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Brilliant Digital Entertainment Inc – ‘10QSB’ for 9/30/05

On: Monday, 11/14/05, at 4:31pm ET · For: 9/30/05 · Accession #: 1170918-5-811 · File #: 1-14480

  As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

11/14/05  Brilliant Digital Entertainm… Inc 10QSB       9/30/05    4:114K                                   Hill Carol Lee/FA

Quarterly Report — Small Business — Form 10-QSB
Filing Table of Contents

Document/Exhibit                   Description                      Pages   Size 

 1: 10QSB       Quarterly Report -- Small Business                    36    161K 
 2: EX-31       Ex-31.1                                                2±     8K 
 3: EX-31       Ex-31.2                                                2±     8K 
 4: EX-32       Ex-32.1                                                1      6K

10QSB — Quarterly Report — Small Business
Document Table of Contents

Page	(sequential)	\|	(alphabetic)	Top
			Alternative Formats (Word, et al.) Cautionary Statements and Risk Factors Controls and Procedures Exhibits Financial Statements General and administrative Legal Proceedings License rights Management's Discussion and Analysis or Plan of Operation Part I Financial Information Part Ii Other Information Research and development Restricted cash Sales and marketing Signatures
1	1st Page - Filing Submission
3	Part I Financial Information
"	Item 1. Financial Statements
8	Restricted cash
10	License rights
18	Item 2. Management's Discussion and Analysis or Plan of Operation
23	Sales and marketing
"	General and administrative
24	Research and development
28	Cautionary Statements and Risk Factors
34	Item 3. Controls and Procedures
35	Part Ii Other Information
"	Item 1. Legal Proceedings
"	Item 6. Exhibits
36	Signatures

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================================================================================

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-QSB

[X] Quarterly Report Under Section 13 or 15(d) of the Securities Exchange
Act of 1934

For the quarterly period ended September 30, 2005

[_] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934

For the transition period from __________________ to ______________________.

Commission file number 001-14480

BRILLIANT DIGITAL ENTERTAINMENT, INC.
(Exact Name of Small Business Issuer as Specified in its Charter)

DELAWARE 95-4592204
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)

14011 VENTURA BLVD., SUITE 501
SHERMAN OAKS, CALIFORNIA 91423
(Address of Principal Executive Offices)

(818) 386-2180
(Issuer's Telephone Number, Including Area Code)

Check whether the issuer (i) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 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 |X| No |_|

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

Yes [_] No [X]

State the number of shares outstanding of each of the issuer's classes
of common equity, as of the latest practicable date: Common Stock, par value
$0.001, 56,523,820 issued and outstanding as of November 6, 2005.

Transitional Small Business Disclosure Format (check one):

Yes |_| No |X|

================================================================================

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BRILLIANT DIGITAL ENTERTAINMENT, INC.

INDEX TO FORM 10-QSB

PAGE
----

PART I FINANCIAL INFORMATION................................................3

Item 1. Financial Statements.................................................3

Condensed Consolidated Balance Sheet as of
September 30, 2005 (unaudited)....................................3

Condensed Consolidated Statements of Operations for the
three and nine months ended September 30, 2005 and
September 30, 2004 (unaudited)....................................4

Consolidated Statement of Stockholders' Deficit (unaudited)..........5

Condensed Consolidated Statements of Cash Flows for the
nine months ended September 30, 2005 and
September 30, 2004 (unaudited)....................................6

Notes to Consolidated Financial Statements (unaudited)...............7

Item 2. Management's Discussion and Analysis or Plan of Operation ..........18

Item 3. Controls and Procedures.............................................34

PART II OTHER INFORMATION...................................................35

Item 1. Legal Proceedings...................................................35

Item 6. Exhibits............................................................35

Signatures..........................................................36

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PART I
FINANCIAL INFORMATION

Item 1. Financial Statements

BRILLIANT DIGITAL ENTERTAINMENT, INC.
CONDENSED CONSOLIDATED BALANCE SHEET
(In thousands)
SEPTEMBER 30,
2005
----------
ASSETS (unaudited)
Current assets:
Cash and cash equivalents .............................. $ 1,248
Restricted cash ........................................ 75
Accounts receivable, net ............................... 190
Accounts receivable, related parties ................... 625
Other assets, net ...................................... 20
----------
Total current assets ....................................... 2,158
Property, plant and equipment, net ......................... 95
License rights ............................................. 524
----------
Total assets ............................................... $ 2,777
==========

LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities:
Accounts payable ....................................... $ 709
Accrued expenses, related parties ...................... 728
Accrued expenses ....................................... 735
Guaranteed minimum payments, related party ............. 361
Deferred revenue ....................................... 294
Secured convertible promissory notes,
including accrued interest, net of Debt
Discount of $2,949,000 .............................. 828
----------
Total current liabilities .................................. 3,655
Other long term liabilities ................................ 145
----------
Total liabilities .......................................... 3,800

Stockholders' deficit:
Common stock ........................................... 61
Additional paid-in capital ............................. 76,875
Accumulated deficit .................................... (77,953)
Unrealized gain(loss) on marketable
securities and foreign exchange transactions ........ (7)
----------
Total stockholders' deficit ................................ (1,023)
----------
Total liabilities and stockholders' deficit ................ $ 2,777
==========

See Notes to Consolidated Financial Statements.

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BRILLIANT DIGITAL ENTERTAINMENT, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)

THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------- --------------------
2004 2005 2004 2005
-------- -------- -------- --------
(unaudited) (unaudited)

Revenues:
Marketing services ................. $ 1,461 $ 1,010 $ 4,890 $ 3,324
Licensing and other services ....... 523 360 1,588 1,121
Digital content ................... 130 115 358 273
-------- -------- -------- --------
Total revenues ................ 2,114 1,485 6,836 4,718

Costs and expenses:
Costs of revenues ................... 247 78 945 335
Sales and marketing ................. 282 143 946 524
General and administrative .......... 1,513 808 4,734 2,544
Research and development ............ 122 96 356 293
Depreciation and amortization ....... 6 3 28 16

Loss on impairment of Big Seven ..... 0 0 0 400

Loss on impairment of Altnet purchase 0 0 0 350
-------- -------- -------- --------
2,170 1,128 7,009 4,462
-------- -------- -------- --------
Income(loss) from operations ............. (56) 357 (173) 256
Other income (expense):
Other Income ........................ 1 6 6 8
Interest expense .................... (2,004) (990) (4,445) (2,988)
-------- -------- -------- --------
Total other income (expense) ........ (2,003) (984) (4,439) (2,980)
-------- -------- -------- --------
Net income ( loss) ....................... (2,059) (627) (4,612) (2,724)

Foreign currency translation adjustment
(net of tax effects) .................. 41 19 123 --
-------- -------- -------- --------
Comprehensive loss ....................... (2,018) (608) (4,489) (2,724)
======== ======== ======== ========

Basic and fully-diluted net income (loss)
per share ............................. $ (0.05) $ (0.01) $ (0.11) $ (0.06)
======== ======== ======== ========
Weighted average number of shares used
in computing basic and fully-diluted
net income (loss) per share ........... 42,857 56,524 42,686 48,898
======== ======== ======== ========

See Notes to Consolidated Financial Statements.

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BRILLIANT DIGITAL ENTERTAINMENT, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIT
(In thousands, except share data)
(unaudited)

UNREALIZED
GAIN ON
COMMON STOCK MARKETABLE
----------------------- SECURITIES
ADDITIONAL AND FOREIGN
NO. OF PAID-IN ACCUMULATED EXCHANGE
SHARES AMOUNT CAPITAL DEFICIT TRANSACTIONS TOTAL
---------- ---------- ---------- ---------- ---------- ----------

BALANCE AT DECEMBER 31, 2004 41,916,610 $ 47 $ 73,125 $ (75,228) $ 71 $ (1,985)

Grant of warrants ....... -- -- 3,014 -- -- 3,014
Issuance of shares to
acquire remaining
shares of subsidiary . 7,000,000 $ 7 $ 343 -- -- 350
Issuance of shares to
acquire Big Seven .... 6,666,667 $ 7 $ 393 -- -- 400
Foreign exchange
translation .......... -- -- -- -- (78) (78)
Net loss ................. -- -- -- (2,724) -- (2,724)
---------- ---------- ---------- ---------- ---------- ----------
BALANCE AT SEPTEMBER 30, 2005 55,583,277 $ 61 $ 76,875 $ (77,953) $ (7) $ (1,023)

See Notes to Consolidated Financial Statements

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BRILLIANT DIGITAL ENTERTAINMENT, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
NINE MONTHS
ENDED SEPTEMBER 30,
-------------------
2004 2005
------- -------
(unaudited)
OPERATING ACTIVITIES
Net loss ............................................... $(4,612) $(2,724)
Adjustments to reconcile net loss to the net cash
provided by (used in) operating activities:
Depreciation and amortization ..................... 27 16
Effect of accrued interest expense on
convertible debt and capital funding ........... 226 (257)
Effect of amortization of debt issuance costs ..... 3,869 2,734
Effect of warrant amortization related to
purchase of license rights ..................... 524 524
Impairment Loss on Altnet and Big Seven
purchase ....................................... -- 750

Changes in operating assets and liabilities:
Accounts receivable ............................ 196 1,730
Accounts receivable related party .............. -- (625)
Accrued expenses related party ................. -- (1,431)
Accrued expenses ............................... -- 78
Other assets ................................... 214 103
Accounts payable and accruals .................. (440) 70
Deferred revenue ............................... (54) 262
Notes receivable ............................... 71 --
Guaranteed minimum payments due to related
parties ..................................... (240) (209)
------- -------
Net cash (used in) provided by operating activities .... (219) 1,021

INVESTING ACTIVITIES
Purchase of equipment .................................. (49) (3)
------- -------
Purchase of technology ................................. -- --
------- -------
Net cash used in investing activities .................. (49) (3)

FINANCING ACTIVITIES
Repayments of notes payable ............................ (50) (5)
------- -------
Net cash used in financing activities .................. (50) (5)
------- -------

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ... (318) 1,013

Effect of exchange rate changes on cash ................ 135 (78)
Cash and cash equivalents at beginning of period ....... 880 313
------- -------
Cash and cash equivalents at end of period ............. $ 697 $ 1,248
======= =======

Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest ............................................ $ 0 $ 443
======= =======

See Notes to Consolidated Financial Statements.

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BRILLIANT DIGITAL ENTERTAINMENT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2005

1. BASIS OF PRESENTATION, RISKS AND GOING CONCERN UNCERTAINTY

The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with generally accepted accounting principles
in the United States for interim financial information and with the instructions
to Form 10-QSB and Item 310 of Regulation S-B. Accordingly, they do not include
all of the information and footnotes required by generally accepted accounting
principles in the United States for complete financial statements. The
accompanying unaudited condensed consolidated financial statements reflect all
adjustments that, in the opinion of management, are considered necessary for a
fair presentation of the financial position, results of operations, and cash
flows for the periods presented. The results of operations for such periods are
not necessarily indicative of the results expected for the full fiscal year or
for any future period. The accompanying financial statements should be read in
conjunction with the audited consolidated financial statements of Brilliant
Digital Entertainment, Inc. and consolidated subsidiaries (the "Company")
included in the Company's Form 10-KSB for the fiscal year ended December 31,
2004

The discussion and analysis of the Company's financial condition and
results of operations are based upon its consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States. The preparation of these financial statements
requires the Company to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosure of
contingent assets and liabilities. On an on-going basis, the Company evaluates
its estimates, including those related to reserves for bad debts and those
related to the possible impairment of long-lived assets. The Company bases its
estimates on historical experience and on various other assumptions that are
believed to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying value of assets and liabilities
that are not readily apparent from other sources. Actual results may differ from
these estimates under different assumptions or conditions. The Company's use of
estimates, however, is quite limited, as they have adequate time to process and
record actual results from operations.

The Company is subject to a number of risks similar to those of other
companies in a comparable stage of development including reliance on key
personnel, successful marketing of its services in an emerging market,
competition from other companies with greater technical, financial, management
and marketing resources, successful development of new services, successful
integration of acquired businesses and technology, the enhancement of existing
services, and the ability to secure adequate financing to support future
operations.

The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern, which contemplates
the realization of assets and the satisfaction of liabilities in the normal
course of business. The carrying amounts of assets and liabilities presented in
the financial statements do not purport to represent realizable or settlement
values. However, the Company has suffered recurring operating losses and at

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September 30, 2005, had negative working capital of approximately $4,446,000
(excluding non-cash debt discount of $2,949,000 related to the issuance of
warrants) and a stockholders' deficit of approximately $1,023,000. These factors
raise substantial doubt about the Company's ability to continue as a going
concern. In its report on the Company's financial statements for the year ended
December 31, 2004, the Company's Independent Registered Public Accounting Firm
included an explanatory paragraph expressing substantial doubt about the
Company's ability to continue as a going concern.

The Company is seeking additional funding. There can be no assurance,
however, that the Company will be able to secure additional funding or that if
such funding is available, whether the terms or conditions would be acceptable
to the Company.

2. SIGNIFICANT ACCOUNTING POLICIES

PRINCIPLES OF CONSOLIDATION

The consolidated financial statements include the accounts of the
Company and majority owned and controlled domestic and foreign subsidiaries.
Intercompany transactions have been eliminated.

RESTRICTED CASH

At September 30, 2005, $75,000 of cash was pledged as collateral on
outstanding secured convertible promissory notes and was classified as
restricted cash on the Balance Sheet.

REVENUE RECOGNITION

Under SEC Staff Accounting Bulletin No. 104, generally the Company
recognizes revenue when all of the following criteria are met: (1) persuasive
evidence of an arrangement exists, (2) delivery has occurred or services have
been rendered, (3) the seller's price to the buyer is fixed or determinable, and
(4) collectibility is reasonably assured. In the case of each of the Company's
products and service lines, the Company establishes a contract or insertion
order with its customers with specific requirements for a fixed price, a
delivery schedule, and terms for payment. The Company regularly evaluates the
collectibility of its receivables based on a combination of factors. When a
customer's account becomes past due, it initiates dialogue with the customer to
determine the cause. If the Company determines that the customer will be unable
to meet its financial obligations, due to a bankruptcy filing, deterioration in
the customer's operating results or financial position or other material events
impacting its business, the Company records a specific reserve for bad debt to
reduce the related receivable to the amount it expects to recover given all
information presently available. If circumstances related to specific customers
change, the Company's estimate of the recoverability of receivables could
materially change. At September 30, 2005, the Company had a reserve of $127,000
to cover several customers from whom collectibility is uncertain.

The Company's revenues are derived principally from marketing services,
licensing and other services, and digital content revenue.

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Marketing services revenues are derived from paid search and
advertising agreements. Under the terms of the Company's agreement with Focus
Interactive, Inc. (formerly known as The Excite Network, Inc.), a subsidiary of
Ask Jeeves, Inc., the Company is paid a non-refundable bounty for the
installation of a My Search toolbar on an English speaking user's computer, and
the Company is paid a percentage of the gross profit earned as a result of
clicks on paid search results by any end users of the toolbar. The Company
recognizes revenue as installations are recorded, and as the gross profit share
of paid searches is reported. The Company derives advertising revenue by selling
advertising inventory on behalf of Sharman Networks Limited in exchange for a
percentage of revenue therefrom. Sharman's clients pay a fee based on a cost per
thousand impressions (CPM) or specified conversions delivered (CPA). The Company
also sells advertising for display to users of its Altnet's Peer Points Manager.
The Company recognizes advertising revenue when the conversions are made or
impressions are delivered.

Licensing and other services revenues are derived from the
sub-licensing of the TruNames patent, business development services, and payment
processing services. Under the terms of the Company's patent sublicense
agreement with Sharman Networks Limited, the Company recognizes sublicense
payments as revenue on a monthly basis as earned. The Company negotiates with
third parties that desire to enter into a business transaction with Sharman
relating to the KMD application. The commission paid to the Company is a
percentage of the gross revenue received by Sharman for each transaction entered
into based solely on the Company's efforts. Revenue is recognized from
individual transactions based on the specific terms of the applicable contract,
which may involve (i) a revenue share deal, (ii) a one-time fee paid at signing
or at some other date, or (iii) a combination of these two arrangements.
Non-refundable advance fees are amortized over the life of the contract or as
earned. Revenue share fees are recognized as earned. The Company charges fees to
Sharman Networks as a percentage of gross sales for the use of Altnet's payment
processing gateway on the sale of certain software applications. The Company
recognizes this as revenue when the end user pays for the software application.

Digital content revenues are derived from the Altnet peer-to-peer
business by processing digital media content (music, PC games, software, movies)
for placement on Altnet's peer-to-peer network, and by promoting, distributing,
and selling the content to end users of the network. The Company may charge
clients a processing fee to prepare content for distribution on the network. The
amount of this fee varies based on the number of files, the size of the files,
digital encoding costs, and the preparation of collateral marketing materials,
such as artwork. These fees are recognized as the services are performed. The
Company charges clients for content promotions on a cost per specified number of
downloaded files. A customer typically pre-purchases an agreed number of
downloaded files. The amounts charged vary based on volume and the complexity of
the campaign. These fees are recognized as the download delivery levels are
achieved. The Company charges clients for content sales based on (a) a revenue
sharing basis where the Company receives an agreed upon percentage of the sales
price for each transaction, or (b) a combination of revenue share and a cost per
specified number of downloaded files The revenue from content sales is
recognized when the end user pays for the content and, where relevant, the file
is downloaded by the end user.

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LICENSE RIGHTS

In October 2002, the Company entered into a patent license agreement
with Kinetech, Inc., pursuant to which the Company acquired a license to the
TruNames patent, and in consideration for such license, the Company issued to
Kinetech a warrant to purchase up to 5,000,000 shares of common stock at an
exercise price of $0.001 per share. In July 2003, the Company modified the terms
of the warrants with Kinetech, to accelerate vesting. As a result of the
accelerated vesting and the fact that the Company now recognizes revenue on a
monthly basis from sub-licensing the TruNames patent, the Company determined
that the warrants granted to Kinetech as consideration for the patent rights had
a determinable value. The fair value of the warrants was re-examined at the date
of modification and was based on a Black-Scholes model with the following
weighted average assumptions for 2003: interest rates of 4.5%; dividend yield
rates of 0; volatility factors of expected market price of the Company's common
stock of 50%; and the expected life of the warrants, or 6 years. The value of
these warrants was determined to be $2,096,000 and will be amortized over the
remaining useful life of the patent license agreement, or 3 years. During the
first nine months of 2005, the Company has recorded $524,000 of amortization
expense related to the patent, leaving an unamortized balance of $524,000 at
September 30, 2005, which is reflected on the Balance Sheet as License Rights.

The Company assesses the recoverability of long-lived assets whenever
events or changes in business circumstances indicate that the carrying value of
an asset may not be recoverable. Annual estimated amortization expense for the
remaining long-lived asset for each of the five succeeding years is as follows:

Amortization
Year Expense
----------------- -------------------

2005 $ 174,000
2006 350,000
-------------------
Total $ 524,000
===================

CONCENTRATION OF REVENUE RISK

For the nine months ended September 30, 2005, the Company generated
approximately 100% of its total revenue either directly from Sharman or from
other parties based on activities dependent upon the availability of the Kazaa
Media Desktop to computer users.

For the nine months ended September 30, 2005, Sharman contributed 30%
of the Company's revenue, from content sales, patent licensing, advertising and
payment processing. Focus Interactive, Inc. contributed 70% of the Company's
revenue from bounties earned on activated installations of the My Search
toolbar, and profit sharing on paid searches via the My Search toolbar, as
amended in April, 2005.

The Company maintains the majority of its cash and cash equivalents in
one bank in the United States and with one bank in Australia. The bank account
maintained in the United States is guaranteed by the Federal Deposit Insurance
Corporation ("FDIC") up to $100,000. The banking system in Australia does not
provide the same guarantees. At September 30, 2005 the

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Company had approximately $1,208,000 at the United States bank, which was in
excess of the FDIC insurance limit and approximately $40,000 in the Australian
bank, which was not guaranteed.

3. RELATED PARTY TRANSACTIONS

In May 2003, Altnet entered into a license to use rights to Joltid
Ltd.'s Content Distribution Environment peer-to-peer computer program, commonly
referred to as PeerEnabler. In exchange for the license, Altnet agreed to pay
Joltid a guaranteed monthly fee of $30,000 based on a percentage of revenues
earned from the exploitation of the licensed rights, subject to a maximum
aggregate amount. The Company has reflected the current portion of the
guaranteed payment of $361,000 as a current liability. The company assesses the
recoverability of long-lived assets whenever events or changes in business
circumstances indicate that the carrying value of an asset may not be
recoverable. During the fourth quarter of 2003, in connection with this review,
the Company obtained an independent valuation to assist them in evaluating the
Company's intangible assets for impairment in accordance with FAS 144. An
impairment loss is recognized when the sum of the expected undiscounted future
net cash flows over the remaining useful life, is less than the carrying amount
of the asset. Prior to the impairment evaluation the Company capitalized and
reflected on its balance sheet an asset; Purchased Technology associated with
our purchase of additional shares of our Altnet subsidiary from Joltid. As a
result of the independent evaluation of these assets, the Company recorded an
impairment charge of $1,484,000 during the fourth quarter of 2003. We now own
100% of the outstanding capital stock of Altnet having acquired the remaining
24.5% of Altnet from Joltid, Ltd. on May 17, 2005 in exchange for the issuance
to Joltid of 7,000,000 shares of Brilliant's common stock. At the time we
acquired the shares, we determined that the asset was impaired and we recorded
an impairment charge for the full value of the purchase, totaling $350,000. The
Company paid Joltid $120,000 for services provided during the nine months ended
September 30, 2005, and had an outstanding trade payable to them of $19,176.

The Company entered into a Patent Sublicense Agreement with Sharman,
the distributor of the Kazaa Media Desktop file sharing software application (or
KMD). Pursuant to the Patent Sublicense Agreement, the Company granted Sharman a
limited, non-exclusive sublicense to the Company's rights to the TruNames
patent, which the Company licenses from Kinetech Inc. The TruNames patent covers
a method of identifying digital files based on the actual data contents of the
file, rather than by its name, origin, location, address, or other information
that can easily be changed. As consideration for the sublicense, the Company
will receive from Sharman a monthly license fee. Additionally, in June 2003, the
Company and Altnet entered into a Joint Enterprise Agreement with Sharman, to
act as its exclusive representative for the sale, license and/or other
commercial exploitation of index search results displayed on or otherwise
accessed using the KMD in response to end user search requests. The agreement
also granted the Company a non-exclusive right to enter into agreements with
third parties to provide for the establishment of one or more browse channels
within the KMD that enable users to find and download rights-managed content
from the relevant browse channel in a single click process, and to provide for
all the terms and conditions governing the management, maintenance, operation,
and other elements of each browse channel. The Company shall share in revenues
derived from the browse channels. As of September 30, 2005, the Company has an
outstanding accounts

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receivable balance from Sharman of $625,000, which is classified on the Balance
Sheet as Accounts Receivable Related Parties.

As of September 30, 2005, the Company has an outstanding balance to
Europlay Capital Advisors, LLC of $728,000 which is classified on the balance
sheet as Accrued Expenses Related Parties.

4. SIGNIFICANT AGREEMENTS

SECURED CONVERTIBLE PROMISSORY NOTES

At September 30, 2005, the Company was indebted to its secured debt
holders with aggregate principal and accrued interest of $ 3,777,000, which
indebtedness is due and payable on March 31, 2006 pursuant to an agreement to
extend the maturity date from the previous due date of September 26, 2005. The
principal and accrued interest is convertible by the holders into the Company's
common stock at a price of $0.07 per share, for a total of 53,957,143 shares of
common stock at September 30, 2005. In connection with the extension of the
maturity date of these notes to March 31, 2006, the Company:

(i) adjusted the conversion price of the secured indebtedness from
$0.07 to $0.02 per share effective upon the amendment of the
Company's Amended and Restated Certificate of Incorporation to
provide for a one-for-ten reverse stock split of the
outstanding shares of the Company's common stock (the "Reverse
Split");

(ii) adjusted the purchase price of all warrants issued to the
Holders in consideration of the secured indebtedness and all
amendments thereto (for a total of 73,787,613 common shares),
from $0.07 to $0.02 per share;

(iii) issued to the Holders warrants dated September 26, 2005 and
expiring on October 5, 2009, with an exercise price of $0.02
per share, to purchase an aggregate of 111,000,000 shares of
the Company's common stock; and

(iv) issued to the Holders warrants dated September 26, 2005 and
expiring on October 5, 2009, with an exercise price of $0.02
per share, to purchase an aggregate of 152,738,125 shares of
the Company's common stock, which warrants will vest and
become exercisable effective upon the Reverse Split.

The Company has called a special meeting of its stockholders, presently
scheduled for December 12, 2005, to vote on the Reverse Split, and expects that
the Reverse Split will become effective shortly following the stockholders'
meeting. The Company's failure to effect the Reverse Split constitutes an event
of default under the secured indebtedness.

In addition, the Company agreed to make payments to the note holders in
repayment of the indebtedness as follows: (i) $75,000 per month, plus (ii) 50%
of any quarterly EBITDA in excess of $500,000, plus (iii) 50% of any increased
revenue received from existing sources of revenue or from new sources of
revenue.

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On April 28, 2005, the Company amended its Strategic Alliance and
Distribution Agreement, dated April 14, 2003, with Focus Interactive, Inc.
(formerly known as The Excite Network, Inc.), a subsidiary of Ask Jeeves, Inc.,
to modify the royalty and other economic terms of the Agreement, provide for the
payment by Focus of an additional advance against future royalties and other
payments, and extend the term of the agreement for an additional year. The
agreement with Focus now expires on July 26, 2006, unless terminated earlier in
accordance with its terms. Under the terms of the amendments, we have recorded
only our portion of the advance payment less commission received from Focus as
deferred revenue. Under the terms of our Strategic Alliance and Distribution
Agreement, dated April 14, 2003, as amended in April 2005, we have received from
Focus Interactive, Inc. $1,360,000, which is our portion of an advance against
future payments less commissions. This amount has been recorded as deferred
revenue in the amount of $294,000. A contingent liability exists, on default of
the Agreement, to the extent that we are required to pay back to Focus the
amount of any unearned advance (recorded as deferred revenue) that we received
and any unearned advances that were paid to the other parties benefiting from
the Agreement. Since June, 2003, payments to us by Focus under our agreement
have funded a substantial portion of our working capital. We anticipate
receiving only small cash payments from Focus until approximately November,
2005, when we expect the remaining portion of the advance to be fully earned.

In October 2005, the holders of the Notes agreed to extend the maturity
date of the Notes from September 26, 2005 to March 31, 2006. In consideration of
their agreement to extend the maturity date, we issued to the Note holders
warrants to purchase up to an aggregate of 111,000,000 shares of our common
stock at an exercise price of $0.02 per share. Further we issued to the Note
holders warrants to purchase an additional 152,738,125 shares of the Company's
common stock, which warrants will vest and become exercisable effective upon the
Reverse Split and the conversion price of the secured indebtedness from $0.07 to
$0.02 per share will also become effective. As of September 26, 2005, the
152,738,125 shares are in excess of the Company's authorized number of common
stock. The Company calculated the fair value of the warrants for 111,000,000 of
common stock by using the Black Scholes model with the following inputs:
interest rate of 4.1%; dividend yield of 0; volatility factors of the expected
market price of the Company's common stock of 115%; and the expected life of the
warrants of 4.02 years. The Beneficial Conversion Feature for the warrants to
purchase 111,000,000 shares of common stock is calculated at the commitment date
which is as of September 26, 2005, and the calculated value is limited to the
face amount of the convertible debt which is $3,014,150. Because the debt is due
in six months, the "Debt Discount," (a contra-liability account) is amortized to
"Interest Expense" over 186 days or period of the note extension from September
26, 2005 to March 31, 2006. The Company expensed $65,000 of debt discount in the
third quarter of 2005, with the remainder to be expensed in the fourth quarter
of 2005 and first quarter of 2006.

5. STOCKHOLDERS' DEFICIT

Options and warrants representing common shares of 142,022,319 and
144,943,790 were excluded from the average number of common and common
equivalent shares outstanding in the diluted EPS calculation for the nine months
ended September 30, 2005 and 2004, respectively, because they were
anti-dilutive.

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On October 2005, the Company issued, in consideration of their
agreement to extend the maturity date, warrants to purchase up to an aggregate
of 111,000,000 shares of our common stock at an exercise price of $0.02 per
share. The number of shares underlying each warrant issued to each Holder is
equal to 175% of the face amount of the convertible debt which is $3,014,150
divided by the exercise price of $0.02 per share. In connection with the
issuance of warrants from the Notes, a Beneficial Conversion Feature for the
warrants to purchase 111,000,000 shares of common stock is calculated at the
commitment date which is as of September 26, 2005, and the calculated value is
limited to the face amount of the convertible debt which is $3,014,150 and is
being amortized over 186 days or period of the note extension from September 26,
2005 to March 31, 2006. The Company expensed $65,000 of debt discount in the
third quarter of 2005.

6. COMMITMENTS AND CONTINGENCIES

The Company continues its obligation under two facility leases. As of
September 30, 2005, the commitments under these leases were as follows:

YEAR UNITED STATES AUSTRALIA
---- ------------- ---------
2005 $2,100 $3,000

Rent expense was $101,000 and $55,000 for the nine months ended
September 30, 2004 and 2005, respectively.

In March 2004, in the Federal Court of Australia, New South Wales
District Registry, Brilliant Digital Entertainment, Inc., its subsidiaries
Altnet Inc. and Brilliant Digital Entertainment Pty. Limited, and Kevin
Bermeister and Anthony Rose, the Chief Executive Officer and Chief Technology
Officer, respectively, were joined as defendants in the suit by Universal Music
Australia Pty. Ltd. and other record labels against Sharman Networks Limited and
other defendants, alleging infringement of the copyright in sound recordings
controlled by the plaintiffs. The plaintiffs allege that due to the Company's
business dealings with Sharman Networks Limited, the Company is integrally
involved in the operation of the Kazaa Media Desktop and therefore liable for
the alleged copyright infringement occasioned by its development and
distribution. The plaintiffs are seeking damages under the Australian Copyright
Act of 1968, recovery of costs and interest, and a permanent injunction
restraining the Company from making copies of, communicating to the public, or
distributing the Plaintiff's sound recordings without a license. On September 5,
2005, the Court rendered its judgment in the Australian litigation, declaring
that Sharman Networks Ltd., Altnet Inc., Brilliant Digital Entertainment, Inc.,
Kevin Glen Bermeister and certain other defendants were liable for copyright
infringement for activities associated with the development and distribution of
the Kazaa Media Desktop file sharing software application. The proceeding was
wholly dismissed as against Brilliant Digital Entertainment Pty. Ltd., Anthony
Rose and certain other defendants. We have filed documents to proceed with an
appeal of the Court's decision which we believe

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will be heard sometime during the first quarter of 2006. Any determination of
damages payable by the defendants in the case will be stayed pending appeal of
the lower Court's decision.

In September 2004, through its subsidiary Altnet, the Company filed a
civil lawsuit in the United States District Court Central District of California
against a number of companies and organizations, including the Recording
Industry Association of America, alleging the breach of the "TruNames" patent
which the Company licenses from Kinetech, Inc. In that filing the Company
alleges that some of the defendants infringe on the patent to "spoof"
peer-to-peer users with bogus or corrupted media files, which inhibits the
growth of peer-to-peer for legitimate file sharing and thereby has injured the
Company's business.

7. STOCK BASED COMPENSATION

1996 STOCK OPTION PLAN

The Company adopted a Stock Option Plan (the "1996 Plan"), which became
effective on September 13, 1996. Each director, officer, employee or consultant
of the Company or any of its subsidiaries is eligible to be considered for the
grant of awards under the 1996 Plan. The maximum number of shares of Common
Stock that may be issued pursuant to awards granted under the 1996 Plan is
35,000,000, subject to certain adjustments to prevent dilution. Any shares of
Common Stock subject to an award, which for any reason expires or terminates
unexercised are again available for issuance under the 1996 Plan. The maximum
number of shares of Common Stock with respect to which options or rights may be
granted under the 1996 Plan to any executive or other employee during any fiscal
year is one-half of the number of shares reserved for issuance under the amended
1996 Plan Although any award that was duly granted may thereafter be exercised
or settled in accordance with its terms, no shares of Common Stock may be issued
pursuant to any award made after September 13, 2006. Options granted generally
have a term of 10 years and usually vest over 4 years at the rate of 25% per
year beginning on the first day in the year subsequent to the year of the grant.

The Company accounts for employee stock options or similar equity
instruments in accordance with Statement of Financial Accounting Standards
(SFAS) No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123"). SFAS
No. 123 defines a fair-value-based method of accounting for employee stock
options or similar equity instruments. This statement gives entities a choice to
recognize related compensation expense by adopting the fair-value method or to
measure compensation using the intrinsic value method under Accounting
Principles Board (APB) Opinion No. 25, the former standard. If the former
standard for measurement is elected, SFAS No. 123 requires supplemental
disclosure to show the effect of using the new measurement criteria. The Company
uses the intrinsic value method prescribed by APB Opinion No. 25.

These pro forma amounts may not be representative of future disclosures
since the estimated fair value of the options is amortized to expense over the
options' vesting periods. The pro forma effect on net loss for the nine months
ended September 30, 2005 and 2004 is not representative of the pro forma effect
on net loss in future periods because it reflects expense for only three-months'
vesting. Pro forma information in future years will also reflect the

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amortization of any stock options granted in succeeding years. The Company's pro
forma information is as follows:

NINE MONTHS ENDED
SEPTEMBER 30
--------------------------
2004 2005
----------- -----------
Net loss, as reported ............................ $(4,489,000) $(2,724,000)
Employee compensation expense .................... $ (124,000) $ (19,000)
Net loss, pro forma .............................. $(4,613,000) $(2,743,000)
Basic and diluted loss per share, as reported .... $ (0.11) $ (0.06)
Basic and diluted loss per share, pro forma ...... $ (0.11) $ (0.06)

The fair value of the options as examined at the date of grant is based
on a Black-Scholes model with the following weighted-average assumptions for
2005 and 2004, respectively: interest rates of 4.5% and 5.5%; dividend yields of
0% for both years; volatility factors of the expected market price of the
Company's common stock of 50.0% and 50.0%; and expected life of the options of 3
years for both years. These assumptions resulted in a weighted average fair
value of $0.06 per share for stock options granted in 2004 and 2005.

The Black-Scholes model was developed for use in estimating the fair
value of traded options. The Company's employee stock options have not been
traded. In addition, the assumptions used in option valuation models are highly
subjective, particularly the expected stock price volatility of the underlying
stock. Because changes in these subjective input assumptions can materially
affect the fair value estimate, in management's opinion, the existing models do
not provide a reliable single measure of the fair value of its employee stock
options.

8. GUARANTEES

In November 2002, the FASB issued FIN No. 45 "Guarantor's Accounting
and Disclosure Requirements for Guarantees, including Indirect Guarantees of
Indebtedness of Others - an interpretation of FASB Statements No. 5, 57 and 107
and rescission of FIN 34."

Under its bylaws, the Company has agreed to indemnify its officers,
directors and employees for certain events or occurrences arising as a result of
the officer, director, or employee serving in such capacity. The maximum
potential amount of future payments the Company could be required to make under
these indemnification agreements is unlimited. However, the Company has a
directors and officer liability insurance policy that mitigates its exposure and
enables it to recover a portion of any future amounts paid, subject to the
applicable terms of the policy. As a result of its insurance policy coverage,
the Company believes the estimated fair value of these indemnification
agreements is minimal and has no liabilities recorded for these agreements as of
September 30, 2005.

The Company occasionally enters into indemnification provisions under
(i) its agreements with other companies in its ordinary course of business,
typically with business partners, contractors, customers, and landlords, and
(ii) its agreements with investors. Under

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these provisions the Company generally indemnifies and holds harmless the
indemnified party for losses suffered or incurred by the indemnified party as a
result of the Company's activities or, in some cases, as a result of the
indemnified party's activities under the agreement. These indemnification
provisions often include indemnifications relating to representations made by
the Company with regard to intellectual property rights. These indemnification
provisions generally survive termination of the underlying agreement. In
addition, in some cases, the Company has agreed to reimburse employees for
certain expenses and to provide salary continuation during short-term
disability. The maximum potential amount of future payments the Company could be
required to make under these indemnification provisions is unlimited. The
Company has not incurred material costs to defend lawsuits or settle claims
related to these indemnification agreements. As a result, the Company believes
the estimated fair value of these agreements is minimal. Accordingly, the
Company has no liabilities recorded for these agreements as of September 30,
2005.

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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

The information contained in this Form 10-QSB is intended to update the
information contained in our Annual Report on Form 10-KSB for the year ended
December 31, 2004 and presumes that readers have access to, and will have read,
the "Management's Discussion and Analysis of Financial Condition and Results of
Operations" and other information contained in such Form 10-KSB. The following
discussion and analysis also should be read together with our consolidated
financial statements and the notes to the consolidated financial statements
included elsewhere in this Form 10-QSB.

THIS DISCUSSION SUMMARIZES THE SIGNIFICANT FACTORS AFFECTING THE
CONSOLIDATED OPERATING RESULTS, FINANCIAL CONDITION AND LIQUIDITY AND CASH FLOWS
OF BRILLIANT DIGITAL ENTERTAINMENT FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2005
AND SEPTEMBER 30, 2004. EXCEPT FOR HISTORICAL INFORMATION, THE MATTERS DISCUSSED
IN THIS MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION ARE FORWARD
LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES AND ARE BASED UPON
JUDGMENTS CONCERNING VARIOUS FACTORS THAT ARE BEYOND OUR CONTROL. ACTUAL RESULTS
COULD DIFFER MATERIALLY FROM THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS
AS A RESULT OF, AMONG OTHER THINGS; THE FACTORS DESCRIBED BELOW UNDER THE
CAPTION "CAUTIONARY STATEMENTS AND RISK FACTORS."

OVERVIEW

Brilliant Digital Entertainment, Inc. is a company which, through our
Altnet, Inc. subsidiary, operates a peer-to-peer-based content distribution
network that allows us to securely and efficiently distribute a content owner's
music, video, software and other digital files to computer users via the
Internet. Using internally developed and licensed technology, we have created
technologies for a private, or "closed" peer-to-peer network, which allows us to
centrally control the distribution of a digital file, with authorization from
the copyright owner, directly from one computer user (peer) to another (peer).
Our ability to control files distributed over our private network, as well as
our use of widely available digital rights management (or DRM) technologies from
Microsoft Corporation, TryMedia Systems, Softwrap Limited and others prevent the
distribution of unauthorized files over our network and help to protect against
the unauthorized use of a digital file once it resides on an end user's
computer. We commercialize Altnet by partnering with third party operators of
web sites and other Internet applications to enable users of those web sites and
applications to search for and download digital files over the Altnet network.
We also operate a payment processing "gateway" that enables computer users to
purchase content distributed over our network.

We own 100% of the outstanding capital stock of Altnet and manage all
of its day-to-day operations. We acquired the remaining 24.5% of Altnet from
Joltid, Ltd. on May 17, 2005 in exchange for the issuance to Joltid of 7,000,000
shares of Brilliant's common stock. Joltid, Ltd. is the company from whom we
license a substantial portion of Altnet's peer-to-peer technology. Previously,
we increased our ownership of Altnet from 51% to 75.5% in May 2003, when we
acquired 1,102,500 shares of Altnet's common stock from Joltid in exchange for
7,000,000 shares of Brilliant's common stock. We also issued to Joltid 1,000,000
shares of Brilliant's common stock as consideration for an option to purchase
Joltid's remaining shares of Altnet. The option, which was scheduled to expire
in May 2005, entitled us to purchase Joltid's

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remaining 1,102,500 shares of Altnet common stock in exchange for 7,000,000
shares of Brilliant's common stock, with a value of $350,000. In May 2005, we
exercised the option and acquired Joltid's remaining interest in Altnet. Prior
to these transactions, we received 51% of the outstanding capital stock and
Joltid, Ltd. received 49% of the capital stock. Neither party was required to
make a capital contribution in connection with the formation of Altnet. At the
time of the transaction, the only significant asset owned by Altnet was its
technology.

Our revenues are derived principally from marketing services, licensing
and other services, and digital content revenue.

Marketing services revenues are derived from paid search and
advertising services. Under the terms of our agreement with Focus Interactive,
Inc. (formerly know as The Excite Network, Inc.), now owned by Ask Jeeves, Inc.,
we are paid a non-refundable bounty for the installation of each My Search
toolbar bundled for distribution with our Altnet Loyalty Points Manager on an
English speaking user's computer, and we are paid a percentage of the gross
profit earned as a result of clicks on paid search results by any end users of
these toolbars. We recently announced an online advertising revenue-sharing fund
that will be split with top independent labels including V-2, Artemis,
Epitaph/Anti, Side One Dummy and Palm, Simmons/Latham, and Koch Media, all
Altnet music licensors. These labels will share the revenue generated from
advertising that appears in the user interface of popular Peer to Peer
applications. The fund will be split proportionately based on content licenses
issued whether the music content is offered for sale, trial or for free. In
exchange for services performed by us we will receive a fee from the fund. We
also sell advertising for display to users of our Altnet's Peer Points Manager.
We use a portion of the advertising revenue we earn through this program to
compensate content owners for the content end users view by redeeming points
they have earned through Altnet's Peer Points Manager program.

Licensing and other services revenues are derived from our sublicense
of rights to the TruNames patent, business development services, and payment
processing services. Under the terms of our patent sublicense agreement with
Sharman Networks, we recognize sublicense revenue on a monthly basis as earned.
We negotiate with third parties that desire to enter into a business transaction
with Sharman Networks relating to the Kazaa Media Desktop (or KMD) software
application. We receive a percentage of the gross revenue received by Sharman
Networks for each transaction entered into based solely on our efforts. We also
generate fees from processing payments for the purchase of digital content using
the Altnet payment processing gateway. In early February 2005, we stopped
processing payments for Kazaa Plus for which we were receiving a payment
processing fee.

Digital content revenues are derived from processing digital media
content (music, PC games, software, movies) for placement on our Altnet
peer-to-peer network, and by promoting, distributing, and selling the content to
end users which we access via our Internet affiliates. We may charge clients a
processing fee to prepare content for distribution on the network. The amount of
this fee varies based on the number of files, the size of the files, digital
encoding costs, and the preparation of collateral marketing materials, such as
artwork. We charge clients for content promotions on a

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cost per specified number of downloaded files. The amounts charged vary based on
volume and the complexity of the campaign. We charge clients for content sales
based on a revenue sharing basis where we receive an agreed upon percentage of
the sales price for each transaction or a combination of revenue share and a
cost per specified number of downloaded files.

SIGNIFICANT CHALLENGES AND RISKS

Our future success will depend on our ability to overcome the following
operational challenges:

o Our ability to acquire in-demand content from independent and
major musical recording and filmed entertainment companies;

o Our ability to diversify our reliance upon one large
distribution partner, Sharman Networks Limited;

o Our ability to increase revenue from our core business - the
distribution of content over the Altnet network;

o Our ability to raise the funding necessary to support the
sales, marketing, and research and development necessary to
grow the Altnet business;

o Our ability to either pay or restructure our secured debt and
unsecured trade payables; and

o A successful appeal to the unfavorable ruling rendered by the
Court in the Australian litigation in which we are involved.

We intend to continue to aggressively pursue content acquisition with
both the major and smaller independent musical recording and filmed
entertainment companies in order to address our content needs and to increase
revenue from the distribution of content. To date, our efforts in this regard
have been hampered by the litigation surrounding our largest distribution
partner, Sharman Networks, over the legality of the KMD. Despite our efforts, we
have been unable to obtain download licenses for music files from the major
musical recording companies, even though these companies have granted licenses
to our competitors. Several of these musical recording companies have sued us in
the Federal Court of Australia for activities relating to our business dealings
with Sharman Networks. A ruling was handed down by the Federal Court of
Australia in early September, 2005 and we are currently appealing that decision.
There can be no assurance that we will be granted such licenses at any time in
the future.

On September 5, 2005, the Court in the Australian litigation in which
we are involved rendered its judgment, declaring that Sharman Networks Ltd.,
Altnet Inc., Brilliant Digital Entertainment, Inc., Kevin Glen Bermeister and
certain other defendants were liable for copyright infringement for activities
associated with the development and distribution of the Kazaa Media Desktop file
sharing software application. The proceeding was wholly dismissed as against
Brilliant Digital Entertainment Pty. Ltd., Anthony Rose and certain other
defendants. We have filed documents to proceed with an appeal of the Court's
decision which we believe will be heard sometime during the first quarter of
2006. Any determination of damages payable by the defendants in the case will be
stayed pending appeal of the lower Court's decision. If the appeal is not
successful, the Company and certain of our officers may be subject to
substantial

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damages, and we may be prevented from engaging in certain business activities.
Either of these results would have a material adverse affect on our ability to
continue as a going concern.

In order to reduce our reliance on a single large distribution partner,
we will continue to pursue other distribution outlets for our products including
peer-to-peer application providers seeking to commercialize their applications,
web sites with traffic seeking an easy way to manage content provisioning
solutions and content oriented web sites with targeted traffic seeking to sell
content.

We intend to continue our pursuit of additional capital to fund our
expansion efforts and to pay both our secured debt holders and unsecured trade
creditors. At September 30, 2005, we were indebted to our secured note holders
with aggregate principal and accrued interest of $3,777,000, and our trade
payables, including related parties, were $2,533,000. We are also working with
both our secured debt holders and certain of our unsecured trade creditors to
restructure amounts owed them into long-term arrangements. We did complete an
extension of the secured debt that was due on September 26, 2005 to March 31,
2006. However, there can be no assurance that we will be successful in raising
additional capital to pay these obligations, or in restructuring these
obligations to avoid a payment default.

The accompanying financial statements have been prepared assuming that
we will continue as a going concern, which contemplates the realization of
assets and the satisfaction of liabilities in the normal course of business. The
carrying amount of assets and liabilities presented in the financial statements
do not purport to represent realizable or settlement values. We have suffered
recurring operating losses and at September 30, 2005, had negative working
capital of approximately $4,446,000 (excluding non-cash debt discount of
$2,949,000 related to the issuance of warrants) and a stockholders' deficit of
approximately $1,023,000. These factors raise substantial doubt about our
ability to continue as a going concern. We anticipate that our current cash
reserves, plus our expected generation of cash from existing operations in 2005,
may not be sufficient to fund our anticipated expenditures. Consequently, we may
require additional equity or debt financing during 2005, the amount and timing
of which will depend in large part on our spending program. The report of our
Independent Certified Public Accountants for the December 31, 2004 financial
statements included an explanatory paragraph expressing substantial doubt about
our ability to continue as a going concern.

SETTLEMENT AGREEMENT AND MUTUAL RELEASE

On June 16, 2005, we issued 6,666,667 shares of our Common Stock to
Harris Toibb, with a value of $400,000, in exchange for all of the ownership
interests in Big Seven Entertainment, LLC. The shares were issued to Harris
Toibb in accordance with the terms of that certain Assignment of Rights
Agreement, dated June 15, 2005, among Harris Toibb, Michael Toibb and Omni
Management Group, LLC, and acknowledged by us, whereby Michael Toibb assigned to
Harris Toibb, in consideration of a cash payment, Michael Toibb's rights under
that certain Settlement Agreement and Mutual Release, dated as of June 16, 2004,
among us, Big Seven Entertainment, LLC, Michael Toibb and the other parties
thereto. Pursuant to the terms of the Settlement Agreement and Mutual Release,
we agreed to acquire from Michael Toibb, on or before the first anniversary of
the date of the Settlement Agreement and Mutual

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Release, all of the ownership interest in Big Seven Entertainment, LLC in
exchange for the issuance of 6,666,667 shares of our Common Stock.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosure of contingent assets and
liabilities. On an on-going basis, we evaluate our estimates, including those
related to reserves for bad debts. We base our estimates on historical
experience and on various other assumptions that are believed 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 may differ from these
estimates under different assumptions or conditions. Our use of estimates,
however, is quite limited, as we have adequate time to process and record actual
results from operations.

Our critical accounting policies are described in Note 2 to the
consolidated financial statements included in Item 1 of this Form 10-QSB. We
believe our most critical accounting policies include revenue recognition, the
corresponding accounts receivable and long-lived asset impairment. We believe
the following critical accounting policies affect our more significant judgments
and estimates used in preparation of our consolidated financial statements.

Under SEC Staff Accounting Bulletin No. 104 (SAB 104) and AICPA
Statement of Position 97-2 (SOP 97-2), we recognize revenue when all of the
following criteria are met: (1) persuasive evidence of an arrangement exists,
(2) delivery has occurred or services have been rendered, (3) the seller's price
to the buyer is fixed or determinable, and (4) collectibility is reasonably
assured. In the case of each of our product and service lines we establish a
contract or insertion order with our customers with specifics for requirements,
a fixed price, a delivery schedule, and terms for payment. Unless cash is paid
in advance, our receivables are recorded as revenue is earned. We regularly
evaluate the collectibility of our receivables based on a combination of
factors. When a customer's account becomes past due, we initiate dialogue with
the customer to determine the cause. If we determine that the customer will be
unable to meet its financial obligations to us, due to a bankruptcy filing,
deterioration in the customer's operating results or financial position or other
material events impacting their business, we record a specific reserve for bad
debt to reduce the related receivable to the amount we expect to recover given
all information presently available. If circumstances related to specific
customers change, our estimates of the recoverability of receivables could
materially change.

Long-lived assets and intangible assets with determinable lives are
reviewed for impairment quarterly or whenever events or circumstances indicate
that the carrying amounts of assets may not be recoverable in accordance with
SFAS No. 144, "ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG LIVED ASSETS".
We evaluate recoverability of assets to be held and used by comparing the
carrying amount of an asset to future net undiscounted cash flows to be
generated by the asset. If such assets are considered to be impaired, the
impairment to be recognized is measured as the amount by which the carrying
amount of the assets exceeds the

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fair value of the assets. Such reviews assess the fair value of the assets based
upon our estimates of the future cash flows we expected the assets to generate.
In response to changes in industry and market conditions, we may be required to
strategically realign our resources in the future, which could result in an
impairment of long lived assets.

RESULTS OF OPERATIONS

REVENUES. Revenues decreased 32% from $6,836,000 for the nine months
ended September 30, 2004 to $4,718,000 for the nine months ended September 30,
2005. Revenues by groups of similar service were as follows:

REVENUES 2004 2005 NET CHANGE
--------------------------------- -------------- -------------- ----------
Marketing services............... $4,890,000 $3,324,000 (32%)
Licensing and other services..... 1,588,000 1,121,000 (29%)
Digital content.................. 358,000 273,000 (24%)
-------------- -------------- ----------
Total Revenue.................... $6,836,000 $4,718,000 (31%)
============== ============== ==========

Marketing services revenue decreased to $3,324,000 for the nine months
ended September 30, 2005 from $4,890,000 for the nine months ended September 30,
2004 primarily as a result of a decrease in revenue from our agreement with
Focus Interactive, Inc. Licensing and other services revenues decreased to
$1,121,000 for the nine months ended September 30, 2005 from $1,588,000 for the
nine months ended September 30, 2004, due to a decrease in payment processing
revenues as a result of our discontinuation of processing Kazaa Plus
transactions that occurred in early February, 2005. Digital content revenue
decreased from $358,000 for the nine months ended September 30, 2004, to
$273,000 for the nine months ended September 30, 2005 primarily as a result of a
decrease in software sales through the Altnet Network.

COST OF REVENUES. Cost of revenues decreased from $945,000 for the nine
months ended September 30, 2004, to $335,000 for the nine months ended September
30, 2005. This net decrease of $610,000 is primarily related to a substantial
decrease in the costs associated with the operation of our payment gateway
services as a result of our discontinuation of processing for Kazaa Plus.

SALES AND MARKETING. Sales and marketing expenses decreased by 46% from
$946,000 for the nine months ended September 30, 2004 to $524,000 for the nine
months ended September 30, 2005. The net decrease of $422,000 in 2005 is due
primarily to a reduction in marketing and promotion costs of $274,000 spent to
support our marketing efforts for the Altnet network, and a reduction in
commissions of $148,000.

GENERAL AND ADMINISTRATIVE. General and administrative expenses
primarily include salaries and benefits of management and administrative
personnel, rent, insurance costs, professional fees and non-cash warrant
expense. General and administrative expenses decreased $2,190,000, or 46%, from
$4,734,000 for the nine months ended September 30, 2004 to $2,544,000 for the
nine months ended September 30, 2005. This decrease is primarily attributable to
payroll related cost savings of $765,000 and decreases in legal costs of
$1,043,102.

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RESEARCH AND DEVELOPMENT. Research and development expenses include
salaries and benefits of personnel conducting research and development relating
to our Internet web site, payment gateway and related information database, and
the development of the Altnet Peer Points Manager software application. These
costs decreased from $356,000 for the nine months ended September 30, 2004 to
$293,000 for the nine months ended September 30, 2005, as most of the
development costs incurred for the development of our Peer Points program and
our payment gateway have been incurred.

DEPRECIATION. Depreciation expense relates to depreciation of fixed
assets such as computer equipment and cabling, furniture and fixtures and
leasehold improvements. These fixed assets are depreciated over their estimated
useful lives (up to five years) using the straight-line method. Depreciation
expense was $28,000 for the nine months ended September 30, 2004 as compared to
$16,000 for the nine months ended September, 2005, as many of the depreciable
assets have been fully depreciated.

LOSS ON IMPAIRMENT OF BIG SEVEN AND ALTNET. At the time we acquired the
remaining shares of Altnet from Joltid and purchased the shares of Big Seven, we
determined that both Big Seven and Altnet were impaired and we recorded an
impairment charge for the full value of the purchases, totaling $750,000.

OTHER INCOME AND EXPENSE. Other income and expense primarily includes
interest expense. Other income and expense decreased from net expense of
$4,439,000 for the nine months ended September 30, 2004 to a net expense of
$2,980,000 for the nine months ended September 30, 2005. During the nine months
ended September 30, 2005, interest expense included interest accrued on
outstanding convertible promissory notes and an additional $2,756,000 of
amortized debt issuance costs associated with agreements to further extend the
maturity date of the indebtedness.

LIQUIDITY AND CAPITAL RESOURCES

As of September 30, 2005, our cash and cash equivalents totaled
approximately $1,248,000. This is an increase of $945,000 as compared to
December 31, 2004. As of September 30, 2005, we had a working capital deficit of
$4,446,000 (excluding non-cash debt discount of $2,949,000 related to the
issuance of warrants). Included in this working capital deficit are accounts
payable, accrued expenses and accrued expenses to related parties of $728,000
which are over 90 days past due, and $3,777,000 of secured indebtedness.

Our cash and cash equivalents at September 30, 2005 included $294,000
of an advance against future payments due us from Focus Interactive, Inc. under
our Strategic Alliance and Distribution Agreement, dated April 14, 2003, as
amended in April 2005. Since June, 2003, payments to us by Focus under our
agreement have funded a substantial portion of our working capital. We
anticipate receiving only small cash payments from Focus until approximately
November, 2005, when we expect the remaining portion of the advance to be fully
earned.

We currently satisfy our working capital requirements primarily through
cash flows generated from operations and sales of equity securities. We are
seeking additional funding.

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There can be no assurance that with any additional financing, higher cash flows
will be generated by operations.

CASH FLOWS

Cash flows from operating, investing and financing activities for the
nine months ended September 30, 2005 and 2004 are summarized in the following
table:

ACTIVITY: 2004 2005
-------------------------------------- ------------ ------------
Continuing Operations ................ $ (219,000) $ 1,021,000
Investing ............................ $ (49,000) $ (3,000)
Financing ............................ $ (50,000) $ (5,000)

During the nine months ended September 30, 2005 we had a net increase
in cash of $993,000. The net increase in cash from operating activities during
the nine months ended September 30, 2005 was primarily the result of the net
loss of $2,724,000, a decrease of $209,000 in guaranteed minimum payments, and a
$1,353,000 decrease in accrued expenses. These amounts were offset primarily by
$2,734,000 in non-cash interest expense, $524,000 in non-cash warrant
amortization, a decrease of $1,105,000 in accounts receivable, an increase of
$262,000 in deferred revenue and an impairment loss of $750,000.

We are not generating sufficient cash flow to meet our monthly
obligations and pay our existing current liabilities and secured debt which is
due in March 2006. While we have been successful in the past working with our
secured debt holders to achieve short term extensions, and will continue working
with our secured debt holders and unsecured creditors to restructure our
obligations, there can be no guarantee that we will be successful in our
efforts. Consequently, we may require additional equity or debt financing during
2005 and 2006, the amount and timing of which will depend in large part on our
spending program and our success in restructuring our secured debt and current
liabilities. Our previous financings have been significantly dilutive to our
stockholders and if additional funds are raised through the issuance of equity
securities, our stockholders may experience significant additional dilution.
Furthermore, there can be no assurance that additional financing will be
available when needed or that if available, such financing will include terms
favorable to our stockholders or us. If such financing is not available when
required or is not available on acceptable terms, we may be unable to pay our
secured debt holders as their debt matures or trade creditors under our
contractual terms with them, develop or enhance our products and services, take
advantage of business opportunities or respond to competitive pressures, any of
which could have a material adverse effect on our business, financial condition
and results of operations, and would most likely result in our having to file
for bankruptcy protection under the Bankruptcy Code.

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will be heard sometime during the first quarter of 2006. Any determination of
damages payable by the defendants in the case will be stayed pending appeal of
the lower Court's decision. If the appeal is not successful, the Company and
certain of our officers may be subject to substantial damages, and we may be
prevented from engaging in certain business activities. Either of these results
would have a material adverse affect on our ability to continue as a going
concern.

CONTRACTUAL OBLIGATIONS

At September 30, 2005, we were indebted to our secured debt holders in
the amount of $3,777,000, which indebtedness is due and payable on March 31,
2006, pursuant to an agreement to extend the due date of the debt from September
26, 2005 to March 31, 2006. The principal and accrued interest is convertible by
the holders into our common stock at a price of $0.07 per share, for a total of
54,113,478 shares of common stock at September 30, 2005. In connection with this
extension, in addition to the note holders' previously issued warrants to
purchase up to an aggregate of 73,787,613 shares of common stock at a current
exercise price of $0.07 per share, we:

(i) adjusted the conversion price of the secured indebtedness from
$0.07 to $0.02 per share effective upon the amendment of our
Amended and Restated Certificate of Incorporation to provide
for a one-for-ten reverse stock split of the outstanding
shares of our common stock (the "Reverse Split");

(iv) issued to the Holders warrants dated September 26, 2005 and
expiring on October 5, 2009, with an exercise price of $0.02
per share, to purchase an aggregate of 152,738,125 shares of
our common stock, which warrants will vest and become
exercisable effective upon the Reverse Split.

We have called a special meeting of our stockholders, presently
scheduled for December 12, 2005, to vote on the Reverse Split, and expect that
the Reverse Split will become effective shortly following the stockholders'
meeting. Our failure to effect the Reverse Split constitutes an event of default
under the secured indebtedness.

In addition, we agreed to make payments to the note holders in
repayment of the indebtedness as follows: (i) $75,000 per month, plus (ii) 50%
of any quarterly EBITDA in excess of $500,000, plus (iii) 50% of any increased
revenue received from existing sources of revenue or from new sources of
revenue.

Unless we are able to raise additional capital, which we do not believe
will occur, we will not have sufficient cash in 2006 to repay the senior secured
notes. Accordingly, we may again seek to extend the maturity date of the notes.
We cannot make assurances that the note holders

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will agree to an extension at all or on terms that do not result in further
significant additional dilution to holders of our common stock.

OFF-BALANCE SHEET ARRANGEMENTS

At September 30, 2005 and 2004, we did not have any relationships with
unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance or special purpose entities, which would have
been established for the purpose of facilitating off-balance sheet arrangements
or other contractually narrow or limited purposes. As such, we are not exposed
to any financing, liquidity, market or credit risk that could arise if we had
engaged in such relationships.

NEW ACCOUNTING PRONOUNCEMENTS

In December 2004, the FASB issued SFAS No. 123 (revised), Accounting
for Stock Based Compensation, which supersedes Accounting Principles Board (APB)
Opinion No. 25, Accounting for Stock Issued to Employees, and its related
implementation guidance. This Statement requires a public entity to measure the
cost of employee services received in exchange for an award of equity
instruments based on the grant date fair value of the award (with limited
exceptions); the fair value of that award will be remeasured subsequently at
each reporting date through the settlement date. This Statement is effective as
of the beginning of the first interim or annual reporting period that begins
after December 15, 2005 for small business issuers. The Company currently
applies APB Opinion No. 25 in accounting for its stock based compensation
(options). The amended provisions of SFAS No. 123 had no material effect on the
Company's consolidated financial position or results of operation for the year
ended December 31, 2004.

In December 2004, FASB issued SFAS No. 153, Exchanges of Nonmonetary
Assets an amendment of APB Opinion No. 29. SFAS 153 addresses the measurement of
exchanges of nonmonetary assets. It eliminates the exception from fair value
measurement for nonmonetary exchanges of similar productive assets in paragraph
21(b) of APB Opinion No. 29, Accounting for Nonmonetary Transactions, and
replaces it with an exception for exchanges that do not have commercial
substance. This Statement specifies that a nonmonetary exchange has commercial
substance if the future cash flows of the entity are expected to change
significantly as a result of the exchange. SFAS 153 is effective for nonmonetary
asset exchanges occurring in fiscal periods beginning after June 15, 2005. The
Company is considering the provisions of SFAS No. 153 and its effect on
nonmonetary exchanges in the future.

In May 2005, FASB issued SFAS No. 154, Accounting Changes and Error
Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3. SFAS
154 applies to all voluntary accounting principle changes as well as the
accounting for and reporting of such changes. SFAS 154 is effective for
accounting changes and corrections of errors made in fiscal years beginning
after December 15, 2005.

SFAS 154 requires voluntary changes in accounting principle be
retrospectively applied to financial statements from previous periods unless
such application is impracticable. Changes in depreciation, amortization, or
depletion for long-lived, non-financial assets are accounted for

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as a change in accounting estimate that is affected by a change in accounting
principle, under the newly issued standard.

SFAS 154 replaces APB Opinion No. 20 and SFAS 3. SFAS 154 carries
forward many provisions of Opinion 20 and SFAS 3 without change including those
provisions related to reporting a change in accounting estimate, a change in
reporting entity, correction of an error and reporting accounting changes in
interim financial statements. The FASB decided to completely replace Opinion 20
and SFAS 3 rather than amending them in keeping to the goal of simplifying U.S.
GAAP. The provisions of SFAS No. 154 are not expected to have a material effect
on the Company's consolidated financial position or results of operation.

CAUTIONARY STATEMENTS AND RISK FACTORS

Several of the matters discussed in this document contain
forward-looking statements that involve risks and uncertainties. Factors
associated with the forward-looking statements that could cause actual results
to differ materially from those projected or forecast are included in the
statements below. In addition to other information contained in this report,
readers should carefully consider the following cautionary statements.

RISKS RELATED TO AN INVESTMENT IN OUR COMMON STOCK

THERE IS DOUBT ABOUT OUR ABILITY TO CONTINUE AS A GOING CONCERN. We
currently have a number of obligations that we are unable to meet without
generating additional revenues or raising additional capital. If we cannot
generate additional revenues or raise additional capital in the near future, we
may become insolvent. As of September 30, 2005, our cash balance was
approximately $1,248,000 and we had a working capital deficit of $4,446,000
(excluding non-cash debt discount of $2,949,000 related to the issuance of
warrants). Historically, we have funded our capital requirements with debt and
equity financing. Our ability to obtain additional equity or debt financing
depends on a number of factors including our financial performance and the
overall conditions in our industry. If we are not able to raise additional
financing or if such financing is not available on acceptable terms, we may
liquidate assets, seek or be forced into bankruptcy, and/or continue operations
but suffer material harm to our operations and financial condition. These
measures could have a material adverse affect on our ability to continue as a
going concern.

WE HAVE A HISTORY OF LOSSES, A NEGATIVE NET WORTH AND MAY NEVER ATTAIN
PROFITABILITY. We realized a comprehensive loss of $2,744,000 for the nine
months ended September 30, 2005. Since inception, we have incurred significant
losses and negative cash flow, and as of September 30, 2005 we had an
accumulated deficit of approximately $78 million. We anticipate that we will
continue to generate operating losses for the foreseeable future as we fund
operating and capital expenditures in the areas of sales and marketing,
administration, and research and development, all principally related to
deployment of our Altnet peer-to-peer network and operating infrastructure.
Additionally, as of the date of this report, our current liabilities
significantly exceed our current assets.

Our business model assumes that our growth and substantially all of our
future revenues will be derived from our Altnet peer-to-peer business, which
only became operational in the

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fourth quarter of 2002. This business model is not yet proven and we cannot make
assurances that we will ever achieve or sustain profitability or that our
operating losses will not increase in the future or be inconsistent with the
expectations of the public market. Primarily as a result of our continued
losses, our independent public accountants included an explanatory paragraph in
its opinion on our financial statements wherein they expressed substantial doubt
about our ability to continue as a going concern.

WE HAVE A SUBSTANTIAL NUMBER OF OUTSTANDING DERIVATIVE SECURITIES
WHICH, IF EXERCISED OR CONVERTED INTO COMMON STOCK, WILL RESULT IN SUBSTANTIAL
DILUTION TO OUR STOCKHOLDERS. At September 30, 2005, we had outstanding
$3,777,000 of senior secured indebtedness which is evidenced by convertible
promissory notes due March 31, 2006. The following table illustrates as of
November 10, 2005, the number of shares issued and outstanding, as well as the
number of shares that may be issued in the future upon conversion of outstanding
secured convertible promissory notes and exercise of outstanding options and
warrants. For the purposes of this table we have included all warrants whether
they are "in-the-money" or not, and the number of shares of common stock
underlying the outstanding warrants has been calculated on a "paid-for" exercise
basis, whereby the holder of each warrant receives upon exercise a number of
shares of common stock equal to the number of warrants held. Additionally, we
have assumed the occurrence of the reduction in the conversion price of the
convertible promissory notes from $0.07 to $0.02, and the vesting of warrants to
purchase 152,738,125 shares of our common stock, both of which are conditional
upon our stockholders approving a one-for-ten reverse split of our common stock
at a special meeting of stockholders presently scheduled for December 12, 2005.

PERCENTAGE
SHARES OF OF FULLY
SECURITY COMMON STOCK DILUTED SHARES
------------------------------------------- ----------- -----------
Outstanding Common Stock .................. 56,523,820 9.0%
Secured Convertible Promissory Notes,
with accrued interest ................... 183,728,410 57.8%
Outstanding Warrants ...................... 364,043,959 29.1
Outstanding Options ....................... 25,809,019 4.1%
----------- -----------
Fully Diluted Shares of Common Stock .... 630,105,208 100.0%

Additionally, we anticipate that during 2006, we may need to raise
additional capital. As such, any additional capital raising efforts would cause
further dilution to stockholders. Additionally, any further extensions of the
maturity date of our convertible promissory notes will likely require us to
issue a substantial number of additional warrants to the note holders.

IF WE BECOME INSOLVENT, WE WILL BE IN DEFAULT UNDER OUR SECURED
CONVERTIBLE PROMISSORY NOTES, WHICH COULD RESULT IN OUR OBLIGATION TO PAY
IMMEDIATELY ALL AMOUNTS THEN OUTSTANDING UNDER THE NOTES. If we generally do not
pay, or become unable to pay, our debts as such debts become due, we will
default under our outstanding Secured Convertible Promissory Notes, with
aggregate principal and accrued interest and fees of $3,777,000 at September 30,
2005. If a default occurs, all amounts owed to the holders of the notes would
immediately become due and payable. If we are not able to repay the indebtedness
when due,

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the holders of the notes will be entitled to exercise all of their rights and
remedies, including foreclosure on all of our assets which we pledged as
collateral to secure repayment of the debt.

OUR STOCK PRICE AND TRADING VOLUME FLUCTUATE WIDELY AND MAY CONTINUE TO
DO SO IN THE FUTURE. AS A RESULT, WE MAY EXPERIENCE SIGNIFICANT DECLINES IN OUR
STOCK PRICE. The market price and trading volume of our common stock, which
trades on the Over the Counter Bulletin Board (OTCBB), has been subject to
substantial volatility, which is likely to continue. This volatility may result
in significant declines in the price of our common stock. Factors that may cause
these fluctuations include:

o variations in quarterly operating results;

o the gain or loss of significant contracts;

o changes in management;

o announcements of technological innovations or new products by
us or our competitors;

o recommendations by securities industry analysts;

o dilution to existing stockholders resulting from the issuance
of additional shares of common stock;

o short sales and hedging of our common stock; and

o adverse legal rulings.

Additionally, the stock market has experienced extreme price and
trading volume fluctuations that have affected the market price of securities of
many technology companies. These fluctuations have, at times, been unrelated to
the operating performances of the specific companies whose stock is affected.
The market price and trading volume of our stock may be subject to these
fluctuations.

IF OUR STOCK DOES NOT SUSTAIN A SIGNIFICANT TRADING VOLUME,
STOCKHOLDERS MAY BE UNABLE TO SELL LARGE POSITIONS IN OUR COMMON STOCK. In the
past, our common stock has not experienced significant trading volume on a
consistent basis and has not been actively followed by stock market analysts.
The average trading volume in our common stock may not increase or sustain its
current levels. As a result, we cannot be certain that an adequate trading
market will exist to permit stockholders to sell large positions in our common
stock.

FLUCTUATIONS IN OPERATING RESULTS MAY RESULT IN UNEXPECTED REDUCTIONS
IN REVENUE AND STOCK PRICE VOLATILITY. We operate in an industry that is subject
to significant fluctuations in operating results from quarter to quarter, which
may lead to unexpected reductions in revenues and stock price volatility.
Factors that may influence our quarterly operating results include:

o the introduction or enhancement of software products and
technology by us and/or our competitors,

o our ability to operate and expand our Altnet peer-to-peer
business; and

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o our ability to fund our legal fees.

Additionally, a majority of the unit sales for a product typically
occurs in the quarter in which the product is introduced. As a result, our
revenues may increase significantly in a quarter in which a major product
introduction occurs and may decline in following quarters.

DECREASES IN THE PRICE OF OUR COMMON STOCK COULD INCREASE SHORT SALES
OF OUR COMMON STOCK BY THIRD PARTIES, WHICH COULD RESULT IN FURTHER REDUCTIONS
IN THE PRICE OF OUR COMMON STOCK. Our sales of common stock at a discount to the
market price of our common stock, which may be necessary to raise additional
capital to fund operations, could result in reductions in the market price of
our common stock. Downward pressure on the price of our common stock could
encourage short sales of the stock by third parties. Material amounts of short
selling could place further downward pressure on the market price of the common
stock. A short sale is a sale of stock that is not owned by the seller. The
seller borrows the stock for delivery at the time of the short sale, and buys
back the stock when it is necessary to return the borrowed shares. If the price
of the common stock declines between the time the seller sells the stock and the
time the seller subsequently repurchases the common stock, then the seller sold
the shares for a higher price than he purchased the shares and may realize a
profit.

WE HAVE ADOPTED A NUMBER OF ANTI-TAKEOVER MEASURES THAT MAY DEPRESS THE
PRICE OF OUR COMMON STOCK. Our ability to issue up to 1,000,000 shares of
preferred stock and some provisions of our certificate of incorporation and
bylaws and of Delaware law could make it more difficult for a third party to
make an unsolicited takeover attempt of us. These anti-takeover measures may
depress the price of our common stock by making third parties less able to
acquire us by offering to purchase shares of our stock at a premium to its
market price. Our Board of Directors can issue up to 1,000,000 shares of
preferred stock and determine the price, rights, preferences, privileges and
restrictions, including voting rights, of those shares without any further vote
or action by our stockholders. Our Board of Directors could issue the preferred
stock with voting, liquidation, dividend and other rights superior to the rights
of our common stock. The rights of holders of our common stock will be subject
to, and may be adversely affected by, the rights of holders of the share
purchase rights and of any preferred stock that may be issued in the future. The
issuance of preferred stock, while providing desirable flexibility in connection
with possible acquisitions and other corporate purposes could make it more
difficult for a third party to acquire a majority of our outstanding voting
stock.

RISKS RELATED TO OUR BUSINESS

WE HAVE BEEN SUED IN AUSTRALIAN FEDERAL COURT AS A RESULT OF OUR
BUSINESS DEALINGS WITH SHARMAN NETWORKS LIMITED. In March 2004, in the Federal
Court of Australia, New South Wales District Registry, Brilliant Digital
Entertainment, Inc., its subsidiaries Altnet Inc. and Brilliant Digital
Entertainment Pty. Limited, and Kevin Bermeister and Anthony Rose, the Chief
Executive Officer and Chief Technology Officer, respectively, were joined as
defendants in the suit by Universal Music Australia Pty. Ltd. and other record
labels against Sharman Networks Limited and other defendants, alleging
infringement of the copyright in sound recordings controlled by the plaintiffs.
The plaintiffs allege that due to our business dealings with Sharman Networks
Limited, we are integrally involved in the operation of the Kazaa Media Desktop
and therefore liable for the alleged copyright infringement occasioned by its

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development and distribution. The plaintiffs are seeking damages under the
Australian Copyright Act of 1968, recovery of costs and interest, and a
permanent injunction restraining us from making copies of, communicating to the
public, or distributing the Plaintiff's sound recordings without a license. On
September 5, 2005, the Court rendered its judgment in the Australian litigation,
declaring that Sharman Networks Ltd., Altnet Inc., Brilliant Digital
Entertainment, Inc., Kevin Glen Bermeister and certain other defendants were
liable for copyright infringement for activities associated with the development
and distribution of the Kazaa Media Desktop file sharing software application.
The proceeding was wholly dismissed as against Brilliant Digital Entertainment
Pty. Ltd., Anthony Rose and certain other defendants. We have filed documents to
proceed with an appeal of the Court's decision which we believe will be heard
sometime during the first quarter of 2006. Any determination of damages payable
by the defendants in the case will be stayed pending appeal of the lower Court's
decision. If the appeal is not successful, the Company and certain of our
officers may be subject to substantial damages, and we may be prevented from
engaging in certain business activities. Either of these results would have a
material adverse affect on our ability to continue as a going concern.

WE DERIVE A SUBSTANTIAL AMOUNT OF OUR REVENUE FROM OUR AGREEMENT WITH
FOCUS INTERACTIVE, INC. We recognized installation bounties and search revenues
from our Strategic Alliance, Marketing and Distribution Agreement with Focus
Interactive, Inc., totaling $3,257,000 and $4,755,000 during the nine months
ended September 30, 2005 and fiscal 2004, respectively, representing 69 % and
70% of our total revenues during such periods. If Focus breaches its obligations
to us under our agreement, or the agreement terminates prior to its expiration
date in July, 2006, our revenues and cash flows from operations will be
materially adversely affected.

ALTNET IS AN UNPROVEN BUSINESS VENTURE AND MAY REQUIRE SIGNIFICANT
CAPITAL TO BE SUCCESSFULLY implemented. Our Altnet peer-to-peer business is
unproven and we cannot guaranty that it will be financially successful. The
success of the business will depend, in part, on our ability to enter into end
user agreements with a sufficient number of qualified personal computer owners
to allow the network to work efficiently and effectively, acceptance by
corporate customers of our services, the technical viability of the commercially
available digital rights management, or DRM, software we employ to protect the
proprietary content that will pass through the Altnet network and reside on
network computers, acceptance of content offered through TopSearch, broad
acceptance and use of our micro-payment processing system, and our underlying
peer-to-peer technology. Additionally, we do not have sufficient capital to
internally fund Altnet's development and operations. Consequently, the capital
necessary to fund Altnet and expand the operations will need to come from
outside sources. We cannot make assurances that sufficient capital will be
available at all or on terms acceptable to us to fund Altnet's development and
operations.

ALTNET'S MICRO-PAYMENT PROCESSING SYSTEM IS RELIANT UPON THE TECHNOLOGY
AND SYSTEMS OF THIRD PARTY VENDORS THAT PROVIDE THEIR SERVICES TO ALTNET. We use
the technology and services of third parties to process payment for the
individual sale of digital content over our Altnet peer-to-peer system.
NewGenPay Inc. currently provides payment processing technology and services to
us. The ability to process payment for individual sales at price points well
below $1.00 (better known as micro payments) is integral to our ability to
commercialize the secure distribution and sale of our customers' digital content
to millions of users. Our ability to

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commercialize Altnet could be materially adversely affected if we do not
maintain our relationships with the vendors that provide these services on our
behalf. Additionally, a disruption in these vendors' services, problems with
their technology, or any other matters that interfere with their provision of
services to us could disrupt our ability to collect fees for the digital content
we distribute, which would have a materially adverse affect on our operations
and our relationship with our customers.

OUR FAILURE TO MAINTAIN A STRATEGIC RELATIONSHIP WITH SHARMAN NETWORKS
COULD ADVERSELY AFFECT OPERATING RESULTS. We receive compensation as the
exclusive representative of Sharman Networks for the sale, license, and/or other
commercial exploitation of index search results displayed on or otherwise
accessed using the Kazaa Media Desktop in response to end user search requests.
Additionally, we receive compensation for the sale of advertising campaigns and
other revenue received by Sharman Networks, as a result of our efforts. We also
receive a monthly license fee from Sharman networks in connection with our
sub-licensing of the TruNames patent to them. If we do not maintain our
strategic relationship with Sharman Networks, these sources of revenue may be
eliminated which would adversely affect our financial condition and results of
operations.

OUR FAILURE TO MAINTAIN STRATEGIC RELATIONSHIPS WITH DISTRIBUTION
PARTNERS COULD REDUCE THE NUMBER OF ALTNET PEER-TO-PEER APPLICATIONS WE ARE ABLE
TO DISSEMINATE TO CONSUMERS, WHICH WOULD REDUCE THE NUMBER OF USERS FOR OUR
ALTNET PEER-TO-PEER BUSINESS. We distribute the software necessary to create and
run our Altnet peer-to-peer business primarily by bundling it with Sharman
Networks' Kazaa Media Desktop. We rely on computer users' demand for the Kazaa
Media Desktop to increase the installed base of our Altnet software, which is
necessary to connect users to our private peer-to-peer network. Additionally,
through our agreement with Sharman Networks, Altnet distributes and sells
digital files to users of the Kazaa Media Desktop. Our business, results of
operations and financial condition could be adversely affected if we do not
maintain our distribution relationship with Sharman Networks on acceptable terms
or if this relationship does not achieve the projected distribution of our
Altnet software or sales of authorized digital files.

CURRENT LITIGATION AGAINST SHARMAN NETWORKS LIMITED MAY PREVENT FURTHER
DISTRIBUTION OF OUR ALTNET PEER-TO-PEER SOFTWARE, AND ADVERSELY AFFECT OUR
ABILITY TO DISTRIBUTE AND SELL DIGITAL FILES TO USERS OF THE KAZAA MEDIA
DESKTOP. A disruption in the distribution of the Kazaa Media Desktop or its use
by consumers would adversely impact (1) the future distribution of our Altnet
software, and (2) Altnet's sale of authorized digital files to users of the
Kazaa Media Desktop. For the nine months ended September 30, 2005, we generated
approximately 100% of our total revenues from activities dependent upon the
availability of the Kazaa Media Desktop. If there is a disruption in the
distribution of the Kazaa Media Desktop or its use by consumers, we may not be
able to replace this source of revenue in the short term, or at all. Sharman
Networks, the Kazaa Media Desktop, and other peer-to-peer software products,
currently are the subject of multiple lawsuits, including METRO-GOLDWYN-MAYER
STUDIOS, INC. ET. AL. V. GROKSTER LTD. ET. AL., filed in the United States
District Court for the Central District of California (Western Division) by
twenty-eight entertainment companies claiming that, among other things, the
Kazaa Media Desktop facilitates, contributes to and encourages copyright
infringement. Initially, the District Court granted the defendant's motion for
summary judgment, holding that Grokster's and Streamcast's P2P networks do not
contributorily or vicariously

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infringe the copyrights of the holders of music and movie copyrights, which
decision was affirmed by the U.S. Court of Appeals for the 9th Circuit. The
plaintiffs appealed to the U.S. Supreme Court, which reversed the lower courts'
decisions on summary judgment and remanded the case back to the District Court.
To the extent that Sharman Networks is precluded from distributing the Kazaa
Media Desktop as a result of this litigation, our business and financial
condition could be materially and adversely affected. While we understand that
Sharman Networks is vigorously defending against the claims raised in this
litigation, we are unable to determine at this time whether Sharman Networks
will prevail.

IF OUR PRODUCTS INFRINGE ANY PROPRIETARY RIGHTS OF OTHERS, A LAWSUIT
MAY BE BROUGHT AGAINST US THAT COULD REQUIRE US TO PAY LARGE LEGAL EXPENSES AND
JUDGMENTS AND REDESIGN OR DISCONTINUE SELLING OUR PRODUCT. We believe that our
Altnet software, does not infringe any valid existing proprietary rights of
third parties. Any infringement claims, however, whether or not meritorious,
could result in costly litigation or require us to enter into royalty or
licensing agreements. If we are found to have infringed the proprietary rights
of others, we could be required to pay damages, redesign the products or
discontinue their sale. Any of these outcomes, individually or collectively,
could have a material adverse effect on our business and financial condition.

TO DEVELOP PRODUCTS THAT CONSUMER'S DESIRE, WE MUST MAKE SUBSTANTIAL
INVESTMENTS IN RESEARCH AND DEVELOPMENT TO KEEP UP WITH THE RAPID TECHNOLOGICAL
DEVELOPMENTS THAT ARE TYPICAL IN OUR INDUSTRY. The software market and the PC
industry are subject to rapid technological developments. To develop products
that consumer's desire, we must continually improve and enhance our existing
products and technologies and develop new products and technologies that
incorporate these technological developments. We cannot be certain that we will
have the financial and technical resources available to make these improvements.
We must make improvements to our technology while remaining competitive in terms
of performance and price. This will require us to make investments in research
and development, often times well in advance of the widespread release of the
products in the market and any revenues these products may generate. Until we
become profitable, we will need to fund these research and development efforts
from proceeds we receive from equity or debt financings. We do not have
sufficient resources to fund long term research and development, which is
presently on hold.

ITEM 3. CONTROLS AND PROCEDURES.

Members of the company's management, including our Chief Executive
Officer, President and acting Chief Financial Officer, Kevin Bermeister, have
evaluated the effectiveness of our disclosure controls and procedures, as
defined by paragraph (e) of Exchange Act Rules 13a-15 or 15d-15, as of September
30, 2005, the end of the period covered by this report. Based upon that
evaluation, Mr. Bermeister concluded that our disclosure controls and procedures
are effective.

There were no changes in our internal control over financial reporting
or in other factors identified in connection with the evaluation required by
paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during the
nine months ended September 30 , 2005 that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.

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PART II

OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

As originally disclosed in our Annual Report on Form 10-KSB for the
fiscal year ended December 31, 2003, in March 2004, in the Federal Court of
Australia, New South Wales District Registry, Brilliant Digital Entertainment,
Inc., its subsidiaries Altnet Inc. and Brilliant Digital Entertainment Pty.
Limited, and Kevin Bermeister and Anthony Rose, the Chief Executive Officer and
Chief Technology Officer, respectively, were joined as defendants in the suit by
Universal Music Australia Pty. Ltd. and other record labels against Sharman
Networks Limited and other defendants, alleging infringement of the copyright in
sound recordings controlled by the plaintiffs. The plaintiffs allege that due to
the Company's business dealings with Sharman Networks Limited, the Company is
integrally involved in the operation of the Kazaa Media Desktop and therefore
liable for the alleged copyright infringement occasioned by its development and
distribution. The plaintiffs are seeking damages under the Australian Copyright
Act of 1968, recovery of costs and interest, and a permanent injunction
restraining the Company from making copies of, communicating to the public, or
distributing the Plaintiff's sound recordings without a license.

On September 5, 2005, the Court rendered its judgment in the Australian
litigation, declaring that Sharman Networks Ltd., Altnet Inc., Brilliant Digital
Entertainment, Inc., Kevin Glen Bermeister and certain other defendants were
liable for copyright infringement for activities associated with the development
and distribution of the Kazaa Media Desktop file sharing software application.
The proceeding was wholly dismissed as against Brilliant Digital Entertainment
Pty. Ltd., Anthony Rose and certain other defendants. We have filed documents to
proceed with an appeal of the Court's decision which we believe will be heard
sometime during the first quarter of 2006. Any determination of damages payable
by the defendants in the case will be stayed pending appeal of the lower Court's
decision.

ITEM 6. EXHIBITS

THE FOLLOWING EXHIBITS ARE FILED AS PART OF THIS REPORT:

31.1 Certificate of Chief Executive Officer pursuant to Rule
13a-14(a) under the Securities and Exchange Act of 1934, as
amended.
31.2 Certificate of Acting Chief Financial Officer pursuant to Rule
13a-14(a) under the Securities and Exchange Act of 1934, as
amended.
32.1 Certificate of Chief Executive Officer and Acting Chief
Financial Officer pursuant to Rule 13a-14(b) under the
Securities and Exchange Act of 1934, as amended.

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SIGNATURES

In accordance with the requirements of the Exchange Act of 1934, the
Registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.

BRILLIANT DIGITAL ENTERTAINMENT, INC.

Dated: November 14, 2005 /S/ KEVIN BERMEISTER
------------------------------------------------
By: Kevin Bermeister
Its: President, Chief Executive Officer and
Acting Chief Financial Officer (Principal
Financial and Accounting Officer)

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Dates Referenced Herein and Documents Incorporated by Reference

		Referenced-On Page
This ‘10QSB’ Filing	Date	First	Last	Other Filings

	10/5/09	12	26
	9/13/06	15
	7/26/06	13
	3/31/06	12	29
	12/15/05	27
	12/12/05	12	29	DEF 14A, PRE 14A
Filed on:	11/14/05	36
	11/10/05	29
	11/6/05	1
For Period End:	9/30/05	1	34
	9/26/05	12	26	8-K
	9/5/05	14	35	8-K
	6/16/05	21		4, 8-K
	6/15/05	21	27
	5/17/05	11	18	8-K
	4/28/05	13		8-K
	12/31/04	7	27	10KSB, 10KSB/A, 5, NT 10-K
	9/30/04	2	27	10QSB
	6/16/04	21
	12/31/03	35		10KSB, 10KSB/A, 5
	4/14/03	13	24
	9/13/96	15
				List all Filings

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Filing Submission 0001170918-05-000811 – Alternative Formats (Word / Rich Text, HTML, Plain Text, et al.)

Brilliant Digital Entertainment Inc – ‘10QSB’ for 9/30/05

On: Monday, 11/14/05, at 4:31pm ET · For: 9/30/05 · Accession #: 1170918-5-811 · File #: 1-14480

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Quarterly Report — Small Business — Form 10-QSB
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