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, notation and SmartMusic, that reinforce each other's features and competitiveness. The notation product line includes the well-established Finale® family of music notation software products which are utilized by music colleges and composers around the world in the creation of music scores. Finale serves a large and stable customer base, and generates revenue through sales of new version releases. Also included in the notation product line is MusicXMLTM, the industry standard open format for notation software and Garritan TM sound sample libraries.

SmartMusic® is a subscription-based product directed toward the very large and constantly renewing market of music students and music teachers. SmartMusic combines a software application with a library of thousands of music titles and skill-development exercises. It provides students and musicians with a compelling practice or audition experience and music teachers with the efficiency and effectiveness to reach more students and assess student achievement and growth.

In the fourth quarter of 2011, we announced the acquisition of select assets of Recordare, LLC and the acquisition of Garritan Corporation. We believe these acquisitions provide new products, technology, brands and employees that are complementary to MakeMusic and provide growth and technology opportunities for the future.

Our first quarter of 2012 resulted in a growth in sales for MakeMusic. Overall, net revenue increased 5% compared to the first quarter of 2011. SmartMusic revenue grew 16% due to our year over year subscription growth from 164,836 to 183,331. Notation revenue decreased 3% due to reductions in our sales to distribution partners. We attribute these decreases primarily to the timing of our transition to a new distributor in Japan and lower sales to our distributor in Germany. In addition, sales of Finale NotePad were lower compared to the first quarter of 2011 because we began offering the product as a free download effective with the release of Finale NotePad 2012 on February 15, 2012. The decreases in revenue were partially offset by the added sales of Garritan sound libraries resulting from the acquisition of Garritan Corporation. Gross margin percentages were comparable at 84% in 2012 and 85% in 2011.

Operating expenses increased in the first quarter of 2012, due to increased selling and marketing expenses as a result of the planned expansion of our direct sales force and company-wide strategic sales and marketing initiatives. General and administrative expenses increased primarily due to increased legal and consulting fees relating to the Tax Asset Protection Plan effective February 21, 2012 and increased accounting fees for reporting requirements relating to the December 30, 2011 acquisition and dissolution of Garritan Corporation. Development expenses were greater in the first quarter of 2012 primarily due to personnel costs resulting from the Chief Technology Officer position, which was open in the first of quarter of 2011, and added personnel and development costs to support technology initiatives and the addition of the Garritan sound libraries and MusicXML technologies. In the first quarter of 2011, we incurred expenses of $225,000 relating to a patent infringement settlement. There were no comparable expenses in the first quarter of 2012.

Our net loss before taxes in the first quarter of 2012 was $1,267,000 compared to $354,000 in 2011. The tax benefit in the first quarter of 2012 was $427,000 compared to $174,000 in the first quarter of 2011. As a result of the factors mentioned, we reported net loss of $840,000 in the first quarter of 2012 compared to net loss of $180,000 in the first quarter of 2011.

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

Teachers use the SmartMusic Gradebook™ capability of the educator's subscription to issue assignments to students, receive completed assignments from students, assess student achievement, and manage student records. Music teachers are challenged to reach all of their students in the way they passionately desire. The SmartMusic technology allows teachers to be more efficient and effective, allowing them to affect more of their students in ways they never imagined. SmartMusic also addresses the increasing desire and need of administrators to document the assessment of student's achievement. Assessment standards have become topics of intense interest at the level of state education administrators and MakeMusic is becoming recognized as providing the technology that allows them to accomplish their goals. Students also find that SmartMusic is a more satisfying and helpful way to practice and learn to sing or play a musical instrument. SmartMusic allows practice to be more engaging and rewarding, which results in the acceleration of students' growth and achievement.

SmartMusic 2012 introduced new vocal and site-reading technology and included site-singing exercises which can be assessed for both pitch and rhythm. Choral directors and general music teachers now have access to the same award-winning interactive technology that has been available to band and orchestra directors.

In July of 2011, we released a mobile application called SmartMusic InboxTM. SmartMusic Inbox is a free application for both Android and iOS platforms for mobile use by SmartMusic teachers that enables them to listen and grade assignments with ease and mobility.

We believe that our technological investments in SmartMusic have created a digital pipeline between our growing subscriber base of more than 183,000 and the music publishers who provide SmartMusic content. This growing platform is a strategic asset for MakeMusic. The following table illustrates our quarterly SmartMusic metrics:

                                             Mar-11        Jun-11        Sep-11        Dec-11        Mar-12
Total Subscriptions                           164,836       173,295       176,352       178,609       183,331
Subscriptions purchased during quarter         25,246        24,487        74,550        51,003        24,738
Educator Accounts                               9,727         9,633         9,744        10,544        11,326

Our educational sales organization focuses on direct school district sales, aiming at the 17,000 schools who match our ideal demographic profile. We increased the size of our educational sales force from 7 to 13 in 2011 to strengthen our strategic sales initiatives. During the first quarter of 2012, we hired a sales executive to lead our sales and business development initiatives.

The following table illustrates the total net new SmartMusic educator subscriptions for each quarter during the year ended December 31, 2011 and the quarter ended March 31, 2012:

                                                                                                          Quarterly
Quarter End     Beginning          New           Renewed      Renewal   Subscriptions    Quarter End       Net New
   Date       Subscriptions   Subscriptions   Subscriptions    Rate         Ended       Subscriptions   Subscriptions
 3/31/2011       12,360            741            2,026         77%         2,618          12,509            149
 6/30/2011       12,509            742            2,232         86%         2,591          12,892            383
 9/30/2011       12,892           1,420           3,957         80%         4,972          13,297            405
12/31/2011       13,297            894            2,616         79%         3,327          13,480            183
 3/31/2012       13,480            878            2,067         76%         2,726          13,699            219

We define renewed subscriptions as those subscriptions that educators purchase within the two-month period after their prior subscription ended. Because of changes to the start of school from year to year, fluctuations in the date that music teachers implement their curriculum, and promotional programs that encourage early renewals, the majority of subscribers renew their subscriptions within approximately a two-month window of the anniversary date of their previous subscription rather than exactly on the anniversary date. As a result, we believe that using the above definition of a renewal more accurately reflects the renewal rate for SmartMusic educator subscriptions. In the first quarter of 2012, the educator renewal rate was generally comparable with prior quarters. The educator renewal rate for the first quarter of 2012 was 76% compared to 79% in the fourth quarter of 2011. The educator renewal rate in the first quarter of 2012 decreased slightly compared to the first quarter of 2011 rate of 77%.

In 2012, we are focused on four strategic initiatives that include enhancing our technology architecture, extending our core product value into new product innovations and platforms, developing new and leveraging existing distribution channels and strengthening our marketing strategy focusing on our brand promise.

We have achieved positive cash flow from operations for the last seven years, including the most recent year ended December 31, 2011. Our quarterly results will fluctuate as a result of the seasonality of the education market and timing of our Finale release cycle. Due to current economic conditions, concerns over school budgets and our planned strategic investments, we are cautious regarding our future financial projections. We expect increased revenues and, in particular, growth in SmartMusic subscriptions and sound library sales from the acquisition of Garritan Corporation. However, we are making investments in our operations and technology which we expect will result in reduction in cash balances during 2012.

In our Form 10-K filed with the Securities and Exchange Commission for the year ended December 31, 2011, we identified critical accounting policies and estimates for our business that we are incorporating herein by reference.

                             Results of Operations

Comparison of the three-month period ended March 31, 2012 to the three-month
period ended March 31, 2011



          Net Revenue ($ in thousands)
                                                 3 Months Ended March 31,
                                                                  Incr
                                          2012        2011       (Decr)        %
          Notation                       $ 2,271     $ 2,334     ($   63 )      -3 %
          SmartMusic                       1,930       1,660         270        16 %

          Total                          $ 4,201     $ 3,994     $   207         5 %

Net revenue for the three months ended March 31, 2012 increased compared to net revenue for the three months ended March 31, 2011.

Notation revenue decreased by $63,000 to $2,271,000 when comparing the three-month periods ended March 31, 2012 and 2011. Decreases during the quarter were due to reductions in our channel sales with the largest decline by our distributor in Japan. Additionally, sales of Finale NotePad were lower compared to the first quarter of 2011 because we began offering the product as a free download effective with the release of Finale NotePad 2012 on February 15, 2012. The decreases in revenue were offset by $212,000 of added sales of Garritan sound libraries due to the acquisition of Garritan Corporation.

SmartMusic revenue for the quarter ended March 31, 2012, was $1,930,000, an increase of $270,000, or 16%, over the quarter ended March 31, 2011. The increase in revenue is due to the growth of total SmartMusic subscriptions and an increase in accessory revenue. SmartMusic subscriptions have increased due in part to our direct sales force which focuses on district level sales. Revenue for these subscriptions is recognized over the life of the subscription which is typically 12 months. Total earned SmartMusic subscription revenue for the three-month period ended March 31, 2012 was $1,707,000, an increase of $277,000, or 19%, over the three-month period ended March 31, 2011. This increase was due to the increase in the total number of subscriptions. Total unearned SmartMusic subscription revenue (deferred revenue) was $3,791,000 as of March 31, 2012, an increase of $535,000, or 16%, over the balance at March 31, 2011 and a decrease of $494,000, or 12%, compared to the balance of $4,285,000 at December 31, 2011. Deferred SmartMusic revenue represents the future revenue to be recorded on current subscriptions and fluctuates based on new subscription sales, the total number of subscriptions and the remaining life of those subscriptions.

SmartMusic has shown sustained growth since its launch. More than 11,326 educators have purchased SmartMusic, an increase of 16% over the 9,727 educators that had purchased it as of March 31, 2011. Total SmartMusic subscriptions as of March 31, 2012 number 183,331, representing a net gain of 18,495, or 11%, over the March 31, 2011 subscription count of 164,836.

Many SmartMusic customers, especially new customers, also purchase accessories (primarily microphones) that are used with the software. Revenue for the sales of accessories, included in the SmartMusic revenue category, for the quarter ended March 31, 2012 was $173,000, which was an increase of $16,000, or 10%, from the revenue of $157,000 for SmartMusic accessories in the quarter ended March 31, 2011. This increase is primarily due to an increase in the number of net new subscriptions added during the quarter ended March 31, 2012 as compared to the number of net new subscriptions added during the same period of the prior year.

Gross Profit ($ in thousands)

                                          3 Months Ended March 31,
                                                           Incr
                                   2012        2011       (Decr)        %
                 Notation        $  2,078     $ 2,186     ($  108 )      -5 %
                 SmartMusic         1,452       1,214         238        20 %

                 Total           $  3,530     $ 3,400     $   130         4 %

Gross profit in the quarter ended March 31, 2012 increased by $130,000, to $3,530,000, compared to the quarter ended March 31, 2011. Gross profit for notation decreased for the three months ended March 31, 2012 due to the decrease in notation revenue. The increase in SmartMusic gross profit for the three months ended March 31, 2012 is a result of the increase in SmartMusic revenue and slightly improved accessory margins.

Cost of revenue includes product costs, royalties paid to publishers, amortization of capitalized software development costs for repertoire, software development costs related to the Garritan sound libraries and SmartMusic Gradebook, shipping, and credit card fees. Capitalized SmartMusic repertoire added into SmartMusic is amortized over a five-year period and repertoire development amortization as a percentage of SmartMusic revenue was 11% in the first quarter of 2012 and 12% in the first quarter of 2011. Gross margin as a percentage of sales was 84% for the three months ended March 31, 2012 and 85% for the three months ended March 31, 2011.

Development expense ($ in thousands)

                                          3 Months Ended March 31,
                                    2012         2011       Incr       %
                  Notation        $     804     $   517     $ 287       56 %
                  SmartMusic            548         426       122       29 %
                  Other                 304         272        32       12 %

                  Total           $   1,656     $ 1,215     $ 441       36 %

Development expenses increased 36% to $1,656,000, from $1,215,000, when comparing the three months ended March 31, 2012 and 2011. Development expenses consist primarily of internal payroll, payments to independent contractors and related expenses for the development and maintenance of our Finale notation, Garritan sound libraries, MusicXML, SmartMusic and SmartMusic Gradebook products as well as non-capitalized SmartMusic repertoire development, business systems and quality assurance. Notation development expenses increased due to personnel costs relating to the Chief Technology Officer position, which was open in the first quarter of 2011, and added personnel and contractor costs to support technology initiatives and the Garritan sound libraries and MusicXML technologies. SmartMusic development expenses increased primarily due to personnel costs relating to the Chief Technology Officer position. During the quarter ended March 31, 2012, 144 new SmartMusic large ensemble band, jazz ensemble, and orchestra titles with pre-authored assignments were released, compared to 76 new titles in the quarter ended March 31, 2011. A total of 3,031 large ensemble titles are available in SmartMusic as of March 31, 2012.

Selling and marketing expense ($ in thousands)

                                           3 Months Ended March 31,
                                    2012            2011       Incr       %
                Notation         $      619       $    386     $ 233       60 %
                SmartMusic              738            614       124       20 %
                Other                   326            233        93       40 %

                Total            $    1,683       $  1,233     $ 450       36 %

Selling and marketing expenses primarily consist of marketing, advertising and promotion expenses, business development and customer service activities and payroll. Sales and marketing expenses increased 36% to $1,683,000 in the quarter ended March 31, 2012 compared to $1,233,000 for the quarter ended March 31, 2011. Notation selling and marketing expenses increased primarily due to company-wide strategic marketing initiatives. SmartMusic selling and marketing expenses increased due to increased personnel relating to our direct sales organization and strategic sales and marketing initiatives for SmartMusic. Other selling expenses increased primarily due to website, branding and social media investments.

                                           3 Months Ended March 31,
                                                               Incr
                                 2012             2011        (Decr)         %
            Notation          $       15       $       19     ($    4 )      -21 %
            SmartMusic                15               19          (4 )      -21 %
            Other                  1,453            1,070         383         36 %

            Total             $    1,483       $    1,108     $   375         34 %

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 by 34% to $1,483,000 during the first quarter of 2012 compared to $1,108,000 for the same period of 2011. Other general and administrative costs increased primarily due to legal and consulting fees relating to the Tax Asset Protection Plan that was effective February 21, 2012 and accounting fees for reporting requirements relating to the December 30, 2011 acquisition and dissolution of Garritan Corporation.

Patent litigation accrual

Patent litigation costs of $225,000 were accrued and included in operating expenses during the quarter ended March 31, 2011. There were no comparable expenses in the first quarter of 2012.

Income from operations ($ in thousands)

                                         3 Months Ended March 31,
                                                            Incr
                               2012           2011         (Decr)         %
                Notation     $     640      $   1,264      ($  624 )      -49 %
                SmartMusic         151            155           (4 )       -3 %
                Other           (2,083 )       (1,800 )       (283 )       16 %

                Total        ($  1,292 )    ($    381 )    ($  911 )      239 %

Net loss from operations was $1,292,000 for the three months ended March 31, 2012 compared to $381,000 in the three months ended March 31, 2011.

The notation segment results for the first quarter of 2012 reflect a decrease in income from operations due to lower net revenue and increased development and selling and marketing expenses. Overall, SmartMusic income from operations was comparable. SmartMusic revenue increases due to the increased number of subscriptions were offset by the increased development and selling and marketing expenses. The increase in the other loss is due to increased legal and consulting fees relating to the Tax Asset Protection Plan effective February 21, 2012 and accounting fees for reporting requirements relating to the December 30, 2011 acquisition and dissolution of Garritan Corporation.

Net Loss

Net loss in the first quarter of 2012 was $840,000, or $0.17 per basic and diluted share, compared to net loss of $180,000, or $0.04 per basic and diluted share, in the first quarter of 2011. The increase in net loss in the first quarter of 2012 is primarily due to increased operating expenses as explained above. The tax benefit in the first quarter of 2012 was $427,000, compared to a tax benefit of $174,000 in the first quarter of 2011. The increased tax benefit is attributed to the greater loss from operations.

Liquidity and capital resources

Net cash used by operating activities was $1,083,000 for the quarter ended March 31, 2012, compared to $943,000 of cash used by operating activities in the quarter ended March 31, 2011. The increase in cash used in the first quarter of 2012 compared to the same period in 2011 is primarily due to the greater net loss reported in the first quarter of 2012 partially offset by reduced accounts receivable.

Net cash used in investing activities was $477,000 for the quarter ended March 31, 2012, compared to $186,000 cash used in investing activities for the comparable quarter of 2011. The increase is primarily due to an increase in capitalization of software development, primarily relating to our technology architecture modernization, repertoire development and Garritan sound libraries. Our spending on repertoire development increased due to the overall number of titles being developed.

Net cash used by financing activities was $1,000 in the first quarter of 2012 compared to $324,000 in the first quarter of 2011. During the first quarter of 2011, $291,000 was used to repurchase company shares under the Stock Repurchase Program. The Stock Repurchase Program was discontinued effective May 6, 2011. Therefore, no cash was used to repurchase shares during the first quarter of 2012.

Cash and cash equivalents as of March 31, 2012 was $7,735,000 compared to $10,079,000 as of March 31, 2011. The decrease in cash is due to the purchases of Garritan Corporation and the select assets of Recordare, LLC in the fourth quarter of 2011 for which net cash of $2,344,000 was used. Our quarterly revenues and operating cash flows are typically seasonal, with the first and second quarters being historically lower than the third and fourth quarters. This seasonal pattern is primarily due to timing of the historical upgrade releases of Finale, which in recent years has occurred in the second or third quarters, and school budget cycles. We are not anticipating a product release during 2012 as we focus on upgrading the underlying technology and further product enhancements for future releases.

We are investing in our technology, development and sales and marketing initiatives, and while we expect an increase in our revenues and, in particular, continued growth in SmartMusic subscriptions, plus sales of Garritan sound libraries, we expect an overall reduction in our cash balances over the next twelve months.