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

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

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

MakeMusic develops and markets two product lines, SmartMusic® learning software for band, jazz ensemble, orchestra and voice, and Finale® music notation software. We believe these innovative products reinforce each other's features and competitiveness and will allow us to continue to achieve positive annual operating results. The well-established Finale family of music notation software products provides a solid base business that generates cash and has a large customer database. Music notation software is a niche business since only a small percentage of musicians ever notate music.
The first nine months of 2009 resulted in continued sales growth for SmartMusic and comparable sales for notation products. Overall, we achieved a 6% increase in net revenue over the first nine months of 2008. Gross margin percentages were unchanged at 85% in each of the first nine months of 2009 and 2008. Operating expenses increased 3% in the first nine months of 2009, primarily due to increased business systems expenses as a result of increased staffing and expansion of our systems infrastructure to support our anticipated SmartMusic growth and sales tax expense which had not been collected from our customers in certain states. As a result of the factors mentioned, net income in the first nine months of 2009 was $343,000, compared to net income of $11,000 for the same period last year.
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 engaging, causing students to practice longer and more often. SmartMusic provides access to an ever-increasing library of band, jazz ensemble and orchestra literature. Each title includes individual part assignments authored by respected educators, thereby providing music teachers with a time-saving solution for preparing selections for their next performance. SmartMusic also offers a rich variety of effective practice tools that make practice time more efficient and productive. The combination of making practice time more engaging and productive leads to rapid student skill-development, increased student confidence, higher student retention and stronger music programs.
In April 2007, we introduced SmartMusic Impact®, a web-based grade book that is included with each teacher subscription. We have renamed this feature 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 Gradebook enables teachers to easily send assignments to each of their students. Students complete the assignment on their home computer provided that they have a SmartMusic subscription, or on a school computer equipped with SmartMusic. Submitted assignments are automatically graded

and posted in the teacher's SmartMusic Gradebook thereby providing teachers with the visible means for measuring student achievement.
Our sales organization focuses on direct school district sales activities and site licenses are sold which provide discounts for volume purchases. In June 2009, we slightly modified the definition of our SmartMusic site licenses. In order to continue to qualify for the volume purchase discount, a purchasing entity must have purchased 100 or more subscriptions upon the one-year anniversary of the site license agreement date. If the entity did not achieve the 100 subscription level, it no longer qualifies for the discount and we do not include the site license in our reported totals. The effect of these changes is a slight reduction, but more accurate count of the monthly total site license numbers. The updated SmartMusic monthly site license totals are shown in the SmartMusic metrics table below.
In addition to tracking the total number of subscriptions, we track the number of teachers who use SmartMusic Gradebook and the number of those teachers who are using SmartMusic Gradebook to deliver and manage student assignments to fifty students or more (formerly known as "Impact teachers," now "Gradebook teachers"). As of September 30, 2009, we reported 453 Gradebook teachers compared to 247 Gradebook teachers as of September 30, 2008.
The following table illustrates our quarterly SmartMusic metrics:

                                      Sep-08          Dec-08           Mar-09           Jun-09           Sep-09
Total Subscriptions                    98,119          106,584          110,318          111,059          122,577
Educator Accounts                       9,165            9,185            9,091            8,616            9,003
Educators who have issued
assignments*                              827            1,436            1,874            1,994            1,178
Gradebook Teachers *                      247              601              829              874              453
Site Licenses                             178              203              208              203              236
Site License Educator
Subscriptions                           1,145            1,341            1,461            1,417            1,762

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

Educator accounts have been relatively consistent over the last twelve month period. The SmartMusic target business model is to have music educators increase their use of SmartMusic Gradebook to set up their classes, enroll students and issue assignments, which we believe would result in an increase in student subscriptions. As stated above, 1,178, or 13%, of the teachers who have purchased SmartMusic have utilized SmartMusic Gradebook, and those teachers have 55,772 students receiving SmartMusic assignments. The total student subscriptions associated with these Gradebook accounts are 59,211, an average of 39.6 per Gradebook account. This compares to total student subscriptions associated with Gradebook accounts of 46,363 and an average of 23.3 per Gradebook account as of June 30, 2009.
We are focusing on high-level strategic sales and marketing initiatives to provide enhanced SmartMusic subscriptions sales momentum. During the third quarter of 2009, we partnered with web marketing consultants to expand our social media and general web presence and in September 2009, we hired a Senior Vice President of Marketing to enhance our marketing efforts.
To accelerate the adoption of this target business model and address the lower-than-expected subscription rates in 2008, in the first quarter of 2009 we hired a sales director and increased the focus of our direct sales force on existing SmartMusic teachers that have not yet utilized Gradebook in their curriculum. In addition, our development efforts are 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. These product enhancements were included in SmartMusic 2010, which was released on July 28, 2009.
During the third quarter of 2009 we engaged a third-party user interface design firm to assist in making the SmartMusic and Gradebook experience more intuitive, engaging, rewarding and social. We believe this will result in faster growth of new subscribers and improved retention rates and the enhancements will be included in our next product release. Additionally, we anticipate releasing new titles into our SmartMusic repertoire that will be focused on student fun and making practice more enjoyable

During the second quarter of 2009, we completed research that identified the universe of schools matching the ideal SmartMusic profile. The profile was determined by evaluating our existing customer base and determining the demographic profile of the schools that have fully adopted SmartMusic in their music programs. The total number of schools which matched the profile was approximately 17,000 (representing 31% of schools with instrumental music programs). To allow for targeted marketing and sales efforts to these profile schools, we have integrated this data into our Customer Relationship Management system (CRM) and are utilizing information associated with the current federal stimulus program in our marketing and sales initiatives.
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, December 31, 2008, March 31, 2009, June 30, 2009 and September 30, 2009:

                                                                                                      Quarterly
Quarter End      Beginning           New            Renewed       Subscriptions     Quarter End        Net New
    Date       Subscriptions    Subscriptions    Subscriptions        Ended        Subscriptions    Subscriptions
 9/30/2008           95,632           20,347           20,017           37,877           98,119            2,487
12/31/2008           98,119           17,907           17,942           27,384          106,584            8,465
 3/31/2009          106,584           10,609           12,241           19,116          110,318            3,734
 6/30/2009          110,318            5,256           11,350           15,865          111,059              741
 9/30/2009          111,059           24,456           29,585           42,523          122,577           11,518

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 have achieved positive cash flow from operations for the last five years, including the most recent year ended December 31, 2008. Our quarterly results will fluctuate as a result of the cyclicality of the education market. Due to current economic conditions and concerns over school budgets, we are cautious regarding our ability to continue annual profitability. However, with increased revenues and, in particular, the growth in SmartMusic subscriptions, plus improvements in operational efficiency over the last few years and the establishment of contingency plans to be implemented if our revenue and cash flow objectives are not met, we feel that we can continue to achieve positive operating cash flow for the next twelve months.
In 2009, we began reporting results of operations by two unique reportable segments, Notation and SmartMusic. Historically, net revenue has been reported separately for these two product lines. However, direct and operating costs had not been previously assessed or reported by segment. Therefore, prior year comparative costs are not available and operating costs by segment are not discussed in this Management's Discussion and Analysis of Financial Condition and Results of Operations. For further information on segment reporting, refer to Note 6 to the financial statements appearing in Part I, Item 1 of this report.
Critical Accounting Policies
In our Form 10-K filed with the Securities and Exchange Commission for the year ended December 31, 2008, we identified critical accounting policies and estimates for our business. There have been no material changes to our application of critical accounting policies and estimates since December 31, 2008, except that we restated our critical accounting policy regarding impairment of goodwill in our Form 10-Q filed with the Securities and Exchange Commission for the quarter ended June 30, 2009. We are incorporating herein by reference our previous disclosures from our 2008 Form 10-K, as updated by our June 30, 2009 Form 10-Q.

                                        3 Months Ended September 30,                                                9 Months Ended September 30,
                                 2009              2008           Incr (Decr)           %              2009                 2008                  Incr (Decr)           %
                                                                                         ($ in thousands)
Notation revenue              $    2,687        $    3,361       $        (674 )          -20 %      $  7,507       $              7,542         $         (35 )           0 %
SmartMusic revenue                 1,385             1,133                 252             22 %         3,592                      2,874                   718            25 %
Other revenue                        274               271                   3              1 %           562                        572                   (10 )          -2 %

Net revenue                        4,346             4,765                (419 )           -9 %        11,661                     10,988                   673             6 %
Cost of revenues                     729               726                   3              0 %         1,760                      1,675                    85             5 %

Gross profit                       3,617             4,039                (422 )          -10 %         9,901                      9,313                   588             6 %
Percentage of net revenue             83 %              85 %                                               85 %                       85 %

Development expense                1,220             1,182                  38              3 %         3,728                      3,466                   262             8 %
Selling and marketing              1,024             1,225                (201 )          -16 %         3,174                      3,365                  (191 )          -6 %
General administrative               814               675                 139             21 %         2,706                      2,515                   191             8 %


Total operating expense            3,058             3,082                 (24 )           -1 %         9,608                      9,346                   262             3 %

Operating income (loss)              559               957                (398 )          -42 %           293                        (33 )                 326           988 %
Other income                          23                14                   9             64 %            55                         50                     5            10 %

Net income before taxes       $      582        $      971       $        (389 )          -40 %      $    348       $                 17         $         331          1947 %
Income tax provision                  (3 )               0                  (3 )            0 %            (5 )                       (6 )                   1            17 %

Net income                    $      579        $      971       $        (392 )          -40 %      $    343       $                 11         $         332          3018 %

Comparison of the three- and nine-month periods ended September 30, 2009 to the three- and nine-month periods ended September 30, 2008 Net revenue. Net revenue decreased 9%, from $4,765,000 to $4,346,000, when comparing the three months ended September 30, 2009 and 2008 and increased 6%, from $10,988,000 to $11,661,000, when comparing the nine months ended September 30, 2009 and 2008. Revenue decreases in the third quarter are due to the earlier release of the Finale 2010 upgrade in June 2009 partially offset by continued sales growth in SmartMusic. In 2008 and prior years, the Finale upgrade had been released in the third fiscal quarter. We anticipate future Finale upgrade releases will occur during the second fiscal quarter. Revenue increases during the nine months ended September 30, 2009 are attributable to the SmartMusic sales growth.
Notation revenue decreased by $674,000, to $2,687,000, when comparing the three-month periods ended September 30, 2009 and 2008 and decreased by $35,000 when comparing the nine-month periods ending September 30, 2009 and 2008. Revenue decreased in the three-month period ended September 30, 2009 due to the early release of Finale 2010. Notation revenue has been generally comparable from 2008 due to stronger direct sales offset by reductions in our channel sales due to economic conditions. In addition, the first nine months of 2008 included revenue from a $133,000 Finale site license, whereas there was no comparable sale in 2009. This decline in revenue from reduced channel sales was offset by sales of Finale NotePad®, which we began charging for in October 2008.
SmartMusic revenue increased by $252,000, to $1,385,000, when comparing the three-month periods ended September 30, 2009 and 2008 and increased by $718,000, to $3,592,000, when comparing the nine-month periods ended September 30, 2009 and 2008. The increase in revenue reflects the continued growth of the SmartMusic product that was originally launched in 2001 and the SmartMusic Gradebook product that was released in 2007. It also reflects the success of our SmartMusic site license program which encourages school district deployment of SmartMusic student subscriptions and our direct sales force which focuses on district level sales. As of September 30, 2009, there were 236 site licenses for SmartMusic with average subscriptions per license of 155.
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 subscription revenue was $988,000 for the three months ended September 30, 2009, a 29% increase over

subscription revenue of $766,000 during the same period in 2008. Subscription revenue was $2,840,000 for the nine months ended September 30, 2009, a 28% increase over subscription revenue of $2,216,000 during the same period in 2008. These increases are due to increases 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 $2,476,000 as of September 30, 2009, an increase of $510,000, or 26%, over the balance at September 30, 2008. Deferred SmartMusic revenue represents the future revenue to be recorded on current subscriptions.
SmartMusic has shown sustained growth since its launch. At September 30, 2009, 9,003 educators have purchased SmartMusic, a decrease of 2% over the 9,165 educators that had purchased it as of September 30, 2008. Total SmartMusic subscriptions as of September 30, 2009 number 122,577, representing a net gain of 24,458, or 25%, over the September 30, 2008 subscription count of 98,119. During the three- and nine-month periods ended September 30, 2009, total subscriptions increased 11,518 and 15,993, respectively, compared to an increase of 2,487 and 11,218, respectively, of total subscriptions during the three- and nine-month periods ended September 30, 2008.
SmartMusic Gradebook is a web-based service that is designed to manage student assignments, recordings and grades while documenting the progress of each student and assessing student achievement. We track the number of teachers who use SmartMusic Gradebook and the number of those teachers who are using SmartMusic Gradebook to deliver and manage student assignments to 50 or more students (formerly known as "Impact teachers," now "Gradebook teachers"). As of September 30, 2009, we had 453 Gradebook teachers with an average of 54 student subscriptions per teacher, compared to 247 Gradebook teachers with an average of 46 student subscriptions per teacher as of September 30, 2008. This is an annual statistic, counting only teachers who have issued assignments to 50 or more students during a school fiscal year. The number of Gradebook teachers restarts at zero on July 1 of each year to correspond with the start of the school year. Therefore, we have gained 453 SmartMusic Gradebook teachers to date during the 2009/2010 school year.
Many SmartMusic customers, especially new customers, also purchase accessories (primarily microphones and foot pedals) that are used with the software. Revenue for the sales of accessories, included in the SmartMusic revenue category, for the three months ended September 30, 2009 was $371,000, which was $15,000, or 4%, more than revenue of $356,000 for SmartMusic accessories in the three months ended September 30, 2008. Sales of accessories for the nine months ended September 30, 2009 were $645,000, which was comparable to revenue of $647,000 for SmartMusic accessories in the nine months ended September 30, 2008.
Gross profit. Gross profit in the three-month period ended September 30, 2009 decreased by $422,000, to $3,617,000, compared to the three-month period ended September 30, 2008. The decrease in gross profit for the three months ended September 30, 2009 is primarily a result of the decrease in net revenue due to the shift in timing of the Finale upgrade release from the third quarter to the second quarter. Gross margin as a percentage of sales was comparable at 83% and 85%, respectively, for the three months ended September 30, 2009 and 2008.
Gross profit in the nine-month period ended September 30, 2009 increased by $588,000, to $9,901,000, compared to the nine-month period ended September 30, 2008. The increase in gross profit for the nine months ended September 30, 2009 is a result of the increase in revenues due to increased SmartMusic subscriptions. Gross margin as a percentage of sales was 85% for each of the nine-month periods ended September 30, 2009 and 2008. Repertoire development amortization as a percentage of SmartMusic revenue was comparable at 11% for each of the nine-month periods ended September 30, 2009 and 2008. We expect amortization related to repertoire development to increase due to the addition of repertoire to SmartMusic in the second half of the year, including the addition of over 300 new large ensemble titles that were included with the release of SmartMusic 2010 on July 28, 2009. Large ensemble titles included in SmartMusic are amortized over a five-year period.
Development expense. Development expenses increased 3%, to $1,220,000 from $1,182,000, when comparing the three months ended September 30, 2009 and 2008 and increased 8%, to $3,728,000 from $3,466,000, when comparing the nine months ended September 30, 2009 and 2008. Development expenses consist primarily of internal payroll, payments to independent contractors and related expenses for the development and maintenance of our Finale notation, SmartMusic and SmartMusic Gradebook products as well as non-capitalized SmartMusic repertoire development, business systems and quality assurance. Personnel and contract labor costs increased from the first nine months of 2009 compared to the same period in 2008 due to staff increases that management believes were necessary in order to achieve numerous product development goals related to the simplification of SmartMusic user interface, enrollment and purchase processes. Additionally, in June 2008 we completed a server co-location

project and expansion of our infrastructure to support our anticipated SmartMusic growth. We anticipate increased development costs in 2009 due to the annualized impact of headcount additions in 2008 and early 2009, engaging a user interface design firm to make the SmartMusic and Gradebook experience more intuitive, engaging, rewarding and social and ongoing expenses related to our infrastructure expansion.
Selling and marketing expense. Selling and marketing expenses primarily consist of marketing, advertising and promotion expenses, business development and customer service activities and payroll. Sales and marketing expenses decreased 16%, to $1,024,000 from $1,225,000, when comparing the three months ended September 30, 2009 and 2008 and decreased 6%, to $3,174,000 from $3,365,000, when comparing the nine months ended September 30, 2009 and 2008, respectively. The decrease in expenses is primarily due to less spending on direct mail marketing costs and tradeshow activities offset by costs relating to the departure of our Chief Marketing Officer in the second quarter of 2009 and hiring of our Education Sales Director. We are focusing on a higher level of strategic marketing initiatives to ensure continued SmartMusic subscriptions sales momentum. We have partnered with web marketing consultants to expand our social media and general web presence and in the third quarter of 2009, we hired a Senior Vice President of Marketing.
General and administrative expense. General and administrative expenses consist primarily of payroll and related expenses for executive and administrative personnel, professional services, facility costs, amortization of certain intangible assets with finite lives, bad debt and other general corporate expenses. General and administrative expenses increased 21% to $814,000 during the three months ended September 30, 2009, compared to $675,000 for the same period of 2008, and increased 8% to $2,706,000 during the nine months ended September 30, 2009, compared to $2,515,000 for the same period of 2008. General and administrative costs increased primarily as a result of sales tax expense and standard annual increases in health insurance premiums, partially offset by decreases in payroll and personnel expenses. Sales tax expense of $254,000 relates to prior years' tax that had not been collected from our customers in certain states. Management is currently evaluating sales tax exposure in other states and the amount of this is not yet estimable.
Operating income. Income from operations decreased to $559,000 for the three months ended September 30, 2009 compared to income from operations of $957,000 for the three months ended September 30, 2008. Income from operations for the . . .