Executive Overview
MakeMusic's mission is to develop and market solutions that transform how music is composed, taught, learned and performed. This is accomplished by:
• Providing integrated technology, content and web services to enhance and expand how music is taught, learned and prepared for performance.

• Providing music education content developers with a technology-enriched publishing platform that leverages their copyrighted assets while simultaneously increasing the content and value of the SmartMusic library.

• Offering software solutions for engraving and electronically distributing sheet music.

MakeMusic develops and markets two product lines, SmartMusic® learning software for band, jazz ensemble, orchestra and choir and Finale® music notation software. We believe these innovative products that reinforce each other's features and competitiveness, will allow us to continue to achieve positive operating results. The well-established Finale family of music notation software products provides a solid base business that generates cash and a large customer database. Music notation software is a niche business with limited growth since only a small percentage of musicians ever notate music.
Our fiscal year 2008 resulted in continued sales growth for MakeMusic and overall, a 4% increase over 2007 net revenue was achieved. SmartMusic revenue grew 40% due to our subscription growth from 86,901 on December 31, 2007 to 106,584 on December 31, 2008 and a price increase implemented in July 2008. Notation revenue declined 6% overall, which we attribute to worldwide economic conditions. Gross margin percentages decreased slightly in 2008 to 84% from 85% in 2007. Operating expenses increased in 2008, primarily due to development expenses as we expanded our systems infrastructure to support our customer base and provide redundancy. Additionally, sales and marketing expenses increased as we expanded our direct sales force. We also recorded $265,000 in costs relating to the departure of our founder and co-Chief Executive Officer in November, 2008. As a result of the factors mentioned, we reported net income of approximately $491,000 in 2008 compared to net income of $650,000 in 2007.
We believe our greatest growth potential lies with SmartMusic, a subscription-based product directed toward the very large and constantly renewing market of music students and their teachers. SmartMusic combines a software application, a library of thousands of titles and skill-development exercises, and a web service to provide students with a compelling experience and teachers with a comprehensive solution.
SmartMusic software enhances and transforms the hours spent practicing by putting students inside a professional band, orchestra, or choir so that they can hear how the music is supposed to be performed and how their part fits in. This makes practicing much more fun, causing students to practice longer and more often. SmartMusic also offers a rich variety of effective practice tools that make practice time more efficient and productive. The combination of making practice time more fun and productive leads to rapid student skill-development, increased student confidence, higher student retention, and stronger music programs.
In April 2007, we introduced SmartMusic Impact®, a web-based grade book that is included with each teacher subscription. We are in the process of renaming this product to SmartMusic Gradebook™ to more clearly define the capability of the product. SmartMusic Gradebook is designed to manage student assignments, grades, and recordings while documenting the progress of each student and assessing student achievement. This provides music educators (and students) with exciting new possibilities to assist in developing strong music programs and complying with accountability requirements. SmartMusic provides access to an ever increasing library of band, jazz ensemble and orchestra literature. Each title includes individual part assignments authored by respected educators, thereby providing music teachers with a time-saving solution for preparing selections for the next public performance. SmartMusic Gradebook enables teachers to easily send assignments to each of their students. Students complete the assignment on their home computer provided that they have a SmartMusic subscription, or on a school computer equipped with

SmartMusic. Submitted assignments are automatically graded and posted in the teacher's SmartMusic Gradebook thereby providing teachers with the visible means for measuring student achievement.
During the third quarter of 2007, we implemented a direct sales initiative for SmartMusic. We hired salespeople to focus on school district sales activities and introduced site licenses offering discounts for volume purchases. As of December 31, 2008 we had executed 212 site licenses and as of December 31, 2007 we had executed 32 site licenses.
With the release of SmartMusic Gradebook in 2007, in addition to the total number of subscriptions, we began tracking teachers who use SmartMusic as well as the number of those teachers who are using the Gradebook to deliver and manage student assignments to fifty students or more (formerly known as Impact teachers, now Gradebook teachers). As of December 31, 2008, we reported 601 Gradebook teachers compared to 357 Gradebook teachers as of December 31, 2007.
The following table illustrates our quarterly SmartMusic metrics:

                                         Dec-07            Mar-08            Jun-08            Sep-08            Dec-08
Total Subscriptions                      86,901            92,776            95,632            98,119            106,584
Educator Accounts                         7,641             8,161             8,165             9,165              9,185
Educators who have issued
assignments*                                862             1,159             1,282               827              1,436
Gradebook Teachers*                         357               498               538               247                601
Site Licenses                                32                47                97               189                212

* Annual statistics that restart on July 1 of each year reflecting the start of the school-year cycle

The 20% growth rate in educator accounts experienced in 2008 has the potential for sizable growth in student subscriptions. However, this growth depends upon teachers increasing their utilization of SmartMusic Gradebook as the means to set up their classes, enroll students and issue frequent SmartMusic assignments. To date, there are not enough teachers that have actively utilized SmartMusic Gradebook to reflect a significant growth rate in subscriptions which has contributed to student subscriptions lagging behind our expectations.
The SmartMusic target business model is based on music educators integrating SmartMusic into their teaching and using the SmartMusic Gradebook to issue frequent assignments which results in an increase in student subscriptions. As stated above, 1,436, or 16%, of the teachers who have purchased SmartMusic have utilized SmartMusic Gradebook and those teachers have 76,711 students receiving SmartMusic assignments. The total student subscriptions associated with these Gradebook accounts are 40,684.
To accelerate the adoption of this target business model and address the lower than expected subscription rates in 2008, we intend to increase the focus of our direct sales force on existing SmartMusic teachers that have not yet utilized Impact in their curriculum, and have developed a training program to assist teachers in getting started with SmartMusic and SmartMusic Gradebook. In addition, our development efforts will be focused on improving and simplifying the SmartMusic purchase processes, Gradebook class set-up, student enrollment and SmartMusic assignments. The overall objective is to make these processes easy and intuitive for both teachers and students.
In the third quarter of 2008, we began tracking new versus renewed SmartMusic subscriptions. The following table illustrates the net new SmartMusic subscription data for the quarters ended September 30, 2008 and December 31, 2008:

                                                                                                                                                 Quarterly
                                  Beginning                New                 Renewed            Subscriptions          Quarter End              Net New
                                Subscriptions         Subscriptions         Subscriptions             Ended             Subscriptions          Subscriptions
3rd Quarter                           95,632                20,347                20,017                37,877                98,119                  2,487
4th Quarter                           98,119                17,907                17,942                27,384               106,584                  8,465

We define renewed subscriptions as those subscriptions that customers purchase within the two month period after their prior subscription ended. Because of changes to the start of school from year to year as well as fluctuations in the date that music teachers implement their curriculum, we commonly see subscribers that have a delay of up to two months in renewing their subscription. As a result, we believe that using the above definition of a renewal more accurately reflects the renewal rate for SmartMusic subscriptions. We intend to report SmartMusic subscription renewals on a quarterly basis.
We have achieved positive cash flow from operations for the last five years, including the current year ended December 31, 2008. With increased revenues and, in particular, the growth in SmartMusic subscriptions, plus improvements in operational efficiency over the last few years, we feel that we can continue to achieve positive operating cash flow on an annual basis in the future. Due to current economic conditions and concerns over school budgets, we are cautious regarding our ability to continue annual profitability. However, we have established contingency plans that will be implemented if certain revenue and cash flow objectives are not met which we believe will be adequate to maintain positive cash flow.
Critical Accounting Estimates
Our financial statements are prepared in conformity with U.S. generally accepted accounting principles. The preparation of these financial statements requires management to make significant estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. We believe that the following are some of the more critical judgment areas in the application of our accounting policies that currently affect our financial position and results of operations.
Allowance for doubtful accounts. Our distribution in domestic and international markets through independent dealers and distributors concentrates relatively large amounts of receivables in relatively few customer accounts; however, none are greater than 10% of the total revenue. Some international customers pay for the product prior to shipment; domestic dealers and distributors who do not prepay are granted payment terms and credit limits based on credit checks and account history. We have successfully done business with most of our dealers and distributors for many years. During fiscal year ended December 31, 2008, we had one distributor that ceased operations and closed its business resulting in a write-off of their uncollectible accounts receivable of $16,300. There were no significant uncollectible accounts in 2007. However, two customer accounts that had ceased operations and were reserved for in 2006 were written off during the fiscal year ended December 31, 2007causing a decrease in the allowance for doubtful accounts that year.
Any sales directly to home users are prepaid and schools submit purchase orders for purchases. MakeMusic records a monthly accrual for potential non-payments, which has historically been sufficient to cover uncollected accounts. Financial conditions in international markets and economic conditions can change quickly and our allowance for doubtful accounts cannot anticipate all potential changes.
Sales returns and allowance reserves. SmartMusic teacher subscriptions automatically renew at the end of their subscription period. Notices of renewal are sent to the teacher in advance and an invoice is sent upon the renewal date. A reserve is booked for those subscriptions that automatically renew and are subsequently cancelled due to teacher relocation, teacher cancellation, or non-payment of accounts. The reserve represents the revenue recognized on unpaid invoices for SmartMusic subscriptions which are more than 120 days overdue and which have had no activity in the preceding three months. The reserve is then evaluated quarterly to determine if any adjustments are necessary.
When a new version of Finale is released, dealers and distributors retain the right to return any unsold versions of the prior release (normally 10% of total prior year sales) in exchange for an equal number of units of the updated version of the product that is returned. The history of these returns is tracked and revenue is deferred based on the expected return rate until the new product is released, at which time the product may be returned for credit provided the customer places an equivalent (number of units) order for the new version.
Inventory valuation. Inventories are stated at the lower of cost or market, with cost being determined on a weighted average cost method. We record a provision to adjust slow-moving and obsolete

inventories to the lower of cost or market based on historical experience and current product demand. The carrying value of inventory is evaluated at least quarterly and adjusted as needed. Inventory is reviewed for obsolescence when the inventory is no longer used in products in their most current released version.
Stock based compensation. SFAS 123R requires us to measure and recognize in our Statements of Income the expense associated with all share-based payment awards made to employees and directors based on estimated fair values. We utilize the Black-Scholes option valuation model to measure the amount of compensation expense we recognize for each option award. There are several assumptions that we must make when using the Black-Scholes model such as the expected term of each option, the expected volatility of the stock price during the expected term of the option, the expected dividends payable and the risk free interest rate expected during the option term. Of these assumptions, the expected term of the options and expected volatility of our common stock are the most difficult to estimate since they are based on the exercise behavior of employees and the expected future performance of our stock. An increase in the volatility of our stock price or an increase in the average period before exercise will increase the amount of compensation expense related to awards granted after December 31, 2008.
Capitalized software costs. Costs incurred in the development of software products are capitalized in accordance with the FASB Statement 86 ("FAS 86"), Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed, which requires the capitalization of certain software development costs incurred after technological feasibility is established. Technological feasibility is established when the detailed program design and all planning and testing activities are completed. Capitalization of computer software costs shall cease when a product is available for general release to customers. We capitalize the costs of producing any new software product, which in 2008 included individual song titles to be included as repertoire with the SmartMusic product. The estimated economic life of SmartMusic Gradebook, whose capitalization and market introduction was completed in 2007, has been established as five years. This five-year amortization period is consistent with the initial licensing term for the large ensemble titles available in SmartMusic that have pre-authored assignments for use by teachers within SmartMusic Impact. Similarly, upon release of a large ensemble song title into SmartMusic, we amortize the related capitalized software costs over the estimated life of the song, not to exceed the five-year licensing period. A reserve is recorded for an estimate of song titles that will not be released. Annual development of notation products consists of maintenance costs that are expensed as incurred. We will continue to review our amortization period for capitalized software costs as considered necessary based upon any new information and information gained in our review of the net realizable value of unamortized costs.
Post contract support. We account for software maintenance in accordance with AICPA SOP 97-2, Software Revenue Recognition which states that revenue for post-contract support (PCS) may be recognized upon the initial sale when PCS is included with the initial license and the cost of providing PCS during the arrangement is insignificant. However, the estimated related costs are accrued in the same period that the sales price is recognized. We provide unlimited, free telephone, e-mail, and on-line technical support to our customers and, therefore, accrue an estimated cost of future support for our notation products in the period of sale.
Impairment of goodwill. We review goodwill for potential impairment at least annually or when events or changes in circumstances indicate the carrying value of goodwill may be impaired. We utilize an analysis of the public market value of our stock as a starting point in assessing whether the carrying value of goodwill is fully recoverable. The assessment of potential impairment requires certain judgments and estimates by us, including the determination of an event indicating impairment, the future cash flows to be generated by assets of the Company, the risks associated with those cash flows, and the discount rate to be utilized. If actual results are not consistent with our assumptions, we may be required to record a goodwill impairment charge.
Deferred tax assets. We have U.S. net operating loss carry-forwards of approximately $19.1 million, and tax credits of approximately $1,054,000. The losses and tax credits are carried forward for federal and state corporate income taxes and may be used to reduce future taxes. At December 31, 2008, we had net deferred tax assets totaling approximately $8.5 million. However, since we currently could not conclude that this net asset is more likely than not to be realized we have recorded a valuation allowance for its full amount.

Results of Operations
The following table summarizes key operating information for the years ended December 31, 2008 and 2007.

                                                 Year Ended December 31,
                                                                Increase
                                    2008         2007          (Decrease)           %
                                    (In $ thousands)         (In $ thousands)
       Notation revenue           $ 10,289     $ 10,980     ($            691 )      -6 %
       SmartMusic revenue            4,070        2,900                 1,170        40 %
       Other revenue                   797          700                    97        14 %

       Net revenue                  15,156       14,580                   576         4 %
       Cost of revenues              2,380        2,228                   152         7 %

       Gross profit                 12,776       12,352                   424         3 %
       Percentage of net sales          84 %         85 %

       Development                   4,633        4,278                   355         8 %
       Selling and marketing         4,318        4,045                   273         7 %
       General administrative        3,385        3,504                  (119 )      -3 %


       Total operating expenses     12,336       11,827                   509         4 %

       Operating income                440          525                   (85 )     -16 %
       Other income                     59          127                   (68 )     -54 %

       Net income before taxes    $    499     $    652     ($            153 )     -23 %
       Income tax expense               (8 )         (2 )                  (6 )     300 %

       Net income                 $    491     $    650     ($            159 )     -24 %

Year ended December 31, 2008 compared to the year ended December 31, 2007 Net revenue. Net revenue increased 4% from $14,580,000 in 2007 to $15,156,000 in 2008.
Notation revenue decreased $691,000 from $10,980,000 for the year ended December 31, 2007 to $10,289,000 for the year ended December 31, 2008. Notation revenue decreases are due to the decline in our channel sales due to economic conditions and the release cycle of our products. Notation revenue for the year ended December 31, 2007 included the release of Allegro 2007 as well as higher sales from the release of Finale Songwriter which was released late in 2006. New versions of Allegro and Songwriter have historically been released biannually.
SmartMusic revenue increased by $1,170,000 from $2,900,000 for the year ended December 31, 2007 to $4,070,000 for the year ended December 31, 2008. The increase in SmartMusic revenue reflects the continued growth of the SmartMusic product that was originally launched in 2001 and the SmartMusic Gradebook product that was released in 2007. We also introduced SmartMusic site licenses in September 2007 with the intent of encouraging school district deployments of SmartMusic student subscriptions. Additionally, in 2007, we established a direct sales force focused on district level sales. As of December 31, 2008, there were 212 site licenses for SmartMusic with average subscriptions per license of 116 and average potential total of 225 subscriptions per license.

SmartMusic is sold to schools, students and music organization members on a subscription basis. Revenue for these subscriptions is recognized over the life of the subscription which is typically 12 months. Total earned SmartMusic subscription revenue for the year ended December 31, 2008 was $3,104,000, an increase of $979,000, or 46%, over the year ended December 31, 2008. This increase is due to the increase in the total number of subscriptions as well as a price increase in July 2008 where teacher subscriptions increased from $100 to $130 and student subscriptions increased from $25 to $30. Total unearned SmartMusic subscription revenue (deferred revenue) was $2,230,000 as of December 31, 2008, an increase of $601,000, or 37%, over the balance at December 31, 2007. Deferred SmartMusic revenue represents the future revenue to be recorded on current subscriptions.
SmartMusic has shown sustained growth since its launch. As of December 31, 2008, 9,185 schools have purchased SmartMusic, an increase of 20% over the 7,641 schools that had purchased it as of December 31, 2007. Total SmartMusic subscriptions as of December 31, 2008 number 106,584, representing a net gain of 19,683, or 23%, over the December 31, 2007 subscription count of 86,901.
In April 2007, we launched SmartMusic Gradebook, a web-based service that is designed to manage student assignments, recordings and grades while documenting the progress of each student and assessing student achievement. With the release of SmartMusic Gradebook, we began tracking teachers that use SmartMusic as well as the number of those teachers who are using SmartMusic Gradebook to deliver and manage student assignments to 50 or more students (formerly Impact teachers). As of December 31, 2008, we had 601 SmartMusic Gradebook teachers with an average of 28 student subscriptions per teacher. This is an annual statistic, counting only teachers who have issued assignments to 50 or more students during a school fiscal year. Therefore, this is a gain of 601 SmartMusic Gradebook teachers during the second half of the year as the number of Gradebook teachers restarts at zero on July 1 of each year to correspond with the start of the school year. At December 31, 2007 we reported 357 Gradebook teachers with an average of 42 student subscriptions per teacher. We believe that not enough teachers have actively utilized SmartMusic Gradebook to reflect a significant growth rate in subscriptions as of December 31, 2008 and we continue to focus specific marketing activities on SmartMusic and SmartMusic Gradebook, including development and market introduction of training materials to facilitate teachers and students getting started with our products. Additionally we intend to increase the focus of our direct sales force on existing SmartMusic teachers that have not yet utilized the SmartMusic Gradebook in their curriculum and anticipate continued growth in the number of new subscriptions in the future.
Many SmartMusic customers, especially new customers, also purchase accessories (primarily microphones and foot pedals) that are used with the software. Revenue for the sales of accessories, included in the SmartMusic revenue category, for the year ended December 31, 2008, was $955,000, which was $183,000, or 24%, greater than revenue of $772,000 for SmartMusic accessories in the year ended December 31, 2007. Accessory revenue represented 6% of total gross revenue and 23% of SmartMusic revenue in 2008. The increase in accessory revenue in 2008 is due to the increase in SmartMusic subscribers. Additionally, we increased the standard price of microphones from $15.00 to $19.95 in January 2008. Because we expect continuing growth in the number of new SmartMusic subscriptions, we also anticipate increases in the amount of revenue we receive from the sales of accessories.
Gross profit. Gross profit increased by $424,000 from $12,352,000 for the year ended December 31, 2007, to $12,776,000 for the year ended December 31, 2008, due to the increase in revenue. Gross margin percentages decreased 1% primarily due to increased repertoire development amortization costs as a result of our increased number of large ensemble titles and amortization on SmartMusic Gradebook development costs which began in April 2007. Cost of revenue includes product costs, royalties paid to publishers, amortization of capitalized notation, repertoire and SmartMusic Gradebook software development costs, shipping, and credit card fees. Gross margin as a percentage of revenue was approximately 84% and 85% for the periods ended December 31, 2008 and 2007, respectively.
Development expense. Development expenses increased $355,000 from $4,278,000 in 2007 to $4,633,000 in 2008. Development expenses consist primarily of internal payroll, payments to independent contractors, and related expenses for the development of our Finale notation, SmartMusic, and SmartMusic Gradebook products, as well as SmartMusic repertoire development, business systems, and quality assurance.

Personnel and contract labor costs increased from the prior year due to staff increases in order to achieve numerous product development goals related to simplification of the SmartMusic enrollment and purchase processes. Additionally, our business systems expenses increased due to the June 2008 . . .