In November 2010, the Company first learned that Fund III had obtained a judgment against the Company in the Regional Court in Munich, Germany, seeking payments of approximately €2,300,000 (approximately USD $3.0 million) due under the above-referenced distribution agreement. Prior to gaining such knowledge, Fund III served upon the Company’s then chief financial officer, as required by law, what was supposed to be the English translation of the lawsuit which Fund III had filed. Instead, Fund III served upon the Company a translation of the Fund IV lawsuit that Fund IV intended to serve on the Company. Because the Company knew of the filing of the Fund IV case before being properly served with that case, the Company had already engaged German counsel to represent its interests in the Fund IV case. Since German counsel’s representation had been noted in the Fund IV case, counsel was awaiting notice from the court or opposing counsel that service of the Fund IV case had occurred. Therefore, when the Fund III case was served with a translation of the Fund IV case, the Company took no action since it believed this matter was already in the hands of its attorney. The failure to respond resulted in a default judgment in the Fund III case for which no proper translation has yet been received. Because of this error in translation, the Company is seeking to have the judgment vacated and believes it will be successful in this regard. The Company is of the opinion when, and if, it is required to defend the litigation, that it has strong defenses to assert, including that Phillips Sales is not obligated to Fund III thereby avoiding the Company’s guaranty obligation. The Company cannot predict the potential outcome.  No amounts have been recorded in the Company’s condensed consolidated financial statements in connection with the liability underlying the claim.

On January 26, 2011, Codemasters Group Holdings Limited filed suit against the Company in the United States District Court for the Eastern District of Virginia, Richmond Division, seeking to enforce a Settlement Agreement under which Codemasters claims that $1,265,000 plus interest thereon is due. No answer has yet been filed. The Company recognizes its liability to Codemasters which has been recorded on its condensed consolidated financial statements but believes it is entitled to certain credits which Codemasters has not reflected in its lawsuit. It is the Company's intent to try to resolve this matter with Codemasters.
 
21

 
11.  Contingencies, Cont.
 
In addition to the foregoing, the Company is engaged in litigation incidental to the Company’s business to which the Company is a party.  While the Company cannot predict the ultimate outcome of these various legal proceedings, it is management’s opinion that, individually, the unfavorable resolution of these matters could have a material effect on the condensed consolidated financial position or results of operations of the Company. As of December 31, 2010, the Company has accrued an aggregate amount of $2,376,153 related to such matters. The Company expenses legal costs as incurred in connection with a loss contingency.

On August 26, 2009, the Company was notified that the SEC was conducting a non-public, fact-finding investigation regarding certain matters underlying the amendment of its Form 10-Q, and the restatement of its financial statements, for the period ended March 31, 2009, and the termination of its former chief financial officer.  The Company has provided the SEC with the documents requested and has cooperated in all respects with the SEC’s investigation.

On September 3, 2010, the Company, Terry Phillips, the Company’s chairman, and Melanie Mroz, the Company’s CEO,  received Wells Notices from the staff of the Securities and Exchange Commission advising that the staff will recommend to the Securities and Exchange Commission that cease and desist orders issue for alleged violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934 and Rules 12b-20 and 13a-13 adopted under this act.  In addition, the staff has alleged violations by Mr. Phillips and Ms. Mroz of Rule 13b-2 and Rule 13a-14 by Ms. Mroz. These alleged violations result from the facts underlying the need to file an amended Form 10Q/A for the fiscal quarter ended March 31, 2009.   
 
From time to time, the Company is subject to various claims and legal proceedings. If management believes that a loss arising from these matters is probable and can reasonably be estimated, the Company would record the amount of the loss, or the minimum estimated liability when the loss is estimated using a range, and no point within the range is more probable than another. As additional information becomes available, any potential liability related to these matters is assessed and the estimates are revised, if necessary.

12.  Gain on Settlement of Trades Payables
 
The gain on the settlement of trade payables at less than recorded values results from negotiations with various unsecured creditors for the settlement and payment of the trade payable at amounts less than that the recorded liability. For the six months ended December 31, 2010, the Company’s gain on settlement of trade payables was as follows:
 
  
 
Net Trade
Payables
Settled
     
Other Assets
Acquired/
Liabilities
Assumed
     
Payments
in Cash
     
Payments
in Equity
     
Forgiveness
of Debt
 
                               
Vendor 1
 
$
12,000
   
$
-
   
$
(10,000
)
 
$
-
   
$
2,000
 
Vendor 2
   
1,064,848
  
   
-
     
(481,726
)
   
-
     
583,122
 
   
$
1,076,848
   
$
-
   
$
(491,726
)
 
$
-
   
$
585,122
 
 
For the six months ended December 31, 2009, the Company’s gain on settlement of trade payable was as follows:

  
 
Net Trade
Payables
Settled
     
Other Assets
Acquired/
Liabilities
Assumed
     
Payments
in Cash
     
Payments
in Equity
     
Forgiveness
of Debt
 
                               
Vendor 1(1)
 
$
6,418,334
   
$
(1,422,334
)
 
$
(2,000,000
)
 
$
-
   
$
2,996,000
 
Vendor 2(2)
   
250,000
     
-
     
(50,000
)
   
(104,500
)
   
95,500
 
Vendor 3
   
232,347
  
   
-
     
(67,358
)
   
-
     
164,989
 
   
$
6,900,681
   
$
(1,422,334
)
 
$
(2,117,358
)
 
$
(104,500
)
 
$
3,256,489
 
 
22

 
12.  Gain on Settlement of Trades Payables, Cont.
 
(1)
In connection with this settlement agreement, the Company received inventory valued at $135,276, assumed the vendor’s future liability for price protection, returns, and defective merchandise, for games previously sold by or held by the Company, estimated to be $306,248, and recorded an inventory write-down, for inventory currently held by the Company, in the amount of $1,251,362 as a result of a reduction to a lower of cost or market value.  The reduction in inventory is required as the Company is prohibited from any future inventory returns and is completely responsible for the final disposition of inventory.
(2)
Consists of 175,000 shares of common stock, which were valued based on the fair market value of the Company’s common stock on the settlement date and 150,000 warrants to purchase common stock, which were valued on the settlement date, at $0.30 per share using the Black-Scholes option pricing model with assumptions of 3.57 years expected term (equivalent to contractual term), volatility of 170.76%, 0% dividend yield, 2.35% risk-free interest rate, and stock price of $0.34 per share.
 
13.  Additional Financial Statement Information
 
Accrued expenses and other current liabilities consist of the following:

   
December 31,
     
June 30,
 
   
2010
   
2010
 
                 
Accrued expenses
 
$
1,705,947
   
$
1,700,208
 
Reserve for marketing development funds (MDF)
   
446,141
     
344,210
 
Commissions
   
157,461
     
161,678
 
Guaranteed royalty payments
   
-
     
135,000
 
Accrued payroll and payroll taxes
   
153,442
     
266,740
 
Customer cash in advance deposits
   
117,786
     
31,793
 
Accrued interest
   
2,132,966
     
1,062,200
 
Other
   
163,880
     
79,882
 
                 
   
$
4,877,623
   
$
3,781,711
 

No other items accounted for greater than five percent of total current liabilities as of December 31, 2010 or June 30, 2010.
 
23

 
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes that appear elsewhere in this report and in our annual report on Form 10-K for the year ended June 30, 2010.
 
This report includes forward-looking statements that are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements can be identified by the use of words such as “anticipate,” “believe,” “estimate,” “may,” “intend,” “expect,” “will,” “should,” “seeks” or other similar expressions. Forward-looking statements reflect our plans, expectations and beliefs, and involve inherent risks and uncertainties, many of which are beyond our control. You should not place undue reliance on any forward-looking statement, which speaks only as of the date made. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this report, and in “Risk Factors” in Item 1A of Part I of our annual report on Form 10-K for the year ended June 30, 2010.

Going Concern

The accompanying condensed and consolidated financial statements have been prepared on a going-concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business.  Our ability to continue as a going concern is predicated upon, among other things, generating positive cash flows from operations, curing the default on the production advance payable, and the resolution of various contingencies.  In their report on our audited financial statements for the year ended June 30, 2010, our independent registered public accounting firm included an explanatory paragraph regarding concerns about our ability to continue as a going concern.
 
Overview
 
We are an independent developer and publisher of interactive entertainment software. We utilize our network of independent studios and developers to create videogames for all popular videogame systems, including:
 
 
·
home videogame consoles such as Microsoft Xbox 360, Nintendo Wii, Sony PlayStation 3 and Sony PlayStation 2;
 
 
·
handheld platforms such as Nintendo DS, Nintendo DSi, Sony PSP, Sony PSPgo and Apple iPhone, game applications for the Next Generation NVIDIA® Tegra™ mobile processor used in Droid phones and tablets; and
 
 
·
personal computers.
 
Our portfolio of games extends across a variety of consumer demographics, ranging from adults to children and hard-core game enthusiasts to casual gamers.
 
We are an “indie” videogame developer and publisher working with independent software developers and videogame studios to create our videogames. We have cultivated relationships globally with independent developers and studios that provide us with innovative and compelling videogame concepts.
 
Our strategy is to establish a portfolio of successful proprietary content for the major videogame systems, and to capitalize on the growth of the interactive entertainment market. We currently work exclusively with independent software developers and videogame studios to develop our videogames. This strategy enables us to source and create highly innovative videogames while avoiding the high fixed costs and risk of having a large internal development studio. Through outsourcing, we are also able to access videogame concepts and content from emerging studios globally, providing us with significant new product opportunities with limited initial financial outlay, compared to internally developed video games.
 
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Sources of Revenue
 
Revenue is primarily derived from the sale of software video games developed on our behalf by third parties and other content partnerships. Our unique business model of sourcing and developing creative product allows us to better manage our fixed costs relative to industry peers.
 
Our operating margins are dependent in part upon our ability to continually release new products that perform according to our budgets and forecasts, and manage our product development costs. Our product development costs include license acquisition, videogame development, and third-party royalties. Agreements with third-party developers generally give us exclusive publishing and marketing rights and require us to make advance royalty payments, pay royalties based on product sales and satisfy other conditions.

Second Quarter 2011 Releases
 
We released the following videogames in the three months ended December 31, 2010:
 
Title
 
Platform
 
Date Released
Sled Shred
 
Wii
 
10/12/10
Noah’s Ark
 
NDS
 
11/2/10
Nail’d
 
X360, PS3, PC
 
11/30/10
SBK X
 
X360, PS3, PC
 
12/7/10
NewU Yoga & Pilates Workout
 
Wii
 
12/7/10
 
 
 Cost of Goods Sold. Cost of goods sold consists of royalty payments to third party developers, license fees to videogame manufacturers, intellectual property costs for items such as trademarked characters and game engines, manufacturing costs of the videogame discs, cartridges or similar media and the write-off of acquired game sequel titles. Videogame system manufacturers approve and manufacture each videogame for their videogame system. They charge their license fee for each videogame based on the expected retail sales price of the videogame. Such license fee is paid by us based on the number of videogames manufactured. Should some of the videogames ultimately not be sold, or the sales price to the retailer be reduced by us through price protection, no adjustment is made by the videogame system manufacturer in the license fee originally charged. Therefore, because of the terms of these license fees, we may have an increase in the cost of goods as a percent of net revenue should we fail to sell a number of copies of a videogame for which a license has been paid, or if the price to the retailer is reduced.
 
We utilize third parties to develop our videogames on a royalty payment basis. We enter into contracts with third party developers once the videogame design has been approved by the videogame system manufacturer and is technologically feasible. Specifically, payments to third party developers are made when certain contract milestones are reached, and these payments are capitalized. These payments are considered non-refundable royalty advances and are applied against the royalty obligations owing to the third party developer from the sales of the videogame. To the extent these prepaid royalties are sales performance related, the royalties are expensed against projected sales revenue at the time a videogame is released and charged to costs of goods sold. Any pre-release milestone payments that are not prepayments against future royalties are expensed when a videogame is released and then charged to costs of goods sold. Capitalized costs for videogames that are cancelled or abandoned prior to product release are charged to “cost of goods sold - royalties” in the period of cancellation.

Warehousing and Distribution Expenses. Our warehousing and distribution expenses primarily consist of costs associated with warehousing, order fulfillment, and shipping. Because we use third-party warehousing and order fulfillment companies in the United States and in Europe, the expansion of our product offerings and escalating sales will increase our expenditures for warehousing and distribution in proportion to our increased sales.
 
Sales and Marketing Expenses. Sales and marketing expenses consist of advertising, marketing and promotion expenses, and commissions to external sales representatives. As the number of newly published videogames increases, advertising, marketing and promotion expenses are expected to rise accordingly. We recognize advertising, marketing and promotion expenses as incurred, except for production costs associated with media advertising, which are deferred and charged to expense when the related ad is run for the first time. We also engage in cooperative marketing with some of our retail channel partners. We accrue marketing and sales incentive costs when revenue is recognized and such amounts are included in sales and marketing expense when an identifiable benefit to us can be reasonably estimated; otherwise, the incentives are recognized as a reduction to net revenues. Such marketing is offered to our retail channel partners based on a single sales transaction, as a credit on their accounts receivable balance, and would include items such as contributing to newspaper circular ads and in store banners and displays.
 
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General and Administrative Expenses. General and administrative expenses primarily represent personnel-related costs, including corporate executive and support staff, general office expenses, consulting and professional fees, and various other expenses. Personnel-related costs represent the largest component of general and administrative expenses. We expect that our personnel costs will increase as the business continues to grow.

Gain on Settlement of Trade Payables. Gain on settlement of trade payables is the result of negotiations with various unsecured creditors for the settlement and payment of trade payables at amounts less than the recorded liability.

Change in Fair Value of Warrant Liability.  Our senior secured convertible notes and certain warrants have been accounted for in accordance with applicable authoritative guidance for derivative instruments which requires identification of certain embedded features to be bifurcated from debt instruments and accounted for as derivative assets or liabilities. The derivative assets and liabilities are initially recorded at fair value and then at each reporting date, the change in fair value is recorded in the condensed consolidated statements of operations.
 
Interest and Financing Costs. Interest and financing costs are attributable to our financing arrangements that are used to fund development of videogames with third parties, which often takes 12-24 months. Additionally, such costs are used to finance the accounts receivables prior to payment by customers.
 
Critical Accounting Policies and Estimates
 
Our condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed consolidated financial statements requires estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Estimates were based on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ materially from these estimates under different assumptions or conditions. 

Our significant accounting policies are described in Note 1 to the accompanying condensed consolidated financial statements and in our annual report on Form 10-K for the year ended June 30, 2010. The following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations.
 
Allowances for Returns, Price Protection and Other Allowances.   We accept returns from, and grant price concessions to, our customers under certain conditions. Following reductions in the price of our videogames, we grant price concessions to permit customers to take credits against amounts they owe us with respect to videogames unsold by them. Our customers must satisfy certain conditions to entitle them to return videogames or receive price concessions, including compliance with applicable payment terms and confirmation of field inventory levels and sell-through rates.
 
We make estimates of future videogame returns and price concessions related to current period revenue. We estimate the amount of future returns and price concessions for published titles based upon, among other factors, historical experience and performance of the titles in similar genres, historical performance of the videogame system, customer inventory levels, analysis of sell-through rates, sales force and retail customer feedback, industry pricing, market conditions and changes in demand and acceptance of our videogame by consumers.
 
Significant management judgments and estimates must be made and used in connection with establishing the allowance for returns and price concessions in any accounting period. We believe we can make reliable estimates of returns and price concessions. However, actual results may differ from initial estimates as a result of changes in circumstances, market conditions and assumptions. Adjustments to estimates are recorded in the period in which they become known.
 
Inventories.  Inventories are stated at the lower of average cost or market. Management regularly reviews inventory quantities on hand and in the retail channel and records a provision for excess or obsolete inventory based on the future expected demand for our games. Significant changes in demand for our games would impact management’s estimates in establishing the inventory provision.
 
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Advances on Royalties.  We utilize independent software developers to develop our videogames and make payments to the developers based upon certain contract milestones. We enter into contracts with the developers once the videogame design has been approved by the videogame system manufacturers and is technologically feasible. Accordingly, we capitalize such payments to the developers during development of the videogames. These payments are considered non-refundable royalty advances and are applied against the royalty obligations owed to the developer from future sales of the videogame. Any pre-release milestone payments that are not prepayments against future royalties are expensed to “cost of goods sold - royalties” in the period when the game is released. Capitalized royalty costs for those videogames that are cancelled or abandoned are charged to “cost of goods sold - royalties” in the period of cancellation.
 
Beginning upon the related videogame’s release, capitalized royalty costs are amortized to “cost of goods sold – royalties,” based on the ratio of current revenues to total projected revenues for the specific videogame, generally resulting in an amortization period of twelve months or less.
 
We evaluate the future recoverability of capitalized royalty costs on a quarterly basis. For videogames that have been released in prior periods, the primary evaluation criterion is actual title performance. For videogames that are scheduled to be released in future periods, recoverability is evaluated based on the expected performance of the specific videogame to which the royalties relate. Criteria used to evaluate expected game performance include: historical performance of comparable videogames developed with comparable technology; orders for the videogame prior to its release; and, for any videogame sequel, estimated performance based on the performance of the videogame on which the sequel is based.
 
Significant management judgments and estimates are utilized in the assessment of the recoverability of capitalized royalty costs. In evaluating the recoverability of capitalized royalty costs, the assessment of expected videogame performance utilizes forecasted sales amounts and estimates of additional costs to be incurred. If revised forecasted or actual videogame sales are less than, and/or revised forecasted or actual costs are greater than, the original forecasted amounts utilized in the initial recoverability analysis, the net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge. Material differences may result in the amount and timing of charges for any period if management makes different judgments or utilizes different estimates in evaluating these qualitative factors.

Intellectual Property Licenses.  Intellectual property license costs consist of fees paid by us to license the use of trademarks, copyrights, and software used in the development of videogames. Depending on the agreement, we may use acquired intellectual property in multiple videogames over multiple years or for a single videogame. When no significant performance remains with the licensor upon execution of the license agreement, we record an asset and a liability at the contractual amount. We believe that the contractual amount represents the fair value of the liability. When significant performance remains with the licensor, we record the payments as an asset when paid to the licensee and as a liability upon achievement of certain contractual milestones rather than upon execution of the agreement. We classify these obligations as current liabilities to the extent they are contractually due within the next 12 months. Capitalized intellectual property license costs for those videogames that are cancelled or abandoned are charged to “cost of goods sold - intellectual property licenses” in the period of cancellation.
 
Beginning upon the related videogame’s release, capitalized intellectual property license costs are amortized to “cost of sales - intellectual property licenses” based on the greater of: (1) the ratio of current revenues for the specific videogame to total projected revenues for all videogames in which the licensed property will be utilized or (2) the straight-line amortization based on the useful lives of the asset. As intellectual property license contracts may extend for multiple years, the amortization of capitalized intellectual property license costs relating to such contracts may extend beyond one year.
 
We evaluate the future recoverability of capitalized intellectual property license costs on a quarterly basis. For videogames that have been released in prior periods, the primary evaluation criterion is actual title performance. For videogames that are scheduled to be released in future periods, recoverability is evaluated based on the expected performance of the specific videogames to which the costs relate or in which the licensed trademark or copyright is to be used. Criteria used to evaluate expected game performance include: historical performance of comparable videogames developed with comparable technology; orders for the game prior to its release; and, for any videogame sequel, estimated performance based on the performance of the videogame on which the sequel is based. Further, as intellectual property licenses may extend for multiple videogames over multiple years, we also assess the recoverability of capitalized intellectual property license costs based on certain qualitative factors, such as the success of other products and/or entertainment vehicles utilizing the intellectual property and the holder’s right to continued promotion and exploitation of the intellectual property.
 
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Significant management judgments and estimates are utilized in the assessment of the recoverability of capitalized intellectual property license costs. In evaluating the recoverability of capitalized intellectual property license costs, the assessment of expected game performance utilizes forecasted sales amounts and estimates of additional costs to be incurred. If revised forecasted or actual videogame sales are less than, and/or revised forecasted or actual costs are greater than, the original forecasted amounts utilized in the initial recoverability analysis, the net realizable value may be lower than originally estimated in any given quarter, which could result in an impairment charge. Material differences may result in the amount and timing of charges for any period if management makes different judgments or utilizes different estimates in evaluating these qualitative factors.
 
Revenue Recognition.  We recognize revenues from the sale of our videogames upon the transfer of title and risk of loss to the customer.   We recognize revenues for software titles when (1) there is persuasive evidence that an arrangement with the customer exists, which is generally a purchase order, (2) the product is delivered, (3) the selling price is fixed or determinable, and (4) collection of the customer receivable is deemed probable. Our payment arrangements with customers typically provide for net 30 and 60 day terms. Advances received for licensing and exclusivity arrangements are reported on the consolidated balance sheets as deferred revenues until we meet our performance obligations, at which point the revenues are recognized. Revenue is recognized after deducting estimated reserves for returns, price protection and other allowances. In circumstances when we do not have a reliable basis to estimate returns and price protection or we are unable to determine that collection of a receivable is probable, we defer the revenue until such time as we can reliably estimate any related returns and allowances and determine that collection of the receivable is probable.
 
We have an arrangement pursuant to which we distribute videogames co-published with another company for a fee based on the gross sales of the videogames.  Under the arrangement, we bear the inventory risk as we purchase and take title to the inventory, warehouse the inventory in advance of orders, ship the inventory and invoices its customers for videogame shipments.  Also under the arrangement, we bear the credit risk as the supplier does not guarantee returns for unsold videogames and we are not reimbursed by the supplier in the event of non-collection. We record the gross amount of revenue under the arrangement as we are not acting as an agent for the principal in the arrangement.

Stock-Based Compensation. We account for stock-based compensation in accordance with ASC Topic 718, Compensation – Stock Compensation. ASC 718 requires companies to estimate the fair value of share-based payment awards on the measurement date using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the consolidated statements of operations.
 
Stock-based compensation expense recognized in the consolidated statements of operations is based on awards ultimately expected to vest and has been reduced for estimated forfeitures. ASC 718 requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.
 
We account for equity instruments issued to non-employees in accordance with ASC Topic 505, Equity, Subtopic 50, Equity-Based Payments to Non-Employees.
 
We estimate the value of employee, non-employee director and non-employee stock options on the date of grant using the Black-Scholes option pricing model. Our determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors.
 
Amortizable Intangible Assets. Intangible assets subject to amortization are carried at cost less accumulated amortization. Amortizable intangible assets consist of game sequels, non-compete agreements and distribution agreements. Intangible assets subject to amortization are amortized over the estimated useful life in proportion to the pattern in which the economic benefits are consumed, which for some intangibles assets are approximated by using the straight-line method. Long-lived assets including amortizable intangible assets are reviewed for impairment in accordance with ASC Topic 360, Property, Plant, and Equipment, whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. Measurement of any impairment loss for long-lived assets and amortizable intangible assets is based on the amount by which the carrying value exceeds the fair value of the asset.
 
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Assessment of Impairment of Goodwill. ASC Topic 350, Intangibles – Goodwill and Other, Subtopic 20, Goodwill , (“ASC 350-20”) requires a two-step approach to testing goodwill for impairment. ASC 350-20 requires that the impairment test be performed at least annually by applying a fair-value-based test. The first step measures for impairment by applying fair-value-based tests. The second step (if necessary) measures the amount of impairment by applying fair-value-based tests to the individual assets and liabilities.
 
To determine the fair values of the reporting units used in the first step, we use a combination of the market approach, which utilizes comparable companies’ data and/or the income approach, or discounted cash flows. Each step requires us to make judgments and involves the use of significant estimates and assumptions. These estimates and assumptions include long-term growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates based on our weighted average cost of capital, future economic and market conditions and determination of appropriate market comparables. These estimates and assumptions have to be made for each reporting unit evaluated for impairment. Our estimates for market growth, our market share and costs are based on historical data, various internal estimates and certain external sources, and are based on assumptions that are consistent with the plans and estimates we are using to manage the underlying business. Our business consists of publishing and distributing interactive entertainment software and content using both established and emerging intellectual properties and our forecasts for emerging intellectual properties are based upon internal estimates and external sources rather than historical information and have an inherently higher risk of accuracy. If future forecasts are revised, they may indicate or require future impairment charges. We base our fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates. 

Change in Fair Value of Warrant Liability. We are required to classify the fair value of certain warrants issued as a liability, with subsequent changes in fair value to be recorded as income (loss) on change in fair value of warrant liability. The fair value of the warrants is determined using the Black-Scholes option pricing model and is affected by changes in inputs to that model including our stock price, expected stock price volatility, the contractual term, and the risk-free interest rate. Our estimate of the expected volatility is based on historical volatility. The expected term of the warrants is based on the time to expiration of the warrants from the date of measurement. Risk-free interest rates are derived from the yield on U.S. Treasury debt securities. We will continue to classify the fair value of the warrants as a liability until the warrants are exercised, expired or are amended in a way that would no longer require these warrants to be classified as a liability.

Consolidated Results of Operations
 
The following table sets forth our results of operations expressed as a percentage of net revenues for the three months and six months ended December 31, 2010 and 2009:
 
   
For the
three months ended
December 31,
     
For the
six months ended
December 31,
  
   
2010
   
2009
   
2010
   
2009